Real World Transactions Using Virtual Currency

“. . . The Virtual Goods Summit is a one day conference focused on the emerging market opportunity for virtual goods and economies. Once restricted to the world of online gaming, virtual goods and currencies are beginning to influence the development of social networks, community sites, and many other new and exciting markets. . . .” From Virtual Goods Summit 2007.
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“. . . Citizens within the virtual world of Second Life will be able to teleport to an in-world pizza restaurant and order their favorite pizza from their favorite national or local pizza chain. But the magic doesn’t stop there with the use of Dynamedia is releasing VirtuReal a revolutionary way for Second Life Citizens to use their Linden Dollars to purchase real world goods. They will be able to purchase real world pizza with their in world Linden Dollars. That’s right virtual world currencies used to purchase real world food. . . .” From Pizza enters the Virtual World of Second Life.
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“. . . A couple of weeks ago it was reported (via PlayNoEvil) that China aims to restrict the trading of virtual currencies that have become popular as a payment method even for third-party services. According to the joint announcement of 14 Chinese government agencies including the Ministry of Public Security and People's Bank of China, virtual currencies should not be used to buy real commodities and can only be traded back to real money for amounts not exceeding the original purchase price, eliminating any opportunity for profits. . . .” From Government rumbles, Chinese virtual money markets stable for now. More here.

Policy Considerations Against Taxing Second Life Wealth

Despite its prolific number of small dollar transactions, its technological origins in the video game industry, and the initial perception that the utility derived from the activities in Second Life are somehow distinguishable from those in the real world, an analysis indicates that taxation of the wealth generated inside Second Life is proper appropriate under current U.S. tax law. [see other discussion here] Nevertheless, this article concludes with a few comments about some of the policy reasons not to tax Second Life. It also raises the most pressing issues that this paper failed to explore.

First, note that “Second Life’s grant of property rights to participants seems to have encouraged far greater experimentation and innovation than other virtual worlds. For example, one participant created a video game within the Second Life virtual world and then sold it to a real-world media company, a transaction that would be impossible in most virtual worlds.” Additional interesting and bizarre issues concerning Second Life come to light everyday. Just to list a few: John Edwards’s Second Life presidential campaign headquarters was vandalized with feces and a picture of him in blackface; a virtual riot broke out between members of the French extremist party National Front and Second Life Left Unity, a socialist and anti-capitalist user-group; reports have arisen that certain users have designed a way to override the mobility of other users and virtually rape unconsenting avatars; hundreds of companies from H&R Block and Colwell Banker to Coco-Cola and Mercedes Benz have an active business presence in Second Life; Reuters has a dedicated Second Life News center; gambling activities have become so wide-spread that the FBI is investigating the criminal activities by U.S. citizens. In essence, Second Life is allowing the public to explore the practical boundaries of a three-dimensional version on the Internet.

Perhaps most importantly is that this innovation is developing something as yet unseen in the real world or on the Internet: a viable system for micro-transfers of wealth with transaction costs approaching zero. The importance of this point cannot be overstated. The Linden Dollar has remained steadily at about L$270 per $1, so real people are activity engaging in millions of transactions that are valued as low around $0.0037. Thus far, these transactions have been secure and easy to administrate through electronic accounts where people can, in essence, deposit U.S. Dollars. From YouTube, which has announced that users will receive revenue according to the popularity of the video they post, to Google AdSense, which derives revenue on a per-click basis, the micro-commodification of the Internet is progressing to the point where society can efficiently and profitably trade in fractions of pennies. As a policy matter, the tax law should recognize the economic reality of these micro-transactions while avoiding spoiling the efficiencies created through plummeting transaction costs.

Leanda Lederman, the author of the article Stranger Then Fiction: Taxing Virtual Worlds discussed above, has suggested elsewhere that rather than including Second Life activity in the income tax, “the better result is to tax sales within Second Life (for Lindens).” While this may eventually be the best solution, it also implicates complicated issues as to whether requiring Linden Lab—a company that makes a point to take a hands-off approach—to withhold taxes from or to issue transaction records to millions of users will stunt the growth that Second Life is currently witnessing. This is an important question that merits further analysis.

Finally, and most unfortunately, this paper failed to provide a detailed analysis of how one measures basis in Second Life. Beyond the key operational limitations analyzed above, this is the next most important issue that could drastically affect how to think about the taxation of Second Life. Whether in the context of everyday users claiming hobby losses, active businesses claiming expense deduction, division of profits among in-world partnerships, or taxation of foreign businesses effectively connected to the U.S., the ability to account for basis will dictate what methods of taxation are plausible.

Regardless of these uncertainties and despite the assertions by Congress’s Joint Economic Committee that “taxing transactions that occur within virtual economies . . . would be a mistake,” it clear that it is only a matter of time before the wealth generated in Second Life (or its technological progeny) will be sufficiently great that Congress is passing virtual-world tax legislation and tax lawyers are specializing in the virtual world sections of the Internal Revenue Code. The implications this could have on currently untaxed income like frequent flyer miles and casino chip will have to be left for another paper. From The Taxation of Virtual Worlds: Understanding Theories of Taxation Through an Analysis of the Second Life Economy by Tim Miano.

