Foreign Currency Transactions
(Foreign Exchange)
FOREX

This page is under development  20,457 words

Much data regarding the older rules are found on the old-school desktop webpage here: http://www.traderstatus.com/forex.htm

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 988 taxed as Sec 1256 election #4 (Treas. Regulations §1.988-3 Requirements, Verification and Independent Verification)

How to make the Sec 1256 taxed as Sec 988 election #5

How to make the Sec 1256 taxed as Sec 988 election#6

How to make the Sec 1256 taxed as Sec 988 election #7 (Treas. Regulations §1.988-1(a)(7) written election and due date for making the election)

#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 TransactionsForeign 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:
  1. Losses  incurred in a trade or business;
  2. Losses incurred in any transaction entered into for profit [e.g. an Investment], though not connected with a trade or business; and
  3. 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

Effective Date: July 26, 2005

Coordinated Issue Paper, All Industries, “Notice 2003-81” Tax Shelter, UIL 9300.31-00

INTRODUCTION

On December 4, 2003, the Service issued Notice 2003-81, 2003-2 C.B. 1223, announcing that it will challenge transactions involving the assignment of offsetting foreign currency options to a charity in order to claim substantial artificial net losses and identifying these transactions as listed transactions for purposes of I.R.C. §§6011, 6111, and 6112. The transaction is designed to create an overall net loss (either ordinary or capital) when a taxpayer transfers two foreign currency contracts to a charity where only one such contract is subject to the mark-to-market rules contained in I.R.C. §1256.

ISSUES

  1. Whether the tax law permits premium income received on a taxpayer’s written “minor” foreign currency option contracts to go untaxed where the taxpayer retains the premium but transfers the obligation associated with the written option to a charity.
  2. Whether a taxpayer participating in this shelter strategy obtained a timing benefit by being able to recognize a loss on a purchased foreign currency option in advance of gain recognition on the premium received for writing a foreign currency option.
  3. Whether a taxpayer’s purported loss is a bona fide loss allowable under I.R.C. §165.
  4. Whether the at-risk provisions of I.R.C. §465 limit the taxpayer’s claimed loss.
  5. Whether the transaction as a whole lacks economic substance and business purpose apart from tax savings.
  6. Whether the provisions of I.R.C. §988 limit a taxpayer’s claimed foreign currency losses.
  7. Whether the Service should assert the appropriate I.R.C. §6662 accuracy-related penalty against a taxpayer who entered into the transaction.
  8. Whether the Service should examine the role of the charity in this transaction.

SUMMARY OF CONCLUSIONS

  1. A taxpayer remains obligated to take into income the premium received for writing a “minor” foreign currency option contract even if it transfers the obligation associated with that written option to a charity.
  2. A taxpayer did not obtain a timing benefit because I.R.C. §1092 does not permit a taxpayer to recognize loss in advance of gain on offsetting foreign currency contracts.
  3. The taxpayer’s loss is not a bona fide loss allowable under I.R.C. §165.
  4. The taxpayer’s loss is limited by the I.R.C. §465 at-risk provisions.
  5. The taxpayer’s loss is disallowed because the transaction as a whole lacks economic substance and business purpose apart from tax savings.
  6. The taxpayer is not entitled to an ordinary loss under I.R.C. §988.
  7. The 20-percent accuracy-related penalty under I.R.C. §6662 should be asserted against a taxpayer entering into this transaction unless the taxpayer is able to establish reasonable cause and good faith under I.R.C. §6664(c)(1) and the applicable regulations.
  8. The agent examining the taxable entity should forward all information gathered about the involvement of the charity to the Exempt Organizations Division of TEGE through the process established by the Notice 2003-81 Issue Management Team.

FACTS

A. Background

Taxpayers deployed Notice 2003-81 transactions in order to offset substantial taxable income (either capital or ordinary) . Taxpayers initiated the transactions by entering into an investment management agreement and opening a trading account managed by the promoter, who is also a registered investment advisor. Generally, the initial capital investment is determined by the anticipated loss needed. The required investment amount is equal to either (1) 15% of the desired ordinary loss or (2) 10% of the desired capital loss. The taxpayer agrees to leave the funds in the account for a five-year period, although funds can be withdrawn at any time subject to significant monetary penalties. A small portion, approximately 1.75%, of the initial capital investment is used to establish a foreign currency trading account that is used to purchase foreign currency option contracts. The remaining balance is invested in a hedge fund of funds that in turn invests in a variety of investment vehicles including other hedge funds, stock funds, commodity funds and currency funds.

B. Foreign Currency “Investment” Strategy

The foreign currency “investment” strategy involves the purchase and sale of a series of foreign currency option contracts denominated in both a foreign currency in which positions are traded through regulated futures contracts and a foreign currency that is not traded through regulated futures contracts. The values of the two currencies underlying the 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”).1 In one version, the taxpayer buys two 180-day European-style digital currency options, pegged to fluctuations in the exchange rate between the U.S. dollar and the euro. These positions are in a foreign currency traded through regulated futures contracts, and thus the taxpayer takes the position that such positions are I.R.C. §1256(g)(2)(A) foreign currency contracts. In the promotional materials, these contracts are referred to as the “major options.” At the same time, the taxpayer sells two 180-day European-style digital currency options, pegged to fluctuations in the exchange rate between the U.S. dollar and a stated European currency. The European currency is one in which positions are not traded on a qualified board or exchange and are not I.R.C. §1256(g)(2)(A) foreign currency contracts. In the promotional materials, these contracts are referred to as the “minor options.” The counterparty is the same for all four currency contracts. Therefore, the initial cash outlay to enter into the foreign currency positions is limited to the net premium among the offsetting contracts.

In a more complex variation of the transaction, the taxpayer enters into a series of 180-day European-style digital options on the same day. Usually, the taxpayer buys two put options and sells two call options pegged to fluctuations in the exchange rate between the U.S. dollar and the euro. This group of options comprises the “major options.” The taxpayer also buys two call options and sells two put options, pegged to fluctuations in the exchange rate between the U.S. dollar and a stated European currency. This group of options comprises the “minor options .” Again, the counterparty is the same for all eight currency contracts and the initial cash outlay is relatively small in reference to the stated notional amounts of the contracts. In some deals, the taxpayer will enter into a second series of 180-day European-style options on the following day.

The values of the respective currencies underlying the foreign currency transactions historically have demonstrated a very high positive correlation with one another. Therefore, the major options will move inversely to the minor options such that any gain in a major foreign currency position will be largely offset by a corresponding, though not always identical, loss in a minor foreign currency position. The bank, which serves as counterparty for these deals, generally makes representations to the taxpayer and trader concerning the statistical probabilities of the potential rate of return from the option positions indicating a profit is possible but unlikely. In fact, according to the analysis provided by the bank, there is usually a better than 50% chance that the taxpayer will lose its entire investment.

