June 2014

Tax Treatment For Nadex Binary Options

June 20, 2014 | By: Robert A. Green, CPA

There’s a bevy of financial instruments to trade on securities and futures exchanges around the world, and derivatives and swaps exchanges offering binary options and swap contracts are increasingly becoming part of the mix. How are these unique instruments treated come tax-time? Can they be considered Section 1256? Let’s delve into binary options and swaps in more detail. (For more background on Section 1256 and its qualified board or exchange requirement, see Tax treatment for foreign futures.”)

Dodd-Frank changed the law
A principal focus of the Dodd-Frank Wall Street Reform and Consumer Protection Act law enacted in July 2010 is better regulation and control of the several-hundred-trillion-dollar derivatives and swaps marketplace. Dodd-Frank requires many privately negotiated derivatives and swaps contracts to clear on derivatives and swaps exchanges to insure collection of margin and to prevent another financial crisis. Remember, AGI wrote too many derivatives and swaps contracts, which it did not have sufficient capital or margin to pay out when markets melted down and counterparties demanded payment in 2008.

Dodd-Frank synchronized regulation and tax law, requiring the IRS to exclude swap contracts from Section 1256. Although Congress required private derivative contracts to clear on Section 1256 exchanges, it didn’t want to reward derivatives contracts with Section 1256 tax advantages.

Before Dodd-Frank, the CFTC had more leeway in designating instruments as “options.” According to a CFTC lawsuit, the CFTC used a limited definition of what constituted an option; e.g. it trades like an option (more on this lawsuit later). According to a CFTC official, “After Dodd-Frank, unless the option expires into a futures contract, the CFTC categorizes it as a swap contract. If the contract expires into cash, it’s a swap contract.”

Regulators don’t drive tax treatment
The Securities and Exchange Commission (SEC) regulates securities and the IRS treats sales of securities with short-term and long-term capital gain/loss tax treatment based on realized gains subject to wash sale loss deferral rules. The Commodity Futures Trading Commission (CFTC) regulates commodities, futures, forex and derivatives and the IRS has varying tax treatment for these different types of financial instruments.

Regulated futures contracts and nonequity options are Section 1256 contracts afforded lower 60/40 capital gains tax rates with MTM accounting reporting realized and unrealized gains and losses at year-end (reported on Form 6781).

If an investor sells physical commodities, capital gain/loss treatment applies and there is no MTM. Conversely, if a farmer sells physical commodities, ordinary treatment applies, but again, there is no MTM.

Forex (interbank spot and forward contracts) falls under Section 988 ordinary gain and loss on realized transactions. Traders may file a contemporaneous “capital gains election” to opt out of Section 988, whereas manufacturers may not.

Notional principal contracts defined as two or more periodic payments — commonly called swaps — receive ordinary gain or loss treatment and MTM accounting applies.

IRS proposed regulations on swaps 
In connection with Dodd-Frank, the IRS issued proposed regulations “Notice of Proposed Rulemaking and Notice of Public Hearing Swap Exclusion for Section 1256 Contracts” (REG-111283-11) on Oct. 17, 2011. Excerpts are provided below, with our notes in italics:

• Summary: .. describe swaps and similar agreements that fall within the meaning of section 1256(b)(2)(B). This document also contains proposed regulations that revise the definition of a notional principal contract under §1.446-3 (Note that swaps generally fall within the definition of “Notional Principal Contracts”.)

• Dodd-Frank Act added section 1256(b)(2)(B), which excludes swaps and similar agreements from the definition of a section 1256 contract. Section 1256(b)(2)(B) provides that the term “section 1256 contract” shall not include— any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement. (All swaps are effectively excluded.)

• Congress enacted section 1256(b)(2)(B) to resolve uncertainty under section 1256 for swap contracts that are traded on regulated exchanges. .. increased exchange-trading of derivatives contracts by clarifying that section 1256 of the Internal Revenue Code does not apply to certain derivatives contracts transacted on exchanges. (Nadex binary options trade on a regulated exchange.)

