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July 15, 2022
US proposed regulations would limit Section 1256 mark-to-market accounting for foreign currency contracts to foreign currency forward contracts
On 5 July 2022, the United States (US) Treasury Department and the Internal Revenue Service (IRS) issued proposed regulations under Internal Revenue Code1 Section 1256 (REG-130675-17), (the Proposed Regulations). The Proposed Regulations would expressly overrule the Sixth Circuit's decision in Wright v. Commissioner, 809 F.3d 877 (6th Cir. 7 Jan. 2016) to limit the term "foreign currency contract" to only certain foreign currency forward contracts, and not foreign currency options. The Proposed Regulations would be generally effective for contracts entered into on or after the date that is 30 days after their publication as final regulations in the Federal Register.
Section 1256(a)(1) treats each "section 1256 contract" held by a taxpayer at the close of the tax year as sold for its fair market value on the last business day of that tax year (and requires taxpayers to take any gain or loss into account for the tax year). For foreign currency options and forward contracts, this gain or loss is ordinary under Section 988, absent an election for certain transactions.
Section 1256(b)(1) defines a Section 1256 contract as any regulated futures contract, any foreign currency contract, any nonequity option, any dealer equity option, and any dealer securities futures contract.
Section 1256(g)(2)(A) defines the term foreign currency contract as a contract that:
Section 1256(g)(2)(B) authorizes Treasury to prescribe regulations as necessary or appropriate to carry out the purposes of the definition of foreign currency contract, including the exclusion of any contract or type of contract from that definition if it would be inconsistent with those purposes.
The Service had historically taken the position that foreign currency options were not "foreign currency contracts," so they were not marked to market under Section 1256.2 It reaffirmed this position in Notice 2007-71 (after inadvertently creating some doubt in Notice 2003-81). This position was upheld by the Tax Court in Summitt v. Commissioner, 134 T.C. 248 (2010); Garcia v. Commissioner, T.C. Memo 2011-85 (2011); and Wright v. Commissioner T.C. Memo. 2014-175 (2014). The Sixth Circuit, however, reversed the Tax Court's decision in Wright, holding that a foreign currency option could be a foreign currency contract because the plain language of Section 1256(g)(2) does not explicitly require the contract to be settled. In Wright, the Sixth Circuit noted that the Treasury Department and the IRS had express authority to change this result for future taxpayers by regulation.
The Proposed Regulations clarify that contracts satisfying the requirements of Section 1256(g)(2)(A) are limited to forward contracts. For purposes of Section 1256, Prop. Treas. Reg. Section 1.1256(g)-2(a) would limit the term foreign currency contract to a forward contract that:
The Proposed Regulations do not define the term "forward contract"; the Preamble notes that current law determines whether a derivative contract is properly characterized as a forward contract for US federal income tax purposes. The Preamble also notes that the IRS may consider applying anti-abuse rules and judicial doctrines to evaluate whether a contract and any related transactions are properly characterized as a forward contract.
The Proposed Regulations would overrule the Sixth Circuit decision in Wright, noting that the legislative history of Section 1256 expressly stated that prior amendments to the definition of a foreign currency contract were merely to include all types of foreign currency contracts — i.e., to expand the term from physically-settled contracts to include cash-settled foreign currency forward contracts as a Section 1256 contract. Therefore, based on the legislative history, "it would be inconsistent with this purpose to construe the term foreign currency contract as including options or other derivatives."
The Proposed Regulations would apply to contracts entered into on or after the date 30 days after the regulations are published as final in the Federal Register. The delayed applicability date is apparently intended to give taxpayers in the Sixth Circuit time to transition. A taxpayer can generally rely on the Proposed Regulations before the applicability date for tax years ending on or after 6 July 2022; taxpayers and their related parties (determined under Section 267(b) without regard to Section 267(c)(3)) and Section 707(b)(1)), however, must consistently follow the Proposed Regulations for all contracts entered into during the tax year ending on or after 6 July 2022, through the proposed applicability date of the final regulations. For taxpayers in other circuits, the IRS continues to adhere to its position that foreign currency options are not foreign currency contracts under Section 1256(g)(2).
The Preamble states that the Proposed Regulations do not change the status of foreign currency options that otherwise qualify as Section 1256 contracts. Specifically, nonequity options are separately listed as Section 1256 contracts in Section 1256(b)(1)(C). Section 1256(g)(3) defines a nonequity option as any listed option that is not an equity option. Section 1256(g)(5) defines a listed option as "any option … traded on (or subject to the rules of) a qualified board or exchange." Therefore, a foreign currency option that is listed on a qualified board or exchange is a "nonequity option" and remains subject to Section 1256.
Taxpayers that have relied on Wright to include foreign currency options in the definition of foreign currency contracts, will need to consider whether they intend to early adopt the Proposed Regulations or await final regulations mandating a transition. In particular, taxpayers should consider any potential system changes and book-tax differences, as well as whether a change in accounting method is necessary and, if so, whether that change is automatic or non-automatic. Taxpayers that have not relied on the Wright decision ought to continue to exclude their over-the-counter foreign currency option contracts from the definition of foreign currency contracts under Section 1256. All taxpayers, regardless of jurisdiction, should continue to treat listed foreign currency options as non-equity options subject to Section 1256.
As the Proposed Regulations do not define the term "forward contract," and the Preamble indicates that the IRS may apply existing anti-abuse rules and judicial doctrines in determining the proper characterization of a transaction, taxpayers should reexamine their transactions to determine whether they are properly characterized as forward contracts or foreign currency options.
In light of the IRS's consistent position that over-the-counter foreign currency options are not foreign currency contracts for purposes of Section 1256, the Proposed Regulations are not surprising. However, the Proposed Regulations appear to reaffirm the view that different types of derivatives may not be economically comparable and thus, are properly subject to different tax regimes.3 This view contrasts with the theme of other recent legislative proposals regarding changes to the taxation of financial derivatives transactions, which would generally impose a single ordinary character rule and a single mark-to-market timing rule for all derivative transactions.4
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (United States), International Tax and Transaction Services, Capital Markets