C. Assignment of Major and Minor Contract to Charity

Prior to the exercise date, that taxpayer assigns two of its open foreign currency contracts to a charity. The first contract is a major currency option contract that is in a loss position at the time of assignment. The taxpayer also assigns the obligation that is associated with a minor currency option contract that is in a gain position at the time of assignment of the obligation. The taxpayer takes the position that (1) the assignment of the major contract (i.e., I.R.C. §1256 contract) is treated as a termination of the contract requiring recognition of the inherent gain or loss in such contract; and (2) the assignment of the minor contract obligation does not trigger the recognition of income because that contract is not covered by the mark-to-market provisions contained in I.R.C. §1256.

 

 

D. Reporting of Transaction for Federal Income Tax Purposes

In some cases, the taxpayer will report the listed transaction on Form 4797, Part II,
Ordinary Gains and Losses as an I.R.C §988 foreign currency transaction. The loss claimed is a direct result from the disparate reporting of the donated major and minor contracts. The major contract in a loss position and the remaining option contracts that are not assigned to the charity are accounted for on Form 4797. The remaining option contract positions when closed effectively offset one another. The reporting exclusion of the gain from the donated minor contract, which closely mirrors the loss reported from the donated major contract, creates the artificial loss claimed by the taxpayer. In other cases, the taxpayer will report the listed transaction on Schedule D, Capital Gains & Losses. In these instances, the taxpayer makes an election pursuant to I. R.C. §988(a)(1)(B) and Treas. Reg. §1.988-3(b)(4) to treat its foreign currency contracts as capital assets in order to claim a capital loss. The taxpayer is required to attach a verification statement to its filed return for a valid capital treatment election.

DISCUSSION

1.  A taxpayer remains obligated to take into income the premium that it received when it writes a “minor” foreign currency option contract and later transfers the obligation associated with that written option to a charity.

Gain and loss on options is accounted for on an open transaction basis. As explained in Notice 2003-81, the justification for open transaction treatment is that the gain or loss on an option cannot be finally accounted for until such time as the option is terminated.  Thus, premium income is not recognized until an option is sold or terminated. Rev. Rul. 58-234, 1958-1 C.B. 279, 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.

Though each taxpayer’s transaction should be evaluated independently, the assignment documents reviewed to date have been three-party arrangements (involving the option writer, holder and charity) that seem to give rise to a novation of the option contracts. Where there is a novation, the option writer’s obligation under the minor option contract terminates on the charity’s assumption of the written option obligation. However, in other cases where a novation does not occur, the writer of the minor foreign currency option writer may well 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 of the liability by the charity causes the option writer’s obligation under the option contract to terminate, then the option writer must recognize gain upon assignment, when the option obligation is assumed. Notice 2003-81. 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). Notice 2003-81. It is generally understood that charities that received these options may have terminated them either contemporaneous with or shortly after the assignments.

Even if a novation did not occur to cause premium income to be recognized, there is still no support for the apparent contention that responsibility for recognizing premium income shifts to the charity as a result of the assignment of the obligation on the written option. At least some of the tax promotional materials associated with this shelter transaction suggest that the gain or premium income received by the taxpayer on the written option must be recognized by the charity (but goes untaxed because of its taxexempt status). However, there is no support for this “too good to be true” result. Rather, the taxpayers and their advisors seem to simply assume that a taxpayer can receive premium income, pass off the obligation associated with having received that premium and not be taxed on the premium. No discussion was found in the materials , including an undated draft shelter memorandum (“Shelter Memorandum”), that explains why the premium received by the taxpayer is not a taxable accession to wealth of the taxpayer. Nor is there any explanation as to how a charity could be taxed on this premium that the charity does not receive.

There is some hint in the promotional materials that the promoters may have been seeking to pass off the transfer of the obligation on the written minor option as a “donation.”  Generally, taxpayers do not recognize gain upon transfer of appreciated property to a qualified charity. See Rev. Rul. 55-138, 1955-1 C.B. 223, modified on other grounds by Rev. Rul. 68-69, 1968-1 C.B. 80. In these challenged transactions, however, property rights were not transferred – only the obligation associated with the out-of-the money (losing) purchased option was transferred. The assumption of an obligation is not a donation of property to which I.R.C. §170 applies. Rather it is a disposition event governed by I.R.C. §1001. Crane v. Commissioner, 331 U.S. 1 (1947). If the assumption of the obligation by the charity also involves the donation of associated property, I.R.C. §1001(b) applies and the transaction is treated as a bargain sale.2 Treas. Reg. §1.1011-2(a)(3); Ebben v. Commissioner, 783 F.2d 906 (9th Cir. 1986). Thus, to the extent there was a transfer of property along with an associated obligation, the taxpayers were, in general, properly advised in this scheme that their charitable deduction for the donated purchased option rights would be reduced by the amount of liability relief provided by the charity that assumed the obligation on the written minor option.

In short, contrary to the advice apparently received by the taxpayers, there is no factual or legal basis for the contention that taxpayers in these shelters shifted the responsibility for recognizing the premium income or gain on the written minor option position to a charity. Rather, the taxpayers only transferred an obligation and must be taxed on the premium that they retain.3

2.  A taxpayer did not obtain a timing benefit because section 1092 does not permit a taxpayer to recognize loss in advance of gain on the offsetting foreign currency contracts.

For several reasons, this foreign currency shelter transaction did not provide a timing benefit to participating taxpayers.

As explained in issue 1, the open transaction doctrine deferred a taxpayer’s recognition of premium income only until it became possible to finally account for the option transaction. As also indicated, a taxpayer will be required to pick up premium income on the minor option at the same time as loss is allowed on the major option under I.R.C. §1256(c) if there was a novation of the minor option. However, even if a novation did not occur, a taxpayer was still required to recognize income when that taxpayer’s secondary obligation under the written minor option contract terminated. That may have occurred in the same tax year as the assignment because the options were short term and are understood to have been closed out by the charities either contemporaneous with or shortly after assignment.

However, even if a charity kept open the written option obligation beyond the year of assignment, a taxpayer still would not have obtained an overall timing advantage. As indicated in Notice 2003-81, the purchased major foreign currency option and the written minor foreign currency option are substantially offsetting positions. Consequently, such positions were parts of a straddle subject to I.R.C. §1092. Thus, under I.R.C. §1092, any mark-to-market loss on the contributed major foreign currency option would have been appropriately deferred to the extent of the taxpayer’s unrecognized gain on the written minor foreign currency option.