• Option on a notional principal contract
Section 1256(b)(2)(B) raises questions as to whether an option on a notional principal contract that is traded on a qualified board or exchange would constitute a “similar agreement” or would instead be treated as a nonequity option under section 1256(g)(3). Since an option on a notional principal contract is closely connected with the underlying contract, the Treasury Department and the IRS believe that such an option should be treated as a similar agreement within the meaning of section 1256(b)(2)(B). (If a Nadex binary option were deemed an option on a NPC, it would be excluded as a NPC per this rule.)

• Ordering rule
The proposed regulations provide an ordering rule for a contract that trades as a futures contract regulated by the Commodity Futures Trading Commission (CFTC), but that also meets the definition of a notional principal contract. The Treasury Department and the IRS believe that such a contract is not a commodity futures contract of the kind envisioned by Congress when it enacted section 1256. (We don’t think the IRS will view Nadex binary options as a futures contract; therefore, will view it as a NPC.)

• Definition of Regulated Futures Contract (RFC)
Section 1256(g)(1) defines a regulated futures contract as “a contract (A) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (B) which is traded on or subject to the rules of a qualified board or exchange.” The apparent breadth of section 1256(g)(1) has raised questions in the past as to whether a contract other than a futures contract can be a regulated futures contract. (The IRS is trying to clean up some loose definitions in the past.)

Trading binary options on Nadex
The derivatives exchange based in the U.S. is the North American Derivatives Exchange (Nadex) which offers retail traders an online trading platform for limited-risk “binary options and spread contracts” based on stock indices, commodities, forex and financial events. Make a speculation and hold it through expiration for an “all or nothing” pay off, which some pundits say is akin to making a bet. Or trade the contract before expiration to cash it in at the current market price fluctuating on Nadex. Most Nadex contracts settle in one hour or one day, and the rest settle in a week or longer.

There is active trading on the Nadex platform/exchange similar to trading platforms on securities and futures exchanges. A trader may not notice much difference, but there are important differences in regulation and tax treatment.

Nadex issued 1099Bs using Section 1256 treatment
For tax years 2004 through 2013, Nadex issued direct members a Form 1099-B reporting Section 1256 tax treatment.

As pointed out in our first blog in this series, Nadex is a domestic board of trade — a category 2 qualified board or exchange (QBE) since it’s a CFTC-regulated “Designated Contract Market”. But that alone is not enough; Nadex binary options still must meet the definition of Section 1256 contracts. In February 2014, Nadex emailed us the following statement: “Nadex has recently been advised by staff of the Commodity Futures Trading Commission that its instruments are considered ‘commodity options’ categorized as ‘swaps.’”

We feel that Nadex binary options probably don’t qualify for Section 1256 
Nadex binary options don’t seem to meet the definition of inclusion in Section 1256 as either a regulated futures contract or a nonequity option, and they seem to meet the definition of exclusion from Section 1256 as a swap contract.

Nadex binary options don’t meet the definition of Section 1256 for “regulated futures contract” (RFC). A Nadex binary option requires full payment in advance — it’s not collateral — and there is no withdrawals based on MTM. Nadex binary options are prepaid bets. There seems to be consensus on this point.

Nadex binary options probably do not meet the definition of Section 1256 for “nonequity options” as they don’t seem to meet the definition of “options” in the tax code (Section 1234a) (see further discussion below). We haven’t seen a private letter ruling, tax opinion letter or tax research supporting a nonequity option argument for Nadex binary options.

Nadex binary options probably are excluded from Section 1256 as swap contracts. The CFTC said they are “commodity options” categorized as swaps. Dodd Frank law enacted Section 1256(b)(2)(B) into law effective July 2011. Section 1256(b)(2)(B) excludes swap contracts from Section 1256 tax breaks. Proposed regs for Section 1256(b)(2)(B) are not yet effective and they define swaps based on the IRS definition of “notional principal contracts” (NPC). NPC normally require two payments whereas Nadex binary options have one payment. The difference between one versus two payments does not seem material to us.

The IRS proposed regulation excludes all notional principal contracts (swaps) from Section 1256. But, the IRS received many comments arguing that exchange-traded swap contracts, as opposed to off-exchange OTC swaps, should not be excluded since the commenters believed they had Section 1256 tax treatment before Dodd-Frank. Until the final regulation 1256(b)(2)(B) is issued, we won’t know the final outcome. Nadex binary options are exchange-traded swaps, not OTC. Even if in final IRS regulations Nadex binary options are not excluded as exchange-traded swaps, they still must qualify as a non-equity option and we don’t think they do.

We suggested to Nadex that they file for a private letter ruling to support using Section 1256 on 1099Bs for Nadex binary option transactions.

CFTC definition of “option”
The Nadex email says the CFTC referred to their binary options as “commodity options.” They are bets that rise or fall based on an underlying market or financial event, they are based on option pricing models and they trade like options. Before Dodd-Frank, the CFTC could use this narrow definition. The issue of whether binary options are “options” in accordance with CFTC regulation came up in court in 2013. As reported on Goodwingaming, “The binary option trading platform Banc de Binary currently faces a civil lawsuit in the District of Nevada brought by the CFTC for allegedly violating ‘the Commission’s ban on trading options off-exchange.’ The regulatory authority of the CFTC covers ‘options’ which are adroitly defined as ‘transaction(s) .. . held out to be of the character of, or . . commonly known to the trade as option(s).’” The defendant argued their binary options are not options per the CFTC’s full regulatory definition. The CFTC argued that only the first part of the definition counts: “What makes an option an option is the first of these three components — price speculation.” This sounds similar to Nadex’s options pricing.

“In a parallel lawsuit brought by the Securities and Exchange Commission, Judge Robert Jones (District of Nevada) agreed, explaining: With a binary option, . . . the purchaser receives neither the stock itself nor the right to purchase the stock in the future. Binary options are in substance pure gambling bets. . . . Binary option givers and buyers do not purport to trade interests in securities any more than tellers and gamblers at a racetrack purport to trade interests in horses. . . . The Court simply cannot agree that a contract under which the purchaser has no putative right to obtain the security is an ‘option.’”

IRS definitions of “option” is different
The tax code definition of an option sounds like the SEC argument rather than the CFTC argument in the above court cases. The main problem with saying that a Nadex binary option is a nonequity option for Section 1256 is that there is no right to receive property, or alternatively to receive cash equal to the right to receive property (in the case of a cash settled option).

Tax court cases and very limited IRS guidance
Industry professionals equate binary options with “digital options” and “paired options.” These terms came up in just a few tax court cases, which are about tax avoidance, not options. We don’t see any statements in these cases that indicate the court viewed binary options as true options. Section 1256 tax treatment is not used on binary options in any of these tax court cases. These cases do not connect the dots for supporting a Section 1256 position.

In The Markell Company, Inc. v. Commissioner, TC Memo 2014-86, “taxpayer/partner wasn’t entitled to multimillion dollar loss on complicated basis-inflating paired options/Son of BOSS (tax shelter) transaction using newly formed LLC/partnership.”..”Paired Options. The paired options in this case consisted of short and long European digital call options. These cash-or-nothing options can be valued by multiplying the present value of the cash payoff amount by the probability calculated from the Black-Scholes-Merton (BSM) model that the digital option will be in the money at the expiration date.” While Markell used paired options, the case is about tax avoidance transactions based on purposely mispricing paired options. (This case does provide tax guidance for treating binary options based on currencies as Section 988 ordinary gain or loss. There is a connection between the binary option and the underlying instrument it’s meant to mimic in price.)

In Douglas R. Griffin, (TC Memo 2011-61), “HydroTemp timely filed a return for the tax year ending June 30, 2003, reporting a $7,524,153 long-term capital gain from the asset sale to Pentair and a $7 million short-term capital loss from the sale of binary options (i.e., options in which the payoff is structured to be either a fixed amount of compensation if the option expires in the money or nothing at all if the option expires out of the money). .. IRS’s position. IRS disallowed HydroTemp’s losses from its claimed binary options sale.” In this case, the court accepted the binary option transactions as legitimate and the taxpayer won the case. (This case may provide tax guidance for treating the sale of binary options before they expire as being capital gain or loss on realized transactions; however, the IRS attorneys did not seem to have focused on the tax treatment of the options, but simply questioned the legitimacy of the transaction . When terminating a binary option short of expiration, perhaps capital gains and loss treatment is applicable, as discussed below.)

