Digital/Virtual Currencies

BitcoinThe Securities and Exchange Commission announced yesterday that a California-based company selling digital tokens to investors to raise capital for its blockchain-based food review service halted its initial coin offering (ICO) and agreed to a cease-and-desist order in which the SEC found that its conduct constituted unregistered securities offers and sales.

According to the SEC’s order, before any tokens were delivered to investors, Munchee Inc. refunded investor proceeds after the SEC intervened.  Munchee was seeking $15 million in capital to improve an existing iPhone app centered on restaurant meal reviews and create an “ecosystem” in which Munchee and others would buy and sell goods and services using the tokens.  The company communicated through its website, a white paper, and other means that it would use the proceeds to create the ecosystem, including eventually paying users in tokens for writing food reviews and selling both advertising to restaurants and “in-app” purchases to app users in exchange for tokens.

According to the cease-and-desist order, in the course of the offering, the company and other promoters emphasized that investors could expect that efforts by the company and others would lead to an increase in value of the tokens.  The company also emphasized it would take steps to create and support a secondary market for the tokens.  Because of these and other company activities, investors would have had a reasonable belief that their investment in tokens could generate a return on their investment.  Munchee consented to the SEC’s cease-and-desist order without admitting or denying the findings.

As the SEC has said in the DAO Report of Investigation, a token can be a security based on the long-standing facts and circumstances test that includes assessing whether investors’ profits are to be derived from the managerial and entrepreneurial efforts of others.

“We will continue to scrutinize the market vigilantly for improper offerings that seek to sell securities to the general public without the required registration or exemption,” said Stephanie Avakian, Co-Director of the SEC’s Enforcement Division.  “In deciding not to impose a penalty, the Commission recognized that the company stopped the ICO quickly, immediately returned the proceeds before issuing tokens, and cooperated with the investigation.”

“Our primary focus remains investor protection and making sure that investors are being offered investment opportunities with all the information and disclosures required under the federal securities laws,” said Steven Peikin, Co-Director of the SEC’s Enforcement Division.

The SEC’s new Cyber Unit is focused on misconduct involving distributed ledger technology and initial coin offerings, the spread of false information through electronic and social media, brokerage account takeovers, hacking to obtain nonpublic information, and threats to trading platforms.  We previously reported on the Cyber Unit’s first action, filed last week, to halt an alleged ICO scam. The SEC also has a Distributed Ledger Technology Working Group that focuses on various emerging applications of distributed ledger technology in the financial industry. The SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin in July 2017 to make investors aware of the potential risks of participating in initial coin offerings.

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BitcoinThe Securities and Exchange Commission announced yesterday that its new Cyber Unit obtained an emergency asset freeze to halt a “fast-moving” Initial Coin Offering (ICO) fraud that raised up to $15 million from thousands of investors since August by falsely promising a 13-fold profit in less than a month.

The SEC filed charges against what it calls a “recidivist Quebec securities law violator” named Dominic Lacroix, and his company, PlexCorps. The complaint, filed in federal court in Brooklyn, alleges that Lacroix and PlexCorps marketed and sold securities called PlexCoin on the internet to investors in the U.S. and elsewhere, claiming that investments in PlexCoin would yield a 1,354 percent profit in less than 29 days. The SEC also charged Lacroix’s partner, Sabrina Paradis-Royer, in connection with the scheme. Based on its filing, the SEC obtained an emergency court order to freeze the assets of PlexCorps, Lacroix, and Paradis-Royer.

The charges are the first filed by the SEC’s new Cyber Unit, which was created in September to focus the Enforcement Division’s cyber-related expertise on misconduct involving distributed ledger technology and initial coin offerings, the spread of false information through electronic and social media, hacking and threats to trading platforms.

“This first Cyber Unit case hits all of the characteristics of a full-fledged cyber scam and is exactly the kind of misconduct the unit will be pursuing,” said Robert Cohen, Chief of the Cyber Unit. “We acted quickly to protect retail investors from this initial coin offering’s false promises.”

