Garcia, TC Memo 2011-85
The Tax Court has held in a summary judgment motion that over-the-counter foreign currency options entered into by a limited liability company (LLC) owned by a taxpayer did not qualify as Code Sec. 1256 foreign currency contracts.
Background. Special tax rules apply to investments in Code Sec. 1256 contracts. Taxpayers must report their gains and losses resulting from trading in Code Sec. 1256 contracts under the mark-to-market rule. Under this rule, each Code Sec. 1256 contract that is held at the close of the tax year is treated as if it were sold for its fair market value on the last business day of the tax year. Any capital gain or loss on a Code Sec. 1256 futures contract that is marked-to-market is treated as if 40% of the gain or loss is short-term capital gain or loss, and as if 60% of the gain or loss is long-term capital gain or loss.
A Code Sec. 1256 contract is any regulated futures contract, foreign currency contract, non-equity option or dealer equity option. (Code Sec. 1256(b)(1)) A Code Sec. 1256 contract doesn't include any securities futures contract, or option on a securities futures contract, unless the contract or option is a dealer securities futures contract. (Code Sec. 1256(b)(2)(A))
For tax years beginning after July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203, 7/21/2010) excludes from the definition of a Code Sec. 1256 contract any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement. (Code Sec. 1256(b)(2)(B))
Under Code Sec. 1256(g)(2)(A), a foreign currency contract is defined as a contract:
... which requires delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts;
... which is traded in the interbank market; and
... which is entered into at arm's length at a price determined by reference to the price in the interbank market.
The issue. The issue before the court was the treatment of “major/minor” foreign currency option transactions. A major foreign currency is a currency in which positions are traded through regulated futures contracts. Minor currency options relate to currencies that are not traded through regulated futures contracts. In a typical major/minor transaction, a taxpayer assigns a major foreign currency long option that has loss potential to a charity. The charity also assumes the obligations with respect to minor foreign currency options. The taxpayer takes the position that the major foreign currency long option assigned to the charity is a Code Sec. 1256 foreign currency contract and marks to market the major foreign currency long option when the option is assigned, thereby recognizing a loss. The taxpayer claims that the charity's assumption of the minor option obligation doesn't cause the taxpayer to recognize gain because the assigned minor foreign currency option isn't a Code Sec. 1256 foreign currency contract. Further, the taxpayer does not recognize gain when the option either expires or terminates.
Facts. Ricardo Garcia owned 100% of a LLC that was treated as a disregarded entity for federal income tax purposes. In December of 2002, the LLC sold eight foreign currency options to Global Advisors V LLC and purchased eight offsetting foreign currency options from Global Advisors. The purchase and sale price were both $21,449,177. The net premium paid by the LLC for the transaction was $30,000 and the maturity date for each option was Dec. 27, 2002. None of the options were securities traded on a qualified board or exchange as defined by Code Sec. 1256(g)(7). Some of these options were pegged to the European euro (euro) and the U.S. dollar (i.e., they were major foreign currency options), and some were pegged to the Danish krone (i.e., they were minor foreign currency options). Some of the foreign currency options also had barrier features.
Under a barrier feature the option could be exercised if the option reaches, or fails to reach, a specified price. “Knock-in” options are not exercisable unless the barrier price is reached before the expiration of the option. “Knock-out” options are exercisable only if the barrier price is not reached before the expiration of the option.
On Dec. 20, 2002, the LLC assigned some long positions and short positions to the Holy Innocents Building Fund (Building Fund), an organization claiming Code Sec. 170(c)(2) charitable status. The Building Fund assumed obligations with respect to the two short positions totaling $5,691,561 and received three long positions valued in the aggregate at $5,694,561, providing for a net value of the positions assigned to the Building Fund of $3,000.
Garcia, as sole member of the LLC, reported a loss of $3 million with respect to the long/major position assigned to the Building Fund. However, Garcia also took the position that because the long positions in minor foreign currency options (denominated in the Danish krone) weren't subject to the Code Sec. 1256 mark-to-market rules, they were not reportable on his income tax return.
IRS issued a notice of deficiency in 2006, disallowing the flow-through loss from the LLC's foreign currency option transactions.
In Summitt, (2010) 134 TC No. 12, the Tax Court held that an S corporation didn't recognize a loss under the Code Sec. 1256 mark-to-market rules on its assignment of a major foreign currency call option to a charity. The foreign currency call option wasn't a foreign currency contract as defined in Code Sec. 1256(b)(2) and Code Sec. 1256(g)(2). But, the Court didn't rule on the income tax treatment of the assignment of the minor foreign currency call option to the charity because there were genuine issues of material fact that required a trial to resolve.
Tax Court's conclusion. Relying on its decision in Summit, the Tax Court concluded that the foreign currency options that Garcia entered into did not fall within the meaning of a foreign currency contract under Code Sec. 1256(g)(2).
The Court found that the foreign currency options were economically distinguishable from contracts covered by Code Sec. 1256. As in Summit, the Court reasoned that a foreign currency option was a unilateral contract that didn't require delivery or settlement unless and until the option was exercised by the holder. An obligation to settle might never arise if the holder did not exercise its rights under the option. The Tax Court stated that it was clear that, as originally enacted in’82, Code Sec. 1256 applied only to forward contracts. Code Sec. 1256 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.
The Tax Court found that the only factual difference between the options in Summit and those in Garcia's case was the barrier feature in the latter. The Court found that this did not change the fact that the derivative was an option.
The Tax Court noted that Garcia's position on his return was backed by a legal tax opinion that he had received. That opinion concluded that: (1) major foreign currency options were subject to the Code Sec. 1256 mark-to-market rules; (2) the assignment of a major foreign currency option to a charity triggers a termination under Code Sec. 1256 and Greene v. U.S. (CA 2 1996), 77 AFTR 2d 96-1588; and (3) the taxpayers had to recognize gains and losses with respect to any major foreign currency option assigned to a charity. However, the Tax Court further noted that unlike in Garcia's situation, Greene dealt with transfers of regulated futures contracts to a charity, and regulated futures contracts are Code Sec. 1256 contracts under Code Sec. 1256(b)(1) and Code Sec. 1256(g)(1).
References: For Code Sec. 1256 foreign currency contract, see FTC 2d/FIN ¶I-7611; United States Tax Reporter ¶12,564.01; TaxDesk ¶228,704; TG ¶10287.