The U.S. dollar has risen in recent years against many other currencies. This in turn has squeezed the overseas profits of, and otherwise created negative foreign currency exposure for, U.S.-based multinationals, while providing a lucrative playing field for foreign currency trading specialists.
Hedging strategies and derivatives may be used to manage foreign currency exposure. One such strategy is foreign currency straddles, which, however, may carry hidden tax issues. Under the Internal Revenue Code, straddles are not viewed per se as a tax-avoidance strategy but rather as investments that can be entered into with the intent to earn profits as part of legitimate business transactions. Because of the potential for abusive transactions, however, Congress has enacted specific rules governing the tax consequences of entering into straddles. These provisions (Sec. 1092) govern certain aspects of the timing and character of income or loss recognized through straddle transactions. Foreign currency transactions raise complex tax issues that taxpayers must address to withstand an IRS challenge. With a focus on a foreign currency straddle transaction example, this article discusses the scope and application of Secs. 1092, 1256, and 988.
Not all straddles are designed to shield investors from economic consequences. In fact, an investor can construct a straddle that will yield a profit if the investor has correctly predicted future price movements. For example, a commodity futures straddle may involve simultaneously holding a long position in a commodity for one delivery month and a short position in the same commodity for a different month. The "spread" refers to the difference in price between the commodity futures contracts for the two delivery months. How the spread widens or narrows affects the profit or loss of a commodity futures straddle. Whether the spread widens or narrows depends on the relative movements of the prices between the two delivery months of the straddle.
Several factors can affect the movement of the spread. A significant factor that affects the amount of the spread between delivery months is the estimated carrying charges, or the costs associated with taking delivery of a commodity in the nearby month and holding it until the distant month. Other factors in the commodities futures markets that affect the movement of a spread include economic conditions, expectations of the size of a pending crop, weather conditions, political factors, demand, and merchandising considerations. These factors can cause a spread to be wider or narrower than the amount of the estimated carrying charges.1
Investors also can use straddle transactions as part of a larger trading strategy. For example, an arbitrage is the simultaneous purchase in one market and sale in another with the expectation of making a profit on price differences in the different markets. An arbitrage of a U.S. Treasury bond (T-bond) straddle against a straddle involving bonds of the Government National Mortgage Association, or Ginny Mae, involves the purchase of Ginny Mae contracts and simultaneous sale of T-bond contracts for settlement on the same date, entered into simultaneously with the sale of Ginny Mae contracts and purchase of T-bond contracts for settlement a given number of months later. Fluctuations in the spreads between these two markets will result in a net gain or loss in the entire position.2 Because a loss on one leg of a straddle is accompanied by a gain on the other leg, a straddle has less risk than an individual, or open, position. Similarly, a balanced straddle has less risk than an unbalanced straddle. Due to the differences in risk, the margin requirements for straddles are frequently less than those for open positions.Arbitrage Trading Strategies in Foreign Currencies
Every taxpayer and virtually every separate business enterprise will be regarded as operating in a principal currency, called the "functional currency." Sec. 985(b)(1)(A) states the general rule that the functional currency for tax purposes will be the dollar. The special rules in Secs. 985-989 provide rules for dealing with various circumstances in which a taxpayer or business enterprise acquires or uses currencies other than the functional currency in some way. The rules provide methods for determining when a taxpayer will recognize gains and losses with respect to nonfunctional currencies for tax purposes and for determining the character and source of any such gains and losses.
Arbitrage trading strategies typically call for the purchase and sale of very large notional amount derivative contracts where the risk of loss is reduced (but not eliminated) by entering into positions in a manner that substantially reduces outright foreign exchange risks. Such positions generally are referred to in the financial markets as straddles. A foreign currency arbitrage trading strategy may employ several major currencies, including currencies of the industrialized nations for which there are regulated futures contracts, as well as the currencies of smaller nations. Currencies such as the euro, British pound, and Swiss franc, for which regulated futures contracts are available ("major currencies"), are employed, as well as the currencies of smaller nations ("minor currencies") for which there are no regulated futures contracts traded on an exchange.
Example: A trade may consist of two forward contracts, a long forward contract to purchase a specified amount of Danish krone (DKK) for a specific amount of U.S. dollars (USD), and the other a short forward contract, of shorter maturity and a different strike price, to sell a specified amount of DKK for a fixed amount of USD. The functional currency of the client is the U.S. dollar, and the forward contracts are investments. The short forward contract is also in a smaller notional amount than the long forward contract.