The SEC’s complaint charges Lacroix, Paradis-Royer and PlexCorps with violating the anti-fraud provisions, and Lacroix and PlexCorps with violating the registration provision, of the U.S. federal securities laws. The complaint seeks permanent injunctions and disgorgement plus interest and penalties. For Lacroix, the SEC also seeks an officer-and-director bar and a bar from offering digital securities against Lacroix and Paradis-Royer.

The SEC’s Office of Investor Education and Advocacy has issued several warnings to investors about scams of companies claiming to be engaging in initial coin offerings. In an Investor Bulletin published in July 2017, the SEC announced that in the context of ICOs, virtual coins or tokens that are offered or sold may be securities, and if they are securities, the offer and sale of these virtual coins or tokens in an ICO is subject to the federal securities laws:

Virtual coins or tokens are created and disseminated using distributed ledger or blockchain technology. Recently promoters have been selling virtual coins or tokens in ICOs. Purchasers may use fiat currency (e.g., U.S. dollars) or virtual currencies to buy these virtual coins or tokens. Promoters may tell purchasers that the capital raised from the sales will be used to fund development of a digital platform, software, or other projects and that the virtual tokens or coins may be used to access the platform, use the software, or otherwise participate in the project. Some promoters and initial sellers may lead buyers of the virtual coins or tokens to expect a return on their investment or to participate in a share of the returns provided by the project. After they are issued, the virtual coins or tokens may be resold to others in a secondary market on virtual currency exchanges or other platforms.

In an Investor Alert from August 2017, the SEC specifically warned that “[f]raudsters often try to use the lure of new and emerging technologies to convince potential victims to invest their money in scams. These frauds include ‘pump-and-dump’ and market manipulation schemes involving publicly traded companies that claim to provide exposure to these new technologies.”

Bitcoin

The Internal Revenue Service has prevailed in its long-running dispute with Coinbase, the largest U.S.-based Bitcoin exchange, with a federal judge ordering Coinbase to comply with a “John Doe” summons seeking customer information. In an opinion issued on November 28, 2017, the court in San Francisco found that the government’s narrowed request for information on Coinbase’s customers served the legitimate purpose of investigating whether Bitcoin users properly reported gains or losses on their income tax returns. The Court also found that the customer records sought by the government were relevant because they can be used by the IRS to determine whether a particular Coinbase customer is tax compliant. Coinbase must now hand over to the IRS records for accounts that had at least one transaction of at least $20,000 value during the period 2013 to 2015. According to Coinbase, this will require it to divulge trading records regarding nearly 9 million transactions conducted by over 14,000 customers. With this data in hand, it will be relatively easy for the IRS to cross-check filed tax returns to determine if Coinbase customers properly reported Bitcoin transactions on their returns. Individuals who failed to do so can expect to hear from the IRS and should consider prompt corrective action, if necessary, to mitigate the consequences of any such inquiry.

A “John Doe” summons is an information-gathering tool that is being used with increasing frequency by the IRS to obtain information and records about a class of unidentified taxpayers if the IRS has a reasonable belief that such taxpayers are engaged in conduct violating U.S. tax laws. Because the identities of the targeted taxpayers are unknown, the summons is denoted with a “John Doe” moniker. Expressly authorized by the Internal Revenue Code, a John Doe summons must first be approved by a federal judge before it can be served. The IRS sought to serve a summons on Coinbase because of its concern that the anonymous nature of virtual currencies like Bitcoin may allow users to engage in tax evasion and other illegal conduct:

Virtual currency, as generally defined, is a digital representation of value that functions in the same manner as a country’s traditional currency. There are nearly a thousand virtual currencies, but the most widely known and largest is bitcoin. Because transactions in virtual currencies can be difficult to trace and have an inherently pseudo-anonymous aspect, taxpayers may be using them to hide taxable income from the IRS.

