Category: Tax Treatment On Financial Products

ETNs Have Different Structures With Varying Tax Treatment

May 17, 2018 | By: Robert A. Green, CPA | Read it on

Exchange-traded notes (ETNs) are structured either as debt securities or prepaid executory contracts, and that makes a critical difference in tax treatment.

“The tax treatment of ETNs is often complicated to determine,” said New York City tax attorney Roger D. Lorence. “You have to review the tax section of each prospectus. In many cases, the offering is an undivided interest in the underlying positions, such as futures, so that the ETN is not an interest in an entity nor itself a security. However, other ETNs are structured as a debt instrument, usually with leverage concerning some index (such as natural gas futures).

ETNs structured as debt securities are taxed similarly to other securities with the realization method for capital gain or loss. (Realization is when you sell the security.) They are subject to Section 1091 wash-sale loss adjustments, which can raise tax liabilities. (Scroll to the end of the blog for more on wash-sale loss adjustments.) Section 475 ordinary gain or loss treatment should apply to these debt securities, too, if the trader qualifies for trader tax status (TTS) and makes the election on time.

ETNs organized as prepaid executory contracts (also referred to as prepaid forward contracts) are not securities. They calculate a rate of return or interest rate based on the movement of an underlying financial instrument, futures index, or equities index. The ETN holder does not own the underlying instrument or index. This can have a significant impact on tax liabilities, as it likely means that Sections 1091 wash sales and 475 MTM should not apply to them. ETN prospectuses say they don’t address Sections 1091 and 475.

Report the sale or exchange of ETNs organized as prepaid executory contracts when realized as short-term and long-term capital gains and losses, except currency ETNs which are ordinary gain or loss treatment.

The problem
Here’s the problem when it comes time to preparing tax returns: Most brokers categorize all types of ETNs as securities on 1099-Bs and make wash-sale loss adjustments. Those adjustments might defer tax losses to the subsequent year, thereby raising tax liabilities. When it comes to ETN prepaid executory contracts, consider deviating from the 1099-B to reverse out wash-sale loss adjustments on these ETNs. Explain why in a tax return footnote. If this presents a significant change in tax liability, consider obtaining a “substantial authority” letter from a tax attorney to support the tax filing. The broker carries over these wash sale loss adjustments as an increase in cost basis in the subsequent year, so don’t forget to reverse that, too. Deviating from 1099-Bs raises complications, so consult a tax advisor.

Options on ETNs: There is a similar problem with CBOE-listed options on volatility ETNs and ETFs. Many broker 1099-Bs classify these options as securities, but there is substantial authority to treat them as non-equity options, which are Section 1256 contracts. As Section 1256 contracts, they are not subject to wash-sale loss adjustments and qualify for lower 60/40 capital gains tax rates. (See How To Apply Lower Tax Rates To Volatility Options, Tax Treatment For Exchange Traded Notes.)

ETN debt securities prospectus
See the Credit Suisse Velocity Shares prospectus applicable to ETN symbol XIV and five related volatility ETNs. Here are excerpts from pages 75-76:

“Debt Securities U.S. Holder Payments or Accruals of Interest Payments or accruals of ‘qualified stated interest’ (as defined below) on a debt security will be taxable to you as ordinary interest income at the time that you receive or accrue such amounts (in accordance with your regular method of tax accounting).

Purchase, Sale and Retirement of Debt Securities: When you sell or exchange a debt security, or if a debt security that you hold is retired, you generally will recognize gain or loss equal to the difference between the amount you realize on the transaction (less any accrued qualified stated interest, which will be subject to tax in the manner described above under Payments or Accruals of Interest) and your tax basis in the debt security.”

ETN prepaid executory contracts prospectus
Among the most-popular traded ETN symbols are VXX, VXZ, XVZ, all prepaid executory contracts issued by iPath. According to IPathETN.com U.S. Federal Income Tax Considerations, “For U.S. federal income tax purposes, Barclays Bank PLC and investors agree to treat all iPath ETNs, except certain currency ETNs, as prepaid executory contracts with respect to the relevant index. If such iPath ETNs are so treated, investors should recognize gain or loss upon the sale, redemption or maturity of their iPath ETNs in an amount equal to the difference between the amount they receive at such time and their tax basis in the securities. Investors generally agree to treat such gain or loss as capital gain or loss, except with respect to those iPath ETNs for which investors agree to treat such gain or loss as ordinary, as detailed in the chart below.”

The UBS Velocity Shares prospectus applicable to EVIX and EXIV states: “In the opinion of our counsel, Sullivan & Cromwell LLP, the Securities should be treated as a pre-paid forward contract…”

Volatility ETN products
In order of volume http://etfdb.com/etfdb-category/volatility/

- iPath S&P 500 VIX ST Futures ETN (VXX) – Prepaid*
- iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB) – Prepaid
- iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) – Prepaid
- iPath S&P 500 Dynamic VIX ETN (XVZ) – Prepaid
- iPath Series B S&P 500® VIX Mid-Term Futures ETN (VXZB) – Prepaid
- Credit Suisse VelocityShares Daily Long VIX Short-Term ETN (VIIX) – Debt**
- UBS VelocityShares VIX Short Volatility Hedged ETN (XIVH) – Debt
- UBS VelocityShares 1X Daily Inverse VSTOXX Futures ETN (EXIV) – Prepaid
- UBS VelocityShares VIX Variable Long/Short ETN (LSVX) – Debt
- UBS VelocityShares VIX Tail Risk ETN (BSWN) – Debt
- UBS VelocityShares 1X Long VSTOXX Futures ETN (EVIX) – Prepaid
Listed on securities exchanges: NYSE, Nasdaq, or Bats.

*Prepaid: The iPath volatility ETNs are prepaid executory contracts
**Debt: a debt security

Tax attorney weighs in
Lorence takes a look at the prospectus for the UGAZ ETN by Credit Suisse, which states that the offerings are short-term debt obligations, longer-term debt obligations, and warrants.

“The debt obligations are clearly described by tax counsel as producing interest income and similar interest-type income (e.g., market discount),” Lorence said. “Debt obligations are classified as securities for Section 1091; although there are issues about whether some commodities offerings, such as futures, are also securities, the UGAZ debt obligations would be securities for Section 1091. Wash sale rules for debt securities limit the substantially identicality of debt obligations by requiring that they be essentially the same bond for market value purposes (e.g., same issuer, same or virtually the same coupon and maturity). In all cases dealing with ETNs and ETFs, I have found these just to be marketing labels, and the tax consequences have to be found in the tax disclosure in the prospectus.”