3.  The taxpayer’s loss is not a bona fide loss allowable under I.R.C. §165.

I.R.C. §165(a) provides that there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise. Treas. Reg. §1.165-1(b) provides that to be allowable as a deduction under I.R.C. §165(a), a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and, except as otherwise provided in I.R.C. §165(h) and Treas. Reg. §1.165-11 (relating to disaster losses), actually sustained during the taxable year. Under I.R.C. §165(b), the amount of the loss from the sale or other disposition of property is the adjusted basis provided in I.R.C. §1011. Treas. Reg. §1.165-1(b) further states that only a bona fide loss is allowable and that substance and not mere form shall govern in determining a deductible loss. See also ACM Partnership v. Commissioner, 157 F.3d 231, 252 (3d Cir. 1998), cert. denied, 526 U.S. 1017 (1999) [“Tax losses . . . which do not correspond to any actual economic losses, do not constitute the type of ‘bona fide’ losses that are deductible under the Internal Revenue Code and regulations”]. Section 165(c) provides that, in the case of an individual, the deduction under §165(a) is limited to losses incurred in a trade or business, losses incurred in a transaction entered into for profit, and certain casualty or theft losses.

In this case, the taxpayer has suffered no real economic loss because the acquisition and disposition of the offsetting option contracts constitute an economically inconsequential investment, with the taxpayer effectively in the same economic position as prior to the purported investment strategy less fees paid to the promoter. See ACM Partnership v. Commissioner, 157 F.3d at 251-252. Accordingly, the loss is not allowable under I.R.C. §165.

I.R.C. §165(c) also disallows the loss for an individual taxpayer. The “loss” in this transaction is not incurred in a trade or business or from a casualty or theft, within the meaning of I.R.C. §165(c)(1) and (3). Therefore, a loss in this transaction is only allowable for an individual if it is incurred in a transaction undertaken for profit. I.R.C. §165(c)(2); Fox v. Commissioner, 82 T.C. 1001 (1984); Smith v. Commissioner, 78 T.C. 350 (1982). For the loss to be allowable, a profit motive must be the taxpayer’s primary motive for engaging in the transaction. Fox v. Commissioner, 82 T.C. at 1020-21 [citing Helvering v. National Grocery Co., 304 U.S. 282, 289 n.5 (1938)].

The taxpayer’s potential profit from this transaction, apart from tax savings, is statistically improbable. Moreover, any profit generated would likely be derived from the capital that was invested in the hedge fund of funds rather than the small amount of capital used to acquire the major and minor contracts. In fact, the tax materials distinguish the two investment components by opining that the “possible profits” from the tax-driven currency option trading and the “expected profits” from investing in the hedge funds create sufficient “economic substance”. Therefore, it is unlikely that a taxpayer can demonstrate a reasonable expectation to earn more than minimal profit solely from the foreign currency investment strategy described above, apart from tax savings. See Knetsch v. United States, 348 F.2d 932, 938 (Ct. Cl. 1965) [The statutory definition of profit under I.R.C. §165(c)(2) “cannot embrace profit seeking activity in which the only economic gain derived therefrom results from a tax reduction.”]. Therefore, the loss is disallowed under I.R.C. §165(c)(2).

4.  The taxpayer’s loss is limited by the I.R.C. §465 at-risk provisions.

I.R.C. §465 generally limits deductions for losses in certain activities to the amount for which the taxpayer is at-risk. In the case of an individual taxpayer, I.R.C. §465 limits the taxpayer’s losses to the amount for which the taxpayer is at risk in the activity. I.R.C. §465(a)(1). I.R.C. §465 applies to all activities engaged in by the taxpayer in carrying on a trade or business or for the production of income. I.R.C. §465(c)(3)(A).  Under those sections, losses incurred in an activity engaged in by a taxpayer carrying on a trade or business or for the production of income is defined broadly to include “excess of the allowable deductions allocable to the activity over the income received or accrued by the taxpayer during the taxable year from the activity.” Lansburgh v. Commissioner, 92 T.C. 448, 454-55 (1989). This interpretation is supported by the legislative history of I.R.C. §465 that provides the at risk limitation applies to losses “regardless of the kind of deductible expenses which contributed to the loss.” S. Rept. 94-938, at 48 (1976), 1976-3 C.B. (Vol.3) 86. In this case, I.R.C. §465 applies to the loss stemming from taxpayer’s purchase of the foreign currency option contracts.

The amount at-risk includes the amount of money and the adjusted basis of any property contributed by the taxpayer to the activity, and any amounts borrowed with respect to the activity to the extent that the taxpayer is personally liable to repay the amount, and to the extent of the fair market value of the taxpayer’s interest in property, not used in the activity, pledged as security for the borrowed amount. I.R.C. §465(b)(1) and (2). Amounts protected against loss by nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements, however, are not at-risk. I.R.C. §465(b)(4). The Senate report promulgated in connection with I.R.C. §465 states in pertinent part that “a taxpayer’s capital is not ‘at risk’ in the business, even as to the equity capital which he has contributed to the extent he is protected against economic loss of all or part of such capital by reason of an agreement or arrangement for compensation or reimbursement to him of any loss which he may suffer.” S. Rept. No. 94-938, Pt. I at 49, 94th Cong., 2d Sess. (1976).

The at-risk rules in I.R.C. §465 are most commonly applied to cases involving nonrecourse liabilities; however, neither the statutory language nor the legislative history interprets the at-risk rules that narrowly. The legislative history notes that the overall purpose of the at-risk rules is to “prevent a situation where the taxpayer may deduct a loss in excess of his econo mic investment in certain types of activities.” S. Rept. No. 938, Pt. I at 48, 94th Cong., 2d Sess. (1976). The legislative history also provides that in evaluating the amount at-risk, it should be assumed that a loss-protection guarantee, repurchase agreement or other loss limiting mechanism will be fully paid to the taxpayer. S. Rep. No. 938, 94th Cong., 2d Sess. 50 n.6 (1976), C.B. 1976-3 at 88. Although the foregoing assumption regarding loss-limiting arrangements does not explicitly claim to interpret I.R.C. §465(b)(4), more than one circuit has found such an interpretation to be reasonable. See e.g., Moser v. Commissioner, 914 F.2d 1040, 1048 (8th Cir. 1990); American Principals Leasing Corp. v. Commissioner, 904 F.2d 477, 482 (9th Cir. 1990) [assuming in both cases that the reference to loss-limiting arrangements in I.R.C. §465 legislative history refers to I.R.C.§465(b)(4)]. I.R.C. §465(b)(4) limits losses to amounts at risk where a transaction is structured, by whatever method, to remove any realistic possibility that the taxpayer will suffer an economic loss.  A theoretical possibility of economic loss is insufficient to avoid the suspension of losses. See Levien v.Commissioner, 103 T.C. 120, 125 (1994).