In late 2016, a federal judge authorized the IRS to serve a “John Doe summons” on Coinbase seeking information about U.S. taxpayers who conducted transactions in virtual currency during 2013, 2014, and 2015. In court documents, the Justice Department stated that Coinbase was the fourth largest exchanger globally of Bitcoin and the largest exchanger in the United States. The Justice Department further stated that Coinbase offered buy/sell trading functionality in 32 countries, maintaining over 4.9 million wallets with wallet services available in 190 countries, serving 3.2 million customers, with $2.5 billion exchanged in Bitcoin. According to the IRS, only 2,500 taxpayers reported transactions in Bitcoin on their U.S. income tax returns during the three years in question, as compared to nearly 500,000 U.S. customers reported by Coinbase during the same period. Coinbase has vigorously resisted the John Doe summons, and the matter has been in litigation for the past year, with the IRS eventually agreeing to narrow the scope of its summons.

In its ruling approving the Coinbase summons, the Court determined that the summons “serves the legitimate purpose of investigating the ‘reporting gap between the number of virtual currency users Coinbase claims to have had during the summons period’ and ‘U.S. bitcoin users reporting gains or losses to the IRS during the summoned years.’” The Court found that Coinbase is the largest U.S. exchange of bitcoin into dollars with at least 5.9 customers served and 6 billion in transactions while only 800 to 900 taxpayers a year have electronically filed returns with a property description related to Bitcoin from 2013 through 2015. This discrepancy, wrote the Court, creates an inference that more Coinbase users are trading bitcoin than reporting gains on their tax returns.

As narrowed, the IRS summons seeks information regarding 8.9 million Coinbase transactions and 14,355 Coinbase account holders. That only 800 to 900 taxpayers reported gains related to Bitcoin in each of the relevant years and that more than 14,000 Coinbase users have either bought, sold, sent or received at least $20,000 worth of Bitcoin in a given year suggests, the Court concluded, that many Coinbase users may not be reporting their Bitcoin gains. Under these circumstances, the Court ruled that IRS has a legitimate interest in investigating these taxpayers.

In a victory for Coinbase, the Court ruled that the scope of information sought by the IRS was overbroad, and trimmed the types of records that would be required to be turned over by Coinbase. Coinbase is only required to produce the following data for its customers: taxpayer identification number; name; date of birth; and address. The Court refused the government’s request for additional information, including account opening records; copies of passports and/or driver’s licenses; wallet addresses; and public keys for accounts/wallets/vaults; “know your customer” due diligence records; and customer correspondence.

As a result of the Court’s ruling, Coinbase must now turn over to the IRS the following documents for accounts with at least the equivalent of $20,000 in any one transaction (buy/sell/send/receive) in any one year during the 2013 through 2015 time period:

  • Taxpayer identification number;
  • Name;
  • Birth date;
  • Address;
  • Records of account activity including transaction logs or other records identifying the date, amount, and type of transaction (purchase/sale/exchange), the post transaction balance, and the names of counterparties to the transaction; and
  • Periodic statements of account or invoices (or their equivalent).

Once it receives the summoned data from Coinbase, the IRS will cross-check tax returns filed by the individuals in question to determine if they properly reported their Bitcoin trading gains and losses. Individuals who have not properly reported their Bitcoin holdings will likely be contacted by the IRS, and the nature of that contact will be dictated by the magnitude of each individual’s tax non-compliance. For Coinbase customers with a relatively small number of unreported transactions, the IRS may simply send a “soft” letter advising them to file amended tax returns. Coinbase users with a greater number of unreported transactions may be selected for audit and face penalties for not properly reporting Bitcoin transactions. The most egregious examples of non-compliance may well face criminal investigation by the IRS, if there is evidence those customers deliberately intended to evade their tax obligations by trading in Bitcoin. As we previously reported, drug trafficking organizations and other illicit actors are using digital currencies with increasing frequency to engage in money laundering.

