Section 1256 generally requires that certain contracts, including “currency contracts,” be marked to market annually. The Internal Revenue Service (IRS) has long maintained that foreign currency options are not foreign exchange contracts subject to Section 1256. Although the IRS has issued various notices and advanced its position in a litigation, it has not issued regulations under Section 1256 to support its position. However, the IRS has received mixed responses from the courts. To this end, in Wright v. Commissioner, 809 F.3d 877 (6th Cir. 2016), the 6th Circuit ruled in favor of the taxpayer, rejecting the IRS’ position. But in doing so, he suggested he would have achieved a different result if the IRS had issued regulations providing that currency options are not subject to Section 1256.
The draft regulations released July 6 respond to the 6th Circuit’s comment and specifically provide that for the purposes of Section 1256, currency options are not treated as currency contracts. The proposed regulations are proposed to apply to contracts entered into on or after the date that is 30 days after the date the final regulations are published in the Federal Register, but as noted above, the proposed regulations reflect the current position of the IRS on the application of Section 1256 to foreign currency options, so according to the IRS it is not a change in the law.
As a backdrop, Section 1256 generally provides that taxpayers who hold a “Section 1256 contract” must mark those contracts to market on the last day of the taxation year and therefore recognize the gain or loss. A “Section 1256 contract” includes non-stock options and “any foreign currency contract”, which is defined as a contract (1) that requires delivery or whose settlement depends on the value of a currency which is a currency in whose positions are also traded through regulated futures contracts, (2) which is traded on the interbank market and (3) which is entered into at arm’s length at a price determined by reference at the interbank market price.
The IRS’ position on foreign currency options stems from its opposition to so-called “major-minor” transactions. These transactions involve a taxpayer buying call and put options in a foreign currency in which regulated futures are traded (the primary currency) and selling call and put options in a foreign currency in which regulated futures contracts are not traded (the secondary currency). The taxpayer would treat major positions as foreign exchange contracts under section 1256 and minor positions as not subject to section 1256. The taxpayer would sell the major currency option purchased with an embedded loss to a charity , and the charity would assume the compensating taxpayer’s written minor currency option. The taxpayer would treat the disposal as a mark-to-market event under section 1256, requiring the taxpayer to recognize the loss, and would treat the assumption by the charity as a non-recognition event under which the taxpayer did not report the gain on the offsetting minor position.
The IRS objected to these transactions, arguing that a foreign currency option does not require the delivery of a foreign currency or whose settlement depends on the value of a foreign currency (that’s to say, the first requirement above) because such an option is a one-sided contract that does not require delivery or settlement until the option is exercised, which may never occur. In addition, the IRS has identified these transactions as listed transactions in Notice 2003-81.
To strengthen the position of the IRS regarding the interpretation of the term “foreign exchange contract”, the proposed regulations explicitly limit the term “forward exchange contract” to include only “forward contracts” (the current wording of the law limits the term to contracts). The other three requirements described above are generally retained in the draft regulations. The effect of this change is to consolidate the position of the IRS that foreign currency options are excluded from the definition of a “foreign exchange contract” and therefore from the application of section 1256, except unless the foreign exchange option otherwise qualifies as a contact under section 1256, for example, as a non-equity option. The IRS noted that the change “clarifies” that a foreign exchange contract must not include forward currency options, indicating that the IRS does not view the proposed regulations as a change in law.
As noted above, the regulations are proposed to apply to contracts entered into on or after the date that is 30 days after the date the final regulations are published in the Federal Register, but a taxpayer may rely on the regulations proposed for tax years ending on or after July 6, 2022, if the taxpayer and its related parties consistently follow the proposed regulations for all contracts entered into during the tax year ending July 6, 2022, or thereafter until the proposed effective date of the final regulations.
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