Second Life's Counterfeit Brands Market

From Protecting real brand names in a virtual world:

". . . Counterfeit goods can be found even in the swankiest malls and department stores in Second Life. Benjamin Duranske, founder of the Second Life Bar Association and a real life lawyer, estimated there was trademark infringement in at least 1 percent of Second Life transactions – about 1.4 million per year. He noted on his blog, Virtually Blind, that a classifieds search for “Gucci” generates 106 hits, while “Vuitton” gets 39 and “Nike” gets the most at 186 hits. None of these companies have endorsed the virtual products.

Virtual stores that sell unauthorized Louis Vuitton purses or Ray-Ban sunglasses could sell shoddy products or otherwise misrepresent the company, which is one reason lawyers say trademark violations are an issue online as well as on the street. “If a guy in Oklahoma is making fake Gucci bags, it’s pretty clear that they infringe, even if they are digital,” Duranske said.

Trademark lawyer Martin Schwimmer said that it’s significant that economic transactions are real on Second Life, distinguishing it from a video game. Many of the same issues are at play as when a street vendor is selling bootleg products. In both cases, the seller is using a company’s brand name to market a product. “It is in to the realm of possibility that someone who buys a $50 Rolex will someday aspire to owning a true Rolex. But ordinarily, the ability to in effect free sample should be the right of the copyright owner.

The current Linden Labs policy is that if someone files an Abuse Report against trademark infringement, they investigate it and remove the products. Last week, the Police Blotter showed they gave an avatar a warning for it. So far, the company hasn’t actively tried to seek out trademark violators. Their official policy states that, “Linden staff generally removes content that uses trademarks without apparent authorization, with or without giving notice to the object owner. This generally includes all real life corporate logos and brand names.”

Duranske compared Linden Labs to an intermediary, like an Internet Service Provider, rather than an entity that should be responsible for policing trademark infringements. He argued that representatives from companies should be the ones logging in and reporting their complaints to Linden Labs. . . . "

Phillip Rosedale's Talk on Second Life (via Fora.tv)

". . . What Do We Learn If We Digitize Everything? After a couple years in the flat part of exponential growth, the steep part is now arriving for the massive multi-player online world construction kit called "Second Life." With 1.7 million accounts, membership in "Second Life" is growing by 20,000 per day. The current doubling rate of "residents" is 7 months, still shortening, which means the growth is (for now) hyperexponential.

For this talk at the The Long Now Foundation the founder and CEO of "Second Life," Philip Rosedale, tried something new for him - a simultaneous demo and talk. His online avatar, "Philip Linden," was on the screen showing things while the in-theater Philip Rosedale was conjecturing about what it all means. "This is a game of 'Can I interest you more in what I'm saying than what's going on on the screen?'"

He showed how new arrivals go through the "gateway" experience of creating their own onscreen avatar, explaining that because intense creativity is so cheap, easy, and experimental, the online personas become strongly held. "You can have multiple avatars in 'Second Life,' but the overall average is 1.25 avatars per person." The median age of users is 31, and the oldest users spend the most time in the world (over 80 hours per week for 10 percent of the residents).

At about 19 mins in Philip talks about emergent behavior, and why the world of Second Life has to be connected, and why it must be a large scale “one world.” [PacificRim Exchange] suspects this concept will keep Linden Lab from breaking up the grid(s) until all other options have been exhausted to address the grid
issues. . . ."
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". . . FORA.tv delivers discourse, discussions and debates on the world's most interesting political, social and cultural issues, and enables viewers to join the conversation. It provides deep, unfiltered content, tools for self-expression and a place for the interactive community to gather online. . . ."

Real World Outsourcing of Virtual Work: Gold Farming, Free Trade, and the Growing Pains of Capitalism in China

". . . A new documentary, Chinese Gold Farmer, travels into several different Chinese gold farms. Several gold farmers tell their own stories and see their everyday struggles to live at the border of the virtual and the real.

Multiplayer online games have given rise to a virtual economy, in which all kinds of virtual assets---from in-game currency to magic shields & whole characters---are traded against real world currency. In China, there are tens of thousands of gaming workshops that hire people to play games like World of Warcraft and Lineage. The gaming workers kill monsters and loot treasures for 10-12 hours a day to produce virtual assets that are exported all over the world. They are called Chinese gold farmers by western gamers and many myths about them are circulated in the game universe.

According to estimates, around 100,000 people in China are employed as gold farmers, as of December 2005. This represents about 0.4% of all online gamers in China. Chinese gold farmers typically work twelve hour shifts, and sometimes up to eighteen hour shifts. Wages depend heavily on location and the size of the gold farming company. One gold farming operation in Chongqing in central China with 23 gold farmers was reported to pay its employees the equivalent of about 120 U.S. dollars per month, while workers at a larger gold farm in Fuzhou earn the equivalent of about 250 U.S. dollars per month. The rising prevalence of gold farming has led to the creation of gold farm brokerages.

