Section 1256 generally requires that certain contracts, including “foreign currency contracts,” be marked-to-market annually. The Internal Revenue Service (IRS) has long maintained that foreign currency options are not foreign currency contracts that are subject to section 1256. Although the IRS released various notices and advanced its position in litigation, it did not issue regulations under section 1256 to support its position. However, the IRS has received mixed responses from courts. To this end, in Wright v. Commissioner, 809 F.3d 877 (6th Cir. 2016), the 6th Circuit ruled in favor of the taxpayer, rejecting the IRS position. But, in so doing it suggested that it would have reached a different result if the IRS had issued regulations providing that foreign currency options are not be subject to section 1256.
Proposed regulations issued on July 6 address the 6th Circuit’s comment and specifically provide that for purposes of section 1256, foreign currency options are not treated as foreign currency contracts. The proposed regulations are proposed to apply to contracts entered into on or after the date that is 30 days after the date final regulations are published in the Federal Register, but as noted above, the proposed regulations reflect the IRS’s existing position as to the application of section 1256 to foreign currency options so in the IRS view, they are not a change in law.
As background, section 1256 generally provides that taxpayers who hold a “section 1256 contract” must mark-to-market such contracts on the last day of the taxable year, and as a result, recognize gain or loss. A “section 1256 contract” includes nonequity options and “any foreign currency contract,” which is defined as a contract (1) 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, (2) which is traded in the interbank market, and (3) which is entered into at arm’s length at a price determined by reference to the price in the interbank market.
The IRS’s position regarding foreign currency options stems from its opposition to so-called “major-minor” transactions. These transactions involve a taxpayer purchasing call and put options in a foreign currency in which regulated futures contracts traded (the major currency) and writing call and put options in a foreign currency in which regulated futures contracts were not traded (the minor currency). The taxpayer would treat the major positions as foreign currency contracts under section 1256 and the minor positions as not subject to section 1256. The taxpayer would assign the purchased major currency option with a built-in loss to a charity, and the charity would assume the offsetting written minor currency option from the taxpayer. The taxpayer would treat the assignment as a mark-to-market recognition event under section 1256, causing the taxpayer to recognize the loss, and treat the assumption by the charity as a non-recognition event under which the taxpayer did not report the gain on the offsetting minor position.
The IRS opposed these transactions by arguing that a foreign currency option does not require delivery of, or the settlement of which depends on the value of, a foreign currency (i.e., the first requirement above) because such an option is a unilateral contract that does not require delivery or settlement until the option is exercised, which may never occur. In addition the IRS identified these transactions as listed transactions in Notice 2003-81.
To reinforce the IRS position with respect to the interpretation of the term “foreign currency contract,” the proposed regulations explicitly limit the term “forward currency contract” to include only “forward contracts” (the current statutory language limits the term to contracts). The other three requirements detailed above generally are retained under the proposed regulations. The effect of this change is to solidify the IRS position that foreign currency options are excluded from the definition of a “forward currency contract,” and thus from the application of section 1256, unless the foreign currency option otherwise qualifies as a section 1256 contact, for example, as a nonequity option. The IRS noted that the change “clarifies” that a foreign currency contract should not include forward currency options, indicating that the IRS does not view the proposed regulations as a change in law.
As noted above, the regulations are proposed to apply to contracts entered into on or after the date that is 30 days after the date final regulations are published in the Federal Register, but a taxpayer may rely on the proposed regulations for taxable years ending on or after July 6, 2022, if the taxpayer and its related parties consistently follow the proposed regulations for all contracts entered into during the taxable year ending on or after July 6, 2022 through the proposed applicability date of the final regulations.