Looking ahead: IRS denies 40/60 treatment for OTC foreign currency options under mark-to-market rules – Financial Services

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The IRS has issued draft regulations clarifying that for purposes of mark-to-market rules under Section 1256, foreign currency contracts include only foreign currencies forward contracts, and that the definition does not include currency options. The proposed regulations do not affect the status of currency options that would otherwise qualify as contracts under Section 1256, such as currency options that trade on certain exchanges; however, OTC currency option holders who previously treated options as foreign exchange contracts under mark-to-market rules may need to re-evaluate their treatment of such options.

Only certain investments such as foreign exchange contracts are subject to section 1256 which requires the annual recognition of gains and losses in capital gains and losses according to a ratio of 40% in the short term and 60% in the long term. Other foreign currency transactions are subject to tax at ordinary income tax rates under Section 988. In a series of cases involving OTC foreign currency options, the Court of the tax ruled that foreign currency options did not constitute foreign currency contracts under Section 1256, relying heavily on legislative history, but was reversed by the Sixth Circuit’s finding that the legislative provision was broad enough to cover currency options. The IRS has now refined the definition of foreign exchange contracts in Section 1256 to include only forward contracts in an effort to resolve the uncertainty created by the Sixth Circuit decision and consistent with previous Tax Court decisions interpreting Section 1256 which distinguished between options and futures contracts on the basis that Currency futures require settlement at expiration while currency options do not require settlement thereof.

The proposed regulations would come into force 30 days after the publication of the final regulations.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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