A Case For Retail Forex Traders Using Section 1256(g) Lower 60/40 Tax Rates

February 25, 2017 | By: Robert A. Green, CPA

Trading leveraged forex contracts off-exchange has different tax treatment from trading currency futures on-exchange. Currency futures automatically have lower “60/40 tax rates” in Section 1256, with 60% benefiting from lower long-term capital gains rates, even on day trading. It’s harder to achieve lower 60/40 tax rates on leveraged forex trading, but worth the effort since 60/40 rates are significantly lower. (See Several Ways To Trade Currencies, Some With Lower Tax Rates.)

Forex trading
Most American retail forex traders open accounts with a CFTC-registered Retail Foreign Exchange Dealer (RFED) or an FCM Forex Dealer Member. By default, off-exchange leveraged spot and forward forex contracts are Section 988 ordinary gain or loss tax treatment. A forex trader may elect capital gains treatment, which on short-term capital gains is the ordinary tax rate. If a forex trader doesn’t “take or make delivery” in cash, there is a case for using Section 1256(g) (foreign currency contracts) on “major” currencies if the trader meets the requirements of Section 1256(g)(2). The same tax treatment applies to Eligible Contract Participants (ECP). Tax treatment is uncertain for spot forex contracts traded with RFED and FCM Forex Dealer Members.

Section 988 foreign currency transactions
By default, spot and forward forex transactions in the interbank market start off in Section 988 “foreign currency transactions,” and they are subject to ordinary gain or loss tax treatment. A forex trader is entitled to file an internal, contemporaneous Section 988 opt-out election, otherwise called a capital gains election, for short-term capital gains and loss treatment. This election can be filed or retracted, on a “good to cancel basis” during the tax year.

Section 988(a)(1)(B) opt-out election: “A taxpayer may elect to treat any foreign currency gain or loss attributable to a forward contract, which is a capital asset in the hands of the taxpayer and which is not a part of a straddle, as capital gain or loss…” The election mentions forwards, not spot. That’s okay since Reg. 1. 988 equates spot forex trades with forwards. Reg. 1. 988-1(b) defines a spot forex contract, and 1.988-2(d)(i)(ii) provides that a spot contract that does not result in taking or making delivery of the nonfunctional currency is analogous to a forward “or similar contract.” The election excludes straddles, which are offsetting positions with substantially reduced economic risk. Straddles include arbitrage trades in forward contracts.

Section 1256(g)(2) foreign currency contracts
After filing a capital gains election, if the forex trader met three IRS requirements for Section 1256(g)(2) listed below, they may use Section 1256 for major currency pairs only. Minor currency pairs remain short-term capital gains. The IRS considers a forex currency pair to be “major” if the same pair trades as a regulated futures contract (RFC) on U.S. futures exchanges.

Section 1256(g)(2) requirements:

(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;
(ii) which is traded in the interbank market;
(iii) which is entered into at arm’s length at a price determined by reference to the price in the interbank market.”

Are retail forex dealers in the interbank market?
It’s uncertain where the IRS draws the line on interpreting (ii) “traded in the interbank market.” When the IRS wrote Section 1256(g) in the mid-1980′s, only banks participated in the interbank market. Advances in trading platforms like ECNs and new regulations established in the “Commodity Futures Modernization Act” (CFMA) of 2000 added new participants to the interbank market, including CFTC-registered Retail Foreign Exchange Dealers (RFED) and Futures Commission Merchant (FCM) Forex Dealer NFA-Members.

Some RFED and FCM forex dealers offer “no dealing desk” execution with immediate client trades made in the interbank market. Others are “dealing desks” offsetting client positions, and netting risk in the interbank market. (See Learn Why The NFA Barred FXCM And What It Means For Forex Traders.)

There is a sound argument for using Section 1256(g) treatment for RFED and FCM Forex Dealer Members, whether they are no-dealing or dealing desks. I am concerned the IRS may draw the line more narrowly, allowing Section 1256(g) for no-dealing desks, only. In the worst case scenario, the IRS could seek to exclude all RFED and FCM forex dealers arguing they are not participants in the interbank market. They are the “retail” window of the interbank market.