The case law, however, is not in complete accord on this issue. In Emershaw v. Commissioner, 949 F.2d 841, 845 (6th Cir. 1991), the court adopted a worst-case scenario approach and determined that the issue of whether a taxpayer is “at risk” for purposes of I.R.C. §465(b)(4) “must be resolved on the basis of who realistically will be the payor of last resort if the transaction goes sour and the secured property associated with the transaction is not adequate to pay off the debt.” quoting Levy v. Commissioner, 91 T.C. 838, 869 (1988). In contrast, the Second, Eighth, Ninth, and Eleventh Circuits look to the underlying economic substance of the arrangements under I.R.C. §465(b)(4). Waters v. Commissioner, 978 F.2d 1310, 1316 (2d Cir. 1992) (citing American Principals Leasing Corp v. United States, 904 F.2d 477, 483 (9th Cir. 1990); Young v. Commissioner, 926 F.2d 1083, 1089 (11th Cir. 1991); Moser v. Commissioner, 914 F.2d at 1048-49. The view, as adopted by these circuits, is that, in determining who has the ultimate liability for an obligation, the economic substance and the commercial realities of the transaction control. See Waters v. Commissioner, 978 F.2d at 1316; Levien v. Commissioner, 103 T.C. 120; Thornock v. Commissioner, 94 T.C. 439, 448 (1990); Bussing v. Commissioner, 89 T.C. 1050, 1057 (1987). To determine whether a taxpayer is protected from ultimate liability, a transaction should be examined to see if it “is structured – by whatever method – to remove any realistic possibility that the taxpayer will suffer an economic loss if the transaction turns out to be unprofitable.” American Principals Leasing Corp. v. United States, 904 F.2d at 483; See Young v. Commissioner, 926 F.2d at 1088; Thornock v. Commissioner, 94 T.C. at 448-49; Owens v. United States, 818 F.Supp. 1089, 1097 (E.D. Tenn. 1993); Bussing v. Commissioner, 89 T.C. at 1057-58. “[A] binding contract is not necessary for [I.R.C. §465(b)(4)] to apply.” American Principals Leasing Corp. v United States, 904 F.2d at 482-83. In addition, “the substance and commercial realities of the financing arrangements presented . . . by each transaction” should be taken into account under I.R.C. §465(b)(4). Thornock v. Commissioner, 94 T.C. at 449. To avoid the application of I.R.C. §465(b)(4), there must be more than “a theoretical possibility that the taxpayer will suffer economic loss.” American Principals Leasing Corp. v United States, 904 F.2d at 483.

In the typical “Notice 2003-81” deal, the counterparty to all the foreign currency contracts is the same. Due to the fact that the currency movements between the euro and European currency used in the minor contracts closely parallel each other, the taxpayer’s cash investment is relatively small. The transaction is carefully structured so that any gain in one option position is largely offset by a loss in another contract. Therefore, the taxpayer’s true at-risk amount equals the net out of pocket premium paid to acquire the aggregate offsetting foreign currency positions.

5.  The taxpayer’s loss is disallowed because the transaction as a whole lacks economic substance and business purpose apart from tax savings.

In addition to the statutory provisions discussed herein, the taxpayer’s purported loss may be disallowed under the economic substance doctrine. This approach would deny the tax benefits arising because the transaction does not result in a meaningful change to the taxpayer’s economic position other than the manufactured loss that results in the purported reduction in tax. See Knestch v. United States, 364 U.S. 361 (1960). The Tax Court has stated that tax law “requires that the intended transactions have economic substance separate and distinct from economic benefit achieved solely by tax reduction.” ACM Partnership v. Commissioner, T.C. Memo. 1997-115, aff’d in part and rev’d in part, 157 F.3d 231 (3rd Cir. 1998). Accordingly, this doctrine is applicable to the typical Notice 2003-81 transaction where the purported tax benefits are unintended by Congress and accomplished by a prearranged deal that serves no economic purpose apart from tax savings.

In determining whether a transaction is to be respected for tax purposes, both the objective economic substance of the transaction and the subjective business motivation are considered. ACM Partnership v. Commissioner, 157 F.3d 231, 247 (3d Cir. 1998); Horn v. Commissioner, 968 F.2d 1229, 1237 (D.C. Cir. 1992); Casebeer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990). Some courts apply a conjunctive analysis that requires a taxpayer to establish the presence of both economic substance (i.e., objective test) and business purpose (i.e., subjective test to determine whether the taxpayer intended the transaction to serve some useful non-tax purpose). See Pasternak v. Commissioner, 990 F.2d 893, 898 (6th Cir. 1993). Other courts apply a less stringent test that either a subjective business purpose or actual economic substance is sufficient. Rice’s Toyota World v. Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985). An alternative analysis views economic substance and business purpose as “simply more precise factors to consider” in determining whether a transaction has any practical economic effects other than the tax benefits created. ACM Partnership v. Commissioner, 157 F.3d at 247. See also Casebeer v. Commissioner, 909 F.2d at 1363; Sacks v. Commissioner, 69 F.3d 982, 985 (9th Cir. 1995); James v. Commissioner, 899 F.2d 905, 908 (10th Cir. 1995). In addition, several courts have applied the economic substance doctrine where a taxpayer was exposed to limited risk and the transaction had a theoretical potential for profit but the profit potential was nominal and insignificant when compared to the tax benefit derived. Gregory v. Helvering, 293 U.S. 465 (1935) [Transaction that is entered into for the primary purposes of creating a loss is subject to special scrutiny to determine whether such loss was bona fide]; Knetsch v. United States, 364 U.S. 361 (1960) [Leveraged acquisition of Treasury bills and accompanying prepaid interest deduction lacked economic substance]; Goldstein v. Commissioner, 364 F.2d 734 739-40 (2d Cir. 1966)[Deduction disallowed even though taxpayer has a possibility of small gain or loss from ownership of Treasury bills]; Sheldon v. Commissioner, 94 T.C. 738, 768 (1990)[Loss disallowed from prearranged substantially offsetting transaction where profit potential “infinitesimally nominal and vastly insignificant” in comparison to loss claimed]; Rice’s Toyota World v. Commissioner, 752 F.2d at 94; [Economic substance inquiry requires an objective determination of whether reasonable possibility of profit existed apart from tax benefits]. See also Compaq Computer Corp v. Commissioner, 277 F.3d at 781; IES Industries v. United States, 253 F.3d at 354 [Applying same objective economic substance test discussed in Rice’s Toyota World].

The doctrine of economic substance should be raised in cases where the facts show that the transaction at issue was primarily designed to generate the tax losses, with little if any possibility for profit, and that such was the expectation of all the parties to the transaction. The wide variety of facts required to support its application should be developed at examination. The administrative record should include documents obtained from the taxpayer, the promoter and other third parties; interviews with the same; and expert analysis of financial data and industry practices. Summonses should be promptly issued whenever necessary to obtain the requisite transactional documents.

In addition to evidence that shows a lack of pre-tax profit potential, facts should be developed demonstrating that the taxpayer and the promoter primarily planned the transaction for tax purposes. Such evidence should include the following: (1) documents or other evidence that the foreign currency option contracts were sold as tax shelters with limited consideration of the underlying economics of the transaction; and (2) evidence that a prudent investor would not have invested in the strategy but for the tax savings. A primary source of such evidence is correspondence between the promoter and the taxpayer, including, but not limited to, offering memos, letters identifying tax goals, e -mails and in-house communications at the offices of the promoter and any other third party involved in the strategy. Written correspondence is the best evidence, but evidence of oral communications regarding tax goals is also useful. Indirect sources of the same include correlations between tax losses generated and tax losses requested, and between the taxpayer’s income and the tax losses generated, particularly if it can be shown that the income to be sheltered was attributable to an unusual windfall, like the liquidation of stock options, or sale of a business. Demonstrations of similarities of the nature and extent of tax losses acquired by other clients of the promoter in this shelter can be very important as well.

