As many practitioners know, Sec. 988 treats most (but not all) gains and losses from foreign currency transactions as ordinary in character. Depending on the taxpayer’s circumstances, this treatment can be favorable or otherwise.
While the full range of exceptions to this rule is beyond the scope of this item, there is one that may be of particular interest to investors.
Example: Individual U.S. investor K holds substantial foreign stocks (on the London Stock Exchange) denominated in foreign currency. K is concerned about possible fluctuations in the U.S. dollar/U.K. pound exchange rate and decides to manage that risk by purchasing a foreign currency option directly from a U.S. investment bank (see the exhibit on p. 741).
In this example, K pays $15,000 for the right to receive (in cash) the net value of the excess of the U.S. dollar (USD) amount over the U.K. pound (GBP) amount on the valuation date. If there is no net positive excess, no additional money changes hands.
More specifically, if on the valuation date the spot exchange rate is 1.6 USD/GBP (i.e., the value of the USD has increased compared with the GBP), K would be entitled to receive $650,000 – (£345,000 × 1.6 USD/GBP) = $98,000. After consideration of the option premium, K’s net profit would be $83,000.
Query: Should this profit be characterized as ordinary income or capital gain? If the latter, what is the holding period? While the answer might seem clear at the outset, getting there is somewhat circuitous and may also require specific action on K’s part in the form of an election by the end of the trade date.
In general, Sec. 988 treats foreign currency gains and losses attributable to a Sec. 988 transaction as ordinary income or loss. Moreover, by its express terms, Sec. 988 overrides any other contrary provisions under chapter 1 of the Internal Revenue Code (Secs. 1–1400U-3, dealing with normal taxes and surtaxes). However, exceptions do apply.
In determining whether a particular arrangement is covered by this rule, Sec. 988(c)(1) treats as a Sec. 988 transaction any specified transaction (e.g., any forward contract, futures contract, option, or similar financial instrument) if the amount the taxpayer is entitled to receive (or is required to pay) by reason of the transaction is determined by reference to the value of one or more nonfunctional currencies. Because the option in this example meets those criteria, it would appear (so far) to constitute a Sec. 988 transaction and presumably give rise to ordinary income.
Interplay with Sec. 1256
Next, consider Sec. 988(c)(1)(D), which provides that the acquisition of any forward contract, futures contract, option, or similar financial instrument is not a Sec. 988 transaction if it represents a regulated futures contract or nonequity option that would be marked to market under Sec. 1256 if held on the last day of the tax year.
Under Sec. 1256(g)(1), a regulated futures contract is a contract for which the amount required to be deposited and the amount that may be withdrawn depend on a system of marking to market and that is traded on or subject to the rules of a qualified board or exchange. In the above example, the option is clearly not a regulated futures contract because no amounts were required to be deposited or able to be withdrawn.
Under Sec. 1256(g)(3), a nonequity option includes any listed option that is not an equity option. Sec. 1256(g)(5), in turn, provides that a listed option is one that is traded on (or subject to the rules of) a qualified board or exchange. Sec. 1256(g)(7) further provides that the term “qualified board or exchange” means (1) an SEC-registered national securities exchange; (2) a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission; or (3) any other exchange, board of trade, or other market that Treasury determines has rules adequate to carry out the purposes of Sec. 1256.
While this statutory language is less definitive than some might like, the IRS has provided guidance in identifying certain entities as qualified boards of exchange for purposes of Sec. 1256. Nevertheless, in the example, the foreign currency option was not traded on (or subject to the rules of) an exchange of any sort. Consequently, the option should not constitute a nonequity option.
As a result, the option should not be excluded from consideration as a Sec. 988 transaction by Sec. 988(c)(1)(D). It would continue to appear (so far) to constitute a Sec. 988 transaction and presumably give rise to ordinary income/loss.
Election to Treat as Capital Gain/ Loss
Having established the option as a Sec. 988 transaction, one of the exceptions to ordinary income/loss treatment is found in Sec. 988(a)(1)(B), which permits taxpayers to elect to treat gains/losses on certain foreign currency arrangements as capital in nature. This exception provides that (unless prohibited in the regulations), among other things, a taxpayer may elect to treat any foreign currency gain or loss attributable to an option that is a capital asset in the hands of the taxpayer and that is not a part of a straddle as capital gain or loss if the taxpayer makes an election and identifies the transaction before the close of the day on which such transaction is entered into (or earlier, as Treasury may prescribe).
Capital asset characterization: In relevant part, Sec. 1221(a) provides the definition of a capital asset as property held by a taxpayer, but it excludes:
- Any commodities derivative financial instrument held by a commodities derivatives dealer; and
- Any hedging transaction that is clearly identified as such before the close of the day on which it was entered into (or such other time as Treasury may by regulations prescribe).
As for the second item, the option is not a hedging transaction because it was not a transaction entered into by the taxpayer in the normal course of the taxpayer’s trade or business primarily:
- To manage risk of price changes or currency fluctuations with respect to ordinary property that is held or to be held by the taxpayer;
- To manage risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer; or
- To manage such other risks as Treasury may prescribe in regulations (Sec. 1221(b)(2)).
