Proposed Treasury Regulations Address (Non) Application of Section 1256 to Over-the-Counter Foreign Currency Options

On July 5, 2022, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) released proposed regulations that clarify that the definition of “foreign currency contract” under section 1256 includes only a foreign currency forward contract (and not a foreign currency option contract). 



Section 1256 provides rules that require taxpayers to account for certain contracts (referred to as “section 1256 contracts”) under a mark-to-market method of accounting, pursuant to which the contract is treated as sold for its fair market value at the end of the year (and any resulting gain or loss is taken into account for the year).

Section 1256(b) defines a section 1256 contract to include, inter alia, regulated futures contracts, nonequity (listed) options (including listed foreign currency, or “FX”, options), and “foreign currency contracts.”  A foreign currency contract is defined under section 1256(g)(2) as a contract that meets three criteria. The first criteria, relevant here, is that the contract “requires delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts” (often referred to as a “major currency”). The other two criteria are that the contract is traded in the interbank market and is entered into at arm's length at a price determined by reference to the price in the interbank market.

Gain or loss on section 1256 contracts is treated as 60 percent long-term and 40 percent short-term (or 60/40) capital gain or loss – unless gain or loss on the contract would otherwise be ordinary, in which case the resulting gain or loss is ordinary. Gain or loss on FX contracts that are section 988 transactions (including a FX forward contract) is ordinary (unless an election is made to treat such gain as capital). Listed FX options and foreign currency regulated futures contracts are not treated as section 988 transactions, and therefore gain or loss on such transactions is generally 60/40 capital (unless an election is made to treat such contract as section 988 transactions).


Application of Section 1256 to FX Options

The application of section 1256 to over-the-counter (i.e., not listed) FX options has been a topic of debate for many years and was the subject of the “major-minor” option transaction that was identified as a listed transaction in Notice 2003-81.  The debate focused on the requirement in section 1256(g)(2) that a foreign currency contract must require delivery of, or the settlement of which depends on the value of, a foreign currency.  Treasury and the IRS have consistently argued that an FX option does not require delivery or settlement (unless and until the option is exercised) and therefore FX options (which may expire worthless such that no delivery or settlement is required) are not “foreign currency contracts” under section 1256(g)(2).

This IRS has litigated the issue on several occasions (in the context of the so-called major-minor transactions).  Although the Tax Court in each instance agreed with the IRS, in Wright v. Commissioner, the Sixth Circuit Court of Appeals reversed the Tax Court, holding that an FX option could be a foreign currency contract based on the plain meaning of section 1256(g)(2). Wright v. Commissioner, 809 F.3d 877, 885 (6th Cir. 2016).  Specifically, the Sixth Circuit found that the plain language of section 1256(g)(2)(A)(i) (“which requires delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts”) does not require settlement, and therefore could include an FX option contract under which settlement of the contract depends on the value of a foreign currency, even if the contract does not mandate settlement.  


Proposed Section 1256 Regulations

The proposed regulations clarify that a “foreign currency contract” as defined in section 1256(g)(2) means only an FX forward contract (and does not include an FX option contract). The proposed regulations do not change the status of listed FX options, which otherwise qualify as section 1256 contracts under section 1256(b)(1)(C) and therefore remain subject to section 1256. 

The proposed regulations do not define the term “forward contract.” Whether a contract is properly characterized as a forward contract for U.S. federal income tax purposes is determined under current law.

The regulations are proposed to apply to contracts entered into on or after the date that is 30-days after publication of final regulations in the Federal Register, although taxpayers (together with their related parties) may rely on the proposed regulations for tax years ending on or after July 6, 2022, subject to certain consistency requirements.

Importantly, with respect to contracts entered into by taxpayers in circuits other than the Sixth Circuit before the effective date of final regulations, the IRS intends to adhere to its prior published position that FX options are not foreign currency contracts under section 1256(g)(2).




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