Wash sale loss adjustments
Congress doesn’t want taxpayers to realize “tax losses” that are not “economic losses.” If you close a securities transaction and re-open it right away, you haven’t closed your financial position in that security. At year-end, many taxpayers do “tax loss selling” of securities in December, and the IRS wash sale rules defer the loss if the taxpayer re-purchases a substantially identical position within 30 days before or after, which means into January of the subsequent year. Thirty days is an eternity for day and swing traders. (Learn more about wash sales.)

See my earlier blog posts: How To Apply Lower Tax Rates To Volatility OptionsTax Treatment For Exchange Traded Notes and Tax Treatment For Volatility Products Including ETNs.

Darren Neuschwander CPA contributed to this blog post.

 

 

 

 

 


How To Apply Lower Tax Rates To Volatility Options

September 9, 2017 | By: Robert A. Green, CPA | Read it on

Update May 8, 2018: Some ETNs, like VELOCITYSHARES 3X LNG NTRL GS ETN (UGAZ), are debt obligations taxed as securities. (Check the tax section of the ETN prospectus.)

These days, volatility can be considered its own asset class, and many types of products have been created to fill this niche. If you trade volatility products, you may have many questions regarding how to treat these items on your tax return. But, guess what? Treatment for these items varies, and some of it is uncertain. Don’t sweat it, though — we are here to provide clarity.

Before delving into the various products and their treatment, it’s important to note that Section 1256 rules apply to “non-equity” options and Section 1256 items receive the coveted lower 60/40 tax rates. (At the maximum tax brackets for 2017, the top Section 1256 contract tax rate is 28% — 12% lower than the top ordinary rate of 39.6%. See 60/40 rates table.)

Several brokerage firms, however, classify options on volatility products as “equity options” taxed as securities. Our CPA firm established a substantial authority position to treat most of these volatility options as non-equity options. Don’t expect brokers to correct 1099-Bs if the tax treatment is uncertain. Be prepared to depart from the 1099-B reporting and include an explanation in footnotes and Form 8275. If your tax savings is significant, it’s wise to obtain a substantial authority opinion from a qualified tax attorney to protect against accuracy-related tax penalties.

CBOE-listed futures on VIX Indexes
Let’s start with a simple one. The CFE-traded VIX futures are “regulated futures contracts” (RFCs) on a qualified board or exchange (QBE). Because Section 1256 includes RFCs, I expect brokers to use Section 1256 for these products. There’s no uncertainty here.

CBOE-listed options on VIX Indexes, ETFs, and ETNs
IRS guidance is unclear, but these general rules should apply.

CBOE-listed options on VIX Indexes are not equity options, referencing a single equity price or narrow-based index of equity prices. They are likely non-equity options included in Section 1256, which references a barometer VIX Index, which does not contain equity prices. Most brokers agree.

CBOE-listed options on VIX securities ETFs, structured as registered investment companies (RICs), are likely equity options because a security ETF RIC acts like a single equity. Most brokers agree.

CBOE-listed options on VIX commodity ETFs, structured as publicly traded partnerships (PTPs), are likely non-equity options because a commodity ETF PTP is not a single equity or narrow-based equity index. Most brokers don’t agree; they treat it as an equity option, and I think you can divert from the broker’s 1099-B to use Section 1256 treatment.

CBOE-listed options on VIX ETNs are likely non-equity options because an ETN is not a single equity or narrow-based equity index. An ETN is a prepaid executory contract. Most brokers don’t agree; they treat it as an equity option, and I think you can divert from the broker’s 1099-B to use Section 1256 treatment.

The values of a narrow-based index must reference actual equity prices. The CBOE-listed options on VIX Indexes do not reference equity prices. Even the CBOE VIX Index for an individual equity (VXAPL) does not reference the equity price of APL, but rather the VIX barometer index for APL. Therefore, it’s likely that VXAPL is also a Section 1256 contract. (See CBOE-listed volatility options.)

Volatility ETFs
Issuers organize volatility ETFs as registered investment companies (RIC) or publicly traded partnerships (PTP). Tax treatment varies by the structure.

Securities ETFs: Securities ETFs are RICs. Selling securities ETF is deemed a sale of a security, calling for short- and long-term capital gains tax treatment using the realization method. RIC ETFs often make short- and long-term capital gains distributions to holders. Brokers report securities ETF proceeds and cost basis for each transaction on Form 1099-B.

Volatility ETFs organized as RICs include:
- REX VolMAXX Long VIX Weekly Futures Strategy ETF (VMAX)
- REX VolMAXX Short VIX Weekly Futures Strategy ETF (VMIN)

Commodities/futures ETFs: These ETFs use the PTP structure, also known as master limited partnerships (MLPs). PTPs issue annual Schedule K-1s passing through income or loss, including Section 1256 income or loss from trading within the PTP. Selling a commodity ETF is deemed a sale of a security, calling for short- and long-term capital gains tax treatment using the realization method.

Taxpayers invested in these ETFs should adjust cost-basis on Form 8949 (capital gains and losses and other income or loss), ensuring they don’t double count Schedule K-1 pass through income or loss. Form 1099-B does not make this cost-basis adjustment, so investors need to make a manual adjustment.

Volatility ETFs organized as PTPs include:
- ProShares VIX Short-Term Futures ETF (VIXY) S&P 500® VIX Short-Term Futures Index
- ProShares VIX Mid-Term Futures ETF (VIXM) S&P 500® VIX Mid-Term Futures Index
- ProShares Ultra VIX Short-Term Futures ETF (UVXY) S&P 500® VIX Short-Term Futures Index
-ProShares Short VIX Short-Term Futures ETF (SVXY) S&P 500® VIX Short-Term Futures Index.
- All are listed on the NYSE Arca securities exchange.

Volatility exchange traded notes
An exchange-traded note (ETN) calculates its rate of return or interest rate based on the movement of an underlying financial instrument, futures index, or equities index. In IRS jargon, most ETNs are a “prepaid executory contract” or “prepaid forward contract” based on the relevant financial instrument or index. (A few ETNs are debt instruments, see more below.)

Report ETN income when realized (sold) as short- and long-term capital gains and losses. Exception: Report currency ETNs with Section 988 ordinary gain or loss treatment.

ETNs structured as prepaid forward contracts are not a security or a commodity, so they should not qualify for Section 475 ordinary gain or loss treatment used by traders eligible for trader tax status and who elected Section 475 on time.