In an IRS Coordinated Issue Paper explaining IRS Notice 2003-81 (Tax Shelters), ,the IRS discusses “option premium” on binary options. “Gain and loss on options is accounted for on an open transaction basis. As explained in Notice 2003-81, the justification for open transaction treatment is that the gain or loss on an option cannot be finally accounted for until such time as the option is terminated. Thus, premium income is not recognized until an option is sold or terminated. Rev. Rul. 58-234.… explains that this is the treatment for the option writer because the option writer assumes a burdensome and continuing obligation, and the transaction therefore stays open without any ascertainable income or gain until the writer’s obligation is finally terminated. When the option writer’s obligation terminates, the transaction closes, and the option writer must recognize any income or gain attributable to the prior receipt of the option premium.” This should be the rule for the receipt of option premium whether the instrument is truly an option or not. This IRS guidance seems weak for building a case that a binary option is treated as a true option and therefore a nonequity option in Section 1256. (In Notice 2003-81, the binary options discussed were based on foreign currency transactions and Section 988 ordinary gain or loss on realized transactions applied by default on the binary options, not Section 1256.)

Tax compliance and planning
In general, we think binary options start off with ordinary gain or loss treatment. In Highwood Partners v. Commissioner (133 TC 1, 2009), digital options based on currency transactions were Section 988 ordinary gain or loss treatment. If you have a Nadex 1099B reporting Section 1256 treatment from binary options based on currencies, you should use Section 988 ordinary gain or loss treatment and not Section 1256, thereby overriding the 1099B.

Swap tax treatment calls for ordinary gain or loss tax treatment, too. Ordinary losses can generate large tax refunds since traders are not subject to the $3,000 capital loss limitation. Caution, large ordinary losses without qualification for trader tax status (business treatment) can lead to some wasted losses and wasted itemized deductions; as those ordinary losses are not a capital loss carryover or a net operating loss carryback or forward.

When a trader sells a Nadex binary option (not based on currency) before expiration, the IRS may view the proceeds as a “termination payment” on the sale of a capital asset, rather than a “period payment” on a swap contract. Normally, termination payments on capital assets are capital gains.

Tax attorneys Mark Feldman and Roger Lorence, and Darren Neuschwander, CPA contributed to this blog. 


IRS Softens Its Stance For Some Taxpayers With Undeclared Offshore Accounts

June 19, 2014 | By: Robert A. Green, CPA

IRS pressure and new Foreign Account Tax Compliance Act (FATCA) rules taking effect July 1, 2014 are intimidating Swiss banks into breaking their sworn legal promise of bank secrecy. Foreign banks are forcing American clients to turn themselves in to the IRS before the bank does so. Turning yourself in on time can lead to lower (but still very significant) penalties and no jail time.

After too many horror stories (see “Expatriate Americans Break Up With Uncle Sam to Escape Tax Rules”) about normal middle-class Americans getting caught up in this tax dragnet, the IRS changed its rules to catch and release the smaller fish. See the IRS news release “IRS Changing Offshore Programs to Ease Burdens, Increase Compliance” (IR-2014-73). Here’s the new IRS program.

IRS Eases Up on Accidental Tax Cheats” says “The Internal Revenue Service is sharply increasing the penalties on U.S. taxpayers who hide assets abroad, while lowering or eliminating fines on taxpayers if their failure to disclose offshore accounts was unintentional, the agency said Wednesday.”

If you want to learn more about these IRS programs, consider a consultation with our tax attorney who is an expert in this area and has handled many cases successfully. Attorney-client privilege will apply.

Update about OVDI: Under transition rules, a taxpayer who entered OVDP before July 1 is entitled to use Streamlined even without opting out of OVDP. On or after July 1, a taxpayer must choose between Streamlined and OVDP and cannot opt out of one into the other. Therefore, a taxpayer who is unsure whether he would be considered negligent or willful should weigh entering OVDP before July 1. Non-willful conduct is conduct that is due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.


IRA Rollover Rule Changes

June 12, 2014 | By: Robert A. Green, CPA

By Darren L. Neuschwander, CPA

There’s an important change in the rules for both traditional and Roth IRA rollovers, which are transactions that let you withdraw funds from one IRA and redeposit them in another IRA without paying income tax on the transaction.

Rollovers are a popular way of moving IRA money around from one investment to another. They are also a way to get a short-term tax-free loan from your IRA as long as you redeposit the funds to the same or another IRA no later than 60 days from the date you made the withdrawal.

One tax-free rollover from an IRA is allowed per year. The one-year waiting period begins on the date you received the IRA distribution, not on the date you roll the funds back into an IRA.

For about 30 years, IRS publications and proposed regulations have supported the general understanding among tax professionals that the one-year waiting period applies separately to each IRA an individual owns. Now, following a recent tax court case (Bobrow, T.C. Memo 2014-21), the IRS stated via Announcement 2014-15 that it will treat all of your IRAs as one IRA for purposes of the one-year waiting period. This more restrictive interpretation to IRA rollovers applies to transactions starting with tax-year 2015 and forward.

Pre-2015 IRA distribution example: Suppose you have four IRAs: A, B, C and D. In March of 2014, you withdrew the balance from A and rolled it over into C within 60 days. In August of 2014, you withdraw the balance from IRA B and roll it over into IRA D within 60 days. Assuming you haven’t previously made any rollovers, neither withdrawal will be taxed because both IRAs A and B are treated separately for purposes of the one-year waiting period.

Post-2014 IRA distribution example: Assume the same facts as in previous example, except the year of the transactions has changed from 2014 to 2015. In this case, the withdrawal from B will be a taxable distribution and also could be hit with a 10% early distribution penalty if you are under the age of 59 ½ . Only the withdrawal from A would be a tax-free rollover. To make matters worse, if the funding of D from the B withdrawal exceeded any allowable regular IRA contribution for 2015, it would be treated as an excess contribution subject to an additional 6% tax unless you withdraw the excess amount by 2015.


Bitcoin is not reported on 2013 FBARs

June 6, 2014 | By: Robert A. Green, CPA

Bitcoin investors store bitcoin on foreign exchanges in countries like Estonia, Russia and elsewhere. Do they have to file bitcoin holdings outside the U.S. on 2013 FBARs due June 30? The IRS just said no.

The following are excerpts from Thomson Reuters/Tax & Accounting’s “IRS official: taxpayers don’t have to report virtual currency on 2013 FBARs”:

“During a recent webinar, an IRS official stated that for purposes of the current filing season, taxpayers aren’t required to report virtual currencies on a Report of Foreign Bank and Financial Accounts (FBAR) with the U.S. Treasury. However, although this previously disputed matter is settled for the present, he stated that this position may well be subject to change.”

“Virtual currency isn’t subject to FBAR reporting … for now. During a recent IRS webinar titled “Reporting of Foreign Financial Accounts on the Electronic FBAR,” Rod Lundquist, Senior Program Analyst in IRS’s Small Business/Self Employed (SB/SE) division, stated that for purposes of the current filing season (i.e., for 2013 FBARs due later this month), taxpayers aren’t required to report Bitcoin on an FBAR. However, he cautioned that IRS is continuing to analyze virtual currency and that this policy could very well change going forward.

The issue of whether Bitcoin is subject to FBAR reporting has been widely debated among the financial and tax online community. One view is that, unless a taxpayer can prove that their bitcoins are within the U.S. (a potentially tricky proposition), then their owner would be required to file an FBAR if his holdings exceed $10,000. However, others question whether a Bitcoin account is truly a “financial account” with a “financial institution” for purposes of the FBAR rules-and, despite the IRS official’s recent pronouncement, these questions are still unanswered.”


Tax treatment for foreign futures

June 2, 2014 | By: Robert A. Green, CPA

EY Global Tax Alerts: (My list below of foreign futures exchanges granted Section 1256 treatment by the IRS is the same as the EY list, which is unchanged on foreign exchanges since 2013.)
- Updated 2018 US Section 1256 qualified board or exchange list
- Updated 2017 US Section 1256 qualified board or exchange list
- Updated 2016 US Section 1256 qualified board or exchange list

A leading global broker Newedge promised Section 1256 treatment for foreign futures traded on Euronext Paris and Euronext Amsterdam exchanges. Our blog helped them retract that promise and agree those exchanges don’t have Section 1256 treatment.

