Usage of OTC FX options as foreign currency contracts under section 1256
Sixth Circuit reaches decision in Wright v. Commissioner
INSIGHT ARTICLE |
A recent Sixth Circuit decision in Wright v. Commissioner reached an unexpected conclusion regarding the treatment of over-the-counter foreign currency (OTC FX) options.1 In Wright, the Sixth Circuit held that the taxpayer’s “major currency” OTC FX option met the definition of a “foreign currency contract” under section 1256(g)(2). What made the ruling unexpected was not necessarily the logic used by the Sixth Circuit, but rather the fact that it contradicts prior Tax Court rulings and the IRS’ formal position.
To start, section 1256(g)(2) defines a foreign currency contract as a contract that must:
- require 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
- trade in the interbank market
- be entered into at arm’s length at a price determined by reference to the price in the interbank market
The IRS and Treasury made clear in Notice 2007-71 they believed foreign currency options, even if the underlying currency has positions traded through regulated futures contracts, are not foreign currency contracts as defined in section 1256(g)(2) and that they intend to challenge any characterizations to the contrary.2 The conclusion depended on the inherit optionality present in an options contract, compared to a forward contract that is required to settle on a specified date.
When reviewing the legislative history, the phrase “or the settlement of which depends on the value of” was not part of the original statute but was added as part of the Tax Reform Act of 1984 in order to allow for cash-settled contracts to be includible.3 Prior to this change, it was clear that an FX option would not require delivery of a foreign currency; however, the amended language created some uncertainty and Notice 2007-71 (issued over two decades after the fact) tried to dispel this uncertainty by stating Congressional intent was never to expand the definition of foreign currency contracts to foreign currency options. That position is further supported through the IRS’ and Treasury’s claim that the legislative history of section 988(c)(1)(E), enacted by the Technical and Miscellaneous Revenue Act of 1988, indicates that a foreign currency option is not a foreign currency contract as defined in section 1256(g)(2).4
Beyond the confines of Notice 2007-71, the Tax Court has been supportive of the IRS’ position in prior cases.5 In Summitt v Commissioner, the court first reviewed the statutory language as “the plain meaning of the words used will control unless there is unequivocal evidence of legislative purpose to override such meaning.”6 The court held that “the statute referred to a contract which required delivery of the foreign currency, not to a contract in which delivery was left to the discretion of the holder.” It then extended its analysis, following the logic in Notice 2007-71, and noted that the original statutory language was not meant to include foreign currency options and the post-1984 added phrase of “or the settlement of which depends on the value of” was strictly meant to allow cash-settled foreign currency forwards. Foreign currency forwards may be physically settled or cash-settled, but, in either case, require settlement at expiration (contrasted with the optional settlement in a foreign currency option).
Accordingly, the Tax Court in Summitt found the statute’s plain language was dispositive and that there is no evidence in the legislative history that a literal reading of the statute would undermine legislative intent. The Summitt Court noted that the statute grants Treasury the authority to prescribe regulations that would exclude any contract or type of contract from the definition of foreign currency contract. Oddly, Treasury has drafted no such regulations in any form despite having the statutory authority to do so for over 30 years.
In the more recent case of Wright, the Tax Court referenced its decisions in Summitt and Garcia and ruled against the taxpayers who had taken the position that the major foreign currency option was a foreign currency contract.7 After losing in Tax Court, the taxpayer appealed to the Sixth Circuit. While acknowledging that the Tax Court’s reasoning appeared to support sound tax policy, the Sixth Circuit disagreed with its analysis of the plain language of the statute.
Surprisingly, the Sixth Circuit’s analysis was very grammatically precise and focused. The court stated that the use of the word “or” between the “delivery” and “settlement” phrase indicates that these phrases describe two ways in which a contract may qualify as a foreign currency contract under section 1256(g)(2). The use of a comma after “delivery of” establishes that the word “requires” does not apply to the settlement prong. Therefore, under the Sixth Circuit’s analysis, a contract where the settlement depends on the value of a foreign currency is a foreign currency contract for purposes of section 1256(g)(2) even if the contract does not require any kind of cash or physical settlement; contradicting the Tax Court’s assertion that to qualify as a foreign currency contract under section 1256(g)(2) the contract must require settlement either physically or in cash. The Sixth Circuit went as far as describing the IRS’ interpretation of the statute as “syntactically incoherent”. Because the Sixth Circuit’s own interpretation of the plain language of the statute clearly provided that the taxpayer’s option met the “settlement prong” of section 1256(g)(2), the court felt any review of the legislative history was not necessary.
The Sixth Circuit in Wright ruled based on their interpretation of the statute as written by Congress and did not find it within their purview to override what they found to be unambiguous statutory language even though their interpretation was likely inconsistent with larger tax policy concerns. They suggested that if Congress wanted to a different result, Congress should have worded the statute differently. Further, Treasury could exercise their authority to issue regulations that could simply exclude foreign currency options from the definition of foreign currency contracts under section 1256(g)(2) but has not done so.
What the ruling in Wright means for taxpayers is not entirely clear. Short of Congress amending the statute, any further developments need to be driven by the IRS and Treasury. Given the Sixth Circuit ruling, the position set forth in Notice 2007-71 needs to be reexamined and modified if necessary for taxpayers subject to Sixth Circuit precedent. If Treasury remains steadfast in its position, taxpayers would benefit from the certainty provided by regulations that clearly exclude foreign currency options from the definition of foreign currency contracts under section 1256(g)(2).
This would be most welcomed for taxpayers within the Sixth Circuit since their appellate court is now in conflict with published guidance and a litigated position of the IRS (and the Tax Court). From a practical perspective, any potential benefit that could be gained from this ruling may very well be squashed by IRS’ refusal to grant a change of accounting method to treat foreign currency options as section 1256 contracts. Other circuit courts may follow the Sixth Circuit, but at this juncture it looks like a taxpayer would need to invest the time and expense to move past the IRS and Tax Court in order to take a gamble on another circuit court (which is not bound by the Sixth Circuit’s ruling). Those outside the Sixth Circuit should be wary in jumping behind the Wright decision because the IRS hasn’t given any indication that it intends to abandon its position of challenging the treatment of major currency8 OTC FX options as section 1256 foreign currency contracts.
1 Wright v. Commissioner, CA-6, 2016-1 U.S.T.C. ¶50,137.
2 Notice 2007-71 modified and supplemented Notice 2003-81, which the IRS believed incorrectly implied that foreign currency options are foreign currency contracts. It’s important to note that the original context of Notice 2003-81 was designating a type of tax avoidance transaction involving offsetting FX currency options as a listed transaction.
3 Tax Reform Act of 1984, P.L. 98-369, 1984-3 (Vol. 1) C.B. 128.
4 Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647, 1988-3 C.B. 377-380.
5Summitt v. Commissioner, 134 T.C. No. 248 (2010). In Garcia v. Commissioner, T.C. Memo 2011-85 (2011), the Tax Court quickly affirmed its ruling in Summitt.
7 Although the taxpayers in Wright were utilizing the major-minor FX option tax shelter described in Notice 2007-71, the issue being litigated related to the application of the foreign currency contract definition and not the overall tax shelter strategy.
8 Currently the major currencies whose contracts are listed and therefore eligible for Section 1256 treatment are:
New Zealand dollar
South African rand