Section 1091 wash sale loss rules apply to securities. ETNs, structured as prepaid forward contracts, are not securities, so they should be exempt from wash sale loss adjustments. Most 1099-Bs treat ETNs as securities, subjecting them to wash sale losses. Consider departing from the 1099-B, explain why on Form 8275, and in some cases, get a substantial authority opinion letter from a tax attorney.

The ETN holder does not own an underlying instrument or futures index, so he or she should not use Section 1256 treatment. In the VXX ETN prospectus, the tax attorneys suggested reasons why the IRS might apply Section 1256 as “possible alternative” tax treatment. But, they did not imply investors should try to use Section 1256 treatment. Our firm’s tax attorneys researched whether there is “substantial authority” for the position that 1256 applies to VXX and they concluded there is no substantial authority. (Read our rationale in our blog post: Tax Treatment For Exchange Traded Notes (ETNs))

Some ETNs, like VELOCITYSHARES 3X LNG NTRL GS ETN (UGAZ), are actual debt instruments, which are taxed as securities, and not prepaid forward contracts. Our tax attorney Roger Lorence says, “The tax treatment of ETNs is often difficult to determine. You have to review the tax section of each prospectus.  In many cases, the offering is an undivided interest in the underlying positions, such as futures, so that the ETN is not an interest in an entity nor itself a security.  However, other ETNs are structured as a debt instrument, usually with leverage with respect to some index (such as natural gas futures).  In my experience “ETN” is a confusing and largely useless label and you have to go deeper to determine the tax characteristics.”

Volatility ETN products include:
In order of volume http://etfdb.com/etfdb-category/volatility/
- iPath S&P 500 VIX ST Futures ETN (VXX)
- iPath S&P 500 VIX Mid-Term Futures ETN (VXZ)
- UBS VelocityShares 1X Daily Inverse VSTOXX Futures ETN (EXIV)
- UBS VelocityShares VIX Variable Long/Short ETN (LSVX)
- UBS VelocityShares VIX Tail Risk ETN (BSWN)
- UBS VelocityShares 1X Long VSTOXX Futures ETN (EVIX)
- iPath S&P 500 Dynamic VIX ETN (XVZ)
- Credit Suisse VelocityShares Daily Long VIX Short-Term ETN (VIIX)
Listed on securities exchanges: NYSE, Nasdaq, or Bats.

Options on volatility ETNs
The CBOE lists options on VXX (ETN). An IRS official in the Chief Counsel’s office for financial products explained to our tax attorney Roger D. Lorence that any option listed on CBOE or other qualified board or exchange whose reference is not a single symbol or a narrow-based index is a non-equity option in Section 1256. The equity option definition has two different prongs: single (equity) symbol and narrow-based (equity) index. Using this rationale, the IRS official said the option on VXX (ETN) is a non-equity option in Section 1256.

As mentioned earlier, our CPA firm established a substantial authority (SA) position to use Section 1256 tax treatment for CBOE-listed options on VIX Indexes, volatility ETF PTP, and ETNs (i.e., VXX). SA means it’s 33% likely to be correct, so tax preparers can sign a tax return including that position and avoid accuracy-related tax penalties.

If you are interested, contact our CPA firm at info@gnmtradertax.com.

Roger Lorence JD and Darren Neuschwander CPA contributed to this content.

Attend our Webinar on Sep. 12, 2017, or watch the recording: Tax Treatment For Volatility Products: Options, Futures, ETFs, and ETNs

 

 

 

 

 

 

 

 

 

 

 


How To Report Bitcoin Cash And Avoid IRS Trouble

August 2, 2017 | By: Robert A. Green, CPA

Forbes

Read it on Forbes.

In light of the Aug. 1 split of Bitcoin into two separate cryptocurrencies, Bitcoin and Bitcoin Cash, many questions remain. While the IRS has issued guidance on cryptocurrency — labeling it an “intangible asset” for investors subject to capital gains and loss treatment using the realization method — it has not issued guidance on cryptocurrency split or “fork” transactions. There are thousands of cryptocurrencies, and many formed in this type of division in the blockchain.

Tax reporting for the receipt of Bitcoin Cash
The initial market price of Bitcoin Cash was $266 per unit, which was 9.5% of the comparable Bitcoin unit price at that time of $2,801. Bitcoin holders were distributed one unit of Bitcoin Cash for each unit of Bitcoin, a separate financial instrument with a liquid market value. In the eyes of the IRS, that’s taxable income. (An alternative name for Bitcoin Cash is BCash.)

Bitcoin holders should report the receipt of Bitcoin Cash on their 2017 income tax returns. It does not qualify as dividend income on Schedule B since a cryptocurrency is not a security. It’s also not considered interest income on a debt instrument or bank deposit. I suggest reporting the value received as “Other Income” on line 21 of Form 1040 —a catchall category for income that does not fit into a standard category.

Some taxpayers might choose to use Form 8949 (Sales and Other Dispositions of Capital Assets) instead. The taxpayer reports the $266 value of Bitcoin Cash as proceeds and 9.5% of Bitcoin cost basis as Bitcoin Cash cost basis. The initial value of Bitcoin Cash was 9.5% of the Bitcoin price at that time. This alternative treatment reduces taxable income by the cost basis amount. Another benefit is capital gains use up capital loss carryovers. I question whether this method would pass muster with the IRS — Bitcoin did not decline in value by a material amount after the split, and that undermines the use of this treatment.

Constructive receipt of income
Some Bitcoin holders mishandled or skipped arranging access to Bitcoin Cash, or their exchange does not support Bitcoin Cash, making retrieval difficult or impossible after Aug. 1, 2017. These taxpayers may believe they don’t have to report the Bitcoin Cash as taxable income since they don’t currently have access to it. While that seems reasonable, the IRS could apply the constructive receipt of income doctrine to argue the Bitcoin holder had access to Bitcoin Cash but turned his or her back on receiving it. Kelly Phillips Erb of Forbes goes into more detail in her article, Bitcoin Shift Could Cause Tax Headaches For Some Users).

Tax reporting for the sale of Bitcoin Cash
If you sold your Bitcoin Cash, you need to use capital gains treatment on Form 8949. For proceeds, enter the selling price. For cost basis, enter the $266 Bitcoin Cash value received per unit as you previously reported it as Other Income on line 21 of your 2017 Form 1040. The holding period for these units of Bitcoin Cash started on Aug. 1, 2017.

A cryptocurrency split is not a tax-free exchange
Taxpayers may feel a cryptocurrency split such as Bitcoin Cash qualifies as a tax-free exchange. I don’t think it does because cryptocurrencies are not securities, where tax-free splits are possible.

