Statutory Language Trumps Tax Policy

By James A. Beavers, J.D., LL.M., CPA, CGMA

The Sixth Circuit held that a contract does not have to require delivery or settlement of a foreign currency to be a foreign currency contract for purposes of Sec. 1256 and, thus, a foreign currency option could be a foreign currency contract.

Background

Terry Wright and his wife, Cheryl Wright, each owned a 50% interest in an investment company called Cyber Advice LLC, which was taxed as a partnership. In December 2002, the Wrights, on the advice of a promoter, undertook what commonly is called a major/minor transaction through Cyber Advice. On Dec. 20, 2002, Cyber Advice purchased a euro put option for $36,177,750 and a euro call option with mirror-image terms from a counterparty. At the same time, Cyber Advice also sold a Danish krone call and a krone put to the counterparty on mirror-image terms.

On Dec. 23, 2002, Cyber Advice assigned the euro put option and krone put option to a charity, the Foundation for an Educated America. At the time of the assignment, the euro put option was valued at $33,018,574 and the krone put option was valued at $33,012,274. Cyber Advice also sold the euro call option to the counterparty and repurchased the krone call option from the counterparty. The Wrights took the position that they did not need to recognize the gain from the assignment of the krone put option to the charity because over-the-counter options on minor foreign currencies such as the krone were not Sec. 1256 contracts to which mark-to-market accounting applied. The Wrights also took the position that recognition of a short-term capital loss from the assignment of the euro put option to the Foundation for an Educated America was proper because the euro put option was a "foreign currency contract" subject to Sec. 1256 and thus the assignment resulted in a termination under Sec. 1256(c). The Wrights reported a $2,970,822 flowthrough loss on their return, which aided in reducing their other capital gains of more than $3.4 million to $454,477.

On examination, the IRS concluded that the Wrights could not claim the capital loss passed through from Cyber Advice because the euro put option was not a foreign currency option subject to the Sec. 1256 mark-to-market rules and issued a notice of deficiency for $603,093. The Wrights subsequently petitioned the Tax Court, contesting the IRS's determination.

The determination of whether the euro put option was a foreign currency contract is based on Sec. 1256(g)(2)(A), which states:

(A) Foreign currency contract. The term "foreign currency contract" means a contract—

(i) which requires delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts,

(ii) which is traded in the interbank market, and

(iii) which is entered into at arm's length at a price determined by reference to the price in the interbank market.

Tax Court's Decision

The Tax Court held, as it had in two other major-minor transaction cases, that an option such as the Wrights' euro option was not subject to mark-to-market accounting because it was not subject to Sec. 1256. The Tax Court explained that a foreign currency option is not subject to Sec. 1256 because a foreign currency option does not require delivery or settlement "unless and until" the holder exercises the option and consequently did not meet the "delivery" or "settlement" requirement under Sec. 1256(g)(2). The Tax Court stated, citing Summitt, 134 T.C. 248 (2010), that it was "clear" that the statute as originally enacted applied only to forward contracts, which require delivery of the foreign currency. In addition, the phrase "or the settlement of which depends on the value of" was added to Sec. 1256 to allow cash-settled forward contracts to come within the term "foreign currency contract." Thus, Sec. 1256(g)(2)(A)(i) mandated that a "foreign currency contract" requires settlement at expiration. The Wrights, feeling they had been wronged, appealed to the Sixth Circuit.

The Sixth Circuit's Decision

The Sixth Circuit reversed the Tax Court and held that the euro put option was a foreign currency contract and that the Wrights were entitled to the loss on its assignment to the charity. The court found that although it appeared that sound tax policy supported the Tax Court's position, it was nonetheless in conflict with the plain language of Sec. 1256.

The court determined that the plain language of Sec. 1256 does not provide that a "foreign currency contract" must require either a "delivery" or a "settlement." Rather, the statute provides that a "foreign currency contract" is (1) "a contract . . . which requires delivery of . . . a foreign currency" or (2) "a contract . . . the settlement of which depends on the value of . . . a foreign currency." Thus Sec. 1256(g)(2)(A)(i) provides that a contract "the settlement of which depends" on the value of a foreign currency is a "foreign currency contract," even if that contract does not mandate that any such settlement occur.

According to the court, to interpret Sec. 1256(g)(2)(A)(i), as the Tax Court had, as a unified provision requiring a settlement to qualify as a foreign currency contract, one would have to read the statute to state that a "foreign currency contract" is (1) "a contract . . . which requires . . . delivery of . . . a foreign currency" or (2) "a contract . . . which requires . . . the settlement of which depends on the value of, a foreign currency." The court found that such a reading was inconsistent with the plain language of the statute because the phrase "a contract . . . which requires . . . the settlement of which depends on the value of, a foreign currency" is syntactically incoherent. Further, the court found that, contrary to the IRS's assertion, the inclusion in Sec. 1256 of a rule that applies to the cash settlement of a contract does not make it "implicit" that a settlement of the contract must actually occur. Instead, Sec. 1256 provides that if a settlement of a "foreign currency contract" does occur, any such settlement must depend on the value of a foreign currency.

The Sixth Circuit freely admitted that sound tax policy did not appear to support the plain language interpretation it was espousing, under which the Wrights were able through the major-minor transaction to create a large tax loss by making a relatively small out-of-pocket outlay. However, the court noted that if Congress had wanted to provide a different result, it could have easily done so by making a small modification in the language of Sec. 1256(g)(2)(A)(i). Also, the court stated that the IRS could prevent the result reached in the case by issuing a regulation that excludes foreign currency options from the definition of foreign currency contract. In addition, according to the court, the IRS might well be able to successfully challenge a transaction such as the Wrights' on economic substance grounds.

Reflections

It would appear fairly clear from the legislative history that the Tax Court's interpretation of Sec. 1256(g)(2)(A)(i) is consistent with congressional intent for the statute. Regardless, as the Sixth Circuit observes, the purported intent does not match up with the statute's actual language. Although courts frequently seem to ignore the plain language of tax statutes, the Sixth Circuit refrained from doing so, stating it believed that the IRS could deal with the problem through regulations or use of the economic substance doctrine and that if the court attempted to reform Sec. 1256, it might unintentionally lead to other tax-avoidance schemes.

Wright, No 15-1071 (6th Cir. 2016)

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