Coinbase has not stated publicly whether it intends to appeal, but in a blog post the company said it was “in the process of reviewing the order” and would “continue to keep our customers updated.” In that same piece, Coinbase noted that the summons affected less than 1 percent of its customer base. Coinbase also said that “[i]n the event that we ultimately produce the documents under this Court order, we intend to notify impacted users in advance of any disclosure.” This advance notice will presumably afford concerned accountholders an opportunity to quickly rectify their tax filings, if they deem it advisable.

Bitcoin

Earlier this week, a federal grand jury in Brooklyn returned an indictment criminally charging a self-described “day trader” with various offenses in connection with an alleged computer hacking scheme involving more than 50 online brokerage accounts. The indictment further alleges that the defendant laundered the proceeds of his crimes using Bitcoin, a cryptocurrency.

The indictment alleges that the defendant and others conspired to hack into victims’ online securities brokerage accounts and used them to place unauthorized trades. As a part of the conspiracy, the defendant is alleged to have used brokerage accounts in his name to place “short sale” offers for publicly-traded companies’ stock at artificially high, above-market prices. Simultaneously, the defendant’s co-conspirators are alleged to have hacked into victims’ online brokerage accounts and used them to place buy orders for the stock at the artificially high prices, matching the defendant’s short sale offers. After using the victims’ accounts to purchase the stock, the defendant and his co-conspirators then re-purchased the stock from the victims’ accounts at market or below-market prices. This series of fraudulent trades usually took place within minutes, and the defendant immediately profited based on the difference between his artificially high short sale price, and the lower price at which he subsequently re-purchased the stock. While discussing the scheme in private messages on Twitter, one of the co-conspirators stated: “legal trading too hard.” The defendant responded that he would be a “good trading partner.”

Shortly before the defendant began the securities fraud scheme, he allegedly agreed to pay one of his co-conspirators one-half of his trading profits. Court documents indicate that the defendant was concerned about sending money to his co-conspirator, noting in a message sent via Twitter direct messaging that it was “sketchy but there are ways.” To mask these payments, the co-conspirator instructed the defendant to pay him in Bitcoin. The defendant opened an account at Coinbase, which is an online platform that allows users to convert currency such as U.S. dollars into Bitcoin, and to send and receive payments in Bitcoin. In total, the indictment alleges that the defendant paid his co-conspirator approximately $237,120 in Bitcoin through his Coinbase account. The defendant’s payments to his co-conspirator using Bitcoin is the basis for the indictment’s conspiracy to commit money laundering in violation of 18 U.S.C. section 1956(h).

Numerous government agencies have expressed concern that the anonymous nature of Bitcoin and other virtual currencies facilitates money laundering and other illicit activity. Most recently, the Drug Enforcement Administration published a report that drug trafficking organizations are increasingly using virtual currencies to enable easy transfer of illicit funds internationally, and that Bitcoin is also being used to facilitate trade-based money laundering schemes, particularly those based in China.

In addition to money laundering, Bitcoin and other virtual currencies can readily facilitate tax evasion by users. In 2013, the U.S. Government Accountability Office issued a report concluding that “some taxpayers may use virtual economies and currencies as a way to evade taxes. Because transactions can be difficult to trace and many virtual economies and currencies offer some level of anonymity, taxpayers may use them to hide taxable income.” In 2014, the Internal Revenue Service published guidance on the tax consequences of the use of virtual currencies, making clear that Bitcoin and similar currencies are property for tax purposes, and a taxpayer can therefore have gain or loss on the sale or exchange of a virtual currency, depending on the taxpayer’s basis.