“Receipt of new Bitcoin Cash assets is a taxable event,” said tax attorney Roger D. Lorence. “Corporate taxation concepts on distributions to shareholders, dividends, spinoffs, split-offs, corporate reorganization nonrecognition events under Section 368 and allied rules, are all not applicable, as cryptocurrency is not a security. The new Bitcoin Cash assets are substantially different economically from the old Bitcoin assets.”

Lorence said the Supreme Court decision in Cottage Savings supports the view that the two classes of Bitcoin assets are not identical and therefore the transfer of the assets is considered a new class for which no nonrecognition provision of the code applies.

The IRS goes after cryptocurrency investors
Many cryptocurrency investors made a fortune the past several years selling high-flying Bitcoin and other cryptocurrencies for cash. Unfortunately, far too many of them did not report this taxable income to the IRS. Some cryptocurrency investors used Section 1031 like-kind exchange tax law to defer taxation, but that may be inappropriate (stay tuned for a blog post on that soon). Some cryptocurrency exchanges issued Form 1099-K, Payment Card and Third Party Network Transactions. The IRS feels they are insufficiently informed, so they are taking action.

Bitcoin rose in price from $13 in 2009 to more than $3,000 on June 11, 2017, and on Aug. 1, 2017, its market cap was $44 billion. Ethereum had a market cap of $21 billion. Bitcoin Cash skyrocketed overnight to a market cap of $12 billion on Aug. 2, 2017. The IRS figures hundreds of thousands of American residents did not report income from sales or exchanges of cryptocurrency and they might be able to collect several billion dollars in back taxes, penalties, and interest.

The IRS recently summoned Coinbase, one of the largest cryptocurrency exchanges, to turn over its customer lists. It later agreed to narrow the scope of the list to people with cryptocurrency transactions worth over $20,000 without a Form 1099-K. (Read IRS Blinks in Bitcoin Probe, Exempts Coinbase Transactions Under $20,000.)

Tax treatment for sales of cryptocurrencies
The IRS was slow to issue guidance for cryptocurrencies. It finally declared cryptocurrencies an “intangible asset,” not a sovereign currency, and sales and exchanges are subject to capital gain or loss treatment for investors and traders, using the realization method. (Read If You Traded Bitcoin, You Should Report Capital Gains To The IRS.)

There is tax controversy brewing with cryptocurrency investors, which means tax exams will escalate. Don’t be greedy: Pay your capital gains taxes on windfall income and amend tax returns to report capital gains before the IRS catches up with you.

Darren Neuschwander CPA, Adam Manning CPA and tax attorneys Roger D. Lorence and Mark M. Feldman contributed to this blog post.


Tax Treatment For Exchange Traded Notes (ETNs)

July 11, 2017 | By: Robert A. Green, CPA | Read it on

Update May 8, 2018: Some ETNs, like VELOCITYSHARES 3X LNG NTRL GS ETN (UGAZ), are debt obligations taxed as securities. (Check the tax section of the ETN prospectus.)

An Exchange Traded Note (ETN) calculates its rate of return or interest rate based on the movement of an underlying financial instrument, futures index, or equities index. In IRS jargon, an ETN is a prepaid executory contract or prepaid forward contract based on the relevant financial instrument or index. The ETN holder does not own the underlying instrument or index, so he or she should not use Section 1256 treatment. Report ETN income when realized as short-term and long-term capital gains and losses, except currency ETNs which are ordinary gain or loss treatment.

Is there an alternative tax treatment using Section 1256?
In my June 27, 2016, blog post Tax Treatment For Volatility Products Including ETNs, I said tax treatment for ETNs was uncertain. I wrote: In the iPath S&P 500 VIX ST Futures ETN (VXX: NYSEArca) prospectus, the tax attorneys suggested that Section 1256 is a “possible alternative” tax treatment. The VXX prospectus said: “Moreover, it is possible that the IRS could seek to tax your ETNs by reference to your deemed ownership of the Index components. In such a case, it is possible that Section 1256 of the Internal Revenue Code could apply to your ETNs, in which case any gain or loss that you recognize with respect to the ETNs that is attributable to the regulated futures contracts represented in the applicable Index could be treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss, without regard to your holding period in the ETNs…”

My above 2016 blog post attracted lots of queries from ETN traders interested in tax advantageous Section 1256 treatment. Some ETN traders requested us to provide “substantial authority” for using Section 1256 treatment on VXX.

No “substantial authority” for using Section 1256 on VXX
Our tax attorney Mark M. Feldman JD, of counsel to Green, Neuschwander & Manning, LLC wrote the following.

I researched whether there is “substantial authority” for the position that 1256 applies to VXX. My conclusion is that there is no substantial authority. Substantial authority (in contrast to “reasonable basis”) requires that the position be anchored in some authority, and not simply be a reasonable possibility. See Treas. Reg. section 1.6662-4(d)(3).

We had discussed (see Green’s June 2016, blog post) whether Rev. Rul. 2008-1 might be relied upon to say that you look through to the underlying positions. After further analysis, and review of articles about Rev. Rul. 2008-1, my conclusion is that Rev. Rul. 2008-1 does not stand for the proposition that you look through to the underlying positions. Rather, Rev. Rul. 2008-1 should be understood as follows, based on its facts:

At inception, the holder delivers the U.S. dollar equivalent of 75 euros, and at maturity, the issuer is required to pay the U.S. dollar equivalent of 75 euros plus the U.S. dollar value at maturity on a return based on euro interest rates. Accordingly, the Service concluded that, for U.S. federal tax purposes, the Instrument is euro-denominated indebtedness of the issuer subject to Section 988. The fact that intervening currency fluctuations may cause the amount of U.S. dollars that the holder receives at maturity to be less than the amount of U.S. dollars that the holder paid at inception did not affect the characterization of the instrument of debt, which, according to the Service, was based on an analysis of payments with respect to the euros.

Thus, Rev. Rul. 2008-1 is simply an application of Section 988: treating this as debt which has an interest rate but is denominated in foreign currency. The Rev. Rul. might not be expanded to cases (like VXX) where the payment is more similar to a derivative contract. Even if the Rev. Rul. were so expanded, this would mean that VXX is treated as indebtedness, not that you look through to its underlying components.