Each contract is referred to as a forward contract, and each pairing of short and long forward contracts is referred to as a combined transaction. This combined transaction requires a small capital commitment but profits if (1) DKK increases in value compared with the USD, (2) DKK interest rates drop, or (3) the DKK yield curve flattens relative to the USD yield curve. Conversely, if exchange rates or interest rates move in the opposite direction, the combined transaction will decrease in value. All the currencies that the client has traded in, and in which it will trade, are actively traded in the interbank currency markets. The client enters into forward contracts in the over-the-counter market to execute the arbitrage strategy because that market is more liquid and provides tighter bid-ask spreads compared with foreign currency transactions on regulated futures exchanges.
A position in a forward contract may be terminated by contacting the counterparty and negotiating a termination payment. Alternatively, a new forward contract may be entered into with the counterparty to neutralize any further risk of loss or opportunity for gain with respect to the original forward contract. Entering into such a neutralizing forward contract will not terminate the initial forward contract. Each party remains legally bound under the original contract. Further, the new contract will not have terms identical to the original contract, since each forward contract will be based on prevailing exchange rates and interest rates on the date it is negotiated. The client does not intend under any circumstances to take delivery of the foreign currency underlying any of the forward contracts. Instead, all forward contracts will be cash-settled.
Interaction With Code Provisions
Because of the complexity of the tax treatment of foreign currency derivatives and offsetting financial instruments, a trader or company should be concerned with the income tax treatment of the transactions used to implement the arbitrage trading strategy. In particular, a trader or company is likely to hold many positions with unrealized but hedged losses. Specifically, the issue arises of whether the trader or company is entitled to deduct embedded losses when these positions are closed. Secs. 1092, 1256, and 988 (each described below) and 263(g) (which disallows a current deduction of certain interest and carrying costs of personal property that are part of a straddle under Sec. 1092) may apply to any or all parts of such transactions. The interaction of Secs. 1092 and 988 is of particular interest.Sec. 1092 Straddle Rules
In general, the Code defines a straddle as "offsetting positions with respect to personal property,"3 where the positions are offsetting because holding one position provides a "substantial diminution" of the risk of loss from holding the other position.4 For this purpose, personal property is limited to property of a type that is actively traded,5 and the term "position" means "an interest (including a futures or forward contract or option) in personal property."6 Rules in Sec. 1092(c)(3) describe six circumstances under which straddle positions will be presumed to be offsetting:
- the positions are in the same personal property (whether established in such property or a contract for such property),
- the positions are in the same personal property, even though such property may be in substantially altered form,
- the positions are in debt instruments of a similar maturity or other debt instruments described in regulations prescribed by the [IRS],
- the positions are sold or marketed as offsetting positions (whether or not such positions are called a straddle, spread, butterfly, or any similar name),
- the aggregate margin requirement for such positions is lower than the sum of the margin requirements for each such position (if held separately), or
- there are such other factors (or satisfaction of subjective or objective tests) as the [IRS] may prescribe by regulations as indicating that that such positions are offsetting.
For purposes of these rules, two or more positions are treated as described in circumstance 1, 2, 3, or 6 only if the value of one or more of such positions ordinarily varies inversely with the value of one or more other such positions.
Generally, if two or more positions qualify as a straddle, a taxpayer cannot deduct a loss realized by disposing of one of the positions to the extent there is unrecognized gain in the position the taxpayer still owns.7 Moreover, if a taxpayer has not held property that is part of a straddle for at least one year before establishing the straddle, the holding period for such property will be reset to zero and will not start until that property is no longer part of a straddle (e.g., when the offsetting position is terminated). Finally, the taxpayer cannot deduct any costs, such as interest, incurred to purchase or maintain the positions making up the straddle. Instead, the taxpayer capitalizes such costs and may only use them to reduce the gain recognized when the profitable side of the straddle is sold.8
In the example, the forward contracts are individually negotiated agreements and are not property of a type that is actively traded. Thus, the forward contracts will not be treated as personal property for purposes of the straddle rules. However (as noted above), forward contracts are positions in personal property.9 Further, foreign currencies for which there is an active interbank market are presumed to be actively traded.10 Therefore, for purposes of the straddle rules, the forward contracts will be positions in actively traded personal property. Both forward contracts that constitute a combined transaction will be positions in the same type of personal property, the foreign currency involved. Further, the value of the forward contract positions in a combined transaction most often will vary inversely (although they will not be perfectly correlated). Thus, each forward contract in a combined transaction will reduce the risk of loss from holding the other forward contract. Therefore, the forward contracts that constitute any combined transaction will more likely than not constitute a straddle potentially subject to the loss deferral and expense capitalization rules described above.