Thomson Reuters CheckPoint tax research on this questions states: “Contracts traded in the interbank market generally include contracts between a commercial bank and another person as well as contracts entered into with a futures commission merchant (FCM) who is a participant in the interbank market. According to the legislative history, a contract that does not have such a bank or FCM, or some other similar participant in the interbank market, is not a foreign currency contract.” The legislative history mentions “FCM, or some other similar participant in the interbank market.” I argue that “some other similar participant” could be a placeholder for RFED, created in 2000, well after Section 1256(g)(2) was written.

Can spot forex contracts be included in Section 1256(g)?
As explained above, Section 988 equated spot with forwards, if the trader does not take or make a delivery. Unfortunately, Section 1256(g) does not recognize spot forex contracts, so I make an argument for inclusion below.

Leveraged spot forex contracts, and forward forex contracts are similar trading products, whereas the IRS only mentioned forwards in the legislative history to Section 1256(g). After Congress had updated the code, it enacted the CFMA of 2000 ushering in leveraged retail off-exchange trading in the spot forex interbank market through CFTC-registered RFED and FCM Forex Dealer Members.

Spot forex contracts have a trade date when initiated, just like forward forex contracts. Spot contracts settle in 1-2 days, and forward contracts settle greater than two days. Forex traders do not “take or make delivery” on leveraged spot forex contracts. For example, with a $2,000 account deposit, a forex trader may buy a spot forex contract priced at $100,000 if using maximum leverage. They are unable to settle the contract in cash with just $2,000 in their account, and they close the trade before it settles, or roll it over. I consider a spot forex contract to be a shorter-term forward contract. Traders use spot forex contracts differently from a manufacturer who executes a “foreign currency transaction” in the spot interbank market for “immediate and fixed delivery.” Rollover fees are evidence of forex contracts for traders.

The Sixth Circuit Court of Appeals Wright decision helps
The Sixth Circuit Court of Appeals reversed the IRS tax court 2014 ruling on Wright vs. Commissioner (6th Cir. 1/7/2016). The case involved forex OTC options where the taxpayer used Section 1256(g) tax treatment. The IRS did not agree, but the appellate court overruled the IRS.

The Sixth Circuit relied on a “literal interpretation” of Section 1256(g)(2): “(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.” The IRS argued forex OTC options don’t settle in cash due to their “optionality” and therefore do not meet this (i) requirement. The appellate court parsed the exact words and comma placements in Section 1256(g)(2) and decided the forex OTC options, in this case, did meet the (i) requirement.

The appeals ruling concluded if Congress and the IRS wanted to exclude a particular type of “foreign currency contract” from Section 1256(g), it should have updated the code accordingly, rather than rely on legislative history. Section 1256(g) does not exclude forex OTC options, so the Sixth Circuit included them.

Spot forex contracts have a stronger case for meeting Section 1256(g)(2)(i) than forex OTC options. Spot forex contracts settle in cash just like forward forex contracts, and they don’t have optionality. Additionally, Section 1256(g) does not exclude spot forex contracts.

I do not see where the appellate court or IRS reviewed how Wright met the second requirement of Section 1256(g)(2), “which is traded in the interbank market.” The court named the private companies that acted as counterparties to Wright on the forex OTC option transactions. The court did not mention the involvement of any banks, FCM or RFED in these transactions. Section 1256(g) does not exclude RFED and FCM forex dealers from being in the interbank market.

Forex OTC options are different from spot forex contracts. RFED don’t offer forex OTC options. Wright purchased forex OTC options with a private tax shelter promoter, not in the spot interbank market. Traders with foreign currency transactions in the spot forex interbank market start off in Section 988 ordinary gain or loss. The Wright court seemed to confer that Wright’s forex OTC options did not have to start in Section 988. Caution: Forex traders should not skip the required contemporaneous Section 988 opt-out election if they want to use Section 1256(g).

If you have any questions, please contact us.

Darren L. Neuschwander, CPA, Roger D. Lorence, JD and Mark Feldman JD contributed to this blog post. 

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