China is in fact dominant in this industry and Jin Ge—a 30-year-old Shanghai native—has done a documentary on "gold farms" in China as part of his doctoral research at the University of California, San Diego. You can read an interview with him here. He is one of the many researchers who has invested his time in investigating how farm owners manage their production and distribution of virtual commodities across the border between the virtual and the real as well as the border between nations. “I tried to find out what this job, combining work and play, means to Chinese gold farmers and how it feels like to live at this peculiar intersection of the virtual and the real.” . . ."

(Hat Tip Freakonomics)

Inter-Virtual-World-Exchange: Contracts, Regulation, and Taxation

". . . Anshe Chung Studios, a company that emerged from inside a virtual world by reinvestment of value created within virtual worlds, is preparing to launch a virtual financial market, financial products and a set of services that are going to allow direct capital flow and investment across virtual world boundaries. No real money trades will be involved. This step will be the first of many in the creation of an open, cross platform Metaverse economy that transcends individual virtual worlds.

"Some virtual worlds like Second Life, Entropia Universe, and IMVU have demonstrated the enormous economic potential that exists when key sectors of a virtual world economy such as content creation, trade, banking and services are privatized. This has lead to a boom in each of these worlds that has yet to be matched by any other economy, real or virtual," says founder Ailin Graef a.k.a. Anshe Chung. "Now the time is right to go further and link these exciting spaces together, to begin with the creation of the global Metaverse."

"In the real world, the flow of capital and investment across national borders has always been a driving force for political progress, economic reforms and the emergence of a global conscience and economy", adds Guni Graef, CEO. "We believe that allowing residents in a virtual world, no matter which one they have chosen to live in, to easily diversify their portfolio of virtual investments into other virtual worlds is going to lead to a paradigm shift. At ACS we are convinced that once capital is flowing freely, people, goods and services will follow and eventually we will see incentive and pressure for the emergence of open tools and standards. It is our vision that one day even traveling across virtual worlds and taking your belongings with you should become as easy as a mouseclick." The new financial market will allow Second Life residents to invest their Linden Dollars directly in ventures such as banks, malls or biospheres in Entropia Universe while those who earned their fortunes in Entropia Dollars will be able to easily diversify their investments into assets such as Second Life virtual land funds, virtual game development businesses or the IMVU fashion design industry. . . ." From Anshe Chung Studios to Link Virtual World Economies.
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". . . [This] clearing and exchange system would be fully governed by private contract with a single company. It is, in essence, a proprietary system with some unspecified exposure to "real world" public regulation. This is by contrast to standard international economics in which the relation of private agreements and public regulations is relatively clear (or at least we have a sense as to how to resolve debates over who regulates what). How the evolution of the online economy will interface with the mainstream economy—and economic regulation—is still an open question.

Despite the hype from some quarters that the online economy is its own entity, separate from the regulatory dinosaurs of the "real" world, I would not sell the mainstream regulators short. How the interactions of old economy regulators and new economy companies evolve will play an important role in determining the success of private attempts at financial market-construction. Moreover, whether this one particular attempt to build a “virtual” financial transfer system will take hold or if it will be overtaken by another privately-run system is a question that will be left to the market. . . ." From Brave New World(s): From International Finance to Inter-Virtual World Finance.
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". . . Unlike poker chips, which are heavily regulated by the casinos that use them as units of exchange, Second Life—and the Internet in general—is more or less a free-form marketplace. “Although Zarin acquired tangible property, the chips, the chips were not property in the relevant tax sense because they were only a ‘local’ medium of exchange, like currency or banknotes. The chips had no independent existence or value other than to facilitate gambling at Resorts [Casino].” While in a casino, “chips are merely symbols denominating the amount of the bets at stake,” the currency and goods in Second Life take on a fungibility of use that pushes the limitations that chips in a confined setting cannot. Not surprisingly, the users of other virtual worlds and other virtual currencies are already testing their supposed boundaries with great success. These parallel innovations inform the potential boundaries of Second Life. Despite clear rules and multiple attempts to eliminate real-money trading of goods from various virtual worlds, third-party grey markets are still used and easily accessible by users. Whereas, Blizzard, the owner World of Warcraft, has tried with minimal success to restrain the continued commodification of its virtual goods by banning real money transactions associated with the game, Sony, the owner of EverQuest, has taken the opposite approach by “creating its own auction site where it can control and profit from the player demand for sales of virtual items.”

Removing these issues from the virtual-world context does not solve the problem, as seen in markets of related technology. Chinese regulators have ordered websites to limit the use of “QQ coins,” a form of virtual money, stemming from “concerns that the online credits might be used for money laundering or illicit trade” after news reports that customers were using credits to “gamble, pay for phone-sex services and to shop online.” In keeping with its mission to create a user-defined world of general use in which people can interact, play, do business, and otherwise communicate, Linden takes an even more hands off approach then Blizzard, Sony, or the Chinese government, and unlike the Resorts casino in Zarin plays little no part in defining how Linden’s are used—in or out of Second Life. Shielding Second Life income from taxation under an imputation theory is proper only to the extent that the Second Life economy can be enforceably bounded—a requirement that is at best tenuous. . . ." From The Taxation of Virtual Worlds: Understanding Theories of Taxation Through an Analysis of the Second Life Economy by Tim Miano.