Section 1256 offers up to 12% lower capital gains tax rates on short-term trading with its attractive 60/40 tax rates. It includes regulated futures contracts (RFCs), broad-based stock indices, options on those indices, options on futures, nonequity options, certain off-exchange foreign currency contracts and a few other items. But it can be a hard club to get into. Among Section 1256 contracts, regulated futures contracts, nonequity options and securities futures contracts must be traded on or subject to the rules of a “qualified board or exchange” (QBE). U.S. exchanges make the list pretty easily, but foreign exchanges don’t. Let’s look at the QBE requirement in more detail.

QBE
Section 1256 includes a list of those exchanges that are considered QBEs. Imagine Section 1256 being a popular club with a bouncer at the door holding a VIP guest list. If the exchange or board of trade you trade on is not on the QBE list, then the contracts you trade are excluded from Section 1256 tax treatment — even if they are regulated futures contracts.

QBEs include national securities exchanges registered with the SEC (category 1), domestic boards of trade designated as a “contract market” by the CFTC (category 2) or any other exchange or board of trade or other market (worldwide) that the CFTC and Treasury determines has rules adequate to carry out the purposes of Section 1256 (category 3).

According to Section 1256, contracts on category 1 and 2 exchanges are deemed RFCs if the contract “(A) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (B) is traded on or subject to the rules of a qualified board or exchange.” (This doesn’t include securities futures contracts.)

The first step in finding out if a product qualifies for Section 1256 is to see if its exchange is on the QBE list. Don’t jump to that conclusion just because you received a 1099B reporting Section 1256 treatment. E&Y’s “Updated 2013 US IRC Section 1256 qualified board or exchange list” is a handy reference.

Notice the North American Derivatives Exchange (Nadex) — a domestic board of trade — is a category 2 because it’s a CFTC-regulated “Designated Contract Market” (DCM). In part two of this blog series, I discuss whether Nadex binary and variable payout options meet the definition of Section 1256 contracts, as either a regulated futures contract, or nonequity option.

Foreign exchanges with QBE status
These category 3 foreign QBEs received a CFTC exemption (“no action letter”) and Treasury/IRS determination granting them QBE status published in a required revenue ruling:

• International Futures Exchanges (Bermuda) Ltd.(inactive)
• Mercantile Division of the Montreal Exchange (inactive)
• Mutual Offset System (Rev. Rul. 87-43). A partnership between Chicago Mercantile Exchange and Singapore International Monetary Exchange Limited
ICE Futures Rev Rul 2007-26

o Per RIA, “a United Kingdom Recognized Investment Exchange that was (1) a wholly-owned subsidiary of a U.S. parent corporation, and (2) overseen by the U.K.’s Financial Services Authority, provided that the exchange continued to comply with all CFTC conditions necessary to retain its no-action relief permitting it to make its electronic trading and matching system available in the U.S.”

Dubai Mercantile Rev. Rul. 2009-4
ICE Futures Canada Rev. Rul. 2009-24
London International Financial Futures and Options Exchange (LIFFE) Rev. Rul. 2010-3

o Per RIA, “Is a regulated exchange of the United Kingdom … Exchange offered electronic trading of commodity futures contracts and other futures and options contracts. Contracts were cleared and settled by Clearing House, a CFTC-regulated Derivatives Clearing Organization. The CFTC had granted Exchange no-action relief permitting it to make its electronic trading and matching system available in the U.S.”

Eurex Deutschland Rev. Rul. 2013-5

o Per RIA, “Is a regulated exchange of Germany, as long as: either CFTC continues to allow Eurex to provide direct access to its electronic trading and order matching system from U.S. under existing no action letter, pending CFTC approval of Order of Registration, or Eurex holds valid Order of Registration as foreign boards of trade (FBOT). IRS grants consent to taxpayers to change to Section 1256 mark to market method for 1st taxable year during which taxpayer holds Eurex Deutschland Contract that was entered on or after 3/1/2013.”

CFTC looks abroad
The CFTC’s reach is global — protecting customers located in the U.S. trading on foreign exchanges.

