Before the Sixth Circuit issued its decision in Wright, 809 F.3d 877 (6th Cir. 2016), on Jan. 7, few tax practitioners would have suggested that over-the-counter (OTC) foreign currency options on "major" currencies should be accorded Sec. 1256 treatment as "foreign currency contracts."
Sec. 1256(g)(2)(A)(i) defines a foreign currency contract in part as a contract "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." Wright brought a fresh perspective on the subject, particularly via a renewed focus on contract settlement as it relates to this definition.
Previous case law stipulated that OTC currency options are not foreign currency contracts, generally interpreting the definition above to require actual settlement of the contract. Since settlement is not required with options, a foreign currency option would therefore not meet the definition of a foreign currency contract. Prior cases (Summitt, 134 T.C. 248 (2010), and Garcia, T.C. Memo. 2011-85) support the assertion that a major foreign currency OTC option is not a foreign currency contract. Furthermore, many regard the language in the statute as intended to apply to forward contracts that require actual delivery of foreign currencies. Notably, the clause "or the settlement of which depends on the value of" was added by Congress in 1984 merely to allow cash-settled forward contracts to still qualify as foreign currency contracts under Sec. 1256, not to broaden the definition to include any contract simply on the basis of its relation to foreign currencies. Finally, Notice 2007-71 clarified that purchased foreign currency options are not foreign currency contracts.
In 2002, Terry and Cheryl Wright entered into a series of options transactions involving major and minor currencies through their partnership interests in Cyber Advice LLC. The IRS identified this type of arrangement in Notice 2003-81 as a listed transaction subject to Sec. 6011 disclosure requirements, Sec. 6111 tax shelter registration requirements, and Sec. 6112 list maintenance requirements. The Wrights purchased substantially offsetting put and call options on the euro (a major currency under Sec. 1256) and also wrote offsetting put and call options on the krone (a minor currency), which had a strong positive correlation with the euro.
Purchased put and call options give the options' buyer the right to sell and buy the underlying security or asset at a given price by a given date. Written put and call options represent the seller's side of that same transaction, whereby the seller would receive an appropriate fee in return for granting the buying and selling rights to the buyer, as described for purchased options. All of the positions entered by the Wrights offset each other in various ways, and the Wrights effectively had very little economic exposure through these option holdings.
Upon depreciation of the purchased euro put options and appreciation of the offsetting written krone put options, the Wrights assigned the holdings in these two positions to a charity. In the tax return filed for 2002 the following year, the Wrights recognized the loss on the assigned euro put options but deferred recognition of the gains on the krone put options. They did so on the premise that the former is subject to the mark-to-market provisions of Sec. 1256 as a foreign currency contract, while the latter contract, on a minor currency, would not be recognized until exercise or lapse of the option contract. Although it was essentially a timing issue, the Wrights were able to generate a substantial tax loss without any real corresponding economic loss.
The IRS assessed a tax deficiency on the premise that the loss recognized on the euro put option was improper due to its not being a foreign currency contract under Sec. 1256. Further, the Service assessed penalties and interest for negligence and substantial understatement of tax. The Wrights unsuccessfully contested this conclusion in the Tax Court, which based its decision on prior case law and the purported intent of Sec. 1256 (Wright, T.C. Memo. 2011-292).
On appeal, the Sixth Circuit reversed the Tax Court's decision and adopted a "plain language" reading of Sec. 1256(g)(2)(A)(i) to conclude that OTC currency options are foreign currency contracts. The court notably interpreted the "settlement of which depends on the value of" clause to merely require that any settlement must rely on the value of a foreign currency; actual settlement of the contract is not required to meet the definition.
This leaves uncertain the appropriate treatment of OTC foreign currency options. Should taxpayers continue non-Sec. 1256 treatment for these instruments based on perceived legislative intent and history, or should they apply the anomaly of an interpretation in Wright going forward?
At this time, either approach is justifiable; however, until further authoritative guidance is available, taxpayers should adhere to a particular methodology once they select it. The impact of switching policies is by nature unpredictable, since it would largely depend on the taxpayer's investment activities. However, it is not difficult to see that the two approaches could yield very different tax results. Ultimately, each taxpayer should evaluate both approaches.
Barring a fact pattern such as in Wright, which featured a listed transaction, most taxpayers under normal circumstances face three questions: First, what is the tax impact of any differences in gain or loss recognized each year? This is largely a timing issue. Second, and more important in evaluating both approaches, what is the economic substance of the stance taken? Does a change in approach offer any advantages in representing the economic activity? Lastly, and perhaps less predictable, what is the prospect for further developments surrounding this controversy, and the permanence of any decision to follow the approach in Wright? The IRS could issue new notices to settle this predicament, and Sec. 1256(g)(2)(B) specifically grants Treasury the power to issue new regulations to exclude any type of contracts deemed to be inconsistent with the purposes of Sec. 1256.
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.