Monday, April 19, 2010

Income tax treatment of foreign currency option gains

Here's an article I wrote (with minor edits to add endnotes) for the November 2009 edition of the AICPA Tax Section's The Tax Adviser (specifically, the Tax Clinic).  I hope you find it useful.

As many practitioners already 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 are beyond the scope of this article, there is one in particular that may be of particular interest to investors.

For this example, let’s say that individual U.S. “Investor” holds substantial foreign stocks (e.g., on the London Stock Exchange) denominated in foreign currency (e.g., UK pounds or “GBP”).  Further, let’s say that Investor is concerned about possible fluctuations in the USD/GBP exchange rate, and so decides to manage that risk by purchasing a foreign currency option as follows directly from a U.S. investment bank:
  • European[i]-style GBP put/USD call, with “non-deliverable” settlement[ii]
  • Not exchange-traded (or subject to the rules of an exchange)[iii]
  • Call currency amount:   USD 650,000
  • Put currency amount:    GBP 345,000
  • Strike price:           1.8841 USD/GBP
  • Reference currency:     GBP
  • Settlement currency:    USD
  • Trade date:             January 2, 200X
  • Valuation date:         December 1, 200X
  • Premium:                USD 15,000
In this example, this means that Investor pays USD 15,000 for the right to receive (in cash) the net value of the excess of the USD amount over the 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 to the GBP), then Investor would be entitled to receive USD 650,000 - (GBP 345,000 x 1.6 USD/GBP) = USD 98,000.  After consideration of the option premium, Investor’s net profit would be USD 83,000.  Query:  Should this profit be characterized as ordinary income, or capital gain?  And 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 Investor’s part in the form of an election by the end of the trade date.
1)      Section 988
a)      In general
In general, Sec. 988 treats foreign currency gains/losses attributable to a “section 988 transaction” as ordinary income/loss.  Moreover, by its express terms, Sec. 988 overrides any other contrary provisions under Chapter 1 of the Internal Revenue Code (sections 1 through 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 “section 988 transaction” any specified transaction (e.g., any forward contract, futures contract, option, or similar financial instrument) if the amount which the taxpayer is entitled to receive (or is required to pay) by reason of such transaction is determined by reference to the value of 1 or more nonfunctional currencies.  Since the option in this example meets those criteria, it would appear (so far) to constitute a “section 988 transaction” and presumably give rise to ordinary income.
b)     Interplay with Sec. 1256
Next, we need to 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 “section 988 transaction” if it represents a regulated futures contract or nonequity option which would be marked to market under Sec. 1256  if held on the last day of the taxable year.
Under Sec. 1256(g)(1), a “regulated futures contract” is a contract with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and which is traded on or subject to the rules of a qualified board or exchange.  In our example, the option is clearly not a “regulated futures contract” since there were no amounts required to be deposited or able to be withdrawn.
Under Sec. 1256(g)(3), a “nonequity option” includes any listed option which is not an equity option.  Sec. 1256(g)(5), in turn, provides that a “listed option” is one which 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 which the Secretary 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.[iv]  Nevertheless, in our 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 “section 988 transaction” by Sec. 988(c)(1)(D).  Therefore, it would continue to appear (so far) to constitute a “section 988 transaction” and presumably give rise to ordinary income/loss.
c)      Election to treat as capital gain/loss
Having established the option as a “section 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), inter alia, a taxpayer may elect to treat any foreign currency gain or loss attributable to an option which is a capital asset in the hands of the taxpayer and which 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 the Secretary may prescribe).
i)        Capital asset characterization
In relevant part, Sec. 1221(a) provides the definition of a “capital asset” as property held by a taxpayer, but excludes:
  • Any commodities derivative financial instrument held by a commodities derivatives dealer,
  • Any hedging transaction which is clearly identified as such before the close of the day on which it was entered into (or such other time as the Secretary may by regulations prescribe).
With respect to the first item, Investor is not a “commodities derivatives dealer” because he is not a person that regularly offers to enter into, assume, offset, assign, or terminate positions in commodities derivative financial instruments with customers in the ordinary course of a trade or business.  Sec. 1221(b)(1)(A).
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 (i) to manage risk of price changes or currency fluctuations with respect to ordinary property which is held or to be held by the taxpayer, (ii) 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 (iii) to manage such other risks as the Secretary may prescribe in regulations.  Sec. 1221(b)(2).
Accordingly, since the option does not meet any of the exceptions in Sec. 1221(a), it is a capital asset and eligible for the aforementioned election.
ii)      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:
  • The taxpayer makes the election by clearly identifying such transaction on his books and records on the date the transaction is entered into. While no specific language or account is necessary for identifying a transaction referred to in the preceding sentence, the method of identification must be consistently applied and must clearly identify the particular transaction subject to the election.
  • The taxpayer must provide verification of the election by attaching a statement to his income tax return that set forth: (i) a description and the date of each election made by the taxpayer during the taxable year; (ii) a statement that each election made during the taxable year was made before the close of the date the transaction was entered into; (iii) a description of any contract for which an election was in effect and the date such contract expired or was otherwise sold or exchanged during the taxable year; (iv) a statement that the contract was never part of a straddle as defined in Sec. 1092; and (v) a statement that all transactions subject to the election are included on the statement attached to the taxpayer's income tax return.
Note:  Taxpayers that do not comply with these requirements run the risk of the IRS invalidating the election.  However, if the failure was due to reasonable cause or bona fide mistake, taxpayers may be able to obtain relief regarding that failure, but the burden of proving it would be on them.  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 independent verification by (1) establishing a separate account (or accounts) with an unrelated broker or dealer through which all transactions to be independently verified pursuant to this paragraph are conducted and reported, (2) having only those transactions entered into on or after the date the taxpayer establishes such account be recorded in the account, (3) having transactions subject to the election entered into such account on the date such transactions are entered into, and (4) obtaining from the broker or dealer a statement detailing the transactions conducted through such account and that includes on such statement the following: “Each transaction identified in this account is subject to the election set forth in section 988(a)(1)(B).”
In this example, it is assumed that Investor fulfilled their obligations with respect to the election under Sec. 988(a)(1)(B), thereby resulting in the treatment of the gain as capital in character.
2)      Section 1256
Pursuant to Sec. 1256(a), certain contracts are generally required to be “marked to market” if held by the taxpayer at the close of the taxable 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., a transfer, lapse, or other disposal during the year).
Sec. 1256(b), by its terms, covers the following types of contracts (and 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 already 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 (since Investor is not a “dealer”), that leaves the question of whether the option is a “foreign currency contract.”
Pursuant to Sec. 1256(g)(2)(A), a “foreign currency contract” is defined as a contract which (i)  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, (ii) is traded in the interbank market, and (iii) 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 and Treasury state that foreign currency options, whether or not 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 their 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 [TRA 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 [TAMRA 1988], which indicates that a foreign currency option is not a foreign currency contract as defined in §1256(g)(2).
  • Moreover, FSA 200025020 (which was issued prior to Notice 2003-81, which was modified and supplemented by Notice 2007-71) provided the following reasoning (internal citations omitted):
“Although the definition of a foreign currency contract provided in section 1256(g)(2) may be read to include a foreign currency option contract, the legislative history of [TCA 1982], which amended section 1256 to include foreign currency contracts, indicates that the Congress intended to extend section 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 section 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 [TRA 1984].  They provide that only dealer equity options (i.e., listed stock options) and listed options (other options listed on exchanges) are section 1256 contracts. The legislative history to these provisions is silent regarding whether the failure to separately include a provision address in the treatment of foreign currency options was due to their having been included within section 1256(g)(2)(A).”
Further, commentators have seemed to accept (or at least not dispute) that foreign currency options are not “foreign currency contracts.” [v]  Consequently, the option should not be treated as a “foreign currency contract” and thus does not fall under Sec. 1256.
3)      Holding Period
Having established that the option is a capital asset, and not subject to Sec. 1256, the final step in our 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 long-term vs. short-term character of the gain (or loss) on the disposition of a capital asset.  In short, that section provides that capital gains are long-term if held for not more than 1 year, and short-term otherwise.
Without going into great detail on this issue (since 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 the reader can see from the above, reaching the ultimate answer to the initial query was not exactly a straightforward proposition, and highlights the need for additional clarity in situations like these.  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.

