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Foreign Exchange Traded Futures The below article has been updated with new research and findings from
GreenTraderTax, click here. The 60/40 Question Section 1256 requires certain types of contracts to be marked to market at year-end, regardless of the taxpayer's status. Gain or loss, under Section 1256(a)(3), is 60% long-term capital gain and 40% short-term capital gain. Long-term capital gains are taxed at a maximum rate of 15% for all sales after May 5, 2003. Short term capital gains are taxed at the normal tax rate. The maximum short term ordinary rate is 35%, effective January 1, 2003. Commodities receive preferential tax treatment over securities (e.g., stocks, stock options, narrow based indices, single stock futures, mutual funds, Exchange Traded Funds (e.g., QQQs) and bonds). Section 1256 Contracts Section 1256 was introduced into law by the Economic Recovery Tax Act of 1981, Pub. L. 97-34, 95 Stat. 172 (effective date June 23, 1981). Section 1256 contains special rules for reporting gains and losses from "section 1256 contracts." Section 1256(b) defines the term "section 1256 contract" (e.g., commodities) as including any regulated futures contract, any foreign currency contract, any non-equity option, any deal equity option and any dealer securities futures contract. The Commodities Futures Modernization Act of 2000 (CFMA) established that broad based indices are also considered commodities. Section 1256(g)(1) provides that the term "regulated futures contract" means a contract (A) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (B) which is traded on or subject to the rules of a qualified board or exchange. A futures contract is not defined in Section 1256. The CFTC defines a futures contract as "an agreement to purchase or sell a commodity for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) which obligates each party to the contract to fulfill the contract at the specified price; (3) which is used to assume or shift price risk; and (4) which may be satisfied by delivery or offset." Only a futures contract that has actually been traded on a CFTC designated contract market or subject to its rules is a regulated futures contract for purposes of § 1256(g)(1). A regulated futures contract can be traded by either a taxpayer as a principal or by a third party acting on the taxpayer's behalf as an agent. Futures contracts that have been traded by two private parties "over the counter" ("OTC") are not traded on a contract market and are not regulated futures contracts for purposes of Section 1256(g)(1). See Revenue Ruling. 87-43, 1987-1 C.B. 252. A futures contract that does not meet these terms may be a non-regulated futures contract. The difference between forward contracts and futures contracts is that the parties to a forward contact generally intend to make and take delivery. Parties to a futures contract are speculators who intend to close out their positions by offset before delivery. Section 1256(g)(7) provides that the term "qualified board or exchange" means (A) a national securities exchange which is registered with the Securities and Exchange Commission; (B) a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or (C) any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of this section. While the Secretary of the Treasury has not taken up its congressional mandate to create legislative certainty in this area, it can be argued that the CFTC, by default, has filled the interstitial legislative gap. Why 60/40 Treatment is Viable Since the enactment of Section 1256 in 1981, a number of contract markets throughout the world have implemented adequate rules and could be determined to be a "qualified board or exchange" within the meaning of Section 1256(g)(7). The Treasury Department's recognition of the appropriate extension of 60/40 tax treatment to foreign exchanges, boards of trade, and other markets pursuant to Section 1256(g)(7)(C) is long overdue and is not likely to be forthcoming anytime soon. While a formal designation as such by the Treasury would expressly make futures contracts traded on these foreign exchanges eligible for treatment as a Section 1256 contract (e.g., eligible for 60/40 capital gain or loss treatment, the lack of such designation by the Secretary does not necessarily preclude 60/40 tax treatment. Operative Analysis For purposes of determining the tax consequences of a transaction, it is necessary to ascertain the legal relationships that exist between the parties to the transaction. In the typical exchange clearing process for a futures or option contract, an exchange clearing house is interposed between the original parties to the transaction, namely, the clearing members who represent the purchaser and seller under the contract. Although there are a series of steps involved in the typical exchange clearing process, the step transaction doctrine provides that these steps are not analyzed separately but are viewed as component parts of a single transaction. In the typical exchange clearing process, the legal relationship between the investor and the broker remains unchanged notwithstanding the fact that an exchange clearing house is interposed between the original parties to the transaction. Relying on this type of analysis, in Revenue Ruling 85-72, The Tax Court, in Johnson v. CIR, T.C. Memo (1993-178), stating that the purpose of Section 1256 is to provide the system of taxation based on marking to market of regulated futures contracts, held the taxpayer’s trading in futures contracts and in futures transactions on the London Metal Exchange were conducted subject to the rules of a board of trade or commodity exchange within the meaning of Section 1256(g)(7). However, in Revenue Ruling 87-43, 1987-1 CB 252, the IRS ruled that Singapore International Monetary Exchange Limited (SIMEX) was a foreign board of trade that was not a qualified board or exchange. In that ruling, the Chicago Mercantile Exchange (CME) and the SIMEX established the Mutual Offset System (System) to provide a process by which customers could establish new positions or offset existing positions on one exchange, during hours in which that exchange is closed for trading, by the execution of a contract on the other exchange. Commodity Futures Trading Commission There is a reasonable basis in fact and law to conclude that futures traded on foreign contract markets with a Rule 30.10 exemption are entitled to classification as Section 1256 contracts (e.g., commodities) with the result that “60/40” tax treatment (defined below) is appropriate. All that is needed is a determination by the Treasury Secretary. In the absence of a forward determination by the Secretary, it may be possible to develop an appropriate and reasonable tax return position in support of 60/40 tax treatment for futures contracts traded on the foregoing foreign contract markets. The CFTC has effectively determined that the foregoing contract markets are exchanges, boards of trade and other markets qualified within the meaning of Section 1256(g)(7) as such boards and exchanges have rules adequate to support the purpose of Section 1256. In addition, it can be posited due to the extensive review conducted by the CFTC’s Division of Market Oversight, futures traded through the foreign entities (listed below) receiving No Action Letters from the CFTC eligible for Section 1256 60/40 tax treatment, pursuant to the analysis presented above.
------------------ Here is a follow up comment from GreenTraderTax Note that although I am sympathetic to the argument that any foreign
board or exchange that has received notification from the CFTC under Rule
30.10 is a qualified board or exchange under Section 1256(g), the IRS
has not ruled on this. |