NFTs - are SMSFs allowed to invest in them? | Heffron

At the end of 2021, the market for non-fungible tokens or NFTs was estimated to reach a staggering USD$41 billion. And some say this amount is understated! It begs the questions, what are NFTs exactly and are SMSFs allowed to invest in them?

Like cryptocurrencies, an NFT is a digital asset created on a blockchain. But whilst cryptocurrencies are identical to each other (I could swap my bitcoin for your bitcoin), NFTs are unique – they are not able to be replicated and are not able to be split up into parts.

In simple terms, an NFT is a digital asset which represents ownership of an underlying asset. The underlying asset could be a digital asset (such as an image) or a physical asset (such as a painting) or a combination of the two. An NFT could even represent ownership of a right to something, like being able to attend an event or view artwork.

What the owner of the NFT is entitled to is determined when the NFT is minted (created). Any terms and conditions (known as a smart contract) are coded into the token at that time and are not able to be later changed.

Although NFTs are traded globally, their legal status and how the token is regulated, differs between countries. So whilst NFTs may have the potential to change the way we transact in future, for now, most applications for NFTs remain in the digital world.

Let’s look at some examples. 

NFTs are changing the way people are gaming online. Traditionally in online gaming, players are rewarded with “in-game prizes” or collectibles as they progress through the game. However, those “things” remain in the game (think about the hours children have spent creating worlds in Minecraft!). With the use of blockchain and NFTs, games have been developed so players can buy and sell game items on NFT marketplaces outside of the game. Ownership is moving from the game builder to the players.

NFTs are also being used in the metaverse to enable individuals to interact in virtual worlds. Decentraland is one such metaverse platform. Users can buy virtual plots of land as NFTs with the platform’s cryptocurrency of choice, MANA, which uses the Ethereum blockchain. In November 2021, a plot of virtual land, called Fashion Street Estate, sold for 618,000 MANA or approximately $2.15m at the time of writing. 

Digital fashion is also a thing. One needs to be able to dress their avatar for the metaverse. Big brand names have been investing in this trend. For example, last year, RTFKT (pronounced “artifact”), a company which creates virtual sneakers and collectibles, sold 600 pairs of limited design sneakers in under 7 minutes for USD$3.1m. Nike acquired RTFKT in December 2021 for an undisclosed amount. Coca-cola and Gucci are examples of other companies which have minted NFTs for the metaverse.

In the real world, artists are minting NFTs to sell their artwork or designs as digital assets. This can include digital collections of music, artwork, videos, memes and even tattoo designs. 

As part of the minting process, an artist is able to include in the smart contract, the rate of any commission payable to them on subsequent transfers of the NFT to new owners. However, unless it forms part of the contract terms, copyright ownership will remain with the artist. As recognised by Sotheby’s, not only do NFTs provide a secondary marketplace, but they “allow for online assets to have verifiable scarcity and ownership that cannot be manipulated”. 

Real world assets may also be sold using an NFT. In a bid to demonstrate the use of NFTs to sell real estate, a home in Florida was recently sold for 210 ETH (or approximately $971,000 at the time of writing) as an NFT. The underlying asset however was not title to the property but a share in a limited liability company, which owns the property.

So now we know a little more about NFTs (high level anyway!), let’s look at whether an SMSF may invest in them. As you can see, since each NFT is unique, it is important to first ascertain the nature of the underlying asset and any terms and conditions. 

Next, to determine whether an SMSF may be permitted to purchase the NFT in question, the trustee should consider issues such as:

• From whom will the SMSF be purchasing the NFT?  An SMSF is not permitted to acquire an NFT from a related party.
• Will the nature of the underlying asset or the associated terms and conditions inherently provide SMSF members with a current day benefit? If so, this will be a breach of the sole purpose test and is prohibited. For example, investing in NFTs for personal use in online gaming will breach the sole purpose test.
• Will the trustee be able to provide suitable evidence to demonstrate the NFT was acquired for the purpose of providing only retirement benefits? It may be very difficult to provide evidence that a fund owned and leased an NFT for use in an online game or metaverse for retirement purposes only without an audit trail to demonstrate the NFT was not used personally etc.
• If the NFT and underlying asset acquired will be regarded as a “collectable” or “personal use asset” – whether the fund will be able to meet the strict requirements of SIS Regulation 13.18AA (including obtaining insurance in the name of fund, storing the asset appropriately, documenting the storage decision and ensuring the asset is not leased or used by a related party). As with real world assets, it may be difficult to satisfy these requirements.
• Whether the platform and cryptocurrency required to acquire and own the NFT will recognise an SMSF as the account owner – the fund must have its own digital wallet. It will be important to establish what reporting will be available to evidence this and if, for example, any read-only access to a digital wallet is possible.
• Will the trustee be able to satisfy the auditor the NFT is recorded at market value in the fund’s financial statements? An NFT which represents ownership in a real asset such as property, may be easier to value since the asset is tangible, rather than say an NFT that represents a digital asset.
• Whether the fund’s trust deed allows for this type of investment. 
• Whether the fund’s investment strategy permits this type of investment, having regard for matters such as liquidity (will there be demand for the NFT) and volatility (as NFTs are bought and sold with cryptocurrencies, this type of asset can experience the same volatility as cryptocurrencies).

There are plenty of issues to consider when determining whether an SMSF can invest in an NFT. It is definitely not a straightforward exercise! In fact, the time, expertise and resources required to determine and then demonstrate an NFT is a permitted investment of an SMSF is often likely to outweigh the benefits of holding this type of investment.

If NFTs become widely adopted as a means of denoting ownership of more traditional investments, legislative amendments and clarity from the regulator will be needed. For example, would a "look through" approach be adopted, so that SMSFs could acquire an NFT from a related party, if the underlying asset is an investment an SMSF would otherwise be permitted to acquire, such as business real property or listed shares.    

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