The 10,000 bitcoins that seven years ago famously paid for the delivery of two Papa John’s pizzas would be worth more than $74 million today.

The exploding value of the cryptocurrency since its first real-world transaction in 2010 is one reason the Internal Revenue Service is pushing to see records on thousands of users of Coinbase Inc., one of the biggest U.S. online exchanges. The company’s digital currency platform allows gains to be converted into old-fashioned dollars in transactions that the IRS alleges are going unreported.

Coinbase and industry trade groups are fighting back in court, claiming the government’s concerns about tax fraud are unfounded and that its sweeping demand for information is a threat to privacy.

Bitcoin tokens
Chris Ratcliffe/Bloomberg

The IRS persuaded a San Francisco federal judge last year to order Coinbase to turn over customer records from 2013 to 2015 for its investigation into whether taxpayers failed to report income. On Thursday, the IRS is scheduled to be back before U.S. Magistrate Judge Jacqueline Scott Corley to ask her to enforce the order that Coinbase has so far defied, even after the government scaled back its request.

"U.S. taxpayers, including Coinbase users, have made use of virtual currencies to avoid the reporting and payment of taxes," the IRS argued in a court filing. The agency said it needs access to customer records to “gain some degree of visibility into a space where it is already necessarily moving about somewhat in the dark."

Law Enforcement

The government argues that bitcoin transactions are also a law enforcement concern because they’re anonymous and hard to track, making the currency popular for money laundering, cyber criminals’ ransom demands and terrorist financing.

Founded in 2012, San Francisco-based Coinbase says it has 12.2 million users, deploying 41 million virtual currency wallets in 32 countries that have so far exchanged $40 billion in digital currency. Its website touts lofty ambitions—an “open financial system” that “can be a great equalizer and lift billions out of poverty while accelerating the pace of innovation around the world.”

The eye-popping surge in the value of bitcoin is a boon for Coinbase, which added more than 100,000 users Nov. 2 in a 24-hour period after CME Group Inc.’s announcement that it plans to introduce bitcoin futures by the end of the year.

Coinbase is asking Corley to reject the IRS summons for customer account information—or at the least, to make the agency produce evidence to show that its inquiry serves a real enforcement purpose.

‘Tough’ Facade

The company argues the IRS is putting on a “tough” facade to appease critics in Congress and elsewhere in the absence of fully developed tax policy and regulations governing digital currencies.

Even after the IRS agreed in July to narrow its summons, which initially sought records on all Coinbase customers, the agency still seeks information for 8.9 million transactions and 14,355 account holders, which is unreasonably broad, the company said in a court filing.

“The IRS is engaging in a massive fishing expedition, hoping to find some evidence of tax avoidance so that the IRS may quiet its critics in Washington, D.C., and justify this misguided adventure,” Coinbase said.

The Digital Currency and Ledger Defense Coalition is supporting Coinbase. It told the judge the current summons is “undoubtedly the first of many to come for the bitcoin industry.”

‘Dangerous’ Precedent

“Granting the summons sets a dangerous precedent for the IRS to thwart technological innovation, strip consumers of their data privacy rights, and discourage individuals from engaging in an otherwise legal activity,” the advocacy group said in a filing.

The IRS said it detected a “reporting gap” between the 500,000 virtual currency users Coinbase reported between 2013 and 2015 and the less than 900 bitcoin users reporting gains or losses for each of those years.

According to a 2014 IRS rule, virtual currencies that can be converted into traditional currency are property for tax purposes. Taxpayers can have a gain or loss depending on the cost, or tax basis, according to the agency.

The IRS said it agreed to narrow its summons after finding that user activity levels were “less vigorous than anticipated.” In a July 6 filing, the agency said it only wants information on users involved in transactions of at least $20,000.

A Justice Department spokeswoman and Coinbase spokesman declined to comment ahead of Thursday’s hearing.

The case is U.S. v. Coinbase, 17-01431, U.S. District Court, Northern District of California (San Francisco).

—With assistance from Olga Kharif

Bloomberg News