In late 2016, a federal judge authorized the IRS to serve a “John Doe summons” on Coinbase – the same virtual currency exchanger used by the day trader charged this week in the case described above – seeking information about U.S. taxpayers who conducted transactions in virtual currency during 2013, 2014, and 2015. In court documents, the Justice Department stated that Coinbase was the fourth largest exchanger globally of Bitcoin and the largest exchanger in the United States. The Justice Department further stated that Coinbase offered buy/sell trading functionality in 32 countries, maintaining over 4.9 million wallets with wallet services available in 190 countries, serving 3.2 million customers, with $2.5 billion exchanged in Bitcoin. According to the IRS, only 2,500 taxpayers reported transactions in Bitcoin on their U.S. income tax returns during the three years in question, as compared to nearly 500,000 U.S. customers reported by Coinbase during the same period. Coinbase has vigorously resisted the John Doe summons, and the matter has been in litigation for the past year. Just yesterday, the federal judge overseeing the litigation indicated in a hearing that she is inclined to permit the IRS to proceed with its investigation of Coinbase customers.

BitcoinIn its recently-published 2017 National Drug Threat Assessment (NDTA), the Drug Enforcement Administration reports that drug trafficking organizations are turning to Bitcoin and other virtual currencies to enable easy transfer of illicit funds internationally. The NDTA is a comprehensive strategic assessment of the threat posed to the United States by domestic and international drug trafficking and the abuse of illicit drugs. The report combines a wide variety of law enforcement reporting and other data to determine which substances and criminal organizations represent the greatest threat to the United States.

The NDTA notes that in order to avoid law enforcement detection and banking regulations, transnational criminal organizations (TCOs) employ various strategies to move and launder drug proceeds into, within, and out of the United States. Preferred methods to move and launder illicit proceeds – such as bulk cash smuggling, money value transfer systems, trade-based money laundering, and through the formal banking sector – remain the same as in past years. Emerging as a new money laundering threat, however, are Bitcoin and other virtual currencies because of their “anonymizing nature and ease of use.” Bitcoin is the most common form of payment for drug sales on dark net marketplaces and is emerging as a desirable method to transfer illicit drug proceeds internationally. Bitcoin is the most widely used virtual currency due to its longevity and growing acceptance at legitimate businesses and institutions worldwide.

The NDTA notes that Bitcoin’s widespread popularity in China has now spread to trade-based money launderers operating in that country. Many trade-based money laundering schemes are China-based, and have historically consisted of the purchase by TCOs of large shipments of “made-in-China” goods via wire transfer or bulk cash carrying from the United States to China. The “made-in-China” goods are then shipped to business owners in Mexico and South America, who in turn reimburse the drug trafficking organizations in local currency. Now, many China-based firms manufacturing goods used in such schemes prefer to accept Bitcoin for payment.

The use of Bitcoin in this type of trade-based money laundering scheme no doubt facilitates the money laundering process for TCOs, which currently face scrutiny from U.S. banks whenever they wire money to Chinese manufacturers. In contrast, the NTDA notes that a TCO purchasing Bitcoin through a licensed money service business without raising red flags will face no further scrutiny when transferring the Bitcoin to China. Many TCOs can also buy Bitcoin from individuals selling Bitcoin on the Internet without any MSB license. Many TCOs will thus be able to convert their cash drug proceeds to Bitcoin and buy Chinese goods with no fear of oversight from a formal financial institution.

The NDTA also notes that Bitcoin is increasingly being used by Over-the-Counter (OTC) Bitcoin brokers who conduct high-risk Bitcoin trading consistent with Chinese capital flight and money laundering. These brokers likely use foreign Bitcoin wallet-hosting services and exchanges that do not properly conduct “know your customer” or anti-money laundering monitoring on Bitcoin purchases. OTC Bitcoin brokers primarily attract two types of clients: those who want to use Bitcoin to move their money out of China and those who want to convert large quantities of cash into Bitcoin. Chinese underground banking systems money brokers sell Bitcoin to drug traffickers for cash earned from drug sales in the United States, Australia, and Europe. This drug cash is then sold to Chinese nationals in exchange for Bitcoin the Chinese nationals use to transfer the value of their assets outside of China. The NTDA concludes that the increasing use of OTC Bitcoin brokers, who are capable of transferring millions of dollars in Bitcoin across international borders as part of a capital flight scheme, is expected to continue to intertwine criminal money laundering networks with capital flight.