The language of the VXX Prospectus (including the 2016 Prospectus), suggesting that one possible treatment would be to look through to the underlying components is based, presumably, on Notice 2008-2 (the “Notice”), not Rev. Rul. 2008-1. The Notice does not say that looking through is the proper treatment, but merely that the IRS is considering “whether the tax treatment of the transactions should vary depending on the nature of the underlying asset (for example, stocks vs. commodities).” That sentence is not sufficient to create substantial authority. (See also 2015 Tax Notes Today 202-8 “VIX IN STICKS AND VAX IN STACKS”, which references articles on VIX-related products and does not change this conclusion.)

In fact, in response to the Notice, there was a paper presented by the New York State Bar Association Tax Section (2008 Tax Notes Today 125-20, at note 26) which recommended to the IRS that Section 1256 60/40 treatment not be extended to ETNs.

New York City tax attorney Roger D. Lorence, of counsel to Green, Neuschwander & Manning LLC says, “I agree with Mark Feldman’s analysis. Instruments that are debt obligations (in form) do not give rise to 1256 treatment. The taxpayer would be arguing against the form of the transaction, which is problematic.”

Other ETNs
According to List of ETNs ExchangeTraded – First Bridge Data, there are many ETNs to trade on exchanges.

  • The iPath Bloomberg Commodity Index Total Return ETN (DJP) prospectus says its “senior secured debt securities.” The tax considerations section discusses taxation of securities, Original Issue Discount (OID), and variable rate securities. The DJP prospectus does not mention Section 1256.
  • The iPath GSCI Total Return Index ETN (GSP) product summary says its “unsecured debt obligations.” The GSP prospectus calls for “Notes Treated as Prepaid Forward or Derivative Contracts.” Like VXX, the prospectus mentions the IRS may assert alternative treatment based on Section 1256.

See IPathETN.com U.S. Federal Income Tax Considerations: “For U.S. federal income tax purposes, Barclays Bank PLC and investors agree to treat all iPath ETNs, except certain currency ETNs, as prepaid executory contracts with respect to the relevant index. If such iPath ETNs are so treated, investors should recognize gain or loss upon the sale, redemption or maturity of their iPath ETNs in an amount equal to the difference between the amount they receive at such time and their tax basis in the securities. Investors generally agree to treat such gain or loss as capital gain or loss, except with respect to those iPath ETNs for which investors agree to treat such gain or loss as ordinary, as detailed in the chart below.” The iPath chart lists currency ETNs subject to ordinary gain or loss treatment. That’s consistent with IRS Revenue Ruling 2008-1 analyzed above. The other ETNs call for capital gain and loss treatment.

ETN investors agree to tax treatment
ETN prospectuses and Website content, including iPath above, state “investors agree to treat all ETNs, except certain currency ETNs, as prepaid executory contracts.” That’s a departure from typical prospectuses which recommend holders adopt a particular tax treatment.

When ETN prospectuses mention alternative tax treatment calling for Section 1256, they say the IRS may assert Section 1256 mark-to-market treatment based on various factors; they are not recommending a holder consider using Section 1256 treatment.

Volatility products with Section 1256 treatment
If you want Section 1256 tax breaks on volatility products, then trade volatility futures like the CBOE Volatility Index (VIX).

Options on VXX ETN
Some clients asked me how options on VXX are treated for tax purposes. I got this reply from our tax attorney Roger D. Lorence. “I located nothing directly on point. However, the better view in my understanding would be that these options are nonequity options and therefore Section 1256 contracts. The options are listed on CBOE and are therefore listed options on a qualified board or exchange. The underlying is, e.g., VXX ETNs. The tax opinion in the prospectus for the ETNs (Sullivan and Cromwell) is that these are prepaid forward contracts, and the holder has an executory contract for the delivery of the underlying futures contracts. Therefore the CBOE listed options are a derivative contract several levels removed from the ultimate underlying. If a holder were to exercise the CBOE options theoretically, they would not receive equity in a single stock or a narrow-based group of stocks based on a narrow-based index.”

Tax attorneys Mark M. Feldman and Roger D. Lorence contributed to this blog post.

 


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. 


Several Ways To Trade Currencies, Some With Lower Tax Rates

| By: Robert A. Green, CPA

Forbes

Several Ways To Trade Currencies, Some With Lower Tax Rates

There are several ways for American retail traders to trade “currencies” and tax treatment varies.

1. U.S. regulated futures contracts
U.S. futures exchanges list the major currency pairs as regulated futures contracts (RFCs). Open a retail account with a CFTC-registered Futures Commission Merchant (FCM).

Currency RFCs automatically have Section 1256 tax treatment with lower 60/40 tax rates. Section 1256 requires mark-to-market (MTM) accounting, which means reporting realized and unrealized capital gains and losses. Because there is no way to generate a long-term capital gain with MTM, Congress agreed that 60% is a long-term capital gain, and 40% is a short-term capital gain, no matter of holding period. (See Section 1256 tax rates vs. ordinary rates below.)

2. Leveraged forex contracts off-exchange 
Most American retail traders open accounts with a CFTC-registered Retail Foreign Exchange Dealer (RFED) or an FCM Forex Dealer Member. (See Learn Why The NFA Barred FXCM And What It Means For Forex Traders.)

By default, foreign currency transactions, including 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. (See A Case For Retail Forex Traders Using Section 1256(g).)

3. Currency exchange-traded funds (ETFs)
Structured as Registered Investment Companies (RIC) listed on a securities exchanges, ETF RICs are securities with short-term vs. long-term capital gains and losses treatment, using the realization method. Short-term capital gains are subject to ordinary tax rates, and capital losses are subject to the $3,000 capital loss limitation against other income.

4. Nadex binary options and spreads based on forex
Nadex is a CFTC-registered derivative exchange offering binary options and spreads. Nadex bases one of its binary options products on price movements in forex. It’s not a forex contract. Nadex issues a Form 1099B for Section 1256 contracts, but I have doubts about their qualification for using Section 1256 tax treatment. Nadex binary options and spreads appear to be “swap contracts” with ordinary gain or loss tax treatment. (Read Tax Treatment For Nadex Binary Options.)

Section 1256 tax rates vs. ordinary rates
The difference in the 60/40 blended tax rate vs. short-term capital gains taxed at ordinary rates is significant throughout the graduated tax brackets. The 60/40 rates vs. ordinary rates are:

4% for the 10% bracket,
6% for the 15% bracket,
19% for the 25% bracket,
20% for the 28% bracket,
22% for the 33% bracket,
23% for the 35% bracket, and
28% for the top 39.6% bracket

No matter what tax bracket you are in, there are significant tax savings using Section 1256.

Additionally, there is a Section 1256 loss carryback election, which can be used to amend the prior three years tax returns, offsetting Section 1256 gains only. Section 1256 has summary tax reporting. It’s a breeze tax-wise.


