Recently, in Wright v. Commissioner, the United States Court of Appeals for the Sixth Circuit has reopened the question of the application of Section 1256[1] to foreign currency options (and also, possibly, to foreign currency swaps or other, similar foreign currency derivatives). Section 1256 requires a taxpayer to treat certain types of derivative contracts held over the course of a taxable year as having been sold for their fair market value at the end of the taxable year. In other words, the holder must “mark-to-market” those derivative contracts for U.S. Federal income tax purposes.  Although the paradigmatic example of contracts subject to Section 1256 are those traded on various regulated futures exchanges, in 1982 Congress expanded Section 1256 to apply to certain “foreign currency contracts” traded “in the interbank market”.[2]

The language of the statute created some confusion as to how broad the definition of a “foreign currency contract” is — in particular, as to whether a foreign currency option or a foreign currency swap falls within this definition.  One plausible interpretation is that the plain language of the statutory definition includes foreign currency options and swaps, as the statute refers to a contract where “settlement […] depends on the value of foreign currency” — a description that seems to apply to option contracts and swap arrangements.  An alternative interpretation would look to the legislative history of the acts enacting the current definition, which would appear to support the conclusion that only the equivalent of foreign currency forward contracts falls within the mandatory mark-to-market regime (and not options or swaps).

The IRS’ position, for the most part, has been that foreign currency options and swaps are not covered by the Section 1256 definition of “foreign currency contract” — although there was a four-year period of uncertainty based on an (apparently) off-hand statement in a Notice.[3] The Tax Court generally had upheld the IRS’ position on multiple occasions that marking to market was not required.  As such, before the Sixth Circuit decided otherwise in Wright, the tax treatment of foreign currency options and swaps seemed to be settled broadly in line with the IRS’ position.

While Wright involves a narrow set of facts about a particular tax shelter, the ramifications of the decision seem further reaching. The Sixth Circuit held that the plain language of the “foreign currency contract” definition could be satisfied by a contract such as an option that did not require delivery or settlement unless it was exercised. The Sixth Circuit found the plain language so clear that it refused to consider legislative history or tax policy. Although the Sixth Circuit did agree that there was no tax policy reason to support their interpretation, the court encouraged the IRS to clarify the ambiguity. Even though the IRS could issue formal regulations to settle the ambiguity permanently, as it stands one federal appellate court has issued an opinion contrary to a relatively stable body of Tax Court precedents and has cast some doubt on the IRS’ view. As such, some uncertainty returns to the question of whether foreign currency derivatives are subject to mark-to-market under Section 1256.

[1] Section references are to the Internal Revenue Code of 1986, as amended.

[2] Section 1256(g)(2).

[3] Notice 2003-81, 2003-2 C.B. 1223.