Virtual Economies of Scale: Jacking-In To the Corporate Metaverse

". . . Regardless of these uncertainties and despite the assertions by Congress’s Joint Economic Committee that “taxing transactions that occur within virtual economies . . . would be a mistake,” it clear that it is only a matter of time before the wealth generated in Second Life (or its technological progeny) will be sufficiently great that Congress is passing virtual-world tax legislation and tax lawyers are specializing in the virtual world sections of the Internal Revenue Code. The implications this could have on currently untaxed income like frequent flyer miles and casino chip will have to be left for another paper. . . ." From The Taxation of Virtual Worlds: Understanding Theories of Taxation Through an Analysis of the Second Life Economy by Tim Miano.
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". . . On the heels of IBM’s recent announcement about their new mainframe-class machines geared for 3D virtual worlds comes the news that Sun Microsystems has constructed its own 3D virtual environment for business. Judging by recent initiatives from Sun and IBM, the latest trend is a corporate-controlled, business-centric virtual world architected for internal use only– call it the intranet metaverse. In Sun’s case, it’s MPK20, a “a virtual 3D environment in which employees can accomplish their real work, share documents, and meet with colleagues using natural voice communication.” The MPK20 environment is built atop the open-source Wonderland software and the Project Darkstar infrastructure designed to run online games.

According to Sun, the key difference between MPK20 and other 3D environments is that it is explicitly designed for business use. The idea is to bring remote workers in Sun’s worldwide offices together into a single embodied space, “where the spacial layout of the 3D world coupled with the immersive audio provides strong cognitive cues that enhance collaboration.” The Wonderland software permits the creation of live, shared applications that are ideal for a workplace environment, Sun says. “The next stage in the MPK20 project is to design complementary physical and virtual work spaces. If personal and team workspaces primarily exist in the virtual world, then people in physical spaces should be able to project their workspace around them no matter where in the world they are and interact seamlessly with people who are remote.”

In IBM’s case, it’s a rough-and-ready 3D environment created by their Innovate Quick team, using the Torque graphics engine from Garage Games. “The project team is exploring ways to scale, and also applying different models of operation,” says Ian Hughes of IBM’s UK branch. Hughes spearheaded IBM’s early explorations of Second Life as a private development lab for the future 3D Internet, where the team creates cool applications like a universal language translator for avatars.

While some Net pundits have quickly dismissed Fortune 500 interest in virtual worlds as mere marketing hype, it’s projects like these which suggest that high tech companies are serious about their potential to transform the Internet. If they privately come up with new protocols and technology that adds real value to the way they do business, the future of the broader Net as a 3D medium is all but insured. By the same token, they may just end up adding another level of aggravation to the conference call. Without a casino or lap-dancing club furry in sight it is a more sober world, maybe, but one perhaps better suited to the business user. . . ." From Sun Aims New 3D Environment at Business and from Here come Virtual World Intranets… Seriously.

(Hat Tip Slashdot)

The Royal Treatment: UK Report on Second Life Legality

". . . A report from a British advisory group said on Monday that governments should apply real-world laws and regulations to virtual currencies in online worlds like Second Life to prevent potential money laundering, fraud, and tax evasion. The Fraud Advisory Panel, set up by the Institute of Chartered Accountants in England and Wales, said legal loopholes were exposing virtual world users to “a growing risk of theft and deception.”

In recent months law enforcement and tax authorities have focused increasing attention on virtual worlds, including a U.S. Congressional probe into virtual world taxation, a German criminal investigation into child pornography in Second Life and a new South Korean law that cracks down on money transfers in online games.

While the report said the dangers were hypothetical at this point, it warned that people seeking to avoid law enforcement and tax authorities were likely to seek out loosely regulated online economies. “My experience has been that fraudsters migrate to areas that are most vulnerable,” said Steven Philippsohn, chairman of the panel’s cybercrime working group. “(They) always benefit where countries are loosely regulated, and this is an environment that is unregulated all together.”

Online money laundering is a primary concern, according to study author Mark Johnson. “I see this as a virtual version of the hawala or hundi system,” said Johnson, who heads risk management firm TRMG, referring to the informal money transfer network that is commonly used through the Middle East, Asia and Africa. “[Hawala] is trust based — I give you 1,000, you give someone else 1,000 — it serves to move money from A to B to C to D while obscuring the trail.”

He recommended treating virtual currencies like the Linden dollar as “real money,” including a requirement for virtual world operators like Linden Lab to report suspicious financial transactions, just as for real-world banks and financial institutions. “At the moment, Second Life had the most sophisticated economic model. But the model is so clearly compelling and successful that there will be a number of variants,” Johnson said. “Linden Lab and its servers are based in the United States. But when you start to get domains based in Belize and the Congo and such — that’s when it really gets messy.” . . ." From UK panel urges real-life treatment for virtual cash.

What Does It Mean that Virtual Worlds Have Economies?

