Sixth Circuit Finds OTC Option on Major Currency is a §1256 Contract

In the case of Wright v. Commissioner, 117 AFTR 2d ¶ 2016-319 the Sixth Circuit Court of Appeals reversed the holding of the Tax Court holding that an over the counter foreign currency option in a major currency is not a §1256 contract (TC Memo 2011-292).

The issue was of import because if it wasn’t, then the taxpayer would not be allowedloss created by a major-minor tