Foreign Currency Transactions
(Foreign Exchange)
FOREX
NEW RULES EFFECTIVE OCTOBER 18, 2010 for U.S. RESIDENTS ONLY
- 50:1 margin on most FX pairs including the four U.S. crosses Euro/USD, GBP/USD, USD/JPY and USD/CHF
- 20:1 margin on most FX exotics including all other pairs offered i.e. GBP/JPY etc. (These margin levels can be reduced at any time by the CFTC)
- NO HEDGING of positions will be allowed. Currently if you are at an off shore entity you can hedge
- FIRST IN FIRST OUT.(FIFO) If you have multiple positions on a pair you must close them out in order which they were opened
- No Spot Gold and Silver
- No Foreign Banks or Off-Shore FX Brokers
- Most retail OTC forex transactions are banned, pursuant to Section 742(c) of the Act
- “…A person … shall not offer to, or enter into with, a person that is not an eligible contract participant, any agreement, contract, or transaction in foreign currency except pursuant to a rule or regulation of a Federal regulatory agency allowing the agreement, contract, or transaction under such terms and conditions as the Federal regulatory agency shall prescribe…”
Links to some of the information found on this web page:
How to make the Sec 988 taxed as Sec 1256 election #1
How to make the Sec 988 taxed as Sec 1256 election #2 (Internal Revenue Code Sec. 988)
How to make the Sec 988 taxed as Sec 1256 election #3 (Internal Revenue Code Sec. 988)
How to make the Sec 1256 taxed as Sec 988 election #5
How to make the Sec 1256 taxed as Sec 988 election#6
#8 How to report on your tax return
#9 Where to report on your tax return
#10 When losses exceed $50,000 – what to report on your tax return (IRS Publication 334)
#11 When losses exceed $50,000 – what to report on your tax return (IRS Schedule C instructions)
#12 What to report on your tax return
#13 How to report on your tax return (Notice 2003-81)
#14 Coordinated Issue Paper “Notice 2003-81” Tax Shelter
#15 IRS Notice 2003-81 #16 IRS Notice 2007-71 (Modification of Notice 2003-81)
Summary: Foreign Currency Transactions, Foreign Exchange Markets or FOREX have very complex tax issues.
There are three ways private investors can trade in FOREX directly or indirectly:
- The spot market (default taxation is generally under IRC §988 for ordinary gains & losses).
- Forwards and futures:
- default taxation is under IRC §988 for ordinary gains & losses.
- unless items normally M2M at December 31st, in which case taxation is under IRC §1256 for “60/40” capital gains & losses.
- Options:
- default taxation is under IRC §988 for ordinary gains & losses.
- unless items normally M2M at December 31st, in which case taxation is under IRC §1256 for “60/40” capital gains & losses.
The above defaults can be elected out of:
- IRC §988 items can be taxed under IRC §1256 for “60/40” capital gains & losses if the proper election is made.
- for certain hedge funds defined under under §988(c)(1)(E)(iii) this results in special §1256 “0/100” capital gains & losses.
- IRC §1256 items can be taxed under IRC §988 if the proper election is made.
Generally for IRC §988 items to be taxed under IRC §1256 the election is made before the close of the day on which such transaction is entered into, pursuant to I RC §988(a)(1)(B) and Treas. Reg. §1.988-3(b)(4). This can be verified as being done when the transactions are executed in an isolated, separate brokerage account as described under Treas. Regs 1.988-3(b)(5)(ii)(D).
Generally for IRC §1256 items to be taxed under IRC §988 the election is made on or before January 1st (or, if later on or before when taxpayer holds a position) pursuant to IRC §988(c) by the individual or by the partners of a partnership.
Character of the gain or loss (by default): Currency gains and losses of individuals when engaging in business or investment type activities are ordinary gains and losses. See §988(a)(1)(A) and §988(e). Currency gains of individuals engaging in personal activities are capital gains. (but pursuant to §988(e)(2)(B) personal currency gains per transaction that are under $200 are generally exempt). Currency losses of individuals engaging in personal activities are nondeductible personal expenditures. See §165 and §262.
- 1.165-1(e) Limitation On Losses Of Individuals. In the case of an individual, the deduction for losses granted by section 165(a) shall, subject to the provisions of section 165(c) and paragraph (a) of this section, be limited to:
- Losses incurred in a trade or business;
- Losses incurred in any transaction entered into for profit [e.g. an Investment], though not connected with a trade or business; and
- Losses of property not connected with a trade or business and not incurred in any transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft, and if the loss involved has not been allowed for estate tax purposes in the estate tax return. For additional provisions pertaining to the allowance of casualty and theft losses, see §§1.165-7 and 1.165-8, respectively.
Reporting (by individual taxpayers filing IRS Form 1040): Ordinary gains and losses are treated as interest income or interest expense.
- Some taxpayers use Form 4797, Part II.
- Some taxpayers use Form 1040, line 21 instead of Form 4797.
- Any other appropriate place where interest income or interest expense should be reported.
- Net losses from a single position that exceed $50,000 generally need to be reported on IRS Form 8886 as well.
Capital Gains and Losses are reported on Schedule D (and, if appropriate, on IRS Form 6781). If the IRC §988 election was made then the taxpayer is required to attach a verification statement.
Pooling funds: PAMM (Percentage Allocation Management Module or sometimes Percentage Allocation Money Management) LAMM (Lot Allocation Management Module) MAM (Multi-Account Management)
http://seekingalpha.com/instablog/364088-james-bibbings/469221-the-end-of-pamm-forex-allocations
http://www.interactivebrokers.com/en/p.php?f=friendsFamilyAccounts&ib_entity=ir
quotes:
http://www.marketcenter.com/forex/
Currency and Forward Currency Contracts Foreign currency transactions present issues related to the timing of recognition, the character (capital or ordinary), and the source (domestic or foreign) of the gain or loss. In 1986, Congress enacted comprehensive tax laws concerning the treatment of foreign currency transactions. 333 Prior to those laws, various rulings and court decisions provided guidance as to the treatment of such transactions. 334 /Footnote/ 333 §§985-989. For a detailed discussion of foreign currency transactions, see 184 T.M., Transactions in Stock, Securities, and Other Financial Instruments. /Footnote/ 334 Rev. Rul. 74-7, 1974-1 C.B. 198 (Foreign currency is capital asset; gain or loss realized on reconversion of currency is capital); Gillin v. U.S., 423 F.2d 309 (Ct. Cl. 1970); American Home Prods. Corp. v. U.S., 601 F.2d 540 (Ct. Cl. 1979) (Foreign currency is capital asset); Natl.-Standard Co. v. Comr., 80 T.C. 551 (1983), aff’d, 749 F.2d 369 (1984) (Change in value of U.S. dollars in relation to foreign currencies produces ordinary gain or loss). United States currency might constitute a capital asset, however, if it is not legal tender, not in circulation, or valued in the market primarily by its numismatic rather than its face value. See California Fed. Life Ins. Co. v. Comr., 76 T.C. 107 (1981), aff’d, 680 F.2d 85 (9th Cir. 1982) (U.S. Double Eagle gold coins are capital assets). The exchange gain or loss in a foreign currency denominated transaction arises due to a change in the exchange rate between the booking date (the date that an asset or liability is taken into account for U.S. tax purposes) and the date on which payment is made or received. 345 With certain exceptions, the exchange gain or loss is treated as ordinary income or loss. 346 /Footnote/ 345 §988(b). /Footnote/ 346 §988(a)(1)(A). Forward contracts for the sale of foreign currency constitute property interests. 347 Thus, an assignment of a currency futures contract produces capital gain or loss under general tax principles. Under the comprehensive tax laws enacted in 1986, capital gain or loss treatment is still available for forward contracts, future contracts, or options in foreign currencies if the contracts or options are otherwise capital assets, are not part of a straddle transaction, and are identified prior to the close of the day on which the transactions are entered into. 348 /Footnote/ 347 Carborundum Co. v. Comr., 74 T.C. 730 (1980); PLR 7847004. /Footnote/ 348 §988(a)(1)(B).