Sec. 1256 Mark-to-Market Rules
A Sec. 1256 contract is marked to market at the end of each tax year—i.e., a taxpayer must treat each Sec. 1256 contract as if sold at the end of the year for its fair market value (FMV), and any gain or loss must be taken into account for that year.11 Thus, to the extent the taxpayer holds forward contracts that constitute Sec. 1256 contracts at the end of the last business day of its tax year, those Sec. 1256 contracts will be treated as sold for their FMVs. Additionally, when a taxpayer terminates a Sec. 1256 contract position during the year, the contract is marked to market.12 This treatment is required if a taxpayer (1) offsets a Sec. 1256 position, (2) makes or takes delivery under a Sec. 1256 contract, (3) exercises or is exercised on a Sec. 1256 option position, (4) makes or is the recipient of an assignment under a Sec. 1256 option, or (5) closes a position by lapse or otherwise.13
A Sec. 1256 contract is defined as any of the following types of contracts: (1) any regulated futures contract, (2) any foreign currency contract, (3) any nonequity option, (4) any dealer equity option, or (5) any dealer securities futures contracts.14 For this purpose, a foreign currency contract is a contract that (1) requires delivery of, or the settlement of which depends on the value of, a foreign currency in which positions are also traded through regulated futures contracts; (2) is traded in the interbank market; and (3) is entered into at arm's length at a price determined by reference to the price in the interbank market.15 A forward contract based on any major currency will meet these three criteria and thus will constitute a Sec. 1256 contract.
A forward contract in any minor currency (shown in the example) will not be a Sec. 1256 contract because no regulated futures contracts in any minor currency trade on any exchange. Thus, any forward contracts constituting a combined transaction in a minor currency will not be subject to Sec. 1256 or to any other mark-to-market requirement. Therefore, in the example, the client will not recognize any gain or loss on any such contracts in effect at the end of the client's tax year under a mark-to-market system. Instead the client only will recognize gain or loss on the sale, exchange, or termination of these forward contracts.16
Sec. 1256(a)(4) provides that if all of the offsetting positions of a straddle consist of Sec. 1256 contracts (and such a straddle is not part of a larger straddle), Secs. 1092 and 263(g) do not apply with respect to the straddle. A combined transaction in major currencies will constitute a straddle that consists of Sec. 1256 contracts. Assuming that a combined transaction consisting of Sec. 1256 contracts is not part of a larger straddle entered into by the client, Sec. 1092 and Sec. 263(g) will not apply to such a combined transaction.Sec. 988
In general, Sec. 988 provides that gain or loss with respect to "Sec. 988 transactions" is treated as ordinary income or loss. Sec. 988 transactions are certain specified transactions in which the taxpayer either receives or pays amounts in a nonfunctional currency, and the definition of Sec. 988 transactions specifically includes forward contracts.17 Limited provisions to elect out of Sec. 988 treatment include: (1) Sec. 988(a)(1)(B), an election that applies to certain forward and other contracts that are not part of a straddle and that are capital assets in the taxpayer's hands, and (2) Sec. 988(c)(1)(E), which applies to certain qualified funds electing to treat as capital in character all gains and losses from trading in forward contracts.
Therefore, absent a specific exception or election out of Sec. 988 treatment, it is clear that the client in the example should treat the minor foreign currency contracts at issue as Sec. 988 transactions and that gain and loss relating to such transactions should be ordinary in character. To the extent the transactions form part of a straddle under Sec. 1092, a taxpayer could be limited in its ability to realize losses for tax purposes until the taxpayer realizes the gain portion of the straddle.18 However, neither Sec. 1092 nor Sec. 988 requires or permits a taxpayer to mark to market loss positions that form part of a straddle unless and until the taxpayer has closed out the positions.
Recharacterization and Sec. 988
The IRS could use Regs. Sec. 1.988-2(f) in an examination to recharacterize a minor foreign currency transaction. This regulation provides:
If the substance of a transaction described in §1.988-1(a)(1) differs from its form, the timing, source, and character of gains or losses with respect to such transaction may be recharacterized by the Commissioner in accordance with its substance.
The regulations provide two examples of transactions that should be recharacterized. One involves currency swap contracts that are economically equivalent to lending transactions in U.S. dollars, and the other involves transactions that are denominated as forward currency contracts but are actually spot purchases of foreign currency (not giving rise to Sec. 988 gain or loss).19 In each example in the regulations, the substance of the transaction is economically different from the substance of a Sec. 988 transaction—that is, the economic substance of the transaction is unrelated to fluctuations in the value of nonfunctional currencies.
