Forex Tax Update
November 11, 2010
We’ve been working on a major update to our forex tax treatment research and content recapped here.
Don't get alarmed, our new conclusions confirm prior challenges on spot forex tax treatment and support our prior conclusions. We continue to believe retail spot forex contracts in major currencies may qualify for lower 60/40 tax rates in Section 1256g (foreign currency contracts), riding the coattails of interbank forward contracts — after making a valid opt-out election from Section 988 (foreign currency transactions). The new CFTC forex trading rules (covered on our blog) may help our case since the CFTC Chairman's "Gensler letter" implies the term "spot forex" is a misnomer since it's "futures-like."
We plan to offer forex traders revised "substantial authority" tax opinion letters to support their forex tax treatment. Several large forex traders asked for these opinion letters because they and their tax preparers want peace of mind on their tax filings and protection from potential tax penalties. Current rules require "substantial authority" which doesn’t mean it's a guarantee to win.
As pointed out on prior calls and blogs, some forex traders are considering currency futures since after the new CFTC forex rules the leverage is similar to retail spot forex, plus the lower 60/40 tax rates clearly apply to futures. Is U.S. forex trading safe? pointed out that the NFA recently fined some retail forex brokers for abusive practices on their software trading platforms. Why take a risk on spot forex tax treatment if you can trade currency futures instead? It's not that simple, of course, and there are many other factors to consider.
As we have indicated, spot forex isn't specifically mentioned by the IRS and court cases as being specifically allowed in Section 1256g; only forwards are mentioned, hence the risk in tax treatment. Recent court cases and Notice 2007-71 barred forex options from Section 1256g because they don't require settlement with the currency; the option holder could decide not to exercise. Forward forex contracts require settlement in physical currency and we argue that spot forex does too.
There's a lot at stake tax-wise. Remember, with lower Section 1256 60/40 tax rates, the maximum blended tax rate is 23 percent, a whopping 12 percent less than the current maximum ordinary tax rate of 35 percent. Forex traders are counting on GreenTraderTax to defend their 60/40 tax treatment on spot forex.
Foreign currency futures contracts on U.S. exchanges are reportable as Section 1256 contracts with lower 60/40 tax rates (60 percent are long term capital gains) and mark-to-market (MTM). Conversely, all forex (foreign exchange interbank) contracts are subject to Section 988 (foreign currency contracts) ordinary gain or loss treatment by default. Traders, but not manufacturers, may file an internal election on a contemporaneous basis to “opt out” of Section 988 into capital gains and loss treatment. This is called the “capital gains election.” With this election, forex forward contracts in major currencies are treated as Section 1256g capital gains and losses with the lower 60/40 tax treatment.
It’s important to note that Section 1256g only specifically mentions forex interbank forward contracts, for which regulated futures contracts exist too. In other words, it applies only for the major currencies, and excludes the minor currencies for which futures contracts don’t exist. The IRS considers Section 1256 an exclusive club and it doesn’t want to allow other types of financial products in, so it doesn’t open flood gates to 60/40 tax rates.
A case in point is forex options. Some forex traders tried to squeeze forex options into the definition of Section 1256g (foreign currency contracts). At first, the IRS accepted that in Notice 2003-81, but the IRS and Tax Court reversed that ruling in Notice 2007-71 and Summitt v. Comr. , 134 T.C. No. 12 (2010), barring forex options from Section 1256g.
The crucial point to understand is there are no cases or current IRS rulings stating whether “spot” forex is eligible for Section 1256g. While some tax professionals are taking a conservative position, our belief is that spot forex qualifies for Section 1256g if the taxpayer closes out the position. We are willing to provide a “substantial authority” tax opinion to traders, so if they are audited by the IRS, they will avoid paying penalties if a court decides against them.
Professional forex traders vs. online forex traders
There are key differences between professional forex traders and this newer breed of online forex traders. Professional forex traders often trade “forward contracts” (rather than spot forex) because forwards have more transparency and better pricing than spot.
Forward forex traders trade major currencies for which regulated futures contracts (RFCs) exist; therefore, after filing an internal capital gains election, they can use Section 1256g 60/40 tax treatment. Most professional forward forex traders make their living trading forwards and count on lower 60/40 tax rates each year — currently up to 12 percent lower tax rates (2010 rates). (More on Section 1256 below.)
Compare the professionals to the online forex trader. Most online forex traders are new to forex; some moved from the online securities or futures trading space. Many have very low account sizes ($2,500 to $25,000) and lack the capital, clout and connections to trade forwards in the (non-retail) interbank market.
Forwards settle in more than 48 hours and spot settles in less than 48 hours, usually overnight. Only larger professional traders can arrange the credit and clout to trade forwards, generally with high leverage. Smaller traders only have access to spot forex since it settles overnight and if they continue the trade they must roll it over. Margin is settled daily in this regard.
The online forex-trading marketplace didn’t pick up steam until the early 2000s. When the online securities trading revolution suffered a bear market in the 90s, brokers and traders stepped into the forex market. This became possible when larger banks democratized interbank market access with new retail software trading platforms. It was also a beneficiary of the Commodity Futures Modernization Act of 2000, where regulators agreed on turf.
The key difference: Online forex traders mostly trade spot contracts, whereas professional traders have access to lower-priced forward contracts. But are spot and forward forex contracts given the same tax treatment?
The Section 988 and Section 1256 conflict
Before we go any further, let’s identify the two alternatives for reporting forex trading income and losses. Section 988 has ordinary gain or loss treatment. Losing traders prefer Section 988 because it eliminates capital-loss limitations, allowing full ordinary loss treatment against any type of income. Section 1256 has lower 60/40 capital gains tax rates. Profitable traders prefer Section 1256 because it reduces their tax rates on trading gains. Section 1256 has a three-year carry-back feature, but only against 1256 gains in those years. Section 988 ordinary loss treatment can be a problem if the trader doesn’t have trader tax status (business treatment) and has negative tax income. In that case, the excess forex ordinary losses are wasted and can’t be included in capital loss or business net operating loss carry backs or forwards.
In 1982, Congress added “foreign currency contracts” to the Section 1256 definition (Section 1256g). Congress wanted to accommodate currency traders, putting forex (OTC interbank off-exchange markets) on par with RFCs — the original 1256 contracts (like currency futures).
Although forward contracts are mentioned in Section 1256g, they’re also mentioned in Section 988 and, therefore, they receive ordinary 988 treatment unless a trader makes a contemporaneous internal election to opt out of 988 for 1256.
Spot and forwards tax treatment
Some tax professionals treat spot contracts as part of Section 988 (with no ability to elect 1256), whereas other tax professionals — like Green & Company CPAs, LLC – think spot contracts in major currencies that also have regulated futures contracts may be treated like forwards with Section 1256g treatment.
Section 988 regulations state that if a trader doesn’t take or make delivery of the actual currency – and most traders don’t make or take delivery – then the spot contract can be treated like a forward contract. Traders don’t make or take delivery in non-functional currencies for the spot forex contracts they trade. Rather, they trade the contracts before settlement in the same way they trade forward forex. The only difference is spot settles in less than 48 hours and forward settles in more than 48 hours. These are some of the reasons for a “substantial authority” argument to treat forex spot in major currencies like forwards to elect into Section 1256g.
However, the IRS and the courts have not given any guidance as to whether spot contracts qualify for Section 1256g. In fact, the recent case of Summitt v. Comr. along with IRS Notice 2007-71 have caused some tax professionals to question whether spot contracts can so qualify. Summitt and Notice 2007-71 both held that OTC foreign currency call options do not qualify for Section 1256g because Section 1256g was aimed at forward contracts, not OTC options. Some tax professionals have the sense that the IRS is seeking to be stingy in expanding 1256g treatment to financial instruments which were not clearly mentioned in the Congressional Reports published at the time that Section 1256 was enacted.
A close reading of the Summitt case leads us to believe that Section 1256g does apply to spot contracts. The Summitt Court gave the following reason for its decision: As enacted in 1982, Section 1256g clearly referred to a contract which required delivery of the foreign currency, not to a contract in which delivery was left to the discretion of the holder (which is the case for an option, which is a unilateral contract that does not require delivery or settlement unless and until the option is exercised by the holder). It is also clear that the 1984 amendment to Section 1256g (“or the settlement of which depends on the value of”) was inserted to allow a cash-settled forward contract to come within the term “foreign currency contract”, but not to allow a new class of financial instruments (i.e., OTC options) into 1256g. Foreign currency contracts can be physically settled or cash settled, but they still must require, by their terms at inception, settlement at expiration.
It would seem that spot contracts qualify for Section 1256g under both the 1982 and 1984 definitions, as they aren’t unilateral contracts and do require delivery of the foreign currency or settlement at expiration.
Nevertheless, the issue isn’t free from doubt. The 1982 version of Section 1256g didn’t apply to spot contracts because it didn’t allow for cash settlement of a foreign currency contract. It could be argued that the 1984 amendment didn’t admit a new class of financial instruments — spot contracts — into Section 1256g, just as it didn’t admit OTC options.
A senior IRS official involved in the Summitt case has told us he believes spot contracts do qualify for 1256g, but he was not speaking on behalf of the IRS as an organization.
