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Tax Tips for Forex Traders (Part 3)

02/21/2008 12:00 am EST

Focus: FOREX

Robert Green, CPA


A summary view of forex tax after Notice 2007-71

Currency futures are "regulated futures contracts" in IRC 1256 by default.

OTC currency options are IRC 988 and they are barred from IRC 1256 (Notice 2007-71).

There are also elections to "opt-out"
There are various elections to "opt out" of IRC 988 and IRC 1256, which can serve to navigate again between the two tax treatments.

IRC 988 allows a trader (but not a manufacturer) to "opt out" of IRC 988 ordinary gain or loss treatment into capital gains treatment. This is referred to as the "capital gains" election. If a trader has large capital-loss carryovers, they may want their forex gains to be capital gains (rather than ordinary gains) in order to use up their capital-loss carryovers. Conversely, if an investor (lacking trader tax status) has large forex losses generating net taxable losses, their forex ordinary losses can be permanently wasted. With the capital gains election, they can convert wasted ordinary losses (not allowed for NOL since they are not business traders) into useful capital loss carryovers.

As indicated above, a trader may elect to opt out of IRC 1256 into IRC 988.

Have your cake and eat it too
Both pre- and post-Notice 2007-71, we continue to think it's possible for most forex traders to get the best of both (tax) worlds: ordinary loss treatment on spot and forward forex trading losses (rather than capital-loss limitations), and IRC 1256 lower 60/40 tax rates on forward forex contracts (and maybe spot forex, too, with more aggressive interpretations of the law – see above).

IRC 988 versus IRS 1256 tax treatment
IRC 988, by default, has ordinary gain or loss treatment. Losing traders prefer IRC 988, since it does away with capital-loss limitations, allowing full ordinary loss treatment against any type of income.

IRC 1256, by default, has lower 60/40 capital gains tax rates. Profitable traders prefer IRC 1256, since it reduces their tax rates on trading gains. IRC 1256 has a three-year carry back feature, but only against 1256 gains in those years.

More about the intentions of Congress and the IRS
In lay terms, Congress realized that trading in the forex market resembled trading in the currency futures markets and that currency traders often traded both forex and futures in one coordinated trading program.

It would be wrong, confusing, and open the door to tax cheating, however, to only allow ordinary gain or loss treatment on forex and 60/40 tax treatment on futures. This is the reason Congress added "foreign currency contracts" to IRC 1256–to allow for navigation between IRC 988 and IRC 1256. Hedging forex with futures and vice versa can also tie IRC 988 and 1256 together.

IRC 988 must remain intact as well, as it mostly applies to manufacturers, global corporations, and hedgers of those businesses. Hence, the continued conflicts remain in IRC 988 and 1256.

Congress gave the IRS the right to figure out tax reporting abuse and to bar certain instruments from coveted IRC 1256 60/40 treatment. This is exactly what happened with the IRS Notices 2003-81 and 2007-71. Notice 2003-81 was issued to combat tax cheating and the Service applied a literal reading of foreign currency contracts. 2007-71 later corrected 2003-81 and unfortunately it barred OTC currency options from 60/40 treatment.

History of IRC 1256 on "foreign currency contracts"
The definition of Section 1256 contracts includes certain forward contracts for the future delivery of foreign currency:

"A forward contract is similar to a futures contract in that it contemplates delivery of a specified quantity of goods, at a specified price, at some specified date in the future. Forward contracts differ, however, because they are private contracts in which the parties remain entitled to performance from each other. No organized market or established mechanism is available for terminating a taxpayer's position prior to the delivery date, as in the case of futures. In addition, the terms of a forward contract are usually not standardized, and forward contracts, unlike futures, do not typically involve mark-to-market procedures or margin requirements (although contract parties may agree on such measures amongst themselves)."

Informally, the IRS has indicated that it refers to “the OTC market maintained by banks to purchase and sell foreign currency and financial products,” and noted that “Congress intended to include within the definition of a foreign currency contract bank forward contracts in currencies that are [also] traded through RFCs because bank forward contracts are economically comparable to and used interchangeably with RFCs.” FSA 200025020 (June 23, 2000).

"Before ERTA (older tax law) was enacted, the tax consequences of trading in forward and futures contracts were basically the same. The ERTA regime, however, created disparity in the tax treatment of the instruments given that Section 1256 only applied initially to RFCs (regulated futures contracts), not to forward contracts. Congress subsequently came to view forward contracts as being economically comparable to, and traded interchangeably with RFCs despite the differences noted above. The volume of trading through forward contracts in foreign currency was substantially greater than foreign currency trading on futures exchanges, and forward currency prices were readily available. Accordingly, in order to eliminate the disparity created by ERTA, the scope of Section 1256 was expanded in 1982 to encompass the foreign currency contracts described below."

"As added to the Code in 1982, Section 1256(b)(2) provides that a foreign currency contract constitutes a Section 1256 contract. Under Section 1256(g)(2)(A), a foreign currency contract is any contract that meets three requirements. First, the contract must require delivery of a foreign currency in which positions are also traded through RFCs (or alternatively, the contract must contemplate a settlement that depends on the value of such a traded currency). Currently (this old statement is no longer true), only a handful of currencies are traded through RFCs, including the Canadian dollar, British pound, Japanese yen, Swiss franc, and German mark (pre-Euro). Other actively exchanged currencies are not so traded, and as a result, forward contracts involving those currencies are not subject to Section 1256 (e.g., Italian lire)." Our comment: this list of currencies is dated and it has greatly expanded to all the major currencies over the years, so a case can be made that most spot forex has RFCs traded in those same currencies.

"In IRS Field Service Advice Memorandum 200025020, the Service, after noting the lack of a definition of the 'Interbank market' in the statute, offered the following guidance:

"The Interbank market refers to the OTC market maintained by banks to purchase and sell foreign currency and financial products. The Interbank market is not a formal market, but rather a group of banks holding themselves out to the general public as being willing to purchase, sell or otherwise enter into certain transactions. The Service broadly interprets the Interbank market to include all banks and investment banks (as the terms are generally used in the marketplace).

More tomorrow in Part 3. Part 1 |  Part 2  |  Part 4

By Robert Green of

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