Two members of Congress have introduced a bill that would exempt from income tax transactions under $600 conducted using Bitcoin or other digital currencies. Currently, the Internal Revenue Service treats digital currencies like Bitcoin as property, meaning that on every transaction using Bitcoin, the taxpayer must recognize either a gain or loss for tax purposes depending on his or her basis in the digital currency and report such gain or loss on an income tax return. The IRS does not recognize any de minimus transaction amount, meaning that a taxpayer using Bitcoin to purchase a cup of coffee must recognize gain or loss on the transaction. Representatives Jared Polis (D-Colo.) and David Schweikert (R-Ariz.), co-chairs of the Congressional Blockchain Caucus, have introduced the Crytocurrency Tax Fairness Act of 2017 to exempt small purchases with digital currency up to $600 from tax reporting and burdensome recordkeeping requirements.

In a press release announcing the bill, Rep. Polis said that “[c]ryptocurrencies can be used for anything from buying a cup of coffee to paying for a car, to crowdfunding a new startup and more and more consumers are choosing to use this type of payment. To keep up with modern technology, we need to remove outdated restrictions on cryptocurrencies, like Bitcoin, and other methods of digital payment. By cutting red tape and eliminating onerous reporting requirements, it will allow cryptocurrencies to further benefit consumers and help create good jobs.”

Rep. Schweikert added that “[i]ndividuals all over the world are starting to use cryptocurrencies for small every day transactions, yet here in the States we have fallen behind and make cryptocurrency use more of a challenge than it needs to be. “With this simple legislative change, anyone can make digital payments to buy a newspaper or a bike without worrying about tax code challenges.”

According to their press release, Polis and Schweikert relaunched the Congressional Blockchain Caucus in February. The caucus educates, engages, and provides research to help policymakers implement smart regulatory approaches to the issues raised by blockchain-based technologies and networks. Blockchain is a decentralized distributed ledger that is the main technology powering cryptocurrencies such as Bitcoin and Ethereum. By using math and cryptography, blockchain supplies a decentralized database of every transaction involving value. This creates a record of authenticity that is verifiable by a user community, increasing transparency and reducing fraud. Crytocurrencies, like Bitcoin and Ethereum, are used for purchases, trade, and payment across the globe. The estimated value of the cryptocurrecy economy is $162 billion.

Meanwhile, the IRS is continuing its aggressive efforts to identify the users of digital currency through litigation involving a “John Doe summons” on Coinbase Inc., a leading virtual currency exchanger. The IRS believes that because virtual currency transactions are difficult to trace, offer relative anonymity, and lack third-party information reporting, taxpayers may be using them to hide taxable income.  In a press release announcing the John Doe summons, then-Principal Deputy Assistant Attorney General Caroline D. Ciraolo, head of the Justice Department’s Tax Division, said that “[a]s the use of virtual currencies has grown exponentially, some have raised questions about tax compliance.  Tools like the John Doe summons authorized today send the clear message to U.S. taxpayers that whatever form of currency they use – bitcoin or traditional dollars and cents – we will work to ensure that they are fully reporting their income and paying their fair share of taxes.”  According to the IRS, there is a significant reporting gap between the number of virtual currency users reported by Coinbase during the period 2013 through 2015 and the total number of taxpayers reporting gains or losses to the IRS during that same period (807, 893, and 802, respectively). In addition, it has been reported that the IRS is utilizing Chainanalysis software to identify owners of virtual currencies.

irsThree influential members of Congress have questioned the Internal Revenue Service’s strategy for addressing the tax treatment of digital or virtual currencies, such as Bitcoin, and its efforts to uncover the identities of taxpayers who used such currencies through a “John Doe” summons to Coinbase, a virtual currency exchanger in San Francisco. In a letter dated May 17, 2017, Orrin G. Hatch, Chairman of the Senate Finance Committee; Kevin Brady, Chairman of the House Ways and Means Committee; and Vern Buchanan, Chairman of the Oversight Subcommittee of the House Ways and Means Committee, wrote to IRS Commissioner John Koskinen to express concern about the manner in which the IRS is undertaking to treat digital currencies for tax purposes.

