Multinational corporations conducting business in foreign countries often enter into foreign currency derivatives to hedge their exposure with respect to anticipated acquisition or disposition of nonfunctional currency (i.e., generally a currency other than the currency in which the corporation keeps its books). Multinationals may manage this risk between affiliates rather than entering into foreign currency derivatives with third parties.
For certain foreign currency derivatives, such as a foreign currency forward contract, Sec. 1256 provides special timing rules. Whether those rules under Sec. 1256 apply to a foreign currency derivative depends on the definition of “foreign currency contract.” The stakes for multinational corporations can be fairly high in the current market, where foreign currency values can change rapidly.
Under the Sec. 1256 special timing rule, a taxpayer must determine taxable income or expense in respect of any foreign currency contract annually on a mark-to-market basis (i.e., by treating the contract as if it were sold at the end of each tax year). Sec. 1256(a)(2) further provides that a taxpayer must make proper adjustments to gain or loss subsequently recognized on the sale, disposition, or settlement of such contract. This rule generally is referred to as the “mark-on-disposition” rule. (These mark-to-market timing rules do not apply to a Sec. 1256 contract that is a hedge clearly identified before the close of the day on which the taxpayer entered into the transaction (Sec. 1256(e).)
Sec. 1256 also contains a special income characterization rule, which generally does not apply to foreign currency contracts. In general, gain or loss from foreign currency contracts is ordinary under Sec. 988, absent certain elections. However, gain or loss (including mark-to-market gain or loss) on a Sec. 1256 contract generally is treated as 40% short-term capital gain or loss and 60% long-term capital gain or loss. This overlap is resolved by the application of Sec. 988 ordinary income treatment, absent an election, to the extent that the contract is not an exchange-traded regulated futures contract. Therefore, gain or loss arising from a disposition or settlement of a foreign currency forward contract generally ought to be ordinary in character, regardless of whether the contract represents a foreign currency contract under Sec. 1256(g)(2). This item briefly examines the definition of a foreign currency contract and, in particular, whether the definition includes foreign currency forward contracts entered into between nonbank counterparties.
Foreign Currency Contract
Under Sec. 1256(g)(2)(A), a foreign currency contract is subject to the mark-to-market timing rule if:
- It requires delivery of, or its settlement depends on the value of, a foreign currency that is a currency in which positions are traded through regulated futures contracts (defined by Sec. 1256(g)(1));
- It is traded in the interbank market; and
- It is entered into at arm’s length at a price determined by reference to the price in the interbank market.
While there was some ambiguity on this point until recently, the IRS has concluded that foreign currency options ought not be considered foreign currency contracts for purposes of Sec. 1256(g)(2) (see Notices 2007-71 and 2003-81). Thus, this item focuses on foreign currency forward contracts.
A currency in which positions are traded through regulated futures contracts is often referred to as a “major” currency by practitioners, while a currency in which positions are not traded through regulated futures contracts is often referred to as a “minor” currency. Accordingly, only foreign currency contracts on major currencies may be subject to Sec. 1256 if they are traded in the interbank market.
To be a “foreign currency contract” under Sec. 1256, the contract must be traded in the interbank market. The Code offers little definition of the term “interbank market,” under either Sec. 1256 or other Code sections that use analogous concepts (see Regs. Sec. 1.1273-2(f)). Sec. 1256, as enacted as a part of the Economic Recovery Tax Act of 1981, P.L. 97-34, provided rules applicable to exchange-traded regulated futures contracts on foreign currencies but did not provide rules applicable to economically similar over-the-counter contracts entered into with banks.
In 1982, Congress expressed concern that taxpayers using economically comparable contracts received different tax treatment (see H. Rep. 97-794, 97th Cong., 2d Sess. 23 (1982)). Taxpayers using exchange-traded regulated futures contracts received 60% long-term and 40% short-term capital gains regardless of the holding period. A taxpayer with an interbank foreign currency contract had entirely short-term gain unless it held a long contract for the long-term capital gains holding period. (This was before the enactment of Sec. 988, which caused gains and losses from foreign currency contracts to be treated as ordinary.)
Congress did not, however, intend that all foreign currency forward contracts be characterized as Sec. 1256 contracts. Specifically, Congress noted that
[c]ontracts traded in the interbank market generally include not only contracts between a commercial bank and another person but also contracts entered into with a futures commission merchant who is a participant in the interbank market. A contract between two persons neither of whom is a futures commission merchant or similar participant in the interbank market is not a foreign currency contract under this provision. (Emphasis added.) (H.R. Conf. Rep. 97-986, 97th Cong., 2d Sess. 4213 (1982).)
The IRS, in administrative guidance, has concluded that the interbank market refers to the over-the-counter market maintained by banks to purchase and sell foreign currency and financial products. Specifically, the IRS stated that the interbank market is not a formal market but rather a group of banks holding themselves out to the general public as being willing to purchase, sell, or otherwise enter into certain transactions (see FSA 200025020).
The IRS also broadly interprets interbank market to include all banks and investment banks (as the terms are generally used in the marketplace). Due to the IRS’s seemingly broad interpretation of the term “interbank market,” taxpayers must consider whether a foreign currency forward contract negotiated between two private parties, neither of which is a bank or provides bank-like services to customers, qualifies as a foreign currency contract within the meaning of Sec. 1256(g)(2).
While the IRS may take a broad view of the definition of “foreign currency contract,” it is not clear that its view trumps Congress’s expressed intent that the term not include contracts entered into by private parties where neither party is a bank, futures commission merchant, or other “similar participant” in the interbank market. Accordingly, a privately negotiated currency forward contract between two parties, neither of which is a bank (in the broadest sense), arguably would not appear to be subject to Sec. 1256.
However, for many multinational companies, this conclusion may not be the end of the analysis. If a large multinational company has one or more treasury centers that perform bank-like functions for the parent company’s affiliates, it seems difficult to draw the line between a foreign currency forward contract between two “private” parties and a bank foreign currency forward contract. Could such a treasury center be viewed as a “similar participant in the interbank market”? This might require a facts-and-circumstances analysis to determine the level of participation of these treasury centers in the interbank market, the frequency of dealings in the interbank market, and the nature of the specific terms of the contract between the parties.
If it is determined that particular foreign currency forward contracts are not subject to Sec. 1256 (because neither affiliate of the multinational company is a participant in the interbank market), such contracts ought to give rise to gain or loss based on realization-based timing principles. Note that resolving the potential application of Sec. 1256 does not by itself resolve the overall timing treatment of foreign currency forward contracts. Rules such as the straddle rules (under Sec. 1092), the hedging rules (under Sec. 1221 and Regs. Sec. 1.446-4), and the specific elective foreign currency integration rules (under Regs. Sec. 1.988-5) each might affect the timing of gain or loss on a foreign currency forward contract. However, to understand the potential application of each of these provisions, the potential application of Sec. 1256 to the foreign currency contract first must be determined.