As Fintech Comes of Age, Government Seeks an Oversight Role

The Beatles sang “I’m the taxman, and you’re working for no one but me.” The Internal Revenue Service is delivering that message to users of Bitcoin as it demands information from Coinbase, the largest virtual currency exchange that maintains “wallets” for holding digital value. The government wants to know about the identities of those who may be trying to hide income.

As the world of financial technology has gone from a geeky backwater to the forefront of innovation, regulators are following along by seeking a role in overseeing how the firms operate and determining who may be abusing their services. You know that fintech has come of age when the government comes knocking at the door just like it does with any other bank or broker.

Transactions in virtual currencies like Bitcoin are recorded on a public ledger, but the identity of those actually buying or selling is not available. Coinbase wallets give users a measure of anonymity that they would not have if dealing with large amounts of cash at a bank, something that has garnered the attention of the I.R.S. The inspector general for tax administration in the Treasury Department issued a report in September criticizing the agency for not developing a program to ensure that Bitcoin users were complying with the tax laws.

On Nov. 30, a federal magistrate judge in San Francisco approved a “John Doe summons” to Coinbase that requires it to identify Americans who maintained wallets transacting in virtual currencies at any time from 2013 through 2015. The company’s website says it has 4.9 million customers, so the government will be able to obtain information about a substantial number of people who have traded Bitcoin over the three years identified.

The I.R.S. uses this type of summons when it does not know the identity of the taxpayers who may have violated the law. This method means it is a civil investigation at this point, but if there are indications of large-scale tax evasion, the Justice Department could start a criminal inquiry into Bitcoin traders.

Because this type of financial information is so personal, federal law requires the I.R.S. to show a reasonable basis that an “ascertainable group” may have failed to comply with the tax laws and that the information is not readily available from other sources. Unlike an investigation of a particular individual who can challenge a summons, the I.R.S. goes into court unopposed and the judge considers only the application and any information provided to support the request, known as an ex parte proceeding.

In 2014, the I.R.S. issued a notice that virtual currencies were property, which means that every transaction may result in a capital gain or loss, depending on the value at the time of each trade. That would be like having to figure out how much a dollar was really worth on the currency market when it went into your pocket and then was used — a reporting nightmare for those who engage in a number of transactions. It is understandable that Bitcoin users would simply ignore the need to report gains and losses.

The summons to Coinbase looks to be an effort to respond to the lack of action on the virtual currency front by focusing on more nefarious uses of virtual currencies. The government submitted an affidavit from an I.R.S. agent describing information received in its investigation that indicated Bitcoin users have not properly reported transactions.

The government identified three instances of possible tax evasion to justify the broad demand for information from Coinbase, essentially pointing to these cases as the tip of an iceberg of violations. One individual started using virtual currencies after offshore banks became too cumbersome to hide assets, the government said. Two companies tried to evade paying taxes by designating transactions in Bitcoin as “technology expenses” to make them appear to be just ordinary costs of doing business.

Needless to say, Coinbase is unhappy about having to turn over information about its customers. A statement issued in response to the filing for the John Doe summons says “we are extremely concerned with the indiscriminate breadth of the government’s request. Our customers’ privacy rights are important to us,” vowing to “oppose the government’s petition in court.”

The information sought is not outside the norm for this type of sweeping investigation. In 2014, a federal district judge in Manhattan issued a summons for records from FedEx, DHL and United Parcel Service for information about deliveries from 2005 to 2013 from an offshore firm that helped Americans avoid paying taxes. In 2015, a Miami federal district judge issued a summons to Bank of America and Citibank for almost nine years of records from correspondent accounts they maintained on behalf of a bank in Belize that was used to shield assets.

Unfortunately, there is little Coinbase can do to resist this type of demand for information once it is approved by the court. It could refuse to provide the information and then appeal an order requiring it to comply with the summons, but the anonymity cherished by many Bitcoin users is unlikely to get much traction when there is evidence of potential tax evasion. Failing to provide the information could also result in Coinbase being found in contempt of court, which can result in substantial fines until it chooses to comply.

The I.R.S. inquiry shows how Coinbase is now important enough to draw the same kind of scrutiny as more established banks. That shift also is apparent in a new initiative by the Comptroller of the Currency, one of the federal banking regulators, that would allow fintech companies to apply for a new charter to become a “special purpose national bank.”

As The New York Times reported, the idea is to extend oversight to companies moving into services provided by traditional banks that have largely avoided direct regulation. The new type of charter could help fintech firms avoid dealing with a patchwork of laws that make expanding their businesses more difficult while extending federal regulatory oversight.

One of the crucial requirements for any bank or broker is compliance with the strict rules against money laundering, especially the “know your customer” requirement that largely prevents secret accounts and untraceable transactions. An interesting question is whether companies like Coinbase that provide a repository for virtual currencies will migrate toward becoming more like banks or stock brokerages that would remove the anonymity they now provide to users of their services.

The key to the tax system is identifying taxpayers who may be trying to skirt reporting requirements. Virtual currency and the fintech industry as a whole have grown outside the traditional regulatory system, but their size and emerging importance mean that more oversight is on the doorstep.

When your client base is large enough for the taxman to go on a fishing expedition to see who is using your services, you have truly come of age. Whether that attention is welcome is another issue.