If You Traded Bitcoin, You Should Report Capital Gains To The IRS

February 16, 2017 | By: Robert A. Green, CPA

Forbes

If You Traded Bitcoin, You Should Report Capital Gains To The IRS

The IRS considers cryptocurrencies, including Bitcoin, to be “intangible property.” Investors and traders holding cryptocurrency as a capital asset should use capital gain or loss tax treatment on sales and exchanges, with the realization method. For example, if you buy Bitcoins with U.S. dollars and later sell them for U.S. dollars, a capital gain or loss needs to be reported on that transaction. An exchange of one cryptocurrency for another cryptocurrency is a taxable sale transaction, even though U.S. dollars are not involved in the transaction.

Americans also trade Bitcoin or leveraged Bitcoin contracts on Bitcoin exchanges, and they should report realized capital gains and losses on each trade, even if the trader doesn’t convert underlying Bitcoin back into U.S. dollars.

It’s similar to having a foreign-based brokerage account, denominated in a foreign currency (i.e., Euros), where a trader buys and sells European equities held in Euros, and does not convert Euros back to U.S. dollars during the year. Two potential choices for tax reporting: Convert Bitcoin to U.S. dollars on each purchase and sale transaction using the Bitcoin market price that day denominated in U.S. dollars, or perhaps the IRS will allow using Bitcoin as a functional currency, using an average Bitcoin vs. U.S. dollar conversion rate for the tax year.

The CFTC does not permit American retail customers to trade leveraged Bitcoin contracts on unregistered Bitcoin exchanges. (Read my related blog post: If You Want To Trade Bitcoins, First Learn CFTC Rules.)

Whether it’s legal or not under CFTC regulations, the IRS requires American resident taxpayers to report Bitcoin trading income and losses worldwide on U.S. resident tax returns. It doesn’t matter whether you repatriate funds back to the U.S., or not.

IRS guidance on cryptocurrency
In March 2014, the IRS issued long-awaited guidance (IRS Notice 2014-21) labeling cryptocurrency, including Bitcoin, “intangible property.” Investors and traders hold Bitcoin as a capital asset, so it receives capital gain and loss treatment. The AICPA and others have requested further guidance on virtual currency from the IRS. For investors and traders, I have a few unresolved questions below.

Intangible property is not a security, yet it seems logical that several tax rules for investors and traders are similar, whereas a few others are not.

Cryptocurrency is like securities in these cases

  • Use the realization method for sales of cryptocurrency held as a capital asset, which means you defer reporting of the capital gain or loss until closing the position.
  • Don’t use mark-to-market accounting at year-end, which means you don’t report unrealized gains and losses.
  • Use holding period rules to distinguish between short-term vs. long-term (12 months or longer) capital gains and losses. The long-term capital gains rates are lower than short-term rates, taxed as ordinary income.
  • The $3,000 capital loss limitation against other income applies.
  • Report each trade separately on Form 8949 (Sales and Other Dispositions of Capital Assets); we assume the IRS does not permit summary reporting. It’s OK to attach a report from your broker listing an accounting for each cryptocurrency trade.

Cryptocurrency is unlike securities in these cases

  • I don’t think you’ll have to make wash sale loss adjustments since Section 1091 wash sale rules only mention securities, not intangible property. Hopefully, the IRS will clarify this issue.
  • Traders qualifying for trader tax status may not elect Section 475 ordinary gain or loss treatment on cryptocurrency. Section 475 covers securities and commodities, not intangible property.
  • Cryptocurrency is not sovereign currency or forex with Section 988 ordinary gain or loss treatment, or Section 1256(g) foreign currency contract treatment. The IRS and CFTC call cryptocurrency “currency,” but not “foreign currency.”

Onshore and offshore cryptocurrency exchanges do not issue American investors or traders a Form 1099B.

Read my prior blog post: IRS Guidance On Bitcoin Transactions.

Nadex offered Bitcoin binary contracts in 2016
The North American Derivatives Exchange, Inc. (Nadex), a U.S.-based CFTC-regulated derivatives exchange, offered Bitcoin binary contracts for part of 2016. On Dec. 16, 2016, Nadex filed a Self-Certification to Delist Bitcoin.

Over the past several years, Nadex issued Americans a Form 1099B for Section 1256 contracts. That’s an advantageous tax treatment with lower 60/40 tax rates, and I doubt whether it’s correct to use Section 1256 tax treatment for Bitcoin binary contracts. (Read Tax Treatment For Nadex Binary Options.)

Bitcoin and foreign bank account reporting
U.S. residents with a foreign bank, brokerage, investment and another type of account (including retirement and insurance in some cases) who meet reporting requirements must e-file FinCEN Form 114, Report of Foreign Bank and Financial Account. If your foreign bank and financial institution accounts combined are under $10,000 for the entire tax year, you fall under the threshold for filing FinCEN Form 114.

The IRS allowed taxpayers to exclude Bitcoin from 2013 foreign bank account filings. It’s not clear if the IRS continues to allow an exclusion of Bitcoin, or Bitcoin derivative contracts, on current year FinCEN 114 filings. Suppose you have Bitcoin or Bitcoin derivative contracts held at a foreign Bitcoin exchange. When in doubt, and considering significant penalties for non-compliance, it’s probably wise to include these Bitcoin accounts on FinCEN 114. (Read Bitcoin Is Not Reported On 2013 FBARs.)

For another update on cryptocurrency tax treatment, read Taxation of Virtual Currency, Jan. 16, 2017, Bloomberg, by Elizabeth R. Carter.


CFDs: Tax & Regulatory Treatment

January 18, 2017 | By: Robert A. Green, CPA

On rare occasion, traders ask me how to report “Contracts For Difference” (CFD) trades on their U.S. resident income tax returns. CFD trading is widespread in the UK, with the primary purpose to avoid UK stamp duty tax on shares. More countries are flirting with financial transaction taxes (FTT), so CFD trading platforms may grow around the world.

Definition of a CFD
A CFD is a derivative; a contract between a buyer and seller based on the price of an underlying financial instrument, like a particular equity or futures contract. It’s a bet that the price of an asset will increase or decrease over a set period. Whichever party is underwater on the contract at closing date must pay the other party to settle the CFD contract. It’s not a security, commodity, or futures contract; it’s an off-exchange contract similar to forex.