Internal Revenue Code Sec. 988. Treatment Of Certain Foreign Currency Transactions
988(a) General Rule Notwithstanding any other provisions of this chapter– 988(a)(1) Treatment As Ordinary Income Or Loss 988(a)(1)(A) In General Except as otherwise provided in this section, any foreign currency gain or loss attributable to a section 988 transaction shall be computed separately and treated as ordinary income or loss (as the case may be).
988(a)(1)(B) Special Rule For Forward Contracts, Etc. Except as provided in regulations, a taxpayer may elect to treat any foreign currency gain or loss attributable to a forward contract, a futures contract, or option described in subsection (c)(1)(B)(iii) which is a capital asset in the hands of the taxpayer and which is not a part of a straddle (within the meaning of section 1092(c), without regard to paragraph (4) thereof) as capital gain or loss (as the case may be) if the taxpayer makes such election and identifies such transaction before the close of the day on which such transaction is entered into (or such earlier time as the Secretary may prescribe).
988(a)(2) Gain Or Loss Treated As Interest For Certain Purposes To the extent provided in regulations, any amount treated as ordinary income or loss under paragraph (1) shall be treated as interest income or expense (as the case may be).
988(a)(3) Source 988(a)(3)(A) In General Except as otherwise provided in regulations, in the case of any amount treated as ordinary income or loss under paragraph (1) (without regard to paragraph (1)(B)), the source of such amount shall be determined by reference to the residence of the taxpayer or the qualified business unit of the taxpayer on whose books the asset, liability, or item of income or expense is properly reflected.
988(a)(3)(B) Residence For purposes of this subpart– 988(a)(3)(B)(i) In General The residence of any person shall be– 988(a)(3)(B)(i)(I) in the case of an individual, the country in which such individual’s tax home (as defined in section 911(d)(3)) is located, 988(a)(3)(B)(i)(II) in the case of any corporation, partnership, trust, or estate which is a United States person (as defined in section 7701(a)(30)), the United States, and 988(a)(3)(B)(i)(III) in the case of any corporation, partnership, trust, or estate which is not a United States person, a country other than the United States.
If an individual does not have a tax home (as so defined), the residence of such individual shall be the United States if such individual is a United States citizen or a resident alien and shall be a country other than the United States if such individual is not a United States citizen or a resident alien.
988(a)(3)(B)(ii) Exception In the case of a qualified business unit of any taxpayer (including an individual), the residence of such unit shall be the country in which the principal place of business of such qualified business unit is located.
988(a)(3)(B)(iii) Special Rule For Partnerships To the extent provided in regulations, in the case of a partnership, the determination of residence shall be made at the partner level.
988(a)(3)(C) Special Rule For Certain Related Party Loans Except to the extent provided in regulations, in the case of a loan by a United States person or a related person to a 10-percent owned foreign corporation which is denominated in a currency other than the dollar and bears interest at a rate at least 10 percentage points higher than the Federal mid-term rate (determined under section 1274(d)) at the time such loan is entered into, the following rules shall apply:
988(a)(3)(C)(i) For purposes of section 904 only, such loan shall be marked to market on an annual basis.
988(a)(3)(C)(ii) Any interest income earned with respect to such loan for the taxable year shall be treated as income from sources within the United States to the extent of any loss attributable to clause (i).
For purposes of this subparagraph, the term “related person” has the meaning given such term by section 954(d)(3), except that such section shall be applied by substituting “United States person” for “controlled foreign corporation” each place such term appears.
988(a)(3)(D) 10-percent Owned Foreign Corporation The term “10-percent owned foreign corporation” means any foreign corporation in which the United States person owns directly or indirectly at least 10 percent of the voting stock.
988(b) Foreign Currency Gain Or Loss For purposes of this section–
988(b)(1) Foreign Currency Gain The term “foreign currency gain” means any gain from a section 988 transaction to the extent such gain does not exceed gain realized by reason of changes in exchange rates on or after the booking date and before the payment date.
988(b)(2) Foreign Currency Loss The term “foreign currency loss” means any loss from a section 988 transaction to the extent such loss does not exceed the loss realized by reason of changes in exchange rates on or after the booking date and before the payment date.
988(b)(3) Special Rule For Certain Contracts, Etc. In the case of any section 988 transaction described in subsection (c)(1)(B)(iii), any gain or loss from such transaction shall be treated as foreign currency gain or loss (as the case may be).
988(c) Other Definitions For purposes of this section– 988(c)(1) Section 988 Transaction 988(c)(1)(A) In General The term “section 988 transaction” means any transaction described in subparagraph (B) if the amount which the taxpayer is entitled to receive (or is required to pay) by reason of such transaction–
988(c)(1)(A)(i) is denominated in terms of a nonfunctional currency, or 988(c)(1)(A)(ii) is determined by reference to the value of 1 or more nonfunctional currencies. 988(c)(1)(B) Description Of Transactions For purposes of subparagraph (A), the following transactions are described in this subparagraph:
988(c)(1)(B)(i) The acquisition of a debt instrument or becoming the obligor under a debt instrument.
988(c)(1)(B)(ii) Accruing (or otherwise taking into account) for purposes of this subtitle any item of expense or gross income or receipts which is to be paid or received after the date on which so accrued or taken into account.
988(c)(1)(B)(iii) Entering into or acquiring any forward contract, futures contract, option, or similar financial instrument.
The Secretary may prescribe regulations excluding from the application of clause (ii) any class of items the taking into account of which is not necessary to carry out the purposes of this section by reason of the small amounts or short periods involved, or otherwise.
988(c)(1)(C) Special Rules For Disposition Of Nonfunctional Currency 988(c)(1)(C)(i) In General In the case of any disposition of any nonfunctional currency–
988(c)(1)(C)(i)(I) such disposition shall be treated as a section 988 transaction, and 988(c)(1)(C)(i)(II) any gain or loss from such transaction shall be treated as foreign currency gain or loss (as the case may be).
988(c)(1)(C)(ii) Nonfunctional Currency For purposes of this section, the term “nonfunctional currency” includes coin or currency, and nonfunctional currency denominated demand or time deposits or similar instruments issued by a bank or other financial institution.
988(c)(1)(D) Exception For Certain Instruments Marked To Market 988(c)(1)(D)(i) In General Clause (iii) of subparagraph (B) shall not apply to any regulated futures contract or nonequity option which would be marked to market under section 1256 if held on the last day of the taxable year.
988(c)(1)(D)(ii) Election Out 988(c)(1)(D)(ii)(I) In General The taxpayer may elect to have clause (i) not apply to such taxpayer. Such an election shall apply to contracts held at any time during the taxable year for which such election is made or any succeeding taxable year unless such election is revoked with the consent of the Secretary.
988(c)(1)(D)(ii)(II) Time For Making Election Except as provided in regulations, an election under subclause (I) for any taxable year shall be made on or before the 1st day of such taxable year (or, if later, on or before the 1st day during such year on which the taxpayer holds a contract described in clause (i)).
988(c)(1)(D)(ii)(III) Special Rule For Partnerships, Etc. In the case of a partnership, an election under subclause (I) shall be made by each partner separately. A similar rule shall apply in the case of an S corporation.
988(c)(1)(D)(iii) Treatment Of Certain Partnerships This subparagraph shall not apply to any income or loss of a partnership for any taxable year if such partnership made an election under subparagraph (E)(iii)(V) for such year or any preceding year.
988(c)(1)(E) Special Rules For Certain Funds 988(c)(1)(E)(i) In General In the case of a qualified fund, clause (iii) of subparagraph (B) shall not apply to any instrument which would be marked to market under section 1256 if held on the last day of the taxable year (determined after the application of clause (iv)).
988(c)(1)(E)(ii) Special Rule Where Electing Partnership Does Not Qualify If any partnership made an election under clause (iii)(V) for any taxable year and such partnership has a net loss for such year or any succeeding year from instruments referred to in clause (i), the rules of clauses (i) and (iv) shall apply to any such loss year whether or not such partnership is a qualified fund for such year.
988(c)(1)(E)(iii) Qualified Fund Defined For purposes of this subparagraph, the term “qualified fund” means any partnership if– 988(c)(1)(E)(iii)(I) at all times during the taxable year (and during each preceding taxable year to which an election under subclause (V) applied), such partnership has at least 20 partners and no single partner owns more than 20 percent of the interests in the capital or profits of the partnership,
988(c)(1)(E)(iii)(II) the principal activity of such partnership for such taxable year (and each such preceding taxable year) consists of buying and selling options, futures, or forwards with respect to commodities,
988(c)(1)(E)(iii)(III) at least 90 percent of the gross income of the partnership for the taxable year (and for each such preceding taxable year) consisted of income or gains described in subparagraph (A), (B), or (G) of section 7704(d)(1) or gain from the sale or disposition of capital assets held for the production of interest or dividends,
988(c)(1)(E)(iii)(IV) no more than a de minimis amount of the gross income of the partnership for the taxable year (and each such preceding taxable year) was derived from buying and selling commodities, and 988(c)(1)(E)(iii)(V) an election under this subclause applies to the taxable year.
An election under subclause (V) for any taxable year shall be made on or before the 1st day of such taxable year (or, if later, on or before the 1st day during such year on which the partnership holds an instrument referred to in clause (i)). Any such election shall apply to the taxable year for which made and all succeeding taxable years unless revoked with the consent of the Secretary.
988(c)(1)(E)(iv) Treatment Of Certain Currency Contracts 988(c)(1)(E)(iv)(I) In General Except as provided in regulations, in the case of a qualified fund, any bank forward contract, any foreign currency futures contract traded on a foreign exchange, or to the extent provided in regulations any similar instrument, which is not otherwise a section 1256 contract shall be treated as a section 1256 contract for purposes of section 1256.
988(c)(1)(E)(iv)(II) Gains And Losses Treated As Short-term In the case of any instrument treated as a section 1256 contract under subclause (I), subparagraph (A) of section 1256(a)(3) shall be applied by substituting “100 percent” for “40 percent” (and subparagraph (B) of such section shall not apply).
988(c)(1)(E)(v) Special Rules For Clause (iii)(i) 988(c)(1)(E)(v)(I) Certain General Partners The interest of a general partner in the partnership shall not be treated as failing to meet the 20-percent ownership requirements of clause (iii)(I) for any taxable year of the partnership if, for the taxable year of the partner in which such partnership taxable year ends, such partner (and each corporation filing a consolidated return with such partner) had no ordinary income or loss from a section 988 transaction which is foreign currency gain or loss (as the case may be).
988(c)(1)(E)(v)(II) Treatment Of Incentive Compensation For purposes of clause (iii)(I), any income allocable to a general partner as incentive compensation based on profits rather than capital shall not be taken into account in determining such partner’s interest in the profits of the partnership.
988(c)(1)(E)(v)(III) Treatment Of Tax-exempt Partners Except as provided in regulations, the interest of a partner in the partnership shall not be treated as failing to meet the 20-percent ownership requirements of clause (iii)(I) if none of the income of such partner from such partnership is subject to tax under this chapter (whether directly or through 1 or more pass-thru entities).
988(c)(1)(E)(v)(IV) Look-thru Rule In determining whether the requirements of clause (iii)(I) are met with respect to any partnership, except to the extent provided in regulations, any interest in such partnership held by another partnership shall be treated as held proportionately by the partners in such other partnership.
988(c)(1)(E)(vi) Other Special Rules For purposes of this subparagraph– 988(c)(1)(E)(vi)(I) Related Persons Interests in the partnership held by persons related to each other (within the meaning of sections 267(b) and 707(b)) shall be treated as held by 1 person.
988(c)(1)(E)(vi)(II) Predecessors References to any partnership shall include a reference to any predecessor thereof.
988(c)(1)(E)(vi)(III) Inadvertent Terminations Rules similar to the rules of section 7704(e) shall apply.
988(c)(1)(E)(vi)(IV) Treatment Of Certain Debt Instruments For purposes of clause (iii)(IV), any debt instrument which is a section 988 transaction shall be treated as a commodity.
988(c)(2) Booking Date The term “booking date” means– 988(c)(2)(A) in the case of a transaction described in paragraph (1)(B)(i), the date of acquisition or on which the taxpayer becomes the obligor, or 988(c)(2)(B) in the case of a transaction described in paragraph (1)(B)(ii), the date on which accrued or otherwise taken into account.
988(c)(3) Payment Date The term “payment date” means the date on which the payment is made or received.
988(c)(4) Debt Instrument The term “debt instrument” means a bond, debenture, note, or certificate or other evidence of indebtedness. To the extent provided in regulations, such term shall include preferred stock.
988(c)(5) Special Rules Where Taxpayer Takes Or Makes Delivery If the taxpayer takes or makes delivery in connection with any section 988 transaction described in paragraph (1)(B)(iii), any gain or loss (determined as if the taxpayer sold the contract, option, or instrument on the date on which he took or made delivery for its fair market value on such date) shall be recognized in the same manner as if such contract, option, or instrument were so sold.
988(d) Treatment Of 988 Hedging Transactions 988(d)(1) In General To the extent provided in regulations, if any section 988 transaction is part of a 988 hedging transaction, all transactions which are part of such 988 hedging transaction shall be integrated and treated as a single transaction or otherwise treated consistently for purposes of this subtitle. For purposes of the preceding sentence, the determination of whether any transaction is a section 988 transaction shall be determined without regard to whether such transaction would otherwise be marked-to-market undersection 475 or 1256 and such term shall not include any transaction with respect to which an election is made under subsection (a)(1)(B). Sections492, 1092 and 1256 1 shall not apply to a transaction covered by this subsection.
988(d)(2) 988 Hedging Transaction For purposes of paragraph (1), the term “988 hedging transaction” means any transaction– 988(d)(2)(A) entered into by the taxpayer primarily– 988(d)(2)(A)(i) to manage risk of currency fluctuations with respect to property which is held or to be held by the taxpayer, or 988(d)(2)(A)(ii) to manage risk of currency fluctuations with respect to borrowings made or to be made, or obligations incurred or to be incurred, by the taxpayer, and 988(d)(2)(B) identified by the Secretary or the taxpayer as being a 988 hedging transaction. 988(e) Application To Individuals.– 988(e)(1) In General.– The preceding provisions of this section shall not apply to any section 988 transaction entered into by an individual which is a personal transaction.
988(e)(2) Exclusion For Certain Personal Transactions.– If– 988(e)(2)(A) nonfunctional currency is disposed of by an individual in any transaction, and 988(e)(2)(B) such transaction is a personal transaction, no gain shall be recognized for purposes of this subtitle by reason of changes in exchange rates after such currency was acquired by such individual and before such disposition. The preceding sentence shall not apply if the gain which would otherwise be recognized on the transaction exceeds $200.
988(e)(3) Personal Transactions.– For purposes of this subsection, the term `personal transaction’ means any transaction entered into by an individual, except that such term shall not include any transaction to the extent that expenses properly allocable to such transaction meet the requirements of– 988(e)(3)(A) section 162 (other than traveling expenses described in subsection (a)(2) thereof), or 988(e)(3)(B) section 212 (other than that part of section 212 dealing with expenses incurred in connection with taxes).
(Added Pub. L. 99-514, title XII, Sec. 1261(a), Oct. 22, 1986, 100 Stat. 2587, and amended Pub. L. 100-647, title I, Sec. 1012(v)(2)(A), (3), (4), (6)-(8), title VI, Sec. 6130(a), (b), Nov. 10, 1988, 102 Stat. 3529, 3530, 3717; Pub. L. 101-239, title VII, Sec. 7811(i)(7), Dec. 19, 1989, 103 Stat. 2410; Pub. L. 105-34, title XI, Sec. 1104(a), Aug. 5, 1997, 111 Stat 788; Pub. L. 106-170, title V, Sec. 532(b), Dec. 17, 1999, 113 Stat 1860.)
Internal Revenue Code Section 1256 Contract
A section 1256 contract is any:
1. Regulated futures contract,
2. Foreign currency contract,
3. Nonequity option,
4. Dealer equity option, or
5. Dealer securities futures contract.
Regulated futures contract. This is a contract that:
1. Provides that amounts that must be deposited to, or can be withdrawn from, your margin account depend on daily market conditions (a system of marking to market), and
2. Is traded on, or subject to the rules of, a qualified board of exchange. A qualified board of exchange is a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, any board of trade or exchange approved by the Secretary of the Treasury, or a national securities exchange registered with the Securities and Exchange Commission.
Foreign currency contract. This is a contract that:
1. Requires delivery of a foreign currency that has positions traded through regulated futures contracts (or settlement of which depends on the value of that type of foreign currency),
2. Is traded in the interbank market, and
3. Is entered into at arm’s length at a price determined by reference to the price in the interbank market.
Bank forward contracts with maturity dates that are longer than the maturities ordinarily available for regulated futures contracts are considered to meet the definition of a foreign currency contract if the above three conditions are satisfied.
Special rules apply to certain foreign currency transactions. These transactions may result in ordinary gain or loss treatment. For details, see Internal Revenue Code section 988 and Regulations sections 1.988-1(a)(7) and 1.988-3.
Internal Revenue Code Sec. 988. Treatment Of Certain Foreign Currency Transactions 988(a) General Rule Notwithstanding any other provisions of this chapter– 988(a)(1) Treatment As Ordinary Income Or Loss 988(a)(1)(A) In General Except as otherwise provided in this section, any foreign currency gain or loss attributable to a section 988 transaction shall be computed separately and treated as ordinary income or loss (as the case may be). 988(a)(1)(B) Special Rule For Forward Contracts, Etc. Except as provided in regulations, a taxpayer may elect to treat any foreign currency gain or loss attributable to a forward contract, a futures contract, or option described in subsection (c)(1)(B)(iii) which is a capital asset in the hands of the taxpayer and which is not a part of a straddle (within the meaning of section 1092(c), without regard to paragraph (4) thereof) as capital gain or loss (as the case may be) if the taxpayer makes such election and identifies such transaction before the close of the day on which such transaction is entered into (or such earlier time as the Secretary may prescribe).
Treas. Regulations §1.988-1(a)(7) 1.988-1(a)(7) Special rules for regulated futures contracts and non-equity options–
1.988-1(a)(7)(i) In general.
Except as provided in paragraph (a)(7)(ii) of this section, paragraph (a)(2)(iii) of this section shall not apply to any regulated futures contract or non-equity option which would be marked to market under section 1256 if held on the last day of the taxable year.
1.988-1(a)(7)(ii) Election to have paragraph (a)(2)(iii) of this section apply.
Notwithstanding paragraph (a)(7)(i) of this section, a taxpayer may elect to have paragraph (a)(2)(iii) of this section apply to regulated futures contracts and non-equity options as provided in paragraph (a)(7)(iii) and (iv) of this section.
1.988-1(a)(7)(iii) Procedure for making the election.
A taxpayer shall make the election provided in paragraph (a)(7)(ii) of this section by sending to the Internal Revenue Service Center, Examination Branch, Stop Number 92, Kansas City, MO 64999 a statement titled “ELECTION TO TREAT REGULATED FUTURES CONTRACTS AND NON-EQUITY OPTIONS AS SECTION 988 TRANSACTIONS UNDER SECTION 988(c)(1)(D)(ii)” that contains the following:
1.988-1(a)(7)(iii)(A) The taxpayer’s name, address, and taxpayer identification number;
1.988-1(a)(7)(iii)(B) The date the notice is mailed or otherwise delivered to the Internal Revenue Service Center;
1.988-1(a)(7)(iii)(C) A statement that the taxpayer (including all members of such person’s affiliated group as defined in section 1504 or in the case of an individual all persons filing a joint return with such individual) elects to have section 988(c)(1)(D)(i) and section 1.988-1(a)(7)(i) not apply;
1.988-1(a)(7)(iii)(D) The date of the beginning of the taxable year for which the election is being made;
1.988-1(a)(7)(iii)(E) If the election is filed after the first day of the taxable year, a statement regarding whether the taxpayer has previously held a contract described in section 988(c)(1)(D)(i) or section 1.988-1(a)(7)(i) during such taxable year, and if so, the first date during the taxable year on which such contract was held; and
1.988-1(a)(7)(iii)(F) The signature of the person making the election (in the case of individuals filing a joint return, the signature of all persons filing such return).
The election shall be made by the following persons: in the case of an individual, by such individual; in the case of a partnership, by each partner separately; effective for taxable years beginning after March 17, 1992, in the case of tiered partnerships, each ultimate partner; in the case of an S corporation, by each shareholder separately; in the case of a trust (other than a grantor trust) or estate, by the fiduciary of such trust or estate; in the case of any corporation other than an S corporation, by such corporation (in the case of a corporation that is a member of an affiliated group that files a consolidated return, such election shall be valid and binding only if made by the common parent, as that term is used in section 1.1502-77(a)); in the case of a controlled foreign corporation, by its controlling United States shareholders under section 1.964-1(c)(3). With respect to a corporation (other than an S corporation), the election, when made by the common parent, shall be binding on all members of such corporation’s affiliated group as defined in section 1504 that file a consolidated return. The election shall be binding on any income or loss derived from the partner’s share (determined under the principles of section 702(a)) of all contracts described in section 988(c)(1)(D)(i) or paragraph (a)(7)(i) of this section in which the taxpayer holds a direct interest or indirect interest through a partnership or S corporation; however, the election shall not apply to any income or loss of a partnership for any taxable year if such partnership made an election under section 988(c)(1)(E)(iii)(V) for such year or any preceding year. Generally, a copy of the election must be attached to the taxpayer’s income tax return for the first year it is effective. It is not required to be attached to subsequent returns. However, in the case of a partner, a copy of the election must be attached to the taxpayer’s income tax return for every year during which the taxpayer is a partner in a partnership that engages in a transaction that is subject to the election.