In the typical case, the transaction fails both prongs of the economic substance analysis. The following facts underscore a lack of a legitimate potential or realistic possibility for a pre-tax profit (i.e objective prong): First, the taxpayer’s profit potential from the aggregate foreign currency options is severely limited by the offsetting nature of the respective contracts. Although not a traditional straddle, the option contracts create substantially offsetting positions whereby any gain in one contract is offset in another contract. Second, the profit, if any, would be derived from the contractual provision that required a payment equal to twice the premium amount to the holder if the strike price was at or above a stated amount on the exercise date. Third, the net premium paid to enter the option contracts is a mere 1.75% of the actual loss claimed. Fourth, any potential profit realized would be further reduced by significant up -front transaction costs. The fees paid to the promoter were 5% for a capital loss or 6% for any ordinary loss desired. Fifth, the only true profit potential comes from the additional hedge fund investment that represents a distinct investment separate from the foreign currency scheme. This “real” investment, which was a prerequisite to obtaining the desired loss, provides the trappings of legitimacy and creates the illusion of profit when aggregated with the tax shelter investment. These facts persuasively demonstrate the lack of any realistic potential for pre-tax profit from the foreign currency strategy.

The transaction also fails the subjective economic substance prong. Typically, the taxpayer has significant taxable income (either capital gain income or ordinary income) unrelated to the transaction. Through participation in this transaction, the taxpayer is able to choose the character and amount of the loss needed to offset the unrelated income. The close connection between the taxable income being sheltered and the claimed loss suggests that the taxpayer did not enter into this transaction for a business purpose. As the Tenth Circuit has recognized, “correlation of losses to tax needs coupled with a general indifference to, or absence of, economic profits may reflect a lack of economic substance.” Keeler v. Commissioner, 243 F.3d 1212, 1218 (10th Cir. 2001), citing Freytag v. Commissioner, 89 T.C. 849, 877-878 (1987). Here, the taxpayer does not have a substantial non-tax purpose for entering into the structured transaction other than the creation of an artificial tax loss.

If the revenue agent, after consultation with Financial Products specialist and/or economist, determines that it is appropriate to assert economic substance with respect to a specific transaction, consideration must be given to possible appellate venue. As discussed herein, various circuits apply different standards in determining whether a transaction lacks economic substance. Prior to asserting economic substance, the examiner should consult with local Counsel to determine the appropriate standard in their jurisdiction.

In cases where a taxpayer who invested in the transaction is unable to establish that (1) the transaction changes in a meaningful way (apart from Federal income tax consequences) the taxpayer’s economic position and (2) that the taxpayer has a substantial non-tax purposes for entering into such transaction and the transaction is a reasonable means of accomplishing such purpose the tax benefits, fees or expenses, related thereto, may be disallowed.

6. The taxpayer is not entitled to an ordinary loss under I.R.C. §988.

I.R.C. §§985-989, which were enacted as part of the Tax Reform Act of 1986, set forth a comprehensive set of rules for the treatment of foreign currency transactions. In general, I.R.C. §988(a)(1)(A) provides that foreign currency gain or loss attributable to an I.R.C. §988 transaction is computed separately and treated as ordinary income or loss. The I.R.C. §988 foreign currency transaction rules generally apply to forward contracts, futures contracts, options contracts and similar financial instruments.

The legislative history of I.R.C. §§985-989 suggests a consistent concern about tax motivated transactions. The Senate Finance Committee Report accompanying the Tax Reform Act of 1986 stated that one of the two reasons I.R.C. §§985-989 were enacted was prior law provided opportunities for tax motivated transactions. S. Rep. No. 313., 99th Cong., 2d Sess. 450 (1986). Accordingly, in enacting I.R.C. §§985-989, Congress granted broad authority for the Service to promulgate regulations “as may be necessary or appropriate to carry out the purposes of [I.R.C. §§985-989]. . . .” I.R.C. §989(c). The legislative history to the TAMRA, in discussing the law prior to the enactment of TAMRA, stated that “[t]he Secretary has general authority to provide the regulations necessary or appropriate to carry out the purposes of new subpart J. For example, the Secretary may prescribe regulations appropriately recharacterizing transactions to harmonize the general realization and recognition provisions of the Code with the policies of §988.” H.R. Rep. No. 795, 100th Cong., 2d Sess. 296 (1988); S. Rep. No. 445, 100th Cong., 2d Sess. 311 (1988) (containing identical language).

In response to Congressional concern about tax motivated transactions, the Service, under the authority of I.R.C. §989(c), promulgated Treas. Reg. §1.988-2(f) and Treas. Reg. §1.988-1(a)(11). Treas. Reg. §1.988-2(f) states that if the substance of a transaction differs from its form, the Commissioner may recharacterize the timing, source, and character of gains or losses with respect to the transaction in accordance with the substance of the transaction. Treas. Reg. §1.988-1(a)(11) states, in relevant part, that the Commissioner may exclude a transaction or series of transactions which in form is an I.R.C. §988 transaction from the provisions of I.R.C. §988 if the substance of the transaction, or series of transactions indicates that it is not properly considered an I.R.C. §988 transaction.

In this case, the transaction at issue may be recharacterized in accordance with its substance so that the taxpayer is required to take i nto account gain as well as the economically corresponding loss under Treas. Reg. §1.988-2(f). For purposes of I.R.C. §988, the Service may adjust the timing of the transaction at issue consistently with its substance and require the taxpayer to recognize gain upon the transfer of the minor contract to the charity on the date of such transfer. The taxpayer’s ordinary loss as reported on its return does not reflect the substance of the transaction because the Investor is not economically exposed to fluctuations in the values of the foreign currency positions. The claimed loss is not the result of exposure to exchange rate fluctuations, but rather of differences in timing of recognition of economically offsetting gain and loss positions in an engineered transaction. Accordingly, under Treas. Reg. §1.988-2(f), the taxpayer is required to take both gain and loss into account consistently.

Alternatively, the loss may be excluded from I.R.C. §988 under Treas. Reg. §1.988-1(a)(11) because the reported loss is due to the different reporting methods of the major and minor contracts and does not reflect changes in foreign currency exchange rates.  Excluding the transaction from the provisions of I.R.C. §988 under this alternative approach, however, would result in capital loss treatment. Barnes Group v. United States, 697 F. Supp 591 (D. Conn. 1988).

7. The 20 percent accuracy-related penalty under I.R.C. §6662 should be asserted against a taxpayer entering into this transaction unless the taxpayer is able to establish reasonable cause and good faith under I.R.C. §6664(c)(1) and applicable regulations.

