Currency contracts subject to Sec. 1256 mark-to-market rules would be defined as including only futures contracts, according to proposed regulations from the IRS and Treasury released Tuesday (REG-130675-17).
The new definition, which would be added to O. Reg. Second. 1.1256(g)-2, would define an exchange contract within the meaning of Sec. 1256 as requiring delivery or whose settlement depends on the value of a foreign currency traded in the interbank market. The contract must also be concluded under arm’s length conditions at a price determined by reference to the interbank market price.
The last 38 years of developments in foreign currency trading and Sec. 1256, which provides tax treatment at the market price of specified contracts, indicated the need for a more precise definition, the preamble to the proposed regulations states. Additionally, the proposed settlement would reverse a Sixth Circuit ruling in 2016 that actually included foreign currency options like Sec. 1256 contracts.
Congress intended, by amending s. 1256 in the Deficit Reduction Act of 1984, PL 98-369, to include cash-settled forward foreign exchange contracts within the definition of a foreign exchange contract in this section, in addition to the original requirement (1981 ) delivery of the currency, thus adding contracts settled by reference to the value of the currency, explains the preamble.
However, the legislative history of s. 1256 does not indicate that Congress intended to include OTC currency options, whether or not they were settled in cash. Therefore, “it would be inconsistent with this purpose to interpret the term foreign exchange contract to include 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, in addition to currency contracts, a variety of other types of instruments, some of which may involve foreign currencies.
For example, they include equity-free options, under Sec. 1256(b)(1)(C), defined in s. 1256(g)(5) as “any option…that is traded on (or subject to the rules of) a qualified board or exchange.” These non-stock options may include foreign currency options, notes the preamble.
Treatment at market price under Sec. 1256 means that these specified contracts are treated for tax purposes as if they had been sold at fair market value on the last business day of each tax year and any gain or loss is taken into account accordingly for that tax year. (generally 60% long-term capital gain or loss and 40% short-term capital gain or loss). Usually dry. 1256 contracts include, in addition to foreign exchange and non-equity options, regulated futures, broker stock options and broker stock futures (all with certain exceptions) (Sec. 1256( (b)(1)).
The preamble also notes that in holding that a currency option could be a currency contract under Sec. 1256(g)(2), the Sixth Circuit in Wright, 809 F.3d 877 (6th Cir. 2016), rev’g TC Memo. 2011-292, concluded that the plain language of Sec. 1256(g)(2)(A) included foreign currency contracts that do not require settlement. The appeals court, however, noted that the Treasury and the IRS “had the express authority to alter this outcome for future taxpayers” (under section 1256(g)(2)(B)), the court says. preamble.
The IRS has also designated as listed transactions certain transactions involving foreign currency options that it incorrectly considers to be treated as Sec. Contracts 1256(g)(2) (Notice 2003-81, as amended by Notice 2007-71).
The proposed rule would apply to contracts entered into on or after the date of 30 days following the final publication of the rule in the Federal Register; the applicability date is intended to give Sixth Circuit taxpayers time to transition from holding in Wright to the proposed settlement. For contracts entered into in other circuits, “the IRS intends to continue to adhere to its previously published position that currency options are not currency contracts under section 1256(g) (2)”, reads the preamble.
Taxpayers may also rely on proposed regulations for taxation years ending on or after the date the proposed regulations are published in the Federal Registerprovided that 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 of publication of the proposed regulations up to the date of applicability proposed final settlements.
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