1.988-1(a)(7)(iv) Time for making the election–
1.988-1(a)(7)(iv)(A) In general.
Unless the requirements for making a late election described in paragraph (a)(7)(iv)(B) of this section are satisfied, an election under section 988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section for any taxable year shall be made on or before the first day of the taxable year or, if later, on or before the first day during such taxable year on which the taxpayer holds a contract described in section 988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section. The election under section 988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section shall apply to contracts entered into or acquired after October 21, 1988, and held on or after the effective date of the election. The election shall be effective as of the beginning of the taxable year and shall be binding with respect to all succeeding taxable years unless revoked with the prior consent of the Commissioner. In determining whether to grant revocation of the election, recapture of the tax benefit derived from the election in previous taxable years will be considered.
1.988-1(a)(7)(iv)(B) Late elections.
A taxpayer may make an election under section 988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section within 30 days after the time prescribed in the first sentence of paragraph (a)(7)(iv)(A) of this section. Such a late election shall be effective as of the beginning of the taxable year; however, any losses recognized during the taxable year with respect to contracts described in section 988(c)(1)(D)(ii) or paragraph (a)(7)(ii) of this section which were entered into or acquired after October 21, 1988, and held on or before the date on which the late election is mailed or otherwise delivered to the Internal Revenue Service Center shall not be treated as derived from a section 988 transaction. A late election must comply with the procedures set forth in paragraph (a)(7)(iii) of this section.
1.988-1(a)(7)(v) Transition rule.
An election made prior to September 21, 1989 which satisfied the requirements of Notice 88-124, 1988-51 I.R.B. 6, shall be deemed to satisfy the requirements of paragraphs (a)(7)(iii) and (iv) of this section.
1.988-1(a)(7)(vi) General effective date provision.
This paragraph (a)(7) shall apply with respect to futures contracts and options entered into or acquired after October 21, 1988.
Treas. Regulations §1.988-3 Character of exchange gain or loss.
1.988-3(a) In general. The character of exchange gain or loss recognized on a section 988 transaction is governed by section 988 and this section. Except as otherwise provided in section 988 (c)(1)(E), section 1092, section 1.988-5 and this section, exchange gain or loss realized with respect to a section 988 transaction (including a section 1256 contract that is also a section 988 transaction) shall be characterized as ordinary gain or loss. Accordingly, unless a valid election is made under paragraph (b) of this section, any section providing special rules for capital gain or loss treatment, such as sections 1233, 1234, 1234A, 1236 and 1256(f)(3), shall not apply.
1.988-3(b) Election to characterize exchange gain or loss on certain identified forward contracts futures contracts and option contracts as capital gain or loss– 1.988-3(b)(1) In general. Except as provided in paragraph (b)(2) of this section, a taxpayer may elect, subject to the requirements of paragraph (b)(3) of this section, to treat any gain or loss recognized on a contract described in section 1.988- 2(d)(1) as capital gain or loss, but only if the contract —
1.988-3(b)(1)(i) Is a capital asset in the hands of the taxpayer;
1.988-3(b)(1)(ii) Is not part of a straddle within the meaning of section 1092(c) (without regard to subsections (c)(4) or (e)); and
1.988-3(b)(1)(iii) Is not a regulated futures contract or nonequity option with respect to which an election under section 988(c)(1)(D)(ii) is in effect. If a valid election under this paragraph (b) is made with respect to a section 1256 contract, section 1256 shall govern the character of any gain or loss recognized on such contract.
1.988-3(b)(2) Special rule for contracts that become part of a straddle after an election is made. If a contract which is the subject of an election under paragraph (b)(1) of this section becomes part of a straddle within the meaning of section 1092 (c) (without regard to subsections (c)(4) or (e)) after the date of the election, the election shall be invalid with respect to gains from such contract and the Commissioner, in his sole discretion, may invalidate the election with respect to losses.
1.988-3(b)(3) Requirements for making the election.
A taxpayer elects to treat gain or loss on a transaction described in paragraph (b)(1) of this section as capital gain or loss by clearly identifying such transaction on its books and records on the date the transaction is entered into. No specific language or account is necessary for identifying a transaction referred to in the preceding sentence. However, the method of identification must be consistently applied and must clearly identify the pertinent transaction as subject to the section 988(a)(1)(B) election. The Commissioner, in his sole discretion, may invalidate any purported election that does not comply with the preceding sentence.
1.988-3(b)(4) Verification.
A taxpayer that has made an election under section 1.988-3(b)(3) must attach to his income tax return a statement which sets forth the following:
1.988-3(b)(4)(i) A description and the date of each election made by the taxpayer during the taxpayer’s taxable year;
1.988-3(b)(4)(ii) A statement that each election made during the taxable year was made before the close of the date the transaction was entered into;
1.988-3(b)(4)(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;
1.988-3(b)(4)(iv) A statement that the contract was never part of a straddle as defined in section 1092; and
1.988-3(b)(4)(v) A statement that all transactions subject to the election are included on the statement attached to the taxpayer’s income tax return. In addition to any penalty that may otherwise apply, the Commissioner, in his sole discretion, may invalidate any or all elections made during the taxable year under section
1.988-3(b)(1) if the taxpayer fails to verify each election as provided in this section
1.988-3(b)(4). The preceding sentence shall not apply if the taxpayer’s failure to verify each election was due to reasonable cause or bona fide mistake. The burden of proof to show reasonable cause or bona fide mistake made in good faith is on the taxpayer.
1.988-3(b)(5) Independent verification–
1.988-3(b)(5)(i) Effect of independent verification. If the taxpayer receives independent verification of the election in paragraph (b)(3) of this section, the taxpayer shall be presumed to have satisfied the requirements of paragraphs (b)(3) and (4) of this section. A contract that is a part of a straddle as defined in section 1092 may not be independently verified and shall be subject to the rules of paragraph (b)(2) of this section. 1.988-3(b)(5)(ii) Requirements for independent verification. A taxpayer receives independent verification of the election in paragraph (b)(3) of this section if —
1.988-3(b)(5)(ii)(A) The taxpayer establishes a separate account(s) with an unrelated broker(s) or dealer(s) through which all transactions to be independently verified pursuant to this paragraph (b)(5) are conducted and reported.
1.988-3(b)(5)(ii)(B) Only transactions entered into on or after the date the taxpayer establishes such account may be recorded in the account.
1.988-3(b)(5)(ii)(C) Transactions subject to the election of paragraph (b)(3) of this section are entered into such account on the date such transactions are entered into.
1.988-3(b)(5)(ii)(D) The broker or dealer provides the taxpayer a statement detailing the transactions conducted through such account and 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).”
