GreenTraderTax Blog
GreenTraderTax
Spot forex update

January 29, 2011

By Robert Green CPA and Mark Feldman JD

It’s not clear if spot forex traders can elect out of Section 988 (ordinary gain or loss treatment) with a capital gains election into the lower 60/40 tax rates of Section 1256(g). Interbank (forex) forwards are allowed, but spot forex isn’t specifically mentioned and the IRS has been reluctant to expand the definition.

If you have significant trading gains on spot forex contracts, the Section 1256 tax rates (such as foreign currency forwards) — which are up to 12 percent lower than the ordinary tax rates currently — may be very material and desirable to you, your forex fund and/or managed account investors. Forex transactions are reported in summary form. It’s not clear in the tax code when you should use cash vs. MTM treatment. If using Section 1256(g), MTM treatment is required.

We will discuss these issues in our upcoming Forex Tax Webinar scheduled for March 1. A recording is available.

We will also discuss the fact that forex brokers generally don’t report rollovers as realized transactions. Most forex brokers treat rollover interest as part of forex trading gains and losses and we make a case for how brokers are correct in not treating it as interest income.

Another forex tax update
We last discussed forex tax treatment in our Forex Tax Update blog. Here’s an important update on further developments.

We’re having ongoing discussions about retail forex tax treatment, specifically spot forex, with IRS officials in charge of writing Section 1256 regulations (the lower 60/40 tax rates on futures). We’re also speaking with a wide spectrum of players in the industry to understand the various types of retail forex trading which exist. This process will culminate in a face-to-face meeting with the IRS officials. We hope to convince the IRS to provide formal written guidance stating that retail forex qualifies for Section 1256; failing that, we will seek informal guidance from the IRS. This process may take some time, but in the meantime, we will get a better sense of what the IRS is thinking, and this will help us advise our clients properly even before the IRS makes a decision.

We believe there is at least “substantial authority” for the view that retail forex qualifies for Section 1256(g) 60/40 treatment. However, you should realize that not all of what is commonly called “retail forex” or “spot forex” necessarily qualifies. For example, it’s necessary for the forex to be traded on the “interbank market,” and we need to determine that the particular forex platform that you use qualifies. It is therefore important that you speak with us so that we can determine whether your situation falls within 1256(g).

Is retail spot forex a true Interbank transaction?
Many retail forex brokers use a software trading platform like MetaTrader. In our phone discussions with IRS officials, we sensed friction in their view of retail trades executed on some retail software platforms, challenging if those trades are true transactions in the Interbank forex market.

One leading forex brokerage firm explained that they transact in large block trades for spot forex with a major bank in the Interbank market — we call that a wholesale trade — and the retail forex broker then breaks up those block trades into pieces, redistributing them to their retail customers. As we explained to the IRS, these are retail trades in the Interbank market that go through a wholesale/retail distribution model, just like in other industries.

We’ve heard that other forex brokers have less direct connection with the Interbank market and in a sense make their own market with retail customers, with the firm taking the other side of trades with their customers. Some of these brokers may net their book of long and shorts on given currencies and then cover their risk in the direct Interbank market. The IRS may seek to deny Section 1256(g) with these brokers claiming the trades don’t meet the requirement of being in the Interbank market. Remember, retail spot forex is “off-exchange.” We need more interaction with forex industry players to fine-tune our arguments here, so contact us to discuss it.

The NFA recently published enforcement actions and fines against retail forex brokers Gain Capital and IKON, citing among other issues “slippage” in prices from using their software platforms. Read those actions to learn more about how regulators view the retail forex marketplace using software trading platforms.

Section 1256(g) requirements are specific
Forex brokers are offering retail transactions based on wholesale transactions and price references in the Interbank market. The IRS may argue that if a retail broker makes a “house market” in offsetting trades with retail customers and doesn’t transact significantly in the Interbank market, their trades aren’t true Interbank trades.

In 1986, the IRS added Section 1256(g) foreign currency contracts to Section 1256 and specifically only included “forward contracts.” Electronic trading in spot forex wasn’t possible in 1986, it only became prevalent after 2000.

There are three IRS requirements for inclusion in Section 1256(g):
1. The forward forex contract is traded in the Interbank market
2. The forex contract can be marked.
3. The delivery is based on the value of the foreign currency.

This last point was the reason forex OTC options were bounced out of Section 1256(g) in Revenue Ruling 2007-71.

In a variety of financial instruments, plenty of financial institutions and players act as market makers, and transactions are routed in all sorts of different ways. In our view, it’s unfair for the IRS to assert that retail forex in any form is not a true Interbank transaction. It’s designed, packaged and sold that way and clients and regulators hold brokers accountable for pricing that matches prices in the Interbank market. If it walks and quacks like a duck, it’s a duck.

Will the IRS assert that spot forex is a physical currency?
Before spot forex can enter coveted Section 1256(g), it first must get a ticket out of Section 988, ordinary gain or loss rules. The IRS will only allow a foreign currency transaction to opt-out of Section 988 if it’s a forex contract for future delivery like forwards. Spot settles in 24 or 48 hours and clients trade it electronically, starting with a spot trade and either exiting or rolling over the position before it settles in 24 or 48 hours.