I.R.C. §66624 imposes an accuracy-related penalty in an amount equal to 20 percent of the portion of an underpayment attributable to, among other things: (1) negligence or disregard of rules or regulations and (2) any substantial understatement of income tax.  Treas. Reg. §1.6662- 2(c) provides that there is no stacking of the accuracy-related penalty components. Thus, the maximum accuracy-related penalty imposed on any portion of an underpayment is 20 percent (40 percent for gross valuation misstatements), even if that portion of the underpayment is attributable to more than one type of misconduct. See D.H.L. Corp. v. Commissioner, T.C. Memo. 1998-461, aff’d in part and rev’d on other grounds, remanded by 285 F.3d 1210 (9th Cir. 2002).

In order to facilitate the examiner’s review of the relevant facts and circumstances associated with application of the I.R.C. §6662 penalty, this paper first provides a general overview of the law associated with the penalty where there is (a) negligence or disregard of rules or regulations and (b) any substantial understatement of income tax.  After the general overview, some more practical suggestions are offered based on the information that has been reviewed to date – including the above -referenced shelter promotion materials and Shelter Memorandum. Much of the focus in that later discussion is on substantial understatement.

Negligence or Disregard of Rules or Regulations

Negligence under I.R.C. §6662 includes any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code or to exercise ordinary and reasonable care in the preparation of a tax return. See I.R.C. §6662(c) and Treas. Reg. §1.6662-3(b)(1). Negligence also includes the failure to do what a reasonable and ordinarily prudent person would do under the same circumstances. See Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967), aff’g 43 T.C. 168 (1964); Neely v. Commissioner, 85 T.C. 934, 947 (1985). Treas. Reg. §1.6662-3(b)(1)(ii) provides that negligence is strongly indicated where a taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return that would seem to a reasonable and prudent person to be “too good to be true” under the circumstances. A return position that has a reasonable basis as defined in Treas. Reg. §1.6662-3(b)(3) is not attributable to negligence. Treas. Reg. §1.6662-3(b)(1).

“Disregard of rules and regulations” includes any careless, reckless, or intentional disregard of rules and regulations. A disregard of rules or regulations is “careless” if the taxpayer does not exercise reasonable diligence in determining the correctness of a position taken on its return that is contrary to the rule or regulation. A disregard is “reckless” if the taxpayer makes little or no effort to determine whether a rule or regulation exists, under circumstances demonstrating a substantial deviation from the standard of conduct observed by a reasonable person. Additionally, a disregard of the rules and regulations is “intentional” where the taxpayer has knowledge of the rule or regulation that it disregards. Treas. Reg. §1.6662-3(b)(2).

The term “rules and regulations” includes the provisions of the Internal Revenue Code, temporary or final treasury regulations, and revenue rulings or notices (other than notices of proposed rulemaking) issued by the Internal Revenue Service and published in the Internal Revenue Bulletin. Treas. Reg. §1.6662-3(b)(2). Therefore, if the facts indicate that a taxpayer took a return position contrary to any published notice or revenue ruling, the taxpayer may be subject to the accuracy-related penalty for an underpayment attributable to disregard of rules and regulations, if the return position was taken subsequent to the issuance of the notice or revenue ruling.

The accuracy-related penalty for disregard of rules and regulations will not be imposed on any portion of underpayment due to a position contrary to rules and regulations if: (1) the position is disclosed on a properly completed Form 8275 or Form 8275-R (the latter is used for a position contrary to regulations) and (2) in the case of a position contrary to a regulation, the position represents a good faith challenge to the validity of a regulation.5 Treas. Reg. §1.6662-3(c). This adequate disclosure exception applies only if the taxpayer has a reasonable basis for the position and keeps adequate records to substantiate items correctly. Treas. Reg. §1.6662-3(c)(1). Moreover, a taxpayer who takes a position contrary to a revenue ruling or a notice has not disregarded the ruling or notice if the contrary position has a realistic possibility of being sustained on its merits. Treas. Reg. §1.6662-3(b)(2).

The taxpayer has the ultimate burden of overcoming the presumption that the Service’s determination of negligence is correct. Marcello v. Commissioner, 380 F.2d 499, 507 (5th Cir. 1967). With respect to examinations commencing after July 22, 1998, however, the Service must first meet the burden of production with respect to negligence. I.R.C. §7491(c); Higbee v. Commissioner, 116 T.C. 438, 446 (2002).

Substantial Understatement

A substantial understatement of income tax exists for a taxable year if the amount of the understatement exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000 ($10,000 for a corporation, other than an S corporation or a personal holding company). I.R.C. §6662(d)(1). Specific rules apply to the calculation of the understatement when any portion of the understatement arises from an item attributable to a tax shelter. For purposes of I.R.C. §6662(d)(2)(C), a tax shelter is a partnership or other entity, an investment plan or arrangement, or other plan or arrangement where a significant purpose of such partnership, entity, plan or arrangement is the avoidance or evasion of federal income tax. I.R.C. §6662(d)(2)(C)(iii). Because a significant purpose of the Notice 2003-81 transaction is tax avoidance, it is a tax shelter pursuant to I.R.C. §6662(d)(2)(C). Different rules, however, apply depending upon whether the taxpayer is a corporation or an individual or entity other than a corporation.

In the case of any item of a taxpayer other than a corporation, which is attributable to a tax shelter, understatements are generally reduced by the portion of the understatement attributable to: (1) the tax treatment of items for which there was substantial autho rity for such treatment, and (2) the taxpayer reasonably believed that the tax treatment of the item was more likely than not the proper treatment. I.R.C. §6662(d)(2)(C)(i).6 The substantial authority standard is an objective standard involving an analysis of the law and application of the law to relevant facts. Treas. Reg. §1.6662-4(d)(1). Here, there was no substantial authority for the tax treatment of this transaction. A taxpayer is considered to have reasonably believed that the tax treatment of an item is more likely than not the proper tax treatment if (1) the taxpayer analyzes the pertinent facts and authorities, and based on that analysis reasonably concludes, in good faith, that there is a greater than 50% likelihood that the tax treatment of the item will be upheld if the Service challenges it, or (2) the taxpayer reasonably relies, in good faith, on the opinion of a professional tax advisor, which clearly states (based on the advisor’s analysis of the pertinent facts and authorities) that the advisor concludes there is a greater than 50% likelihood the tax treatment of the item will be upheld if the Service challenges it. Treas. Reg. §1.6662-4(g)(4). However, a taxpayer cannot claim to have reasonably relied in good faith on the opinion of a professional tax advisor if the requirements of Treas. Reg. §1.6664-4(c)(1) are not met. Treas. Reg. §1.6662-4(g)(4)(ii). (As a practical matter, the requirement that the opinion take into account the particular motivations and circumstances of the taxpayer makes reliance on a “canned” opinion inherently questionable.) This is discussed further under “Reasonable Cause Exception” below.