INTERNAL REVENUE SERVICE NATIONAL OFFICE FIELD SERVICE ADVICE
MEMORANDUM FOR ASSOCIATE DISTRICT COUNSEL
FROM: DEBORAH A. BUTLER ASSISTANT CHIEF COUNSEL CC:DOM:FS
SUBJECT: Section 1256 Contracts and Section 988 Transactions
This Field Service Advice responds to your memorandum dated November 23, 1999. Field Service Advice is not binding on Examination or Appeals and is not a final case determination. This document is not to be cited as precedent.
CONCLUSIONS
1. A may have traded in RFCs as defined in §§1256(b)(1) and 1256(g)(1). Additional factual development is required.
2. A foreign currency contract may include a non-regulated foreign currency futures contract and a forward contract in foreign currency traded on the interbank market.
3. Foreign currency option contracts are not foreign currency contracts pursuant to §1256(g)(2). Transactions in these contracts may qualify as §988 transactions. The gains or losses on foreign currency options contracts that are not nonequity options will be characterized as ordinary gains or losses, pursuant to §988(c)(1)(B)(iii).
4. To the extend that A was in the trade or business of engaging in §988 transactions, any losses incurred could affect the taxpayers’ NOL.
5. If C is viewed as an agent of A, its trading activity may be aggregated with A’s activity in determining whether he was a trader or investor.
6. The taxpayers have properly amended their Tax Court petition in this case to raise the new issues with respect to the carryforward to the Year 3 tax year of NOLs allegedly incurred by the taxpayers in the Year 1 through Year 2 tax years. http://www.irs.gov/pub/irs-wd/0025020.pdf
short n’ sweet explanation found elsewhere on the web…
Forex Trading
Forex trades are not reported to the IRS the same as stocks and options, or futures. Forex trades are considered by the IRS as simple interest and the gain or loss is reported as “other income” on Form 1040 (line 21). No special schedules or matched trade lists are necessary.
short n’ sweet explanation #2 as suggested by larger hedge funds…
Section 988 gain or loss
While we are aware of no specific IRS instructions regarding the proper reporting of Section 988 gain or loss, we recommend that such amounts be reflected on Form 4797, Part II, line 10.
National Futures Association (NFA) is the industry-wide, self-regulatory organization for the U.S. futures industry. http://www.nfa.futures.org/
FOREX Education site: http://www.forex-day-trading.com/forex-education/
Their tax info page: http://www.forex-day-trading.com/forex-taxes/
Auditors
| aRank: Based on a total universe of 2,289 U.S. and international hedge fund managers and CTAs representing US$317.1 billion in assets under management reporting a single Auditor relationship to TASS Research as of 12/31/02. In this ranking, where appropriate the group or parent company name is used. |
Legal Counsels
| aRank: Based on a total universe of 1,638 U.S. and international hedge fund managers and CTAs representing US$214.1 billion in assets under management reporting a single Legal Counsel relationship to TASS Research as of 12/31/02. In this ranking, where appropriate the group or parent company name is used. |
IRS Publication 550:
Loss transactions. For individuals, a loss transaction is any transaction that results in a deductible loss if the gross amount of the loss is at least $2 million in a single tax year or $4 million in any combination of tax years. A loss from a foreign currency transaction under Internal Revenue Code section 988 is a loss transaction if the gross amount of the loss is at least $50,000 in a single tax year, whether or not the loss flows through from an S corporation or partnership.
IRS Publication 334:
Reportable transactions. You must file Form 8886, Reportable Transaction Disclosure Statement, to report certain transactions. You may have to pay a penalty if you are required to file Form 8886 but do not do so. You may also have to pay interest and penalties on any reportable transaction understatements. Reportable transactions include (1) transactions the same as or substantially similar to tax avoidance transactions identified by the IRS, (2) transactions offered to you under conditions of confidentiality for which you paid an advisor a minimum fee, (3) transactions for which you have, or a related party has, contractual protection against disallowance of the tax benefits, (4) transactions that result in losses of at least $2 million in any single tax year ($50,000 if from certain foreign currency transactions) or $4 million in any combination of tax years, (5) transactions resulting in book-tax differences of more than $10 million on a gross basis, and (6) transactions with asset holding periods of 45 days or less and that result in a tax credit of more than $250,000. For more information, see the Instructions for Form 8886.
IRS Schedule C instructions:
Reportable Transaction Disclosure Statement: Use Form 8886 to disclose information for each reportable transaction in which you participated. Form 8886 must be filed for each tax year that your federal income tax liability is affected by your participation in the transaction. You may have to pay a penalty if you are required to file Form 8886 but do not do so. You may also have to pay interest and penalties on any reportable transaction understatements. The following are reportable transactions.
- Any transaction resulting in a loss of at least $2 million in any single tax year or $4 million in any combination of tax years. (At least $50,000 for a single tax year if the loss arose from a foreign currency transaction defined in section 988(c)(1), whether or not the loss flows through from an S corporation or partnership.)
- Any transaction resulting in a book-tax difference of more than $10 million on a gross basis.
Investor Reporting
You may be required to provide the following information.
1. Reportable transaction disclosure statement.
2. Tax shelter registration number.
Reportable Transaction Disclosure Statement
Use Form 8886 to disclose information for each reportable transaction in which you participated. Generally, you must attach Form 8886 to your return for each year that your tax liability is affected by your participation in the transaction. In addition, for the first year Form 8886 is attached to your return, you must send a copy to:
Internal Revenue Service
LM:PFTG:OTSA
Large & Mid-Size Business Division
1111 Constitution Avenue,
NW Washington, DC 20224
If you fail to file Form 8886 as required or fail to include any required information on the form, you may have to pay a penalty. See Penalty for failure to disclose a reportable transaction later under
Penalties.
The following discussion briefly describes reportable transactions. For more details, see the instructions for Form 8886. Reportable transaction. A reportable transaction is any of the following.
• A listed transaction.
• A confidential transaction.
• A transaction with contractual protection.
• Loss transactions. • Transactions with a significant book-tax difference.
• Transactions with a brief asset holding period. This category includes transactions that result in your claiming a tax credit (including a foreign tax credit) of more than $250,000 if the asset giving rise to the credit was held by you for 45 days or less.
Listed transaction. A listed transaction is a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has determined to be a tax-avoidance transaction. These transactions have been identified in notices, regulations, and other published guidance issued by the IRS. For a list of existing guidance, see the instructions for Form 8886.
Confidential transaction. A confidential transaction is one that is offered to you under conditions of confidentiality and for which you have paid an advisor a minimum fee. A transaction is offered under conditions of confidentiality if the advisor who is paid the fee places a limit on the disclosure of the tax treatment or tax structure on you and the limit protects the advisor’s tax strategies. The transaction is treated as confidential even if the conditions of confidentiality are not legally binding on you.
Transaction with contractual protection. Generally, a transaction with contractual protection is a transaction in which you or a related party has the right to a full or partial refund of fees if all or part of the intended tax consequences of the transaction are not sustained, or a transaction for which the fees are contingent on your realizing the tax benefits from the transaction.
Loss transactions. For individuals, a loss transaction is any transaction that results in a deductible loss if the gross amount of the loss is at least $2 million in a single tax year or $4 million in any combination of tax years. A loss from a foreign currency transaction under Internal Revenue Code section 988 is a loss transaction if the gross amount of the loss is at least $50,000 in a single tax year, whether or not the loss flows through from an S corporation or partnership. Certain losses (such as losses from casualties, thefts, and condemnations) are excepted from this category and do not have to be reported on Form 8886 (see Form 8886 instructions). For information on other exceptions, see Revenue Procedure 2003-24 in Internal Revenue Bulletin 2003-11. This Internal Revenue Bulletin is available at www.irs.gov/pub/irs-irbs/irb03-11.pdf.
