Federal Income Tax Treatment of OTC Foreign Currency Options Altered by Sixth Circuit
Sometimes the decision reached in a court case truly surprises you because the underlying law that drives that decision seems so fully settled. Terry L. Wright v. Commissioner, just decided by the 6th Circuit Court of Appeals, is one such case.
The underlying law in question is the federal income tax treatment of over-the-counter (“OTC”) foreign currency options on a so-called “major” currency, such as the Euro. An OTC option is a non-exchange traded option. A foreign currency option is a unilateral contract that does not require delivery or settlement unless and until the option is exercised; an obligation to settle may never arise if the holder does not exercise its rights under the option. This is contrasted with a foreign currency forward contract which is a bilateral contract between a seller and a buyer that obligates the seller, at the time of signing, to settle his obligation to perform by either delivering the currency or making cash settlement. (See Mark D. Summitt v. Commissioner, cited in Wright.) A major foreign currency is a currency in which positions are traded through regulated futures contracts (such as on a U.S. futures exchange).
In Wright, the appeals court held that, based on the literal language of the applicable statute, IRC Sec. 1256(g)(2)(A), OTC foreign currency options are Section 1256 contracts, and, accordingly, are subject to mark-to-market accounting. (In contrast, an option that is not a Section 1256 contract is generally taxed on an “as realized” basis, i.e., when it is sold, exchanged or otherwise disposed.) In doing so, the appeals court took a position contrary to the lower court in Wright, the Tax Court in other cases, the IRS and the legislative history of IRC Sec. 1256(g)(2), as well as the guidance of numerous practitioners who advise on financial products and transactions, all of which viewed OTC foreign currency options on a major currency as not qualifying as Section 1256 contracts.
IRC Sec. 1256(g)(2)(A) states that a “foreign currency contract” – which is one of the categories of section 1256 contracts – is a contract:
- which requires delivery of, or the settlement which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts,
- which is traded in the interbank market, and
- which is entered into at arm’s length at a price determined by reference to the price in the interbank market.
As originally enacted in 1982, the statute referred to a contract which required delivery of the foreign currency and not to a contract in which delivery was left to the discretion of the holder. According to legislative history, IRC Sec. 1256(g) was amended in 1984 by adding the phrase “or the settlement which depends on the value of,” (in bold above) to allow a cash-settled forward contract to come within the term “foreign currency contract” if the cash-settled forward contract required, by its terms at inception, settlement at expiration.
Nonetheless, the appeals court held that the literal language is clear, so clear that it did not need to resort to legislative history to interpret IRC Sec. 1256. Specifically, the court’s view was that the plain language of IRC Sec. 1256 does not provide that a foreign currency contract must require either a delivery or a settlement. If Congress wanted to require a delivery or a settlement, it could have amended the statute accordingly, but in the view of the appeals court, it did not do so. Bad drafting? Rather, the appeals court maintains that the statute provides that a “foreign currency contract” is (1) “a contract … which requires delivery of … a foreign currency” or (2) “a contract … the settlement of which depends on the value of … a foreign currency,” even if that contract does not require that any such settlement occur. An OTC foreign currency contract on a major currency will certainly satisfy the latter prong.
The court conceded that in the context of the case at hand, which involved a tax shelter transaction, there was “no conceivable tax policy that supports this interpretation of the plain language of Sec. 1256, and none has been suggested to us by the parties.” The court pointed out that Congress gave the Secretary of the Treasury the authority in IRC Sec. 1256(g)(2)(B) to prescribe regulations to exclude any type of contract from the “foreign currency contract” definition if the inclusion of that type of contract would be “inconsistent” with the purposes of IRC Sec. 1256.
If one parses the language of the statute literally, and without the benefit of legislative history, a reasonable argument can certainly be made that OTC foreign currency options are included in the definition of foreign currency contracts. However, it seems equally clear that this was not the intent of the drafters of IRC Sec. 1256(g)(2)(A). So, the IRS needs to evaluate where it goes from here. It can timely petition the 6th Circuit for a rehearing. But what treatment does it really prefer? Wright was a tax shelter case; in a non-shelter situation, would the IRS prefer mark-to-market, or “as realized” treatment for OTC foreign currency options? Should clarifying regulations be proposed? Meanwhile, the Wright decision is now precedent in the 6th Circuit – Kentucky, Michigan, Ohio and Tennessee. Elsewhere, the decision will no doubt be taken into account when the issue arises, but what seemed like settled law is now in flux. More clarity is in order.