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This week's LGJ revisits the always popular topic of taxing virtual worlds.

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This week's Law of the Game on Joystiq tackles virtual world taxes.

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The proposed "Game Tax" from Wisconsin state senator Jon Erpenbach has gained quite a bit of attention, and accordingly, I thought it was worth addressing a few key points. First, I'm sure many folks are wondering why they should care about a tax in a state in which they don't live. The simple answer is that tax ideas seem to spread. If Wisconsin adds such a tax, it will only be a matter of time before a dozen other states follow suit. In short, the long term picture is not pretty for gamers if one state begins taxing games.

The second question is what type of tax is this? There are two likely candidates, those being the "Sin Tax" and the "Luxury Tax." The concept of a sin tax is that because the government wants to discourage a behavior and because that behavior has a proven, clearly demonstrated, and direct negative impact on society, the government taxes the item to both discourage the behavior and offset the negative impact. For example, cigarettes are taxed because they are linked to lung cancer. Alcohol is taxed because drunk drivers kill thousands every year. Video games, however, would be taxed due to an unproven link to a theoretical change in behavior for a small number of users. The link is not nearly as defined as, say, drinking to drunk driving.

The other possibility is considering it a luxury tax. The idea here is that some things are just so extravagant that people should pay extra, or from a different viewpoint, that the people who want to buy certain things are well enough off that they can afford to pay more taxes. A good example of products often hit with a luxury tax are expensive cars. The assertion here would be that video games are a "luxury item," and therefore are so unnecessary that gamers should have to pay more for them. However, given that books, music, movies, and all other forms of entertainment are not subject to such a tax, it does not follow that any aspect of the "video game" so separates the medium from other forms of entertainment as to draw the line there.

This would appear to be nothing more than another cheap shot at a scapegoated industry for the basic purpose of continuing to fill the already bloated public coffers, which serves to continue to perpetuate the problem of government over-spending. Far be it for me to dictate public policy in Wisconsin, but a video game tax is simply not a logical answer to the issue presented. I'm certain there are many other ways to fund the "keep non-violent juvenile offenders out of adult prisons" program.

[Via GamePolitics]

A point I brought up in my 2005 paper, which was recently touched on by Symantec according to an article, is the possibility for money laundering through MMO games. The idea is simple enough: push money through virtual transactions to lose the connection to crime. According to the report:

"... a criminal enterprise could open several thousand MMOG accounts. Each could be used to trade with other players in the purchase or sale of in-game assets, the funds from which would ultimately be withdrawn from the accounts. Since thousands of accounts may engage in millions of transactions, each with small profits or losses, it would be difficult to trace the true source of the funds when they are withdrawn. These transactions can be conducted worldwide without the oversight that typically accompanies international bank remittances. In fact, in February 2007, China's central bank and finance ministries called upon companies to stop trading QQ coins and virtual currencies, presumably to curb the unregulated exchange of currency."

I estimate that Symantec's solution to the problem is with greater security and client verification. However, a more simplistic approach would be taxation on virtual revenue, even if the concept is opposed by players. Think of it this way: Right now, income from sales in MMO games is supposed to be reported as ordinary income. Many people neglect to do this whatsoever. If, instead, there was automatic reporting to the IRS (or other country's tax agency, based on the residence of the player) of income derived from MMO sales, then the tax agency would know to expect payment from said individuals. Moreover, it ties a person to the MMO account, eliminating the possibility of spreading one person over 100 accounts and going unnoticed. Of course, this would have to be based on a cash out value, as has been suggested before by both myself and Bryan Camp. In any event, the process of losing money in the transaction generally makes different things less appealing as money laundering vehicles, and thus virtual taxation could be one answer to the problem.


[Via Kotaku]

Your "buy in" is the purchase of ammo. Your health bar is your wager. You lose money for damage taken, and gain money for damage inflicted. This is the basic concept behind the first true "gambling" First Person Shooter, Kwari, and it seems like a mild adaptation of the basic concept in poker to a completely new game and genre. This is truly a game of skill that you wager upon.

However, while the concept is a step beyond the model employed by sites such as Tournament.com, the legality is still questionable in the United States. As I've pointed out before, the Unlawful Internet Gambling Enforcement Act ("UIGEA") was created, at least in part, with online poker particularly in mind. Hence, the Skill Game Protection Act ("SGPA") is proposed to specifically exempt games for skill, which includes poker, from the UIGEA. However, the SGPA hasn't passed, and so therefore it is reasonable to assume that the UIGEA still encompasses games of skill until the courts say otherwise, even though the UIGEA is quite ambiguous on the matter.. As such, even though Kwari is purely a skill game, it may be covered. But, the overwhelming ambiguities in the UIGEA may provide Kwari with a loophole, or the SGPA would almost certainly exempt Kwari from the UIGEA.