Transactions with a significant book-tax difference. This category includes transactions that result in book-tax differences of more than $10 million in any tax year. The book-tax difference is the amount by which the amount of any income, gain, expense, or loss item from the transaction for federal income tax purposes differs on a gross basis from the amount of the item for book purposes for any tax year.
Internal Revenue Code Sec. 988 Tax Shelter
http://www.irs.gov/businesses/article/0,,id=141473,00.html
“Notice 2003-81” Tax Shelter |
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Part III – Administrative, Procedural and Miscellaneous
Tax Avoidance Using Offsetting Foreign Currency Option Contracts
Notice 2003-81
The Internal Revenue Service and the Treasury Department are aware of a type of transaction, described below, in which a taxpayer claims a loss upon the assignment of a section 1256 contract to a charity but fails to report the recognition of gain when the taxpayer’s obligation under an offsetting non-section 1256 contract terminates. This notice alerts taxpayers and their representatives that these transactions are tax avoidance transactions and identifies these transactions, and those that are substantially similar to these transactions, as listed transactions for purposes of §1.6011-4(b)(2) of the Income Tax Regulations and §§301.6111-2(b)(2) and 301.6112-1(b)(2) of the Procedure and Administration Regulations. This notice also alerts parties involved with these transactions of certain responsibilities that may arise from their involvement with these transactions.
FACTS
A taxpayer pays premiums to purchase a call option and a put option (the purchased options) on a foreign currency. The following sentence is an erroneous conclusion of law. The currency is one in which positions are traded through regulated futures contracts, and the purchased options, therefore, are foreign currency contracts within the meaning of section 1256(g)(2)(A) of the Internal Revenue Code and section 1256 contracts within the meaning of section 1256(b). This sentence should have stated: The taxpayer takes the position that the purchased options are foreign currency contracts within the meaning of §1256(g)(2)(A) of the Internal Revenue Code and §1256 contracts within the meaning of §1256(b). The purchased options are reasonably expected to move inversely in value to one another over a relevant range, thus ensuring that, as the value of the underlying foreign currency changes, the taxpayer will hold a loss position in one of the two section 1256 contracts. The taxpayer also receives premiums for writing a call option and a put option (the written options) on a different foreign currency in which positions are not traded through regulated futures contracts. Thus, the written options are not foreign currency contracts within the meaning of section 1256(g)(2)(A), nor are they section 1256 contracts within the meaning of section 1256(b). The written options are reasonably expected to move inversely in value to one another over a relevant range, thus ensuring that, as the value of the underlying foreign currency changes, the taxpayer will hold a gain position in one of the two non-section 1256 contracts.
The values of the two currencies underlying the purchased and written options (i) historically have demonstrated a very high positive correlation with one another, or (ii) officially have been linked to one another, such as through the European Exchange Rate Mechanism (ERM II). Thus, as the currencies change in value, the taxpayer reasonably expects to have the following potential gains and losses in substantially offsetting positions: (1) a loss in a purchased option and a gain in a written option; and (2) a gain in a purchased option and a loss in a written option. At any time, the taxpayer’s loss in the purchased option position that has declined in value may be more or less than the taxpayer’s gain in the offsetting written option position that has appreciated in value. Similarly, the taxpayer’s gain in the remaining purchased option position may be more or less than the taxpayer’s loss in the remaining written option position. A material pre-tax profit or rate of return, or both, on the transaction is possible but unlikely.
The taxpayer assigns to a charity the purchased option that has a loss. The charity also assumes the taxpayer’s obligation under the offsetting written option that has a gain. As with all written options, the amount of gain on the option is limited to the premium received for the option. In the same tax year, the taxpayer may dispose of the remaining purchased option and offsetting written option.
Because the purchased option assigned to the charity is a section 1256 contract, the taxpayer relies on section 1256(c) and Greene v. United States, 79 F.3d 1348 (2d Cir. 1996), to mark to market the purchased option when the option is assigned to the charity and to recognize a loss at that time. In contrast, because the assumed written option is not a section 1256 contract, the taxpayer claims not to recognize gain attributable to the option premium. Specifically, the taxpayer claims that the charity’s assumption of the option obligation does not cause the taxpayer to recognize gain and that the taxpayer also does not recognize gain either at the time the option expires or terminates or at any other time.
ANALYSIS
Rev. Rul. 58-234, 1958-1 C.B. 279, clarified by Rev. Rul. 68-151, 1968-1 C.B. 363, holds that an option writer does not recognize income or gain with respect to a premium received for writing an option until the option is terminated, without exercise, or otherwise. Accord Rev. Rul. 78-182, 1978-1 C.B. 265; Koch v. Commissioner, 67 T.C. 71 (1976), acq. 1980-2 C.B. 1. Rev. Rul. 58-234 explains that this is the treatment for the option writer because the option writer assumes a burdensome and continuing obligation, and the transaction therefore stays open without any ascertainable income or gain until the writer’s obligation is finally terminated. When the option writer’s obligation terminates, the transaction closes, and the option writer must recognize any income or gain attributable to the prior receipt of the option premium.
In some cases, the option writer’s obligation under the option contract may terminate on the charity’s assumption of the written option obligation. In other cases, the writer will have a continuing obligation because the writer may be called upon to perform if the charity fails to perform or to reimburse the charity for any losses or expenses it may incur if called upon to perform. If an assumption terminates the option writer’s obligation under the option contract, the option writer must recognize gain when the option obligation is assumed. If the assumption does not terminate the option writer’s obligation under the option contract, the option writer must recognize the premium when the option writer’s obligation under the option contract terminates (other than through an exercise of the option against, and performance by, the option writer).
These general principles remain applicable even if the assumption of the option writer’s obligation is part of what the taxpayer claims is a donative transaction. Cf. Diedrich v. Commissioner, 457 U.S. 191 (1982) (noting that if a donee pays a gift tax obligation arising from a donative transfer, the donative nature of the transaction does not preclude income recognition by the donor on the obligation assumed). Here, the taxpayer has made a transfer to the charity of the purchased option, and the charity has assumed the burden of the written option. No aspect of the taxpayer’s transfer or the charity’s assumption (or their combination) relieves the taxpayer from its duty under the Code to account for the gain attributable to the premium originally received by the taxpayer for assuming the burden of writing the option. See Lucas v. Earl, 281 U.S. 111 (1930) (holding that a taxpayer may not avoid inclusion of future earned income by making a gratuitous transfer of the right to receive the income).
Finally, if the taxpayer has any unrecognized gain on the written option at the end of the year in which the assumption occurs (e.g., the assumption did not terminate the option writer’s obligation under the option contract), the mark-to-market loss on the offsetting contributed section 1256 contract will be deferred under section 1092.