Is CFD trading legal for American retail customers?
Some American retail customers trade CFDs with counterparties that are not registered with the Commodity Futures Trading Commission (CFTC) or another U.S. regulator to allow CFD trading by American retail customers. I asked the CFTC and National Futures Association (NFA) if that is legal, and both said CFTC regulations for American retail customers apply to counterparties, not American retail customers. Does that imply that CFD trading may be legal for American retail customers, and illegal for counterparties? Perhaps, yes, but I am not sure. It’s risky for American retail customers to trade CFDs because the CFTC may take enforcement action against their counterparties.

U.S. tax treatment of CFD trading
For U.S. tax treatment, CFDs are deemed to be swap contracts, with ordinary gain or loss treatment using the realization method. It’s not a capital gain or loss. Like with Section 988 forex, use summary reporting of trades listing the net trading “Other Income or Loss” on Form 1040 line 21. Report interest expense on long positions as margin interest expense: Business interest with trader tax status, and investment interest expense with investor tax status.

Foreign brokers do not issue a 1099-B tax report to customers or the IRS, and U.S. taxpayers are responsible for reporting all trading gains and losses in worldwide accounts, whether they take distributions from a foreign account or not.

If a trader bases the foreign account in foreign currency, then currency conversion issues apply. Section 988 forex rules apply to physically-held foreign currency, and the trader may not file a capital gains election on physical currency. Therefore, it’s ordinary gain or loss with the realization method, which means when the foreign currency is converted back into U.S. dollars.

Report foreign bank or financial accounts to U.S. Treasury
Foreign CFD trading accounts are subject to foreign bank and financial account reporting (FBAR) on FinCEN Form 114, e-filed annually with U.S. Treasury.

Swaps use ordinary gain or loss treatment
The Dodd-Frank financial regulations promised to clear private swap transactions on exchanges to protect the markets from another swap-induced financial meltdown — remember those credit default swaps with insufficient margin in 2008? When Dodd-Frank was enacted, traders’ hoped that clearing on futures exchanges would allow Section 1256 lower 60/40 capital gains tax treatment. They were wrong: Congress and the IRS immediately communicated that tax-advantaged Section 1256 would not apply to all types of swap transactions, and they confirmed ordinary gain or loss treatment. One exception: Futures swaps on U.S. commodities exchanges probably have Section 1256 treatment. Read Tax Treatment for Swaps, Options On Swaps, Futures Swaps, And Options On ETFs Partially Consisting Of Swaps.

Swaps use the realization method
Swap contracts are Section 1.446-3 “Notional Principal Contracts” (NPC) with ordinary gain or loss tax treatment using the realization method, not the mark-to-market (MTM) accounting method. The realization method means a trader does not report a taxable gain or loss until the position is closed (realized). Conversely, with MTM, a taxpayer reports realized and unrealized gains and losses at year-end.

Many active traders qualify for trader tax status, and they timely elected Section 475 MTM ordinary gain or loss treatment, but Section 475 MTM does not apply to NPC; Section 475 only applies to securities and commodities (Section 1256 contracts).

Regulations for counterparties working with American retail customers
The CFTC and SEC require counterparties offering leveraged financial products to American retail customers to register with the CFTC, SEC or another regulator. The CFTC considers a CFD contract based on the underlying price of forex, to be a CFD and not a forex contract. I don’t know any counterparties currently registered with a U.S. regulator for conducting business with American retail customers in CFDs.

The Dodd-Frank Act requires clearing of swap contracts for American retail customers on U.S. exchanges. For example, security-based swaps on Apple equity for retail investors clear on a U.S. securities exchange.

North American Derivatives Exchange, Inc. (“Nadex”), a US-based CFTC-regulated exchange offers binary options and spreads on stock indices, forex, commodities, and events. Nadex is a CFTC Designated Contract Market and Derivatives Clearing Organization. U.S. regulators do not allow American retail customers to trade on other domestic or foreign binary option trading platforms because they are off-exchange.

UK-based CFD brokers
I emailed a few UK-based CFD brokers and asked them if they do business with Americans retail customers. One said, “Unfortunately we don’t work with US citizens living in the US.” I asked why and he said, “There is a difference in the regulation in the US and UK. Therefore, we are not allowed to offer our service to US citizens.” Another UK CFD broker said something similar.

Taxes: Even if a CFD counterparty is in breach of U.S. regulations for American retail customers, which they do at their peril, the trader still owes taxes to the IRS on worldwide income, whether they repatriate funds back to the U.S. or not.

Proprietary trading firms
I recently heard about a foreign proprietary trading firm charging Americans for education in CFD trading. After completion of the curriculum, the company offers the student rights to trade CFDs in a sub-trading account. As an independent contractor (IC) prop trader, the firm pays the IC consulting fees based on their performance in the sub-trading account. There is no 1099-Misc from a foreign payor, but the fee income is taxable as ordinary income. I wonder if U.S. regulators would view this as CFD trading, or just consulting services.


Tax Treatment For Volatility Products Including ETNs

June 27, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

After the Brexit referendum vote on June 24, 2016, volatility-based financial products skyrocketed in price, and by Monday, June 27, prices had subsided. That’s volatility!

There are many different types of volatility-based financial products to trade, and tax treatment varies. For example, CBOE Volatility Index (VIX) futures are taxed as Section 1256 contracts with lower 60/40 MTM tax rates. The NYSE-traded SVXY is an exchange-traded fund (ETF) taxed as a security. The iPath S&P 500 VIX Short-Term Futures (VXX) is an exchange-traded note (ETN), and while tax treatment is similar to an ETF, there is uncertain tax treatment on ETNs. I focus this blog post on tax treatment for ETNs.

How ETN’s work
Per TAX STRATEGIES FOR LONG-SHORT EQUITY, Practical Tax Strategies, Sep 2014: “An exchange traded note (ETN) can be linked directly to an active index. An ETN is similar to a bond except the interest rate is replaced with the return of an index.” “ETNs include significant creditor risks because they are not backed by underlying assets, but only by the issuer’s ability to pay at maturity (which may be 30 years in the future).” This creditor risk probably increased after the Brexit vote, as many of these banks operate in the U.K. and European Union. Day traders are not as concerned with creditor risks.

VXX prospectus discusses tax treatment
In the prospectus for iPath® S&P 500 VIX Short-Term Futures ETN, tax attorneys write “by purchasing the ETNs you agree to treat the ETNs for all U.S. federal income tax purposes as a pre-paid executory contract with respect to the applicable Index. If the ETNs are so treated, you should generally recognize capital gain or loss upon the sale, early redemption or maturity of your ETNs in an amount equal to the difference between the amount you receive at such time and your tax basis in the ETNs. The U.S. federal income tax consequences of your investment in the ETNs are uncertain.”

