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In re Tax Liabilities of Does

United States District Court, N.D. California

November 17, 2016

IN THE MATTER OF THE TAX LIABILITIES OF JOHN DOES, United States persons who, at any time during the period January 1, 2013, through December 31, 2015, conducted transactions in a convertible virtual currency as defined in IRS Notice 2014-21.

          CAROLINE D. CIRAOLO Principal Deputy Assistant Attorney General

          JEREMY N. HENDON AMY MATCHISON Trial Attorneys, Tax Division U.S. Department of Justice

          BRIAN J. STRETCH United States Attorney Northern District of California

          COLIN C. SAMPSON Assistant United States Attorney, Tax Division

          UNITED STATES' MEMORANDUM IN SUPPORT OF EX PARTE PETITION FOR LEAVE TO SERVE JOHN DOE SUMMONS

         The United States of America submits this memorandum in support of its petition for an order approving the service of an Internal Revenue Service “John Doe” summons on Coinbase, Inc. for information related to transactions conducted in convertible virtual currency as defined in IRS Notice 2014-21. Pursuant to 26 U.S.C. § 7609(h)(2), the Court's determination to approve a John Doe summons shall be made ex parte and shall be made solely on the petition and supporting affidavits. Thus, the pleadings filed in this proceeding will not be served upon any person or entity and no other filings are permitted from other persons or entities. Accordingly, this matter is ripe for the Court's consideration. The United States requests that the Court review the petition and supporting documents and enter the proposed order at the Court's earliest opportunity.

         INTRODUCTION

         The IRS is responsible for monitoring ways in which United States taxpayers evade their United States tax obligations by concealing or otherwise failing to report their proper amount of taxable income and thus underpay their taxes. The ever-changing digital age and innovation pose new risks for the IRS and tax compliance by United States taxpayers. One such innovation is the creation of virtual currency which, unlike U.S. dollars or other government-issued currencies, does not have a physical coin or bill associated with their circulation and is not owned by any government.

         Since 2009, the use of virtual currency has increased exponentially. Some users value the relatively high degree of anonymity associated with virtual currency transactions because only a transaction in virtual currency, such as buying goods or services, is public and not the identities of the parties to the transaction. Because of that, virtual currency transactions are subject to fewer third-party reporting requirements than transactions in conventional forms of payment. However, due to this anonymity and lack of third-party reporting, the IRS is concerned that U.S. taxpayers are underreporting taxable income from transactions in virtual currencies. Further, because the IRS considers virtual currencies to be property, United States taxpayers can realize a taxable gain from buying, selling, or trading in virtual currencies. There is a likelihood that United States taxpayers are failing to properly determine and report any taxable gain from such transactions.

         In order to identify taxpayers who have may have underpaid taxes associated with transactions in virtual currency, the United States brings this ex parte proceeding under § 7609(f) and (h) of the Internal Revenue Code (26 U.S.C.) for leave to serve a John Doe summons on Coinbase. The John Doe summons seeks records relating to transactions in convertible virtual currency as defined in IRS Notice 2014-21. See Declaration of Senior Revenue Agent Davide Utzke in Support of Ex Parte Petition for Leave to Serve “John Doe” Summons (“Utzke Decl”) Exhibit B. The John Does whose identities are sought by the summons are United States persons who, at any time during the period January 1, 2013, through December 31, 2015, conducted transactions in a convertible virtual currency. The issuance of the summons is warranted here because (i) the summons relates to an ascertainable group or class of persons; (ii) there is a reasonable basis for believing these U.S. taxpayers failed to comply with internal revenue laws; and (iii) information sufficient to establish these U.S. taxpayers' identities is not readily available to the IRS from other sources.

         BACKGROUND

         A. What virtual currency is and how it works

         Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. Utzke Decl. ¶ 7. In some situations, virtual currency operates like “traditional currency, ” i.e., the coin and paper money of a country that is designated as legal tender. However, it does not have legal tender status in any jurisdiction. Id. A virtual currency is considered “convertible” if it has an equivalent value in traditional currency or acts as a substitute for traditional currency. Convertible virtual currency can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other traditional or virtual currencies. Id.

         In order to transact in a virtual currency system, a user would need to create a “wallet.” A wallet is a digital computer file that contains information necessary to send and receive units of a virtual currency. Id. at ¶ 8. When the wallet is created, a random wallet address is generated; this is a unique alphanumeric identifier, which is conceptually similar to an e-mail address. Id.

         A wallet holds any number of public keys and their associated private keys. The public key and private key are conceptually similar to a user ID and a digital signature, respectively. In order to exchange units of a virtual currency, a virtual currency user needs to electronically send their public key to anyone with whom they want to transact. Id. at ¶ 9. The public key contains information that verifies the wallet and the private key is used to authenticate a transaction. Only once the transaction is signed by both parties, is the transaction complete. A completed transaction is then introduced to a network of computers monitored by competing groups of people called miners. After computers on the network confirm that a transaction is authentic, the transaction is posted to a “block” - a grouping of transactions. When a specified number of confirmed transactions have been grouped, a block is formed. Id. at ¶ 11. Miners then compete against each other to find a solution to a mathematical puzzle that depends on the contents of the block; once a solution is found, that block will be added to the blockchain.

         Miners maintain the integrity of the blockchain: a sequential public list of all transactions. Miners also validate transactions that go into the blockchain with the motive of earning virtual currency. Id. When a new block is added to the blockchain, new virtual currency coins are generated and awarded to the miner who discovered the mathematical puzzle solution that allows the new block to be added to the blockchain. The cycle then repeats. Id.

         All transactions in a virtual currency blockchain can be viewed by the public on any computer connected to the Internet. However, the blockchain transactional history only reveals the date, the time, the amount (denominated in virtual currency), and the wallet addresses associated with a transaction. The blockchain does not identify the actual identities of the wallet owners. Id. at ¶ 12.

         There are nearly a thousand virtual currencies, but the most widely known virtual currency, and largest by capitalization, is bitcoin. Other virtual currencies mimicking bitcoin using the blockchain technology are known as alternative coins or altcoins for short. Just a few examples of altcoins are Ethereum, Litecoin, Ripple, Feathercoin, and Dogecoin. Id. at ¶ 13.

         B. How virtual currency can be obtained and used

         In order to buy virtual currency with a medium of exchange denominated in a traditional currency, such as a conventional check, credit card, wire, or Automated Clearing House (ACH) electronic payment, a virtual currency user will have to find some way to transfer traditional currency to someone who already has virtual currency and wishes to exchange it for traditional currency. Id. at ΒΆ 14. In theory, this could be anyone with a virtual currency; in practice, this tends ...


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