Suggestions for how to proceed
Traders should consult a forex tax expert. GreenTraderTax (Green & Company CPAs, LLC) provides consultation and tax preparation services. Our tax attorneys provide tax opinions when needed. Our Web site (www.greentradertax.com) is for educational purposes only. We are not responsible for any positions you extrapolate and take on your own.
We have not seen the IRS disallow forex tax treatment based on our positions to date; however, it’s difficult to know how the IRS will react in the future. Its possible one IRS agent will deny ordinary loss treatment for forex trading losses whereas another will deny lower 60/40 tax rates on forex trading gains.
We believe a “substantial authority” position (which is weaker than a “more likely than not” position) supports treating spot the same as forwards, provided the spot is in a major currency that also has a RFC. It’s wise to receive a substantial authority tax opinion to claim Section 1256 60/40 lower tax rates on spot trading gains. The Internal Revenue Code allows relying upon substantial authority to avoid penalties.
We have several other arguments supporting our case beyond the scope of this content.
CFTC calls “spot” forex a misnomer
Recent developments from the CFTC and NFA for the retail forex marketplace — calling for less leverage among other things — shed some light on these open tax questions. We believe the CFTC’s recent findings may help our case for treating spot forex like forwards forex for purposes of fitting into Section 1256g after a duly filed opt-out election from Section 988.
Financial market regulators and their rules are different from the IRS and their tax rules. The IRS may not respect these additional arguments, since regulations don’t necessarily set precedent for tax purposes.
In forging their new 2010 rules for the forex marketplace, the CFTC and NFA studied the retail “spot” forex marketplace, and they came up with some findings that shed light on the question of what truly is spot forex, and how it differs from forwards.
In his well-known “Gensler-Letter” in 2009, CFTC Chairman Gary Gensler asked Congress for more authority to regulate the retail spot forex marketplace. Chairman Gensler argued that retail spot forex trading platforms were successfully evading CFTC regulation by mislabeling their trading platforms as “spot forex” transactions; he thought they were more appropriately “futures-like” and therefore under the CFTC umbrella of regulation. To that point in 2009, futures were clearly regulated by the CFTC and NFA. For further info on forex regulations and the history, see our blog articles on this subject.
Think about how a trader speculates for profit in the retail spot forex trading marketplace. Most don’t have the capital, credit and connections to open a forward trading account for trades that can be open for 48 hours or longer — the longer the period, the more the risk and the more credit comes into question. The retail spot forex trading platforms were created in 2000 just as traders searched for ways to play the forex market and retail brokers looked for ways to offer forex opportunities to their customers.
Traders buy the Euro on a given day and that spot contract settles in less than 48 hours. What does this mean? It means the trader pays for the Euros with a market (software platform) price on a given second and they need to trade the contract away before it settles the next day, as most traders are unable and unqualified to take delivery. The trader puts up $1 out of 100 to buy the Euro (100:1 leverage). After the new CFTC forex rules, this changes to $1 in 50 (50:1 leverage on major currencies). These traders don’t have enough money for the rest of the leverage, so they can’t pay up for delivery. If the trader wants to continue the trade, they roll it over, meaning they execute another similar trade the next day.
The important point is that spot forex traders are doing the same speculative forward-looking trading as forward forex traders or currency futures traders. Since they can’t buy forex forwards, they buy spot forex and roll the positions over daily, simulating forwards trading.
If the trader bought and took delivery on the currency spot, they would hold physical currency and then they could not opt out of Section 988. There’s a risk the IRS could say spot forex simulates holding the physical currency itself and therefore no opt out is allowed at all, as is the case with physical currency. But that can’t happen because the IRS specifically wrote in Section 988 traders could opt-out of Section 988 on spot forex when they don’t take or make delivery — which is the case for spot forex traders. Therefore, if the capital gains election is allowed, spot should be allowed in Section 1256g too.
Here’s another confusing point about spot and trade vs. settlement dates. Trades in forex or securities trade on one day and may settle for delivery on a later day. Spot traders are sort of taking advantage of the time frame before trade and settlement date.
This type of retail spot forex trading didn’t exist until after 2000, well after Section 1256g was created and amended by the IRS in 1982 and 1984, respectively. The fact that this type of spot trading wasn’t listed specifically for inclusion in Section 1256g doesn’t mean it was purposely omitted. Rather, it was left out because it didn’t exist at the time.
The IRS may act very technically on all this and say spot is left out of Section 1256g. Our substantial authority opinion should help in a given Tax Court case and protect against tax penalties. We aren’t saying these positions will be won in the end. We think theory and reality is on our side and we should prevail on these positions. Plus, the IRS people we spoke with seem to agree. But, until it’s in writing formally from the IRS, it’s a risk.
If you don’t want any part of this uncertainty, trade currency futures instead.
For more, listen to our Nov. 11 podcast.
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.
Posted 2 years, 9 months ago on November 11, 2010
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