B. What Are Virtual Worlds and What Does It Mean that Virtual Worlds Have Economies?

One of the most important and interesting aspects of virtual worlds such as Second Life is the depth and sophistication of the economies that develop among the users. Perhaps surprisingly, the economies of these virtual worlds frequently satisfy all the fundamental characteristics that neoclassical economic theory demands in the real world. First, the virtual items possessed by users—essentially the actualization of computer software—are no different than any other real-world goods. Users are human beings with real-world and virtual-world needs, and the properties of some of these items satisfy some of those needs. As in the real world, users are aware of the causal relationship between attaining the virtual good and satisfying a need, and users have ways of accessing these goods and retaining control over them. Most importantly, virtual goods are scarce, making them “economic goods” no different than real-world economic goods. This last point is especially true in Second Life, where, unlike other virtual worlds, all the virtual goods are created by the users themselves. “Well over 99% of the objects in Second Life are user created.”

But these virtual items are not merely economic goods. They are economic goods within an interactive environment that satisfies principles of exchange. Different users own different virtual goods and have unique subjective needs, which allow them to reverse value one other’s goods. As users recognize that others have these disparate needs and perceive that if they could trade they would receive a net benefit, the only additional element necessary for exchange is a mechanism for excluding others from using the good without permission. Like the real world, virtual worlds solve this problem by maintaining a system of property rights over virtual goods. Whether users create new goods, receive free goods, or trade others for goods, users hold virtual-world property rights for each of these virtual possessions—a right defined by the ability to exclude and to transfer that ability to another user. Thus, all of the necessary elements for bargained-for positive sum exchange of economic goods exist within Second Life.

These two characteristics, virtual economic goods and virtual environments that foster exchange, are not surprising. Indeed, the economic properties of these virtual goods are equally present in a computerized version of the board game Monopoly. Most people would agree that Monopoly money, helpful as it may to buy Park Place or pay the Luxury Tax, has no value outside of the well defined parameters of its game environment. However, several unique features—now norms within virtual worlds like Second Life—have distorted traditional demarcations of value, wealth, and trade. As noted, users have the ability to barter with each other for virtual items and trade these items among themselves. Users can sell items to each other using this currency in place of bartering. Unlike Monopoly, however, real-world systems of trade such as eBay and PayPal allow virtual-world users to auction/sell the rights to virtual goods or the right to an account that holds virtual goods for real-world currency. These items are subsequently transferred within the virtual world. Additionally, just like Monopoly, most virtual worlds like Second Life have their own form of currency. But perhaps most surprisingly, either through the companies themselves or through sophisticated virtual-world entrepreneurs, some virtual worlds including Second Life have currency exchanges where users can trade real-world currencies for virtual-world currency and vice versa. This means that all currency, goods, and services within the virtual marketplace have a corresponding real-world monetary value.

The implication of this real-world valuation of virtual-world goods is that users can participate in the virtual world for the purpose of creating real-world wealth. As such, there are implicit incentives within this system for users to participate in the activities that are wealth maximizing. Therefore, unlike Monopoly or other virtual-world games that may nevertheless have internal economies, virtual worlds such as Second Life take on the unique and dynamic ability to satisfy a whole range of real-world needs in ways that have never been done—needs that are measured in U.S. Dollars. From The Taxation of Virtual Worlds: Understanding Theories of Taxation Through an Analysis of the Second Life Economy by Tim Miano.

Theories of Taxation Through an Analysis of the Second Life Economy (Part I Introduction & I.A)

PART I: Introduction to Virtual Worlds & Second Life

In order to study the novel legal ramifications of Second Life, one must have a basic understanding of its parameters and nomenclature. Second Life is an Internet-based virtual world first developed by Linden Lab in 2003. Users within Second Life, known as residents, interact within the computer simulated environment via avatars. Avatars are customizable three-dimensional graphical representations of humanoids. More clearly then, the Second Life software acts as a gateway and provides a three-dimensional forum that enables users to interact with each other through motional avatars. This platform creates a sophisticated level of a social network interactivity combined with general aspects of the Metaverse, or the meta-universe, that exists through the instantiation of an Internet-based virtual reality. The stated goal of Linden Lab is to create a world like the Metaverse: a user-defined world of general use in which people can interact, play, do business, and otherwise communicate.

A. An Overview of the Development and Content in Second Life

Second Life is frequently clustered with massively multiplayer online games, such as World of Warcraft or EverQuest, because the software provides a graphical interface and permits user interactivity that appear quite similar to these games. However, Second Life is not a game as it lacks scores, winners/losers, levels, a defined objective, or other such traditional parameters that characterize an activity as a game. Instead, at its inception, the world within Second Life was analogous to an undeveloped tract of land offering little more than open space, which has since been developed with whatever residents want for themselves or for which there is a market. Second Life residents visit this virtual world almost as if it were a real place, exploring what others have created, meeting other residents, socializing, participating in individual and group activities, and buying items (virtual property) and services from one another. Thus, while Second Life is not exclusively a social networking site like MySpace, a user driven commercial forum like eBay, a currency exchange like Citibank, a game like EverQuest, or a encyclopedia like Wikipedia, Second Life contains aspects of all of these things. Given the success of these services to satisfy certain human needs and the ability of residents to create real-world wealth by satisfying the needs of residents, it is not surprising that modified facets of these services make their way into Second Life.