If the item is attributable to a tax shelter and the taxpayer is a corporation, the understatement cannot be reduced.7 I.R.C. §6662(d)(2)(C)(ii). Therefore, if a corporate taxpayer has a substantial understatement that is attributable to a tax shelter item, the accuracy related penalty applies to the underpayment arising from the understatement unless the reasonable cause and good faith exception applies.

Reasonable Cause Exception

I.R.C. §6664(c) provides an exception, applicable to all types of taxpayers, to the imposition of any accuracy-related penalty if the taxpayer shows that there was reasonable cause and the taxpayer acted in good faith. Special rules apply to items of a corporation attributable to a tax shelter resulting in a substantial understatement.

The determination of whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all relevant facts and circumstances. See Treas. Reg. §1.6664-4(b)(1) and Treas. Reg. §1.6664-4(f)(1). All relevant facts, including the nature of the tax investment, the complexity of the tax issues, issues of independence of a tax advisor, the competence of a tax advisor, the sophistication of the taxpayer, and the quality of an opinion, must be developed to determine whether the taxpayer was reasonable and acted in good faith.

Generally, the most important factor in determining whether the taxpayer has reasonable cause and acted in good faith is the extent of the taxpayer’s effort to assess the proper tax liability. See Treas. Reg. §1.6664-4(b)(1); see also Larson v. Commissioner, T.C. Memo. 2002-295; Estate of Simplot v. Commissioner, 112 T.C. 130, 183 (1999) (citing Mandelbaum v. Commissioner, T.C. Memo. 1995-255), rev’d on other grounds, 249 F.3d 1191 (9th Cir. 2001). For example, reliance on erroneous information reported on an information return indicates reasonable cause and good faith, provided that the taxpayer did not know or have reason to know that the information was incorrect. Similarly, an isolated computational or transcription error is not inconsistent with reasonable cause and good faith. Treas. Reg. §1.6664-4(b)(1).

Circumstances that may suggest reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of the facts, including the experience, knowledge, sophistication and education of the taxpayer. Treas. Reg. §1.6664-4(b)(1). The taxpayer’s mental and physical condition, as well as sophistication with respect to the tax laws, at the time the return was filed, are relevant in deciding whether the taxpayer acted with reasonable cause. See Kees v. Commissioner, T.C. Memo. 1999-41. If the taxpayer is misguided, unsophisticated in tax law, and acts in good faith, a penalty is not warranted. See Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988); cf. Spears v. Commissioner, T.C. Memo. 1996-341, aff’d, 98-1 USTC ¶ 50,108 (2d Cir. 1997)[Court was unconvinced by the claim of highly sophisticated, able, and successful investors that they acted reasonably in failing to inquire about their investment and simply relying on offering circulars and accountant, despite warnings in offering materials and explanations by accountant about limitations of accountant’s investigation].

Reliance upon a tax opinion provided by a professional tax advisor may serve as a basis for the reasonable cause and good faith exception to the accuracy-related penalty. The reliance, however, must be objectively reasonable, as discussed more fully below. For example, the taxpayer must supply the professional with all the necessary information to assess the tax matter. The advice also must be based upon all pertinent facts and circumstances and the law as it relates to those facts and circumstances.

The advice must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person. For example, the advice must not be based upon a representation or assumption which the taxpayer knows, or has reason to know, is unlikely to be true, such as an inaccurate representation or assumption as to the taxpayer’s purposes for entering into a transaction or for structuring a transaction in a particular manner. See Treas. Reg. §1.6664-4(c)(1)(ii).

In Long Term Capital Holdings v. United States, 330 F. Supp.2d 122 (D. Conn. 2004), the court concluded that a legal opinion did not provide a taxpayer with reasonable cause where (1) the taxpayer did not receive the written opinion prior to filing its tax return, and the record did not establish the taxpayer’s receipt of an earlier oral opinion upon which it would have been reasonable to rely; (2) the opinion was based upon unreasonable assumptions; (3) the opinion did not adequately analyze the applicable law; and (4) the taxpayer’s partners did not adequately review the opinion to determine whether it would be reasonable to rely on it. In addition, the court concluded that the taxpayer’s lack of good faith was evidenced by its decision to attempt to conceal the losses reported from the transaction by netting them against gains on its return.

Where a tax benefit depends on nontax factors, the taxpayer has a duty to investigate the underlying factors rather than simply relying on statements of another person, such as a promoter. See Novinger v. Commissioner, T.C. Memo. 1991-289. Further, if the tax advisor is not versed in these nontax matters, mere reliance on the tax advisor does not suffice. See Addington v. United States, 205 F.3d 54, 58 (2d Cir. 2000); Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988) Freytag v. Commissioner, 89 T.C. 849, 888 (1987), aff’d,904 F.2d 1011 (5th Cir. 1990). Although a professional tax advisor’s lack of independence is not alone a basis for rejecting a taxpayer’s claim of reasonable cause and good faith, the fact that a taxpayer knew or should have known of the advisor’s lack of independence is strong evidence that the taxpayer may not have relied in good faith upon the advisor’s opinion. See Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43, 98 (2001), aff’d 299 F.3d 221 (3rd Cir. 2002) [“Reliance may be unreasonable when it is placed upon insiders, promoters, or their offering materials, or when the person relied upon has an inherent conflict of interest that the taxpayer knew or should have known about”]; Goldman v. Commissioner, 39 F.3d 402, 408 (2d Cir. 1994) aff’g T.C. Memo. 1993-480 [“Appellants cannot reasonably rely for professional advice on someone they know to be burdened with an inherent conflict of interest”]; Marine v. Commissioner, 92 T.C. 958, 992-93 (1989), aff’d without published opinion, 921 F.2d 280 (9th Cir. 1991). Such reliance is especially unreasonable when the advice would seem to a reasonable person to be “too good to be true.” Pasternak v. Commissioner, 990 F.2d 893, 903 (6th Cir. 1993), aff’g Donahue v. Commissioner, T.C. Memo. 1991-181; Gale v. Commissioner, T.C. Memo. 2002-54; Elliot v. Commissioner, 90 T.C. 960, 974 (1988), aff’d without published opinion, 899 F.2d 18 (9th Cir. 1990); Treas. Reg. §1.6662-3(b)(2).

Similarly, the fact that a taxpayer consulted an independent tax advisor is not, standing alone, conclusive evidence of reasonable cause and good faith if additional facts suggest that the advice is not dependable. Edwards v. Commissioner, T.C. Memo. 2002-169; Spears v. Commissioner, T.C. Memo. 1996-341, aff’d, 98-1 USTC ¶ 50,108 (2d Cir. 1997). For example, a taxpayer may not rely on an independent tax adviser if the taxpayer knew or should have known that the tax adviser lacked sufficient expertise, the taxpayer did not provide the advisor with all necessary information, or the information the advisor was provided was not accurate.” Baldwin v. Commissioner, T.C. Memo. 2002- 162; Spears v. Commissioner, T.C. Memo. 1996-341, aff’d, 98-1 USTC ¶ 50,108 (2d Cir. 1997).

