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.