The CFTC website (international foreign products) says “These regulations are designed to carry out Congress’s intent that foreign futures and foreign options products offered or sold in the U.S. be subject to regulatory safeguards comparable to those applicable to domestic transactions. As set forth in CFTC Regulation 30.4, any domestic or foreign person engaged in activities like those of a futures commission merchant (FCM), introducing broker (IB), commodity pool operator (CPO), or commodity trading advisor (CTA) must register in the appropriate capacity or seek an exemption from registration under CFTC Regulation 30.5 or CFTC Regulation 30.10.”

The first step in finding out if Section 1256 applies is to look up the CFTC no action letter with 30.5 or 30.10 exemption. The CFTC publishes current and pending no action letters at “Foreign Government Agencies and SROs that have Received CFTC Orders under CFTC Regulation 30.10” and “Pending Requests for CFTC Regulation 30.10 Exemption.”

Treasury’s determination is published
The second step is to look up the IRS revenue ruling. The IRS has a two-step process for these determinations.

1. The foreign exchange must submit a private letter ruling requesting QBE status. If the IRS is satisfied that the exchange has sufficient rules for application of Section 1256, it publishes a revenue ruling. The revenue ruling applies to the commodity futures contracts and futures contract options only entered on the named exchange, and not any affiliated exchanges (Note 1). For example, Section 1256 applies for futures traded on Eurex Deutschland, but not for futures traded on an affiliate of Eurex Deutschland.

2. The IRS looks to see if the exchange obtained a CFTC exemption (no action letter). Section 738 of the Dodd-Frank Act gives the CFTC authority to adopt rules and regulations that require registration of a foreign board of trade that provides U.S. participants direct access to the board of trade’s electronic trading system. This proposed registration system is supposed to replace the no-action letter process.

Mergers, partnerships and cooperation lead to questions about QBE status
There have been several cross-border mergers and acquisitions, partnerships and other cooperation agreements between U.S., EU and Asian exchanges and foreign boards of trade. These mergers and affiliations are confusing brokers, who are then confusing their clients. Keep things simple and clear: make sure you see an IRS revenue ruling in the exact name of the exchange you trade on.

When a U.S. QBE has a “mutual offset agreement” with a non-QBE foreign exchange, the IRS treats trades executed on the foreign exchange that are assumed by the U.S. QBE as Section 1256. But trades executed on the U.S. QBE that are assumed by the foreign exchange are not considered Section 1256. This was the case with the CME/SIMEX Mutual Offset System (Rev. Rul. 87-43).

If a U.S. QBE acquires a foreign non-QBE, generally the foreign regulator oversees the foreign non-QBE. The foreign non-QBE does not inherit the U.S. exchange’s QBE status. The foreign exchange must have it’s own CFTC exemption (no-action letter) and request a formal determination by Treasury for foreign QBE status. The ICE Futures 2009 revenue ruling listed above is a similar case. (Note 2 confirmation from IRS)

Dodd Frank rules for swaps
As of 2011, the Dodd-Frank Act requires privately negotiated derivatives contracts to clear on derivatives exchanges or boards of trade. The CFTC is trying to coordinate these rules with similar ones enacted in the EU. Among other things, the CFTC wants EU swaps exchanges to report on trading activities by Americans. Dodd-Frank law and IRS proposed regulations exclude swap contracts from Section 1256.

Many foreign exchanges don’t want U.S. filings
NYC tax attorney Roger Lorence heard from Treasury and IRS officials that several foreign exchanges and boards of trade fear getting involved with the U.S. Treasury and IRS — perhaps due to controversial U.S. FATCA and FBAR reporting — so they don’t want a CFTC exemption and Treasury determination granting them QBE status. But perhaps they will change their minds if Americans demanding QBE status become a major part of their business activity.

Note 1: Preamble to Proposed Regulation § 1.1256(g)-1 

(Part D, 9/16/2011)
D. Qualified Board or Exchange
Section 1256(g)(7)(C) provides that a qualified board or exchange includes any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of section 1256. Section 1.1256(g)-1(a) of the proposed regulations specifies that such determinations are only made through published guidance in the Federal Register or in the Internal Revenue Bulletin. 

Robert Green observation: The proposed reg requires publishing in the Federal Register or Internal Revenue Bulletin, whereas the current 1.1256 regulation requires publishing in an IRS Revenue Ruling. Either way, qualification for Section 1256 requires Treasury/IRS to make a formal determination and publish it for public consumption. Notice the IRS published some of the above Revenue Rulings in the IR Bulletin, whereas others we published as pdf files only. More consistency in publishing would be better.