Transactions that are the same as, or substantially similar to, the transactions described in this notice are identified as “listed transactions” for purposes of §§1.6011-4(b)(2), 301.6111-2(b)(2) and 301.6112-1(b)(2) effective December 4, 2003, the date this notice was released to the public. Variations on these transactions may include positions in other section 1256 and non-section 1256 contracts. Independent of their classification as “listed transactions” for purposes of §§1.6011-4(b)(2), 301.6111-2(b)(2), and 301.6112-1(b)(2), transactions that are the same as, or substantially similar to, the transaction described in this notice may already be subject to the disclosure requirements of section 6011 (§1.6011-4), the tax shelter registration requirements of section 6111 (§§301.6111-1T, 301.6111-2), or the list maintenance requirements of section 6112 ( §301.6112-1). Persons who are required to register these tax shelters under section 6111 but have failed to do so may be subject to the penalty under section 6707(a). Persons who are required to maintain lists of investors under section 6112 but have failed to do so (or who fail to provide those lists when requested by the Service) may be subject to the penalty under section 6708(a). In addition, the Service may impose penalties on parties involved in these transactions or substantially similar transactions, including the accuracy-related penalty under §6662.
The Service and the Treasury recognize that some taxpayers may have filed tax returns taking the position that they were entitled to the purported tax benefits of the type of transaction described in this notice. These taxpayers should consult with a tax advisor to ensure that their transactions are disclosed properly and to take appropriate corrective action.
The principal author of this notice is Clay Littlefield of the Office of Associate Chief Counsel (Financial Institutions and Products). For further information regarding this notice, contact Mr. Littlefield at (202) 622-3920 (not a toll-free call).
Part III – Administrative, Procedural, and Miscellaneous
Modification of Notice 2003-81
Notice 2007-71
This Notice modifies and supplements Notice 2003-81, 2003-2 C.B. 1223, by correcting a statement in the “Facts” portion of Notice 2003-81.
BACKGROUND On December 4, 2003, the Internal Revenue Service (“Service”) and the Treasury Department (“Treasury”) published Notice 2003-81, which described a tax avoidance transaction involving offsetting foreign currency options and identified such transaction and those substantially similar to it as listed transactions for purposes of §1.6011-4(b)(2) of the Income Tax Regulations and §§301.6111-2(b)(2) and 301.6112-1(b)(2) of the Procedure and Administration Regulations.
In the transaction described in Notice 2003-81, a taxpayer pays premiums to purchase a call option and a put option (the purchased options) on a foreign currency in which positions are traded through regulated futures contracts. The purchased options are reasonably expected to move inversely in value to one another over a relevant range, thus ensuring that, as the value of the underlying foreign currency changes, the taxpayer will hold a loss position in one of the two purchased options. The taxpayer also receives premiums for writing a call option and a put option (the written options) on a different foreign currency in which positions are not traded through regulated futures contracts. The taxpayer takes the position that the written options are neither foreign currency contracts within the meaning of §1256(g)(2)(A) nor §1256 contracts within the meaning of §1256(b). The written options are reasonably expected to move inversely in value to one another over a relevant range, thus ensuring that, as the value of the underlying foreign currency changes, the taxpayer will hold a gain position in one of the two written options.
The values of the two currencies underlying the purchased and written options (i) historically have demonstrated a very high positive correlation with one another, or (ii) officially have been linked to one another, such as through the European Exchange Rate Mechanism (ERM II). Thus, as the currencies change in value, the taxpayer reasonably expects to have the following potential gains and losses in substantially offsetting positions: (1) a loss in a purchased option and a gain in a written option; and (2) a gain in a purchased option and a loss in a written option. At any time, the taxpayer’s loss in the purchased option position that has declined in value may be more or less than the taxpayer’s gain in the offsetting written option position that has appreciated in value. Similarly, the taxpayer’s gain in the remaining purchased option position may be more or less than the taxpayer’s loss in the remaining written option position. A material pre-tax profit or rate of return, or both, on the transaction is possible but unlikely.
The taxpayer assigns to a charity the purchased option that has a loss. The charity also assumes the taxpayer’s obligation under the offsetting written option that has a gain. The premium received on that written option is not assigned but is retained by the taxpayer. As with all written options, the amount of gain on the option is limited to the premium received for the option. In the same tax year, the taxpayer may dispose of the remaining purchased option and offsetting written option.
Because the taxpayer takes the position that the purchased option assigned to the charity is a §1256 contract, the taxpayer relies on §1256(c) and Greene v. United States, 79 F.3d 1348 (2d Cir. 1996) to mark to market the purchased option when the option is assigned to the charity and to recognize a loss at that time. In contrast, because the taxpayer takes the position that the assumed written option is not a §1256 contract, the taxpayer claims not to recognize gain attributable to the option premium. Specifically, the taxpayer claims that the charity’s assumption of the option obligation does not cause the taxpayer to recognize gain and that the taxpayer also does not recognize gain either at the time the option expires or terminates or at any other time.
ANALYSIS Although as a general matter the “Facts” portion of Notice 2003-81 correctly describes the transaction at issue, it includes an erroneous conclusion of law. The second sentence in the “Facts” portion of Notice 2003-81 states: “The currency is one in which positions are traded through regulated futures contracts, and the purchased options, therefore, are foreign currency contracts within the meaning of §1256(g)(2)(A) of the Internal Revenue Code and §1256 contracts within the meaning of §1256(b).”
This sentence should have stated “The taxpayer takes the position that the purchased options are foreign currency contracts within the meaning of §1256(g)(2)(A) of the Internal Revenue Code and §1256 contracts within the meaning of §1256(b).” The Service and Treasury do not believe that foreign currency options, whether or not the underlying currency is one in which positions are traded through regulated futures contracts, are foreign currency contracts as defined in §1256(g)(2), and intend to challenge any such characterization by taxpayers.
Section 1256(g)(2)(A) defines a foreign currency contract, in part, as 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 the Tax Reform Act of 1984, P.L. 98-369, 1984-3 (Vol. 1) C.B. 128, 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 the Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647, 1988-3 C.B. 377-380, which indicates that a foreign currency option is not a foreign currency contract as defined in §1256(g)(2).
Subject to the following, §7805(b) relief is granted to taxpayers that adopted an accounting method in reasonable reliance on Notice 2003-81 to treat over-the-counter foreign currency options as foreign currency contracts as defined in §1256(g)(2). Section 7805(b) relief is not granted with respect to options entered into in transactions that are the same or substantially the same as those described in Notice 2003-81. Further, §7805(b) relief is not granted with respect to options entered into in any transaction identified as a listed transaction for purposes of §§1.6011-4(b)(2), 301.6111-2(b)(2) and 301.6112-1(b)(2).
The principal authors of this notice are Mark E. Erwin of the Office of Associate Chief Counsel (International) and Patrick E. White of the Office of Associate Chief Counsel (Financial Institutions and Products). For further information regarding this notice contact Mark E. Erwin at (202) 622-3870 or Patrick E. White at (202) 622-3920 (not a toll free call
Chief Counsel Advice 201045022 LAW Section 1.6011-4(a)1 provides that every taxpayer that has participated, as described in § 1.6011-4(c)(3), in a reportable transaction within the meaning of § 1.6011-4(b) and who is required to file a tax return must file within the time prescribed in § 1.6011-4(e) a disclosure statement in the form prescribed by § 1.6011-4(d). 1. Whether the taxpayers in Situation 1 and Situation 2 have disclosure obligations under § 1.6011-4 as a result of claiming losses under § 165. 2. Whether the disclosure statements provided by the taxpayers in Situation 3 and Situation 4, described below, are complete under § 1.6011-4(d).
Chief Counsel Advice 201045022
Chief Counsel Advice 201045022
Much data regarding the older rules are found on the old-school desktop webpage here: http://www.traderstatus.com/forex.htm