Mechanics of election: Regs. Sec. 1.988-3(b) addresses the requirements of making the Sec. 988(a)(1)(B) capital gain/ loss election. The requirements for that election are as follows:
Observation: Taxpayers that do not comply with these requirements run the risk of having the IRS invalidate the election. However, if the failure was due to reasonable cause or a bona fide mistake, taxpayers may be able to obtain relief regarding that failure, but they have the burden of proving that they are entitled to relief. Fortunately, Regs. Sec. 1.988-3(b)(5) provides a way for most taxpayers to obtain a presumption of having met the statement and verification requirements by getting independent verification. Taxpayers may get this verification by (1) establishing a separate account (or accounts) with an unrelated broker or dealer through which all transactions to be independently verified are conducted and reported; (2) having only those transactions entered into on or after the date the taxpayer establishes the account be recorded in the account; (3) having transactions subject to the election entered into the account on the date the transactions are entered into; and (4) obtaining from the broker or dealer a statement detailing the transactions conducted through the account that includes the following: “Each transaction identified in this account is subject to the election set forth in Sec. 988(a)(1)(B).”
In this example, it is assumed that the investor fulfilled his or her obligations for the election under Sec. 988(a)(1)(B), thereby resulting in the treatment of the gain as capital in character.
Under Sec. 1256(a), certain contracts are generally required to be marked to market if held by the taxpayer at the close of the tax year and are further characterized as generating gain or loss that is 40% short-term capital gain or loss and 60% long-term capital gain or loss. Moreover, Sec. 1256(c) generally provides that Sec. 1256(a) applies even if the contract is not held at year end (e.g., because of a transfer, lapse, or other disposal during the year).
Sec. 1256(b), by its terms, covers the following types of contracts (which are defined under Sec. 1256(g)): (1) any regulated futures contract; (2) any foreign currency contract; (3) any nonequity option; (4) any dealer equity option; and (5) any dealer securities futures contract. Having addressed regulated futures contracts and nonequity options above, and noting that the option is not a dealer equity option or a dealer securities futures contract (because K is not a dealer), that leaves open the question of whether the option is a foreign currency contract.
Under Sec. 1256(g)(2)(A), a foreign currency contract is defined as a contract that:
- Requires delivery of (or the settlement of which depends on the value of) a foreign currency that is a currency in which positions are also traded through regulated futures contracts;
- Is traded in the interbank market; and
- Is entered into at arm’s length at a price determined by reference to the price in the interbank market.
In a nutshell, the option is not a foreign currency contract even though a casual reading might suggest otherwise. The rationale for this conclusion is as follows. In Notice 2007-71, the IRS states that foreign currency options, regardless of whether the underlying currency is one in which positions are traded through regulated futures contracts, are not foreign currency contracts as defined in Sec. 1256(g)(2). Apart from IRS resistance to what they view as an abuse (not relevant to our example), the notice explains that a
foreign currency contract . . . [is] a contract that requires delivery of, or the settlement of which depends on the value of, certain foreign currencies. The original statutory definition, however, did not allow for cash settlement and required actual delivery of the underlying foreign currency in all circumstances. Options, by their nature, only require delivery if the option is exercised. Section 102 of the Tax Reform Act of 1984 added the clause “or the settlement of which depends on the value of.” There is no indication, however, that Congress intended by this addition to extend the definition of “foreign currency contract” to foreign currency options. That conclusion is confirmed by the legislative history to §988(c)(1)(E), enacted by the Technical and Miscellaneous Revenue Act of 1988, which indicates that a foreign currency option is not a foreign currency contract as defined in §1256(g)(2). [Citations omitted.]Moreover, Field Service Advice (FSA) 200025020 (issued prior to Notice 2003- 81, which was modified and supplemented by Notice 2007-71) provided the following reasoning:
Although the definition of a foreign currency contract provided in § 1256(g)(2) may be read to include a foreign currency option contract, the legislative history of the Technical Corrections Act of 1982, which amended § 1256 to include foreign currency contracts, indicates that the Congress intended to extend § 1256 treatment only to foreign currency forward contracts that are traded on the interbank market. There is no indication that foreign currency option contracts were contemplated for inclusion in the statutory definition of a forward currency contract in § 1256(g)(2)(A). Sections 1256(g)(3) and (4) deal comprehensively with options listed on a qualified board or exchange. These provisions were added to the Code by section 102(a)(3) of the Tax Reform Act of 1984. They provide that only dealer equity options (i.e., listed stock options) and listed options (other options listed on exchanges) are § 1256 contracts. The legislative history to these provisions is silent regarding whether the failure to separately include a provision addressing the treatment of foreign currency options was due to their having been included within § 1256(g)(2)(A). [Citations omitted.]Further, commentators have seemed to accept (or at least not dispute) that foreign currency options are not foreign currency contracts. Consequently, the option should not be treated as a foreign currency contract and thus does not fall under Sec. 1256.
Having established that the option is a capital asset and is not subject to Sec. 1256, the final step in the analysis is determining whether the gain on its disposition is long term or short term. Sec. 1222 generally controls the holding period of property in determining the longterm versus short-term character of the gain (or loss) on the disposition of a capital asset. In short, that section provides that capital gains are short term if held for not more than one year and long term otherwise.
Without going into a great deal on this issue (because it should be fairly apparent from the trade and termination dates being less than 12 months), it is clear that the gain is short term in nature.
As can be seen from the above, reaching the ultimate answer to the initial query was not exactly a straightforward proposition, highlighting the need for additional clarity in similar situations. After all, even in this relatively simple example the conclusion was dependent on a close and critical reading of the legislative history, given several easily misinterpreted terms in the statute itself.
Mark Cook is a partner at Singer Lewak LLP in Irvine, CA.
Unless otherwise noted, contributors are members of or associated with Singer Lewak LLP.The editor would like to offer a special thanks to Jennifer Allison, J.D., for her assistance with this column.
For additional information about these items, contact Mr. Cook at (949) 261-8600, ext. 2143, or email@example.com.