Since section 1256(g)(7) was adopted, the Treasury Department and the IRS have issued determinations for six* entities, all of them foreign futures exchanges. See Rev. Rul. 2010-3 (2010-1 CB 272 (London International Financial Futures and Options Exchange)), Rev. Rul. 2009-24 (2009-2 CB 306 (ICE Futures Canada)), Rev. Rul. 2009-4 (2009-1 CB 408 (Dubai Mercantile Exchange)), Rev. Rul. 2007-26 (2007-1 CB 970 (ICE Futures)), Rev. Rul. 86-7 (1986-1 CB 295 (The Mercantile Division of the Montreal Exchange)), and Rev. Rul. 85-72 (1985-1 CB 286 (International Futures Exchange (Bermuda))). The IRS has followed a two step process for making each of the six qualified board or exchange determinations under section 1256(g)(7). See § 601.601(d)(2)(ii)(b).

*Robert Green observation: Eurex Deutschland (Rev. Rul. 2013-5) was published after this preamble date of 9/16/2011.

In the first step, the exchange submitted a private letter ruling to the IRS requesting a determination that the exchange is a qualified board or exchange within the meaning of section 1256(g)(7)(C). Once the IRS determined that the exchange had rules sufficient to carry out the purposes of section 1256, the Treasury Department and the IRS published a revenue ruling announcing that the named exchange was a qualified board or exchange. The revenue rulings apply to commodity futures contracts and futures contract options of the type described under the CEA that are entered into on the named exchange. The revenue ruling does not apply to contracts that are entered into on another exchange that is affiliated with the named exchange.

Robert Green observation: The above important sentences in bold are current law, they are not something new in Proposed Regulation § 1.1256(g)-1.

In determining whether a foreign exchange is a qualified board or exchange under section 1256(g)(7)(C), the Treasury Department and the IRS have looked to whether the exchange received a CFTC “direct access” no-action relief letter permitting the exchange to make its electronic trading and matching system available in the United States, notwithstanding that the exchange was not designated as a contract market pursuant to section 5 of the CEA. Section 738 of the Dodd-Frank Act, however, provides the CFTC with authority to adopt rules and regulations that require registration of a foreign board of trade that provides United States participants direct access to the foreign board of trade’s electronic trading system. In formulating these rules and regulations, the CFTC is directed to consider whether comparable supervision and regulation exists in the foreign board of trade’s home country. Pursuant to section 738, the CFTC has proposed a registration system to replace the direct access no-action letter process. Under the proposed registration system, a foreign board of trade operating pursuant to an existing direct access no-action relief letter must apply through a limited application process for an “Order of Registration” which will replace the foreign board of trade’s existing direct access no-action letter. Many of the proposed requirements for and conditions applied to a foreign board of trade’s registration will be based upon those applicable to the foreign board of trade’s currently granted direct access no-action relief letter.

The IRS has conditioned a foreign exchange’s qualified board or exchange status under section 1256(g)(7)(C) on the exchange continuing to satisfy all CFTC conditions necessary to retain its direct access no-action relief letter. Consequently, if the CFTC adopts the proposed registration system, an exchange that has previously received a qualified board or exchange determination under section 1256(g)(7)(C) must obtain a CFTC Order of Registration in order to maintain its qualified board or exchange status. The IRS will continue to evaluate the CFTC’s rules in this regard to determine if any changes to the IRS’s section 1256(g)(7)(C) guidance process are warranted.

Note 2: Confirmation with IRS
Our tax attorney Roger Lorence spoke with an IRS official responsible for Section 1256 issues, and he confirmed that: “A foreign board or exchange must get a revenue ruling if they have a CFTC 30.10 ruling to receive 1256 treatment for their qualifying contracts. A foreign board that receives a revenue ruling is covered on 1256 but related foreign exchanges are not covered – the revenue ruling only applies to the exchange covered in that ruling. Affiliated foreign exchanges must get their own revenue ruling to qualify under 1256.”

Thank you to our tax attorneys Mark Feldman and Roger Lorence and my co-managing member Darren Neuschwander, CPA for their help with this blog.


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