The Lawyer's Daily: Money laundering, gambling in e-sports M&A: Costs of non-compliance

Canada In the media October 2020

This article was originally published by The Lawyer’s Daily, part of LexisNexis Canada Inc.

The height of the coronavirus pandemic led to a cancellation of most, if not all, of traditional sports activities and that, in turn, led to a surge in demand for e-sports gaming.

The e-sports industry is on track to surpass $1 billion in revenue this year. Titans in the e-sports industry use different product-control strategies for e-sports tournaments. For example, a category of publishers vertically integrates with their premier e-sports titles and maintains complete licensing control. Another category gives third parties complete freedom to organize e-sports tournaments with very little oversight. Other publishers still have chosen to license their e-sports titles through a more traditional franchising model.

Regardless of the strategy employed, all players in the e-sports industry — software creators, game developers, publishers, tournament organizers, retailers and players (participants) — are expected to consider their obligations and potential liability in the face of unique challenges not otherwise experienced in the traditional gaming context. Moreover, investors looking to engage in mergers and acquisitions (M&A) activity in the e-sports industry are expected to be aware of the obligations, risks and challenges faced by participants in the industry and what to focus on when assessing the viability of a transaction. In this article, we briefly highlight potential liability issues that a prudent due diligence exercise would uncover in the context of an e-sports M&A transaction. Those issues arise out of certain global anti-money laundering (AML) regulations, anti-gambling regulations and tax regulations.

AML issues

Money laundering involves the concealment of the origins of illegally obtained money. Games that enable the exchange of fiat currency for in-game currency and which allow players to gamble with purchased in-game currency are likely to be subject to onerous AML regulations in multiple jurisdictions. This is because, through online gaming, fraudsters may use the proceeds of crime to acquire virtual currencies or in-game assets for later resale on third-party marketplaces in exchange for fiat currency. Such transactions are especially difficult to identify with the advent of “cyberlaundering” (which is the concealment of the origins of the illegally obtained virtual currencies or virtual assets) and “micro-laundering” (the illegal transfer of money to an end user through a series of temporally spaced small-dollar transactions).

Participants should be mindful of potential liability stemming from global AML regulations. In Canada for example, starting June 1, 2020, games that allow for the use of virtual currencies or virtual assets are likely to be subject to the Canadian AML regulations (i.e. the Proceeds of Crime (Money Laundering) and Terrorist Financing Act and its associated regulations). Other jurisdictions have similar AML requirements, and participants are encouraged to become aware of AML regulations in force in each jurisdiction in which they operate.

Anti-gambling issues

Gambling on e-sports is booming. In 2018 alone, over $6.7 billion was wagered globally on professional e-sports through both legal and illegal means, and the forecast for the total amount wagered globally is expected to reach $17.2 billion by the end of 2020. However, e-sports betting remains a legal grey zone in many parts of the world. Jurisdictions have taken different approaches to its regulation and legalization. Some governments have even taken steps to regulate various in-game items, such as loot boxes. Participants in this space should remain vigilant of potential liability arising from the creation of illegal gambling platforms for e-sports across multiple jurisdictions. At a minimum, due diligence should be undertaken in the respective jurisdictions in which e-sports activities are carried out either by reason of the fact that participants are located in that jurisdiction or because the e-sports products are located there.

To add to these implications, where e-sports activities are carried out in contravention of prevailing anti-gambling laws, the proceeds or “winnings” derived from those activities are considered illicit proceeds of crime and applicable AML laws are triggered automatically.

Tax issues

Income from e-sports can result in important considerations for gamers. The tax liability of participants will depend on the tax rules of their home jurisdiction and also the rules of any other jurisdiction in which they game or from which they stream gaming content. For instance, income from gaming might be considered to be business income, salary, or non-taxable, depending on the rules of the relevant jurisdictions. Withholding tax and value added tax considerations may also come into play.

What is more, where e-sports activities result in tax evasion or similar illegal activity, the proceeds or “winnings” derived from those activities are considered illicit proceeds of crime, or proceeds derived from tax evasion, and again applicable AML laws are triggered automatically.

Costs of non-compliance

Participants need to be mindful of their obligations in the jurisdictions in which they operate — compliance in this space is an ongoing commitment. The e-sports industry is growing, and with it comes robust and evolving liability frameworks in different jurisdictions. As the market develops, governments may update and amend their regulations to better reflect the needs and realities of the e-sports sector. To further complicate matters, these regulations may be inconsistent across jurisdictions, forcing participants to pay particular attention to which markets they will target. Lastly, participants are generally expected to consider the AML implications of certain in-game activities as well as the tax treatment of prizes to determine any withholding obligations.

If the foregoing issues are left unaddressed, penalties for non-compliance with the relevant AML, anti-gambling, or tax laws can be quite severe (and, in our experience, almost crippling for certain participants). Such penalties generally include significant monetary penalties, administrative penalties, as well as criminal charges and sanctions.