Proposed Regulations Clarify Definition of Foreign Currency Contracts

The Internal Revenue Service (IRS) recently issued proposed reliance regulations clarifying the definition of a “foreign currency contract”. The definition of an investment as a foreign currency contract is important because of Sec. 1256 previously enacted to prevent tax motivated straddles from deferring income or converting short-term capital gains into long-term capital gains. The rule uses mark-to-market requirements on these investment straddles to avoid this – which is why this issue may be important to you.

From Past to Present

In 1984, Congress amended the definition of a foreign currency contract under Sec. 1256(g)(2) to include cash-settled foreign currency forward contracts. At the same time, Congress added nonequity options to the list of Sec. 1256 contracts under Sec. 1256(b)(1). However, the legislative history does not indicate Congress also intended to expand the scope of Sec. 1256(g)(2) to include cash-settled over-the-counter (OTC) foreign currency options.

Currently, Sec. 1256(g)(2)(A) defines a foreign currency contract as one that:

  1. Requires delivery of, or the settlement that depends on the value of, a foreign currency in which positions are also traded through regulated futures contracts
  2. Is traded in the interbank market
  3. Is entered into at arm’s length at a price determined by reference to the price in the interbank market

Sec. 1256(g)(3) defines a “nonequity option” as any listed option. Generally, a listed option is an option traded on or subject to the rules of a qualified board or exchange that isn’t an equity option.

A Listed Transaction

In 2003, the IRS identified — as a listed transaction — a tax avoidance scheme in which taxpayers entered into offsetting foreign currency contracts. The tax avoidance aspects of the scheme relied on treating, as foreign currency contracts, OTC foreign currency options in a currency in which regulated futures were traded.

In 2007, the IRS clarified “foreign currency options” — whether or not the underlying currency is one in which positions are traded through regulated futures contracts — aren’t foreign currency contracts under Sec. 1256(g)(2). Sometimes this transaction is referred to as a “major-minor” transaction because it involves the taxpayer:

  • Buying call and put options in a “major” foreign currency (one in which regulated futures contracts are traded) and,
  • Writing call and put options in a “minor” currency (one in which regulated futures contracts aren’t traded).

After issuing these notices, the IRS challenged taxpayers’ characterization of the major-minor transactions in several cases before the US Tax Court. In a series of rulings, the court held that foreign currency options weren’t foreign currency contracts under Sec. 1256(g)(2). However, in Wright v. Commissioner, the US Court of Appeals for the Sixth Circuit disagreed and held that a foreign currency option could be a foreign currency contract.

The Proposed Regulations

The proposed regulations would provide only a forward contract on foreign currency to be a foreign currency contract under Sec. 1256(g)(2). As a result, foreign currency options would be excluded from the definition of foreign currency contract.

According to the IRS, including options and other derivatives in the definition of foreign currency contract would be inconsistent with the 1984 amendments to Sec. 1256(g)(2) because Congress included only cash-settled foreign currency forward contracts in the amended definition.

However, the IRS may consider applying existing anti-abuse rules and judicial doctrines to a contract and any related transactions to evaluate whether:

  • A transaction is properly characterized as a forward contract, or
  • A transaction characterized as some other type of derivative contract should be treated as a forward contract.

Note: These proposed regulations do not change the status of foreign currency options that otherwise qualify as Sec. 1256 contracts. Also, they do not define the term “forward contract.”

The proposed regulations would apply to contracts entered into on or after the date that’s 30 days after the publication date of the final regulations adopting these proposed rules. The IRS hopes this applicability date will provide taxpayers in the Sixth Circuit time to transition from the holding in Wright to the rules described in the proposed regulations.

However, for taxpayers in other circuits, the IRS intends to continue to adhere to its previously published position that foreign currency options aren’t foreign currency contracts under Sec. 1256(g)(2).

Reliance Requirements

Taxpayers may rely on these proposed regulations for tax years ending on or after July 6, 2022, which includes calendar year 2022. However, this reliance requires the taxpayer and its related parties to consistently follow the proposed regulations for all contracts entered into during the tax year ending on or after July 6, 2022, through the proposed applicability date of the final regulations.

Want to know more? Contact Moore Doeren Mayhew’s international tax advisors today.



Mia Yun



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