In the letter, the three members noted that in March 2014, the IRS released guidance on the tax treatment of digital currencies for the first time. In IRS Notice 2014-21, which consisted of a series of “frequently asked questions” (and answers), the IRS announced that virtual currency would be treated, and taxed, as property. Among other things, this announcement meant that:

  • Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2, and are subject to federal income tax withholding and payroll taxes.
  • Payments using virtual currency made to independent contractors and other service providers are taxable and self-employment tax rules generally apply. Normally, payers must issue Form 1099.
  • The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
  • A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.

In Notice 2014-21, the IRS acknowledged that “there may be other questions regarding the tax consequences of virtual currency not addressed in this notice that warrant consideration,” and invited public comment.  Soon thereafter, the IRS stated informally that virtual currency was not reportable for purposes of the Report of Foreign Bank and Financial Accounts (FBAR), but cautioned that this position could change in the future.

In June 2016, the American Institute of CPAs (AICPA) urged the IRS to issue additional guidance on virtual currency transactions, noting ten areas left unaddressed by Notice 2014-21 and for which guidance was needed:

  • Acceptable valuation and documentation;
  • Expenses of obtaining virtual currency;
  • Challenges with specific identification for computing gains and losses;
  • General guidance regarding property transaction rules;
  • Nature of virtual currency held by a merchant;
  • Charitable contributions;
  • Virtual currency as a “commodity;”
  • Need for a de minimis election;
  • Retirement accounts, and
  • Foreign reporting requirements for virtual currency.

In September 2016, the Treasury Inspector General for Tax Administration (TIGTA) issued a report criticizing the IRS for failing to develop a “coordinated virtual currency strategy” during the two years following issuance of Notice 2014-21:

Although the IRS issued Notice 2014-21, Virtual Currency Guidance, and established the Virtual Currency Issue Team, there has been little evidence of coordination between the responsible functions to identify and address, on a program level, potential taxpayer noncompliance issues for transactions involving virtual currencies. None of the IRS operating divisions have developed any type of compliance initiatives or guidelines for conducting examinations or investigations specific to tax noncompliance related to virtual currencies. In addition, it does not appear that any of the actions already taken by the IRS to address virtual currency tax noncompliance were coordinated to ensure that the IRS maintains a strategic approach to the tax implications of virtual currencies.

TIGTA further pointed out that although the IRS solicited public comments to Notice 2014-21, the agency has taken no actions to address comments received.

In response, the IRS agreed with TIGTA’s recommendations and stated that it “plans to develop a virtual currency strategy including an assessment of whether changes to information reporting documents are warranted.” According to TIGTA, the IRS also agreed that “additional guidance would be helpful and plans to share the recommendation with the IRS’s Office of Chief Counsel for coordination with the Department of the Treasury’s Office of Tax Policy.” To date, however, no such additional guidance from the IRS regarding virtual currency has been issued.

Approximately two months later, however, the IRS issued a “John Doe” summons to Coinbase, a U.S. company that serves as a digital currency wallet where merchants and consumers can conduct transactions using virtual currencies such as Bitcoin and others. A “John Doe” summons is a relatively unknown information-gathering tool that is being used with increasing frequency by the IRS to obtain information and records about a class of unidentified taxpayers if the IRS has a reasonable belief that such taxpayers are engaged in conduct violating U.S. tax laws. Because the identities of the targeted taxpayers are unknown, the summons is denoted with a “John Doe” moniker. Expressly authorized by the Internal Revenue Code, a John Doe summons must first be approved by a federal judge before it can be served. The IRS sought to serve a summons on Coinbase because of its concern that the anonymous nature of virtual currencies like Bitcoin may allow users to engage in tax evasion and other illegal conduct:

Virtual currency, as generally defined, is a digital representation of value that functions in the same manner as a country’s traditional currency. There are nearly a thousand virtual currencies, but the most widely known and largest is bitcoin. Because transactions in virtual currencies can be difficult to trace and have an inherently pseudo-anonymous aspect, taxpayers may be using them to hide taxable income from the IRS. In the court’s order, U.S. Magistrate Judge Jacqueline Scott Corley found that there is a reasonable basis for believing that virtual currency users may have failed to comply with federal tax laws.