There's also a bigger tax implication for players. If you are a master of Kwari and can walk away with thousands of dollars a month, is it ordinary income or gambling winnings? I think the argument can certainly be made that winning in Kwari is no different than what, say, Tiger Woods wins in golf or what any other professional athlete is paid. On the other hand, poker winnings are gabling winnings in the eyes of the IRS. The classification of Kwari winnings could easily go either way, and mean a significant difference in taxable income depending on the result.

[Via Joystiq]

While the US report is due in a little over a month, South Korea has decided to impose a Value Added Tax (VAT) on real money trading in virtual worlds starting in less than a week. Specifically, those who earn between 6 and 12 million won (about $6,500 US to $13,000 US) every half year will have the VAT applied by the middle man, and those earning over 12 million won every half year must apply for a business license and apply the tax themselves.

For those readers in countries that do not use the VAT system (such as the US), here is a quick primer on the concept. Basically, at each stage of production, the value added by the producer is taxed. It is an alternative to sales tax. Here is a simple example:

I make thingamabobs. A thingamabob takes $10 in raw materials, which I can sell to a maker of thingamajigs for $15. He can then sell the completed thingamajig at wholesale for $20. Thingamajigs retail for $25.

Under a 10% sales tax:
The consumer buys the item at retail for $25 and pays an additional $2.50 in sales tax.

Under a 10% VAT tax:

I pay $11.00 for the raw materials ($10 + $1 in VAT)
I charge $16.50 for the thingamabob ($11 + $5 profit + $0.50 in VAT on the profit)
Thingamajigs sell for $22 at wholesale ($16.50 + $5 profit + $0.50 in VAT on the profit)
Thingamajigs sell for $27.50 at retail ($22 + $5 profit + $0.50 in VAT on the profit)

Under both systems, the consumer pays $27.50, each level gets $5 profit, and the government gets its $2.50 in tax. It's more or less a sales tax alternative with some notable criticisms, including complexity in computation and collection compared to a straight sales tax.

To summarize, Korea will be taxing the value added to virtual goods. This could be exceedingly complex, as I can only imagine the argument that will arise over whom is adding value at what stage. More importantly, it is not clear how this will interplay with license agreements that maintain ownership of virtual goods in the game developer.

It would appear the US Federal Government may finally be taking notice of virtual economies, as it is being reported that a report on the matter is due in August. Of course, an in depth dissection will appear on this site once the report is issued.

If I had to make a prediction, I assume that in-game income will be taxed as ordinary income, earned on cashing out from the system and counterbalanced against payments into the system. That would be the most logical and simple approach given the current income tax system.

Of course, just because this is the most reasonable outcome does not mean it will be the actual outcome. There are a whole host of possible classifications. Income from games could be classified as gambling winnings, which are subject to a higher tax and withholding rate than ordinary income (see IRS, forms W2G and 1040). They may even attempt to assign a tax base system to virtual property itself, much like real property gains or loses in value.

Of course, an advisory doesn't necessarily mean a regulation. Check back in August for a complete analysis once the report is made public.

In my previous article, I outlined the basics of the World of Warcraft and Second Life licensing models, along with a business plan that could be applied in the way Sony has implemented Station Exchange for EverQuest II. This article will take a look at the Sony model and explain an alternative model .

Sony Station Exchange

The Sony model is a basic re-sale of license model. Looking at the Station Exchange Service Agreement (which is incorporated in whole in the EverQuest II EULA), (Emphasis added)

You agree that you do not and will not own anything. You agree that, as between you and SOE, SOE owns all copyrights, trademarks and other intellectual property rights in game characters, items and coin (characters, items and coin are, collectively, "Virtual Goods"). SOE hereby grants you the limited right to transfer and receive the licensed right to use Virtual Goods, in return for real money, solely through the Station Exchange and solely in accordance with this Agreement. AS USED IN THIS EXCHANGE AGREEMENT, THE GAME AND ON THE STATION EXCHANGE SITE, TO "SELL" MEANS "TO TRANSFER TO ANOTHER PERSON THE LICENSED RIGHT TO USE VIRTUAL GOODS IN ACCORDANCE WITH THIS EXCHANGE AGREEMENT;" TO "BUY" MEANS "TO RECEIVE FROM ANOTHER PERSON THE LICENSED RIGHT TO USE VIRTUAL GOODS IN ACCORDANCE WITH THIS EXCHANGE AGREEMENT." Accordingly, regardless of SOE's shorthand use of the words "buy" and "sell," whether in this Exchange Agreement, any game, any message board, on the Station Exchange site or elsewhere, SOE has not granted, is not granting and will not grant you ownership of any Virtual Goods.