The IRS expressed some difficulty getting its hands around the idea that spot isn’t a physical currency; when Section 988 was drafted that’s what they had in mind. Spot forex was the bulwark of global corporations to exchange currency. Traders may opt out of Section 988 into capital gain or loss, but only on forex contracts for futures delivery. Does that include spot forex? Yes, it may, according to IRS guidance, if the trader doesn’t take delivery of the currency but exits the position before it settles in 24 or 48 hours.

Spot forex is like a short-term forward
We think the IRS will agree that spot forex is like a short-term forward contract for future delivery. An electronic trader doesn’t buy a currency to take delivery of it. In fact, they aren’t permitted (or qualified with credit) to take delivery. The industry practice is to force exits of those positions before settlement or the transactions are rolled over automatically by the broker, with the current price and margin adjustment necessary to stay in that position.

The CFTC commissioner argued to Congress that spot forex is futures-like — making a similar point about spot being a short-term forward.

One leading broker told us his clients didn’t even realize spot trades had to be exited in 48 hours — they figured all trades would be rolled over by the broker automatically, which is generally the case. Brokers don’t treat spot forex rollovers as realized (closed) transactions; they defer the gain or loss to the final sale of the contract, only making price and margin adjustments with each rollover.

Summary points
Here’s what we’re facing with our current IRS discussions on spot forex tax treatment: Spot forex is truly a short-term forward so traders may opt-out of Section 988 with the capital gains election. That part may not be a big deal to the IRS, since it may prefer that clients be subject to net capital-loss limitations ($3,000 for individuals) than remain in default Section 988 with unlimited ordinary-loss treatment.

It’s going to be difficult to get the IRS to formally agree on opening the coveted door to lower 60/40 tax rates in section 1256(g). Leaving Section 988 means spot isn’t a physical currency and it’s like a short-term forward forex contract. If we can show the retail trade is in the Interbank market, we should meet that first of three requirements for Section 1256(g). In our view, spot forex meets the second requirement that it can be marked, and third requirement that delivery is based on the value of the foreign currency.

Will a “substantial authority” opinion letter help?
Another point to consider is whether or not to get a “substantial authority” opinion letter, otherwise known as a tax opinion letter from a firm like our Green & Company CPAs, LLC.

If you take the position that retail forex qualifies for 1256(g), and the court rules against you, you would be subject to a 20 percent substantial understatement penalty (plus interest on that penalty calculated from the date the tax return was due, plus any extensions) unless you prove there was “substantial authority” for your position. This penalty would be based on the amount of your tax underpayment attributed to this posture taken on retail forex.

The substantial authority standard is less stringent than a “more likely than not” standard (a greater than 50 percent likelihood of being upheld in litigation). A taxpayer doesn’t have substantial authority for a position if it’s “fairly unlikely to prevail in court upon a complete review of the facts and authorities.” The regulations state the weight of authority supporting the treatment of an item must be substantial “in relation to the weight of authorities supporting contrary positions.”

Tax return disclosure
There’s an alternative to getting a substantial authority opinion. You could disclose on your income tax return that it’s based on your belief that retail forex qualifies for 1256(g), and the IRS isn’t allowed to assess the 20 percent substantial understatement penalty. Some taxpayers think tax return disclosure in this manner is undesirable because they may be flagging the item for the IRS, and it may increase the chances of an exam. Therefore, it is important for you to hire a firm like our own experienced in how and when to provide this disclosure.

Rollover trades and rollover interest
Each day or two the spot trade ends and traders must sell or rollover the trade; they can't take delivery of the currency itself. So long as the trader has not finally terminated his position in the currency, some forex platforms do not report a gain or loss on the exchange rate appreciation or depreciation.

There can be large movements in the exchange rate and a large unrealized gain or loss deferred through year-end. These forex platforms provide a year-end statement which doesn’t report the unrealized (in their view) exchange rate gain or loss; they only report the interest-rate spread changes daily — otherwise referred to as “rollover interest.”

When electing into 1256g, MTM is required and no deferral is allowed at year-end on open rollover positions, including both interest and currency appreciation /deprecation. Traders need to get this missing MTM information from their brokers to report the correct realized and unrealized gain/loss to the IRS at year-end.

Our tax preparers aren’t going to be happy with some of these situations, especially when a client stays in Section 988 and doesn’t use MTM reporting.

On one side of a rollover transaction, the rollover interest is being summarized by many forex brokers on their year-end reports — purportedly useable for tax reporting —and on the other side, the deferred rollover price appreciation or depreciation is not being reported on year-end reports. Depending on the type of carry trade” that a trader makes, this inconsistent tax reporting treatment may help or hurt them. We are working more on this area and expect an update on it from us soon.

Bottom line
Until the IRS publishes specific guidance on modern spot forex trading tax treatment, there are plenty of grounds for differing interpretations and tax return postures. We believe our arguments support “substantial authority” tax return positions and that tax return disclosure is probably a good idea if you do it in the right manner. Our CPAs and tax attorneys can help, so contact us soon.

Note about our tax opinion service
We offer our tax opinion service to new clients too. You don't have to be a current tax preparation client to use our service. New clients should start with a 30 or 60 minute consultation with our tax attorney Mark Feldman to discuss their situation and to see if a tax opinion on forex tax treatment is appropriate.

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