This point draws out one of defining characteristics of Second Life. Namely, besides the open land and the basic parameters/limitations/rules of the environment, all of the content is user generated. (“Well over 99% of the objects in Second Life are user created.”) Using open access software, Second Life computer protocol, and three-dimensional modeling tools, any resident can build virtual buildings, landscape, vehicles, furniture, machines, games, people, and generally anything (referred to here as “items”) to use or to sell. Residents can incorporate various graphics, animation, and sound tools to create elaborate, farcical, or realistic content. It is this method of generating content that has given rise to the elaborate system of internal (as opposed to legally enforceable) property rights found in Second Life—one of the necessary conditions for a viable system of exchange. The legal status of the property right is unclear and will be examined in the context of taxation in greater detail in Part III below.

As an introductory matter, under Linden Lab’s Terms of Service agreement, any resident who creates an item retains copyrights in that item. Thus, from the perspective of the virtual-world resident the item is like personal property, but from the perspective of the real-world user the item is like duplicable software and more analogous to intellectual property. For a particular item then, users have some flexibility in how they may exercise their property rights. For example, the user who creates an item can limit it to behave like personal property by labeling it as a “no copy.” This means that a subsequent owner cannot reproduce, but may use, the underlying computer code, raising issues of use rights verses ownership rights. “No mod” on the other hand means that the owner may not modify the item’s characteristics, much like closed source software which is supposed to prevent hacking and customization—creating a more complex hierarchy of use rights. Finally, an owner of an item can label it “no trans,” which disallows transfer of ownership to another resident. Most importantly, all of these limitations can spring upon transfer. That is, creators or current owners can set these rights for future owners, much like land use covenants or servitudes. From a legal perspective then, any piece of property within Second Life can possess a wide array of property rights borrowing from real, personal, and intellectual property that remains, more or less, user-defined.

Theories of Taxation Through an Analysis of the Second Life Economy (Introduction)

Introduction:

A virtual world is a computer simulated environment in which human users interact with each other via graphical representations of themselves. Second Life is an Internet-based virtual world developed and released by Linden Lab in 2003. Other popular examples of virtual worlds include massively multiplayer online games such as World of Warcraft, which boasts more than 8 million users, and EverQuest, which as early as 2002 was estimated to have the 77th largest GDP in the world (between Bulgaria and Russia). Typically, virtual worlds appear similar to the real world, with constraints such as gravity, topography, locomotion, and communication.

One of the most important and interesting aspects of virtual worlds such as Second Life is the depth and sophistication of the economies that develop among the users. In fact, some virtual worlds, including Second Life, have currency exchanges where users can trade real-world currencies for virtual-world currency and vice versa. This means that the currency, goods, and services within the virtual-world marketplace have a corresponding real-world monetary value. The implication of this real-world valuation of virtual-world goods is that users can participate in the virtual-world activities for the purpose of creating real-world wealth. As such, there are implicit incentives within this system for users to participate in the activities that are wealth maximizing.

The overarching purpose of this work is explore the federal income tax consequences of the creation of Second Life—a virtual world where real people can engage in behavior constrained only by the time and effort of the users who wish to have a medium for a particular activity. Because it has developed the most mature systems of property rights, trade, and fungibility of wealth, and because it has been designed intentionally to be a more-or-less unregulated three-dimensional free market, Second Life is the focus of this work. Note, however, that much of the discussion also applies to the many other virtual worlds on the Internet, some of which currently boast millions more users and much larger internal economies than Second Life.

This work will proceed in three major parts. Part I will introduce the basic terminology and boundaries of Second Life and virtual worlds in general. It argues that the goods and services in Second Life posses all of the same economic characteristic as real-world goods and services, and that it is improper to dismiss Second Life as no different than the video games that have, in part, given rise to the technology that makes Second Life possible. Part II will introduce some basic concepts for income taxation and briefly examine the Haig-Simons definition of income. It will examine Haig’s original work that gave rise to this definition, and then, using introductory economic concepts develop the fundamental framework underlying the modern definition of income that Haig and Simons failed to explain. The purpose of this inquiry is to establish that as a purely theoretical matter, the wealth generated from the activities in Second Life is indistinguishable from those in the real world. Finally, having established that Second Life wealth is taxable income under the theoretical premises for § 61, Part III will analyze the activities in Second Life under the current tax law. First it will examine whether the three primary operational limitations that currently exists in the tax code would exempt Second Life from taxation. Second, using partnership tax law as a model, it will explore whether the efficiencies and substantial reduction in transaction costs that are unique Second Life too easily create accidental tax liability such that the current tax law fails to incorporate operational limitations special to Second Life. This work concludes that under the current law the users of Second Life would properly be subject to some form of taxation for their in-world activities. It also briefly speculates at some policy reasons for why the government should delay taxing those activities despite the applicability of the tax law and lists some important tax questions left unanswered by this work. From The Taxation of Virtual Worlds: Understanding Theories of Taxation Through an Analysis of the Second Life Economy by Tim Miano.