"Licensed use" and "licensed right," among other things, means that your game play, acquisition and use of Virtual Goods -- and the transactions you engage in through Station Exchange – are all governed by the provisions of this Exchange Agreement and the Underlying License Agreement and Rules. You agree, therefore, that if you violate any of the provisions of this Exchange Agreement, or any of the provisions of the Underlying License Agreement and Rules, SOE can take any action which it believes is appropriate, including but not limited to terminating your participation in Station Exchange, deleting Virtual Goods associated with any of your accounts, and/or suspending or terminating your accounts entirely.

In short, you still own nothing, but you are allowed to transfer your license in the item for money. You are more or less an intellectual property broker with an odd way of acquiring what you're "selling."

Station Exchange and Income Tax

The only other peculiarity of the Sony system is income tax. If you are selling on Station Exchange, this should be the part you pay attention to. As eBayers have discovered, money from auctions is income, and a PayPal account is a real bank account. The difficulty is determining a starting value for the items being sold. I would contend that the correct base value on all items is $0, and as such all money made from them is reportable, taxable income to the IRS. Under this model, you would only have taxable income if and when you sold an item, but selling any item (or character) would generate taxable income, and taxable income must be reported to the IRS.

Alternatives

Solving the Tax Problem

The whole taxable income problem has two solutions a developer could implement, one which seems more likely than the other. The unlikely solution would be automatic withholding on transactions. This, however, puts quite a burden on the developer, not to mention potential liability for tax fraud. The alternative would be to generate quarterly and annual sales reports for each user. This would help the user file correctly without unduly entangling the developer with the IRS.

Alternative License Structuring

The alternative license structure is one I mentioned in my last article. Basically, rather than allowing the player to re-sell licenses, it is to designate the items, characters, etc. as representations of player effort. The player is then re-selling their "time" and "effort" rather than the license to the object. It operates almost like contract labor. Rather than buying the item, I'm retroactively paying you for the time it took you to get the item, as if I hired you to find it to begin with. The only difficulty would be structuring around the general contract principle that you cannot contract for past performance. If this could be solved, then an alternative to the license resale model can exist.

Conclusion

There's an old saying about there being more than one way to skin a cat. While I'm not a fan of animal cruelty, I do agree that there are usually multiple solutions to any given problem. Here, there may even be more than the two I've suggested, these just happen to be the two that most readily came to my mind. As the MMO genre moves more to this economy, more models are always likely to emerge.

1UP recently posted this article, which originally ran in Games for Windows magazine this month. Taxing virtual economies has been something I've looked into since 2005, and based on the current state of the World (of Warcraft), residents of Azeroth do not need to worry about the IRS auditing them because of the two Darkstone Claymores you found, or the Plated Abomination Ribcage you're wearing.

The article's basic premise is largely correct: Taxable income, as defined by the IRS, includes pretty much everything. This can include income from the sale of intangible property. However, even ignoring the ownership issues presented in the article, the present reality poses a more significant sticking point for the IRS. Specifically, the goods in Azeroth have no actual value. As most players remember, the eBay market for World of Warcraft goods ground to an absolute halt in the wake of a major crackdown. As a result, there is no longer an approximate exchange rate of World of Warcraft gold to US dollars, which further means that items have no value in US dollars, at least not one that is easily determined. Moreover, the market is essentially gone. The occasional friend gives friend $20 for a Spiteblade is not a frequent enough occurrence for the IRS to take notice or care about what is, all in all, now a negligible amount of income.

The closest allegory is a company dealing in its own intellectual property. For this example, let us say a company owns a trademark. Ordinarily, income from the sale of that trademark would be taxable, and changes in the value are reported in taxes (not as income, but the finer points of intellectual property valuation and taxation are a lengthy discussion). However, the company has a freely alienable piece of intellectual property. A player does not. The player is limited to trade their item in the constraints of the game for other property in the game.

This stands in stark contrast to the state of affairs in Second Life, which I will be addressing in an upcoming article. This also stands in contrast to the former state of affairs in the World, when eBay fueled a real world economy for virtual goods. There was a significant argument for taxing virtual goods when they were transferable for real money, and undoubtedly the volume of those transactions raised the eyebrows of at least a few agents of the IRS.

In any event, the likelihood of the IRS opening an Azeroth office seems remote at best, as there is no real world value for them to be taxing because of the basic lack of transferability for actual, taxable income. This will likely remain the case so long as Azeroth remains an economy independent of the US dollar. Should the situation begin to return to the eBay marketplace that dominated until just recently, or should a Second Life approach be taken in, say, World of Warcraft II or World of Starcraft, then the IRS may begin to pay new attention to the resale value of your Nerubian Slavemaker.