Observations Regarding Application of Penalty to This Shelter

When it appears that imposing the accuracy-related penalty is warranted, the examiner needs to carefully evaluate the application of the penalty for each taxpayer that is audited. This review is made somewhat easier by the fact that taxpayers must satisfy more stringent standards to avoid application of the penalty where the substantial understatement is in connection with a tax shelter transaction. From a practical standpoint, it will be critical for the examiner to focus upon whether the taxpayer based its return position on a more likely than not legal opinion of a professional tax advisor that considered all pertinent facts and lines of legal authority. Based on the review of the limited materials gathered to date in connection with this shelter transaction, it may be quite difficult for taxpayers to show that they satisfied that standard.

As an initial matter, the examiner should determine whether the taxpayer obtained or relied upon a signed and dated legal opinion that unambiguously concludes that the taxpayer’s return positions were more likely than not to be sustained if challenged. If the taxpayer has not reasonably relied on such an opinion, then the accuracy-related penalty should be asserted.

Moreover, while all facts would still have to be considered, the accuracy-related penalty should also apply if the taxpayer simply relied on a “canned” legal opinion that does not address that taxpayer’s particular circumstances. Almost by definition, such a “canned opinion could not be reasonably relied upon because it would not address the taxpayer’s particular motivations and other pertinent circumstances.

Even if the taxpayer could have reasonably relied on a “canned” legal opinion or one that is directed to the taxpayer, it will be necessary to evaluate whether the opinion took into account all pertinent facts and lines of legal authority. If the draft Shelter Memorandum is a good barometer of the quality of the opinions, if any, provided to taxpayers, the examiner may find that highly pertinent facts were overlooked or misstated. For instance, it is plainly troubling that the draft Shelter Memorandum reached its conclusions regarding section 1092 by assuming that the assigned foreign currency options were not substantially offsetting positions even though separate promotional documents clearly tout the positions as being almost completely offsetting. Moreover, the legal memorandum virtually ignores all discussion of the economics and legal effects of the assignments.

In addition, it will be critical to examine whether the legal opinion addressed all relevant lines of legal authority. As a guide, the examiner should determine if each of the legal issues raised in this CIP were meaningfully considered. The draft Shelter Memorandum was clearly deficient in that regard. For instance, the legal memorandum failed to consider any authority that addresses the tax accounting for options and failed to consider whether the form of assignment caused gain or loss to be recognized under the open transaction doctrine. Though section 988 was considered, the draft memorandum also failed to consider the anti-abuse rules of Treas. Reg. 1.988-2(f).

8. The agent examining the taxable entity should forward all information gathered about the involvement of the charity to the Exempt Organizations Division of TEGE through the process established by the Notice 2003-81 Issue Management Team.

Through IDRs and otherwise, the agent examining a taxable entity that entered into one of these transactions will obtain information about the involvement of the charity. In all cases, the agent should forward that information to the Exempt Organizations Division of TEGE through the process established by the Notice 2003-81 Issue Management Team. Examiners should refer to the Notice 2003-81 toolkit for the most current EO contact information, including contact person, address, phone and fax numbers.   Information provided by the examiners to Exempt Organizations will be helpful in alerting Examination and Determination Agents so they may identify issues and take appropriate actions.

Exempt Organizations will need to exercise discretion in determining how to proceed with the information that it receives because the nature of the charity’s involvement in these transactions may vary. In some cases, a “charity” may have been created by the promoter or someone affiliated with the promoter specifically to facilitate these transactions. The custom-made charity may purport to engage in appropriate charitable activities, but evidence could show substantial and/or repeated involvement as the accommodation party in the transaction. Other cases may involve charities that are well-established in their appropriate charitable endeavors but that appear as accommodation parties in these or other abusive tax transactions. Their involvement may appear on the books simply as a donation, as a net donation from offsetting options or property, or as part of an investment portfolio.

The Service will apply the full array of enforcement tools to those entities whose focus is on accommodating abusive tax transactions. Playing that role does not further a charitable or other tax-exempt purpose. If this role is apparent in the application process for exemption, the Service will not recognize the entity as exempt. If the Service discovers this abusive behavior after having already recognized the entity as exempt, the Service will move to revoke the entity’s exemption, possibly back to its inception.

Where the Service learns that an otherwise compliant charity has become involved in an abusive transaction as an accommodating party, whether booked as a donation, fee, investment, or otherwise, the charity may expect to be contacted by the Service. The charity may be requested to provide the details of its involvement, information about the transaction and other parties, etc. Depending on the circumstances, this contact may be made by the Exempt Organizations Division as a compliance check with respect to the Form 990 or other return, or as part of an inquiry into the charity’s own taxation and exemption status or other associated tax issues. In the alternative, it may arise as a third-party request for information relating to the examination of a promoter or taxable party. Prior to any contact being made to charity, coordination must first be made with the Exempt Organizations Division. While these transactions, at a minimum, raise questions about an organization’s governance, if significant levels or types of involvement come to light, the Service will take the tax-exempt entity’s involvement into account in determining whether to continue to recognize the entity’s exemption or to apply an appropriate tax.

_____FOOTNOTES_____

  1. In the transactions examined thus far, the strategy consists of the purchase and sale of a series of foreign currency option contracts denominated in both the euro and a currency of a European country (usually the Danish krone) that participates in the ERM II for fixing the participating currency exchange rate against the euro within a narrow fluctuation band.
  2. I.R.C. §170(e) may also affect the amount of the donation.
  3. Because only an obligation is transferred, there is no need to consider whether the premium would be taxed to the taxpayer under the assignment of income doctrine. It stands to reason, however, that if the assignment of income doctrine applies to certain transfers of income rights to charities, it should have been more than obvious to the promoters of this shelter that transferring the obligation but not the premium to a charity would not cause the responsibility for paying tax on the premium to be shifted to the charity.
  4. The American Jobs Creation Act of 2004, P.L. 108-357, 118 Stat. 1418 (the “Act”), was enacted on October 22, 2004. The Act created §6662A, which imposes an accuracy related penalty on understatements with respect to reportable transactions, and amended §6662. I.R.C. §6662A and the amendments to §6662 apply only to tax years ending after October 22, 2004. Thus, this CIP does not discuss §6662A and references §6662 before amendment by the Act.
  5. For returns filed after December 31, 2002, if the position relates to a reportable transaction, adequate disclosure also requires disclosure in accordance with Treas. Reg. §1.6011-4. Treas. Reg. §1.6662-3(c)(1).
  6. It should be noted that the AJCA amendments to I.R.C. §6662, for tax years ending after October 22, 2004, eliminated reduction of the understatement for all taxpayers if the item is attributable to a tax shelter.
  7. See above note for changes made by the AJCA.

 

 

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