Taxation of virtual goods is on the drawing board

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The National Taxpayer Advocate has raised the question of whether the tax code should allow for tax-free transactions of virtual goods.

Taxpayer advocate Nina Olson, in a report to the IRS earlier this year, said that in 2005, about $1 billion in real dollars changed hands in computer-based environments. Online gamers or social networkers use real money to buy virtual currency, which is then used to buy virtual goods. Those 'goods' can be objects, such as virtual birthday cakes posted to social networking sites, or actions, such as the ability to get to a more advanced level in an online game, explained Lora L. Abe, director of marketing for Gambit, a payments engine for online games, in Venture Beat.

Olson's report, recognizing the popularity of virtual goods, said, "Economic activities in virtual worlds may present an emerging area of tax noncompliance, in part because the IRS has not provided guidance about whether and how taxpayers should report such activities."

The Wall Street Journal says that because IRS does not issue guidance, most taxpayers do not report earning relating to the sales of virtual goods.

"Over 16 million people are estimated to have active subscriptions to these environments, many of which have their own virtual economies and currencies," states the report. "To improve voluntary tax compliance, the National Taxpayer Advocate recommends that the IRS issue guidance addressing how taxpayers should report economic activities in virtual worlds."

Observers say this is the first time such a recommendation has been made, although virtual taxation issues have been researched in the U.S. for several years. Other countries, such as China, Sweden, Korea, and the United Kingdom, have already taxed financial transactions in virtual environments, or they are making moves to do so.

Virtual currency may be coming to the hugely popular Facebook, with 200 million active users. CNBC reported earlier this month that Facebook is "hard at work" developing a virtual currency, with the idea that 10 Facebook credits would cost a dollar. The credits could be bought, or obtained from advertisers, and used for trading among users or buying applications, such as an online game.

CNN says that users can buy virtual flowers or teddy bears using online currency called hi5 Coins. The 'gifts' appear on friends' social networking sites. Second Life has an internal currency called Linden dollars, and Second Life creators at Linden Labs report that $27 million is exchanged quarterly in the 3D virtual world. An online game called World of Warcraft offers WoW Gold for players who proceed through the game. The WoW Gold virtual currency is so desired that it is sold on a black market, experts told CNN.

"Selling in-game weapons, armor, and other items to players for real-world cash is a common way for China's online gaming companies to a turn a profit. Internet cafes in China are often packed with chain-smoking teenagers who play World of Warcraft or similar Chinese games for long hours," IDG News Service reported.

One man was even sentenced to three years in prison for extorting virtual items and currency from a user, who was beaten and forced to turn over virtual currency worth 100,000 yuan ($14,700 U.S.), according to Xinhua, China's official news agency.

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