The Play's the Thing: A Theory of Taxing Virtual Worlds by Bryan Camp

Bryan Camp has posted The Play's the Thing: A Theory of Taxing Virtual Worlds on SSRN. Here is the abstract:

Taxation is shadow life. As our culture monetizes more and more life activities, the shadow grows. This article looks at the potential tax issues arising from a new life activity: online role-playing games in virtual worlds. Currently, some 12 million people regularly play such games and the number is growing. Exploring the reach of the Tax Code into virtual world transactions not only responds to the potentially practical needs of millions of U.S. taxpayers, it also permits a reevaluation of core principles of income tax as they interplay with life activities in the context of 21st century American culture.

This article's central thesis is that while player activity in virtual worlds produces measurable economic value to the player, player activity that occurs solely within the online virtual world is not gross income under the law. The article argues for a “cash out” rule. Players whose added wealth consists solely in what are defined as “units of play” should not be taxed unless and until they convert those units into cash or property that is something other than a unit of play. Conversely, when the play ceases, taxation begins. The resulting line-drawing difficulties have nothing to do with player intent nor with “fun” and “games.” Instead, the issue presented is as old as the Tax Code itself: at what point does economic gain become legal gain? The new context of virtual words allows for a renewed exploration of how and why the legal concept of “income” differs, and indeed must differ, from the economic concept.

The article proceeds in three parts. Part I describes the relevant facts of online role-playing games. It describes two popular virtual worlds which sit at opposite ends of the spectrum of online gaming—World of Warcraft and Second Life—and describes how game-related activity produces economic income. Part II reviews the basic rules of income tax, focusing on the broadness of the theory of gross income under section 61. Part II argues that the limits of section 61, whether imposed by Congress, the courts, or the IRS, are best described as operational limits. Part III applies the basic tax rules to virtual worlds and advances a theory based on “units of play” to distinguish between virtual worlds that are games and virtual worlds that are the equivalent of bingo halls or barter clubs. Using the concept of imputed income, Part III discusses the circumstances under which economic activity in-world involving only trade of virtual goods or services for virtual money will cast a real world tax shadow.

(Via TaxProf Blog)

Thought Experiments: Storytelling of Verifiable Imagined Observations

". . . Film studios and publishers avoid the phrase “science fiction.” So do the novelists, film directors and editors in their employ. Cormac McCarthy’s The Road, set during a nuclear winter, is about to become a blockbuster—Oprah Winfrey will tout it on an upcoming TV show as part of her book club. Describe it as “post-apocalyptic,” as most critics did, or as a masterpiece of dystopian literature. Just don’t call McCarthy’s novel “science fiction.” You won’t find the words “science fiction” in Random House’s bio of Arthur C. Clarke Award-winning author China Miéville and 2001: A Space Odyssey. Instead, he’s called the “edgiest mythmaker of the day.” The nose-thumbing is nothing new. In the ‘50s, Robert Heinlein dismissed the term, opting for “speculative fiction.” But today, one might imagine that the term could gain traction. Our lives are entangled with everyday gadgetry Heinlein could only have dreamed of. The impact of science on culture—climate change, stem-cell research, the internet—is the subject of continuous debate. . . ." From Writers, Directors Fear ‘Sci-Fi’ Label Like an Attack From Mars.
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". . . The flip phone design was inspired by the Star Trek original series communicator. Author Victor provided inspiration for the modern the taser. The word “TASER” is an acronym for “Thomas A. Swift’s Electrical Rifle,” so named because the inventor was an admirer of Tom Swift when he was a child. Geosynchronous orbits and geostationary orbits were first popularized by science fiction author Arthur C. Clarke Sir Arthur C. Clarke in 1945 as useful orbits for communications satellites. . . ." From 662 Technology Inventions That Came from Science Fiction.
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" . . . Second Life is one of several virtual worlds that have been inspired by the cyberpunk literary movement, and particularly by Neal Stephenson’s novel Snow Crash. The Metaverse, a phrase coined by Stephenson as a successor to the Internet, constitutes Stephenson's vision of how a virtual reality-based Internet might evolve in the near future. The stated goal of Linden Lab is to create a world like the Metaverse described by Stephenson, a user-defined world of general use in which people can interact, play, do business, and otherwise communicate. Total US Dollars Spent in Second Life in the Last 24h: $2,054,679. . . "
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" . . . An international consortium of nine automakers and two parts suppliers is asking researchers for proposals to develop “virtual humans” - computer programs that will help them design safer cars and trucks. The Global Human Body Models Consortium LLC says the computer models will provide better simulations of crash injuries than current crash dummies. . . ." From ‘Virtual Humans’ Sought for Crash Tests.

A Legal Analysis of Gambling in Second Life

Edited Excerpts From Could Second Life Be In Serious Trouble? The Risk of Real-Life Legal Consequences for Hosting Virtual Gambling by Anita Ramasastry:

Does Second Life's gambling sector violate UIGEA? The creators of Second Life aren't sure. [TM: Background on the economics of SL here.] Thus, at their request, FBI agents have been roaming the virtual landscape of Second Life to visit its virtual casinos. At the end of 2006, Congress passed the Unlawful Internet Gambling Enforcement Act, which forbids banks and other entities from processing payments for Internet gambling transactions, to stop Americans from betting online. However, Americans can now turn instead to virtual casinos to fulfill their urge to wager. Within the marketplace of the popular online virtual world Second Life, in addition to many legitimate businesses, there also reside hundreds of "virtual" casinos offering slot machines, and card games like poker and blackjack.