In an affidavit submitted to the Court in support of its application for a John Doe summons, the IRS claimed that in 2015, only 802 taxpayers reported a Bitcoin transaction on Form 8949.

The “John Doe” summons directed to Coinbase requires that company to produce records identifying U.S. taxpayers who have used its services during the years 2013 and 2015. In response, both Coinbase and one of its customers have sought to quash the summons. In March 2017, the IRS filed a petition in federal court to enforce the summons against Coinbase. Subsequently several Coinbase customers have sought to intervene in the summons enforcement proceeding anonymously. To date, the Court has not ruled on these applications, and Coinbase has not produced any records in response to the summons.

In the Congressional letter to the IRS, the authors express concern with the Coinbase summons, pointing out that the summons is estimated to affect 500,000 active Coinbase customers and would result in the production of millions of pages of transaction records. The letter further points out that “90 percent of these customers engaged in less than $10,000 in cumulative, gross transactions during the entire period requested.” Under these circumstances, the three members question whether the IRS genuinely has a reasonable belief that Coinbase customers are engaging in tax evasion:

However, we strongly question whether the IRS has actually established a reasonable basis to support the mass production of records for half of a million people, the vast majority of whom appear to not be conducting the volume of transactions needed to report them to the IRS. Based on the information before us, this summons seems overly broad, extremely burdensome, and highly intrusive to a large population of individuals. The IRS’s actions in this case also set a dangerous precedent for companies facilitating virtual currency transactions that could be subject to a similar summons.

The letter concludes by demanding that the IRS respond, by June 7, 2017, to a broad set of questions about the agency’s strategy for addressing the tax treatment of digital currencies:

1.  Please describe the IRS’s current digital currency strategy and provide any existing policies and procedures.

a.  What efforts has the IRS made to conduct industry outreach or coordination on its digital currency strategy?

b.  What, if any, industry concerns have been raised and what actions is the IRS taking to address these?

c.  How does the John Doe summons issued to Coinbase fit into the larger IRS digital currency strategy?

2.  As mentioned earlier, to issue a John Doe summons, the IRS must first establish that it has a reasonable basis to believe that the individuals may fail or may have failed to comply with internal revenue law. What is the justification for the IRS’s position that all Coinbase customer records are needed for this timeframe?

a.  When seeking this summons, what provision(s) of the IRC did the IRS believe Coinbase customers not to be in compliance with?

b.  Did the IRS consider issuing a more narrowly tailored summons? If so, what impediments existed to the IRS issuing a more narrowly tailored summons?

3.  TIGTA made three recommendations in its 2016 report referenced above. What is the current status of the IRS’s implementation of each of these recommendations and what actions have been taken to address each one?

4.  How has or will the IRS assess and take into account the compliance burdens on start-up financial technology companies as well as digital currency users (especially those engaging in light to moderate transactional use) when developing and refining its digital currency strategy?

5.  Will the IRS consider a de minimis exemption or other action to remove practical obstacles to such moderate, transactional use of digital currencies?

This letter from Congress is the latest example of criticism of the IRS’s digital currency strategy (or lack thereof). As noted above, the issuance of Notice 2014-21 was helpful in providing initial guidance in this area, but it left unanswered many more questions than it answered, as evidenced by follow-up comments from the AICPA and TIGTA. And the IRS is encountering resistance in its efforts to enforce its John Doe summons to Coinbase. The Congressional letter only adds to the growing chorus calling for the IRS to clarify this area once and for all.