[i] A “European” option may be exercised only at the expiry date of the option, i.e., at a single pre-defined point in time.  An “American” option may be exercised at any time on or before the expiry date.
[ii] “Non-deliverable” settlement means that settlement is made on a net value basis and that currencies do not change hands.
[iii] I.e., not traded on (or subject to the rules of) an SEC-registered national securities exchange, a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of section 1256.
[iv] See, e.g., Rev. Rul. 85-72 (the International Futures Exchange (Bermuda) Ltd.); Rev. Rul. 86-7 (the Mercantile Division of the Montreal Exchange , effective April 18, 1985); Rev. Rul. 2007-26 (ICE Futures, a U.K. Recognised Investment Exchange, effective for ICE Futures Contracts (commodity futures contracts and futures contract options) entered into on or after April 1, 2007); Rev. Rul. 2009-4 (the Dubai Mercantile Exchange, effective for Dubai Mercantile Exchange Contracts (commodity futures contracts and futures contract options) entered into on or after February 1, 2009); PLR 200726006 (an unnamed United Kingdom Recognized Investment Exchange that was a wholly-owned subsidiary of a U.S. corporation and overseen by the United Kingdom's Financial Services Authority, provided that the exchange continued to comply with certain specified conditions).
[v] Mulroney, 921-2nd T.M., Tax Aspects of Foreign Currency, section VII.B.4.:  “Comment: Nonlisted foreign currency options should not fall within the definition of a ‘foreign currency contract,’ even if the denomination currency is a currency in which positions are traded on a qualified board or exchange. This is because §1256(g)(3), which sets forth the definition of a nonequity option, should be viewed as preemptive in terms of the types of options covered under §1256.

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