Unlike the transactions described in the examples in the Treasury regulation, the undisputed substance of the minor foreign currency transactions at issue in the example above is gain or loss resulting from fluctuations in the value of nonfunctional foreign currencies. The example's transactions are clearly not, for example, disguised loans or disguised spot purchases of foreign currency. Therefore, Regs. Sec. 1.988-2(f) should not apply to recharacterize the example's transactions.
Regs. Sec. 1.988-1(a)(11) also does not apply to the example because the transactions do not involve an attempt to avoid the application of Sec. 988. Regs. Sec. 1.988-1(a)(11) provides that the IRS may recharacterize a transaction (or series of transactions) in whole or in part as a Sec. 988 transaction if the effect of the transaction or series of transactions is to avoid Sec. 988. The IRS also may exclude a transaction (or series of transactions) that is a Sec. 988 transaction in form from the provisions of Sec. 988 if the substance of the transaction (or series of transactions) indicates that it is not properly considered a Sec. 988 transaction.
The regulations then provide the example of an individual with a functional currency of the U.S. dollar who holds 500,000 Swiss francs, which have a basis of $100,000 and a fair market value of $400,000 as of a given date. On the next day, the individual transfers the Swiss francs to a newly formed U.S. corporation (or partnership) with the dollar as its functional currency, in a transfer that qualifies for nonrecognition under Sec. 351. On the same date as the transfer, the individual sells the U.S. corporation's stock (or partnership interest) for $400,000. Because the sale of the corporation's stock (or partnership interest) is a substitute for the disposition of an asset subject to Sec. 988, the IRS may recharacterize the sale of the stock as a Sec. 988 transaction.20
Sec. 988: No Marking to Market
In connection with the enactment of Sec. 988, Congress explicitly stated that it did not intend to provide a general mark-to-market approach for foreign currency exchange gain or loss. Furthermore, Congress explicitly provided limited authority for Treasury to provide regulations for the current accrual of exchange gain or loss in certain hedging transactions. As the legislative history makes clear, Congress expressly did not provide Treasury with broad regulatory authority to require marking to market of unrealized foreign currency gains or losses:
The Congress was not persuaded that exchange gain or loss should be currently accrued in most cases. . . . The Secretary is authorized to prescribe rules for the current accrual of exchange gain or loss in certain hedging transactions [not relevant in the example].21
In other words, Congress did not intend to give the IRS and Treasury broad discretion to require marking to market of foreign currency gains or losses. For example, the regulations specifically provide (subject to exceptions not relevant in this article's example) that exchange gain or loss with respect to foreign currency forward contracts "shall not be realized solely because such transaction is offset by another transaction (or transactions)."22 In addition, Regs. Sec. 1.988-1(e) provides:
Except as otherwise provided in these regulations (e.g., § 1.988-5), the amount of exchange gain or loss from a section 988 transaction shall be separately computed for each section 988 transaction, and such amount shall not be integrated with gain or loss recognized on another transaction (whether or not such transaction is economically related to the section 988 transaction).
The exceptions are not relevant to the example, such as the exception for certain identified hedging transactions under Regs. Sec. 1.988-5. The minor foreign currency straddles do not qualify as Sec. 988(d) hedging transactions under the regulations, which provide specific rules and exceptions for integrating separate transactions in the context of Sec. 988. In other words, the regulations under Sec. 988 explicitly require that unrealized losses on a Sec. 988 transaction not be netted against gains from another transaction, even if that transaction is "economically related" to another transaction.23Conclusion
Taxpayers often enter into foreign currency transactions and straddles based on the transactions' economic consequences without fully understanding their tax consequences. Applying tax law to foreign currency transactions requires tax practitioners to have a specialized expertise of the law in this area. Without this specialized expertise, taxpayers cannot be sure that they have properly reported foreign currency transactions on their tax returns.
1See Stoller, T.C. Memo. 1990-659, for a detailed description of such arbitrage trading.
2See Seykota, T.C. Memo. 1991-234.
8See Sec. 263(g).
9See Sec. 1092(d)(2).
10See Sec. 1092(d)(7)(B).
16Secs. 1001 and 1234A.
19See Regs. Secs. 1.988-2(f)(2)(i)-(ii).
20Regs. Sec. 1.988-1(a)(11)(ii).
21Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (JCS-10-87), at 1088 (1987).
22Regs. Sec. 1.988-2(d)(2)(ii)(A).
23Regs. Sec. 1.988-1(e).
Ray Knight is a visiting professor of practice and Lee Knight is a professor of accounting, both at Wake Forest University in Winston-Salem, N.C. For more information about this column, contact firstname.lastname@example.org.