Tax publishers use a similar term: “prepaid forward contracts” and tax treatment calls for deferral of taxes until sale and long-term capital gains rates if held 12 months. Constructive receipt of income rules prevents tax avoidance with offsetting positions.

Traditionally, ETN’s are tax advantaged because they allow deferral until realization (sale) and lower long-term capital gains rates if held 12-months. That’s good for investors. But, day and swing traders don’t benefit from deferral and long-term rates; they incur short-term capital gains taxes throughout the year taxed at ordinary rates.

Traders would rather have the option of using Section 1256 tax treatment on volatility ETNs including lower 60/40 capital gains rates. That’s how the IndexCBOE: VIX is taxed. (60% is lower long-term capital gains rates up to 20%, even on day trades, and the other 40% are short-term capital gains at ordinary rates.) Section 1256 also requires mark-to-market (MTM) accounting, imputing sales on open positions at year-end and that’s not a problem for day traders.

IRS ruling
The IRS caused questions when it issued Rev. Rul 2008-1 about foreign currency linked ETN’s. The IRS also issued Rev. Ruling 2008-2 asking for comments on prepaid forward contracts and similar arrangements. The IRS has not yet issued final guidance on ETN’s.

In Rev. Ruling 2008-1, the IRS “looked through” the currency ETN to the underlying market bet on the Euro and market interest rates. The IRS objected to the ETN benefiting from tax deferral and long-term capital gains rates when the underlying foreign currency transactions (Section 988) would require ordinary gain or loss treatment. Plus, debt instruments require accrual of annual interest income. The IRS knows that traditional ETN tax treatment prejudices Treasury, and it would prefer to accrue income and use ordinary rather than capital gains tax rates.

ETFs based on volatility
The IRS can’t apply this same look through logic to ETF’s because as a “registered investment company” (RIC), security ETF’s are taxed as securities.  A commodity ETF can’t use the RIC structure; it’s a publically traded partnership also taxed as securities. A commodity ETF issues a Schedule K-1 passing through Section 1256 contract income or loss.

ProShares has three volatility ETF’s: ULTRA VIX SHORT-TERM FUTURES ETF (NYSEArca: UVXY), SHORT VIX SHORT-TERM FUTURES ETF (NYSEArca: SVXY), and VIX SHORT-TERM FUTURES ETF (NYSEArca: VIXY).  These ProShares ETF’s are taxed as securities: Unlike ETN’s, ETF RIC’s make annual distributions of income and capital gains to shareholders. ETF’s don’t provide as much deferral as ETN’s.

Possible alternative tax treatments for ETN’s
In the VXX prospectus, tax attorneys suggest that Section 1256 is a “possible alternative” tax treatment. “Moreover, it is possible that the IRS could seek to tax your ETNs by reference to your deemed ownership of the Index components. In such a case, it is possible that Section 1256 of the Internal Revenue Code could apply to your ETNs, in which case any gain or loss that you recognize with respect to the ETNs that is attributable to the regulated futures contracts represented in the applicable Index could be treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss, without regard to your holding period in the ETNs… And, currently, accrue ordinary interest income in respect of the notional interest component of the applicable Index.”

Postscript: In my July 11, 2017, blog post How To Avoid Tax Reporting Trouble With Exchange Traded Notes, I explain there is no substantial authority for ETN holders to use Section 1256 tax treatment.

Options on VXX (added Dec. 16, 2016)
After writing this blog post, some clients asked me how options on VXX are treated for tax purposes. I got this reply from our tax attorney Roger Lorence. “I located nothing directly on point. However, the better view in my understanding would be that these options are nonequity options and therefore Section 1256 contracts. The options are listed on CBOE and are therefore listed options on a qualified board or exchange. The underlying is, e.g., VXX ETNs. The tax opinion in the prospectus for the ETNs (Sullivan and Cromwell) is that these are prepaid forward contracts and the holder has an executory contract for the delivery of the underlying futures contracts.  Therefore the CBOE listed options are a derivative contract several levels removed from the ultimate underlying. If a holder were to exercise the CBOE options theoretically, they would not receive equity in a single stock or a narrow-based group of stocks based on a narrow-based index.”

When traders talk about volatility products, they often conflate tax treatments. Until we get further formal guidance from the IRS, the tax treatment on volatility and other ETN’s is uncertain. Consult with a trader tax expert.

Darren Neuschwander, CPA contributed to this blog post.


IRS Considering “Freeze And Mark” For Section 475 Election

May 10, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

According to Tax Notes article “IRS Considering ‘Freeze and Mark’ for Trader Election” dated Jan. 20, 2016, Robert Williams, branch 3 senior counsel, IRS Office of Associate Chief Counsel (Financial Institutions and Products), said he was optimistic, though cautious, that updated Section 475 regulations will come out by June 30, 2016.

The Tax Notes article mentioned a few significant potential changes that would affect traders in making a new Section 475 election. If codified by the IRS, I expect these changes won’t apply retroactively, so traders who made a 2016 Section 475 election by April 18 should not be affected.

Clarification of the character of income or loss of a Section 481(a) adjustment: The IRS may clarify that it’s a capital gain or loss, rather than an ordinary income or loss, which is the current interpretation. Many traders have benefited from ordinary loss treatment, especially when a Section 481(a) adjustment included wash sale loss deferrals on open trading business positions.

No election deadline: The changes may allow existing taxpayers to make a new Section 475 election throughout the tax year. Currently,  the election deadline is April 15 for existing partnerships and individuals and March 15 for S-Corps. Many existing taxpayers will appreciate doing away with the deadline.

No retroactive application: Williams discussed applying ordinary income or loss treatment on the election date and going forward, and doing away with retroactive application of ordinary income or loss to Jan. 1.

Under current law, when a trader elected Section 475 by April 18, 2016 for 2016 (normally April 15), the election was retroactive to Jan. 1, 2016, so all 2016 trading gains and losses are ordinary income and loss. If a trader qualified for trader tax status (TTS) at year-end 2015, he also makes a Section 481(a) adjustment on Jan. 1, 2016 for unrealized gains or losses on open trading positions on Dec. 31, 2015.

Traders have been able to use hindsight between Jan. 1 and April 15 to make a last-minute decision about electing Section 475. For example, if they have a large trading loss in Q1, they may elect Section 475 to lock in ordinary loss treatment for that loss, and plan to revoke Section 475 in the subsequent year to get back to capital gains treatment to use up capital loss carryovers. That type of hindsight may be lost with these potential updates in the law.

 

 


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