Sixth Circuit Reverses Tax Court; Foreign Currency Option Can be a Foreign Currency Contract.

(Parker Tax Publishing January 20, 2016)

Although the Tax Court's disallowance of a tax loss by the taxpayers made sense to the Sixth Circuit as a matter of tax policy, it found the plain language of the statute clearly provided a different result and the Sixth Circuit reversed the lower court and held that a foreign currency option can be a "foreign currency contract" under Code Sec. 1256. Wright v. Comm'r, 2016 PTC 4 (6th Cir. 2016).

Background

Code Sec. 1256 provides that an investor who holds certain types of derivatives at the close of the tax year must mark to market those derivatives by treating them as having been sold for their fair market value on the last business day of the tax year. A foreign currency that an investor must mark to market at the end of the tax year is called a "Section 1256 contract."

Terry and Cheryl Wright are co-owners of an investment company called Cyber Advice, LLS, which is taxed as a partnership. In 2002, Cyber Advice purchased a euro put option for a premium of approximately $36.2 million, which gave Cyber Advice the right to sell to 1.2 billion euros to a trading company, Beckenham, for $1.3 billion on the expiration date of the option. Cyber Advice also purchased a euro call option from Beckenham with terms that were the mirror-image of the euro put option (i.e. the option gave Cyber Advice the right to buy 1.2 billion euros from Beckenham for $1.3 billion). At this time, Cyber Advice also sold a krone call and krone put to Beckenham on mirror-image terms. Three days later, Cyber Advice assigned the euro put option and krone put option to a charitable organization, the Foundation for an Educated America. Cyber Advice also sold the euro call option to Beckenham and repurchased the krone call option from Beckenham.

In October 2003, Cyber Advice and the Wrights filed their 2002 income tax returns. Cyber Advice reported short-term capital gains and losses for three of its option transactions but did not report gain from the krone put. It reported a total net short-term capital loss of approximately $3 million. The Wrights took the position that they did not need to recognize the gain from the assignment of the krone put option to the Foundation for an Educated America because over-the-counter options on minor foreign currencies such as the krone were not Section 1256 contracts to which mark-to-market accounting applied. The Wrights also took the position that recognition of a short-term capital loss from the assignment of the euro put option to the Foundation for an Educated America was proper because the assignment of the euro put option resulted in a termination under Code Sec. 1256(c) and because the euro put option was a "foreign currency contract" subject to Code Sec. 1256.

Because Cyber Advice was taxed as a partnership, its loss flowed to the Wrights. The Wrights reported an almost $3 million loss on their return, which aided in reducing the Wrights' capital gains from more than $3.4 million to less than $500,000. Thus, the transactions allowed the Wrights to generate a large tax loss at minimal economic risk or out-of-pocket expense. The IRS determined that the Wrights had improperly claimed the almost $3 million net capital loss in relation to the major-minor transactions.

OBSERVATION: A major-minor transaction refers to a currency whose positions are traded through regulated futures contracts (i.e., euros) and a currency that is considered minor because there is not a regulated futures contract for the currency (i.e., the Danish krone).

Analysis

The Tax Court rejected the Wrights' attempt to generate a tax loss in this manner, holding that they could not recognize a loss upon assignment of the euro put option because their option was not a "foreign currency contract" under Code Sec. 1256. The Tax Court explained that a foreign currency option does not meet the "delivery" or "settlement" requirement in Code Sec. 1256(g)(2) because a foreign currency option does not require delivery or settlement "unless and until" the holder exercises the option. The Tax Court cited its decision in Summitt v. Comm'r, 134 T.C. 248 (2010), a case that involved a major-minor transaction. The Tax Court also noted that it was clear that the statute as originally enacted applied only to forward contracts which require delivery of the foreign currency. Further, the Tax Court reasoned that because the phrase "or the settlement of which depends on the value of" was added to Code Sec. 1256 to allow cash-settled forward contracts to come within the term "foreign currency contract," Code Sec. 1256(g)(2)(A)(i) mandated that "foreign currency contracts" require settlement at expiration.

The Wrights appealed to the Sixth Circuit. The issue before the Sixth Circuit was the definition of "foreign currency contract" provided in Code Sec. 1256(g)(2)(A).

The Sixth Circuit reversed the Tax Court and held that the Wrights' euro put option met the "settlement" prong of Code Sec. 1256(g)(2)(A)(i) and thus qualified as a foreign currency contract. The court found the IRS's position that Code Sec. 1256(g)(2)(A)(i) provides that a contract must mandate at maturity either a physical delivery of a foreign currency or a cash settlement based on the value of the currency to be contrary to the plain language of the statute. Contrary to the IRS's assertion, the Sixth Circuit said, the inclusion in Code Sec. 1256 of a rule that applies to the cash settlement of a contract does not make it implicit that a settlement of the contract must actually occur.

The Sixth Circuit observed that, while the Tax Court's disallowance of the Wrights' claimed tax loss makes sense as a matter of tax policy, the plain language of the statute clearly provides that a foreign currency option can be a "foreign currency contract." The court saw no conceivable tax policy that supported its interpretation of the plain language of Code Sec. 1256, but declined to reform the statutory language for two reasons: (1) an attempt to reform Code Sec. 1256 might unintentionally permit other tax-avoidance schemes, and (2) Congress provided two escape hatches to guard against the type of adverse tax policy outcome at issue. First, under Code Sec. 1256(g)(2)(B), the IRS can issue regulations to exclude any type of contract from the "foreign currency contract" definition if the inclusion of this type of contract would be "inconsistent" with the purposes of Code Sec. 1256. Second, the IRS can prevent taxpayers from claiming tax losses based upon transactions involving offsetting foreign currency options by challenging specific transactions under the economic substance doctrine as lacking in economic substance.

For a discussion of Code Sec. 1256 contracts, see Parker Tax ¶116,150. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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