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.

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Photo of Richard M. Corn Richard M. Corn

Richard M. Corn is a partner in the Tax Department. He focuses his practice on corporate tax structuring and planning for a wide variety of transactions, including:

  • mergers and acquisitions
  • cross-border transactions
  • joint ventures
  • structured financings
  • debt and equity issuances
  • restructurings
  • bankruptcy-related transactions

Richard M. Corn is a partner in the Tax Department. He focuses his practice on corporate tax structuring and planning for a wide variety of transactions, including:

  • mergers and acquisitions
  • cross-border transactions
  • joint ventures
  • structured financings
  • debt and equity issuances
  • restructurings
  • bankruptcy-related transactions

Richard advises both U.S. and international clients, including multinational financial institutions, private equity funds, hedge funds, asset managers and joint ventures. He has particular experience in the financial services and sports sectors. He also works with individuals and tax-exempt and not-for-profit organizations on their tax matters.

Richard began his career as a clerk for the U.S. Court of Appeals for the Fourth Circuit Judge J. Michael Luttig and then went on to clerk at the U.S. Supreme Court for Associate Justice Clarence Thomas. Prior to joining Proskauer, he most recently practiced at Sullivan & Cromwell as well as Wachtell, Lipton, Rosen and Katz.

Photo of Martin T. Hamilton Martin T. Hamilton

Martin T. Hamilton is a partner in the Tax Department. He primarily handles U.S. corporate, partnership and international tax matters.

Martin’s practice focuses on mergers and acquisitions, cross-border investments and structured financing arrangements, as well as tax-efficient corporate financing techniques and the tax…

Martin T. Hamilton is a partner in the Tax Department. He primarily handles U.S. corporate, partnership and international tax matters.

Martin’s practice focuses on mergers and acquisitions, cross-border investments and structured financing arrangements, as well as tax-efficient corporate financing techniques and the tax treatment of complex financial products. He has experience with public and private cross-border mergers, acquisitions, offerings and financings, and has advised both U.S. and international clients, including private equity funds, commercial and investment banks, insurance companies and multinational industrials, on the U.S. tax impact of these global transactions.

In addition, Martin has worked on transactions in the financial services, technology, insurance, real estate, health care, energy, natural resources and industrial sectors, and these transactions have involved inbound and outbound investment throughout Europe and North America, as well as major markets in East and South Asia, South America and Australia.