Foreign currency contracts subject to the Sec. 1256 mark-to-market rules would be defined as only including forward contracts, under proposed regulations the IRS and Treasury issued Tuesday (REG-130675-17).
The new definition, which would be added at Regs. Sec. 1.1256(g)-2, would define a foreign currency contract within the meaning of Sec. 1256 as one that requires the delivery of, or the settlement of which depends on the value of, a foreign currency that is traded in the interbank market. The contract must also be entered into at arm's length at a price determined by reference to the price in the interbank market.
The past 38 years of developments in foreign currency trading and Sec. 1256, which provides mark-to-market tax treatment of specified contracts, indicated the need for the more specific definition, the preamble to the proposed regulations states. In addition, the proposed regulations would overrule a Sixth Circuit decision in 2016 that in effect included foreign currency options as Sec. 1256 contracts.
Congress intended, in amending Sec. 1256 in the Deficit Reduction Act of 1984, P.L. 98-369, to include cash-settled foreign currency forward contracts within that section's definition of a foreign currency contract, in addition to the section's original (1981) requirement of delivery of the currency, thus adding contracts settled by reference to the currency's value, the preamble explaines.
However, the legislative history of Sec. 1256 does not indicate Congress intended to include over-the-counter foreign currency options regardless of whether they may be cash-settled. Therefore, "it would be inconsistent with this purpose to construe the term foreign currency contract as including options or other derivatives," the preamble states.
However, the preamble notes, these other types of contracts may nonetheless be governed by Sec. 1256, which encompasses, besides foreign currency contracts, a variety of other types of instruments, some of which may involve foreign currencies.
For example, they include nonequity options, under Sec. 1256(b)(1)(C), defined at Sec. 1256(g)(5) as "any option ... which is traded on (or subject to the rules of) a qualified board or exchange." Such nonequity options may include foreign currency options, the preamble notes.
Mark-to-market treatment under Sec. 1256 means that these specified contracts are treated for tax purposes as if they were sold for their fair market value on the last business day of each tax year and any gain or loss is correspondingly taken into account for that tax year (generally, as 60% long-term capital gain or loss and 40% short-term capital gain or loss). Generally, Sec. 1256 contracts include, besides foreign currency contracts and nonequity options, regulated futures contracts, dealer equity options, and dealer securities futures contracts (all with certain exceptions) (Sec. 1256(b)(1)).
The preamble also notes that, in holding that a foreign currency option could be a foreign currency contract under Sec. 1256(g)(2), the Sixth Circuit in Wright, 809 F.3d 877 (6th Cir. 2016), rev'g T.C. Memo. 2011-292, found that the plain language of Sec. 1256(g)(2)(A) included foreign currency contracts that do not mandate settlement. The appellate court noted, however, that Treasury and the IRS "had express authority to change this result for future taxpayers" (under Sec. 1256(g)(2)(B)), the preamble stated.
The IRS also has designated as listed transactions certain transactions involving foreign currency options it considers erroneously treated as Sec. 1256(g)(2) contracts (Notice 2003-81, as modified by Notice 2007-71).
The proposed regulations would apply to contracts entered into on or after the date 30 days after the regulations are published as final in the Federal Register; the applicability date is intended to allow taxpayers in the Sixth Circuit time to transition from the holding in Wright to the proposed regulations. For contracts entered into in other circuits, "the IRS intends to continue to adhere to its prior published position that foreign currency options are not foreign currency contracts under Sec. 1256(g)(2)," the preamble states.
Taxpayers may also rely on the proposed regulations for tax years ending on or after the proposed regulations are published in the Federal Register, provided the taxpayer and its related parties consistently follow the proposed regulations for all contracts entered into during the tax year ending on or after the date the proposed regulations are published through the proposed applicability date of the final regulations.
— To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.