Second Life's 4.5 million registered users can exchange their U.S. dollars for "Linden dollars," which can be used to transact business only within Second Life itself. Linden's Terms of Service agreement states that Second Life "currency" is merely a "limited license right available for purchase or free distribution at Linden Lab's discretion, and is not redeemable for monetary value from Linden Lab." Linden Lab disclaims any value, cash or otherwise, to data residing on its servers. Thus, the currency is "licensed content," for which a license can be revoked as easily as it is granted. However, one can exchange Linden dollars for U.S. dollars. Residents of Second Life may purchase Linden dollars using Linden Lab's currency exchange (or use other third-party currency exchanges) to convert between Linden dollars and U.S. dollars where the exchange rate fluctuates daily based on usage.

Because UIGEA prohibits gambling businesses from accepting credit cards, checks, or other bank instruments from American gamblers who illegally bet over the Internet, it [appears to track the prohibitions] under U.S. anti-gambling statutes for Second Life casino operators to accept bets placed with Linden dollars. The relevant statutes cover circumstances in which not currency, but simply "something of value," is wagered, and Linden dollars have "value" because they are convertible into U.S. dollars.

But what does that mean for Linden Lab? The UGIEA bans online gambling operators from accepting most forms of funds to be used by the players to gamble on their Websites, to the extent that such transactions occur offshore or are currently illegal under existing state law. [The statute states] that these forms of funds include credit, electronic fund transfers, money-transmitting-business transfers, or checks and similar instruments payable through a financial institution. Furthermore, Second Life [is not] off the hook [simply because] it is not itself an online gambling operator (i.e. simply a host site where casinos are among a variety of business) [because] Second Life might still be liable for aiding and abetting Internet gambling.

Even if UIGEA does apply to Linden Lab and Second Life, a key question remains: Linden Lab itself is located in California, but where do the casino operator reside? If they are offshore, to what extent can Linden can actually block payments to and from their users? For the time being, the FBI is simply exploring this virtual world. But eventually, it is likely that some kind of enforcement or voluntary action by Linden Lab will have to occur, so that Second Life's currently modest gambling operations do not surge further to become a much larger problem. If Linden can indeed figure out how it might block payments to its virtual casinos, that might be the best solution.

Taxation of Second Life: Commerce v. Hobby

". . . How should transactions within Second Life be taxed? My view is that, from a policy perspective, the right result is to tax commercial activity within virtual worlds but not game play. Thus, if Anna is a Second Life entrepreneur raking in the Lindens and Bert uses Second Life to build and furnish a virtual castle to hang out in with his friends, then, as a general matter, Anna should be taxed on her Second Life activities, but Bert shouldn’t be. The problem is how to reach that result.

One possibility would be to provide a "cash-out" rule, along the lines of what I proposed for [World of Warcraft]. The problem I see with this is the extent to which Second Life is a medium for commerce. WoW focuses on a game with a general storyline and goals and prohibits real market trade. Second Life encourages commerce and not only allows but facilitates the exchange of Lindens for dollars. Were sales for Lindens not taxed, that would encourage excessive allocation of resources to virtual businesses. Deferral of taxation would be a larger problem in Second Life than in WoW because of the larger array of business opportunities and the lower risk of deferring cashing out that the legitimacy of exchanging Lindens for dollars provides. Failing to tax sales of virtual items in Second Life could also facilitate tax evasion by sellers who purport to sell a virtual item but actually sell a real one (for Lindens).

Thus, I think the better result is to tax sales within Second Life (for Lindens). That would result in the imposition of tax on commerce such as Anna’s. (Information reporting by Second Life might be required for effective enforcement of the tax.) It would also, at least in theory, tax sales by play-minded users, but the likely outcome for someone such as Bert would not be any actual federal income tax liability because only profit would bear tax. That is, because the expenses of an income-producing "hobby" can be deducted from the income from the hobby under IRC section 183, someone like Bert, who spends more on Second Life than he brings in from it, would not actually owe any federal income tax on his Second Life activities. . ." From Virtual Tax, Part 2 (Hat Tip to TaxProf Blog)
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". . . YouTube CEO Chad Hurley has revealed that the company plans to financially compensate users who produce and upload their content. With Google's purchase of YouTube last year, followed by more aggressive attempts to monetize the site (such as the deal struck with Verizon Wireless), it was inevitable that YouTube would come under pressure to share some of those fruits with ordinary users. . . ." From YouTube To Pay For User-Generated Content.
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Prof. Lederman's argument seems to reasonably follow traditional thinking about sec. 183, but I wonder if the analysis fails to consider the continued monetization of Internet content produced by individuals. This traditional thinking seems to rely too much on the intent of the tax payer. As she properly notes, "Information reporting by Second Life might be required for effective enforcement of the tax." If the law obliges such extensive tracking of Linden dollar with clearly defined USD exchanges rates, what is the added marginal cost of obliging the Linden to enforce the tax on everyone?

Law and Spontaneous Order: Criminal Intent