Currency Option Not a Contract in “Major/Minor” Shelter
The Tax Court held that a foreign currency call option is not a foreign currency contract under the plain language of the IRC § 1256 contract mark-to-market rules. Thus an unrealized loss existing on the date that a foreign currency option was transferred to a charity was disallowed.
Section 1256 requires any foreign currency contract held by a taxpayer at the end of the taxpayer’s tax year or terminated or transferred during it to be marked to market. A foreign currency contract is defined (section 1256(g)(2)(A)) as a contract that (1) involves a foreign currency that is traded through regulated futures contracts, (2) requires the settlement of the contract based on the currency’s value or the delivery of the foreign currency, (3) is traded in the interbank market and (4) is entered into at a price determined by the interbank market.
Mark Summitt was a 10% shareholder in Summitt Inc., a California S corporation. In 2002, Summitt Inc. engaged Multi National Strategies of New York City to advise it concerning the following transactions: Summitt Inc. purchased from Beckenham Trading Co. in New Jersey a 180-day call option to purchase euros from Beckenham and a 180-day put option to sell euros to Beckenham. The notional values of the options were identical, as were their strike prices, so the two options exactly offset each other. On the same date, Beckenham purchased from Summitt Inc. a pair of similarly reciprocal 180-day put and call options involving the Danish krone. Summitt and Beckenham each paid the other nearly $20 million in premiums, with a net payment by Summitt of $17,500.
Two days later, Summitt Inc. assigned its positions in the two call options to a charity. On that date the euro call option position had an unrealized loss of $1,750,535, and the krone call option position had an unrealized gain of $1,745,285. Before the end of 2002, Summitt Inc. and Beckenham closed their put options by offsetting them against each other. The taxpayers took the position that because the euro is a “major” currency traded on the interbank market, its options are section 1256 contracts that must be marked to market (allowing them to recognize a loss), and because the krone is a “minor” currency its options are not section 1256 contracts and are not marked to market (enabling them to avoid recognizing a gain).
The court noted that the two currencies’ values “historically have demonstrated a very high positive correlation with each other.” In Notice 2003-81, the Service described a similar transaction and designated it and those substantially similar as listed transactions under Treas. Reg. §§ 1.6011-4(b)(2), 301.6111-2(b)(2) and 301.6112-1(b)(2). The IRS further described it in Coordinated Issue Paper UIL 9300.31-00, issued in 2005, as a promoted tax shelter.
On its 2002 tax return, Summitt Inc. reported the loss, which flowed through to Mark Summitt and his wife, but excluded the gain. After a series of amended returns and attempted amended returns by Summitt Inc. and Mark Summitt, and a petition by the taxpayers to the Tax Court, the IRS moved for partial summary judgment to disallow the loss on the euro call option and require inclusion of the gain from the krone option.
The taxpayers argued that under the plain language of section 1256, the euro call option was a foreign currency contract. The Tax Court disagreed, noting that section 1256 clearly requires delivery of the currency or a cash settlement, but delivery or settlement will occur under a foreign currency option only if the holder exercises the option. The taxpayers further argued that Congress had added other option contracts, such as nonequity options and dealer equity options, to section 1256, thus indicating its intent to include foreign currency options. The court rejected this argument, stating the inclusion of some options but not foreign currency options implied the opposite, that Congress had not intended to include it. (Nonequity and dealer equity options must be traded on or subject to the rules of a qualified board or exchange.)
The taxpayers also argued that futures, forwards and options are all designed to deal with foreign currency risk and should be treated in the same manner. However, according to the court, these instruments have substantive economic and legal differences justifying different tax treatments. For example, the court said, unlike options, foreign currency forwards generally require delivery or cash settlement and thus could fulfill that requirement of section 1256.
The court denied the portion of the government’s motion for partial summary judgment to require recognition of the taxpayer’s gain from the transfer of the krone option, saying material issues of fact would require a trial. Nor did it address a related issue raised by the IRS and contested by the taxpayers: whether Summitt Inc. was required to recognize in income when it transferred the krone call option position to the charity the nearly $10 million premium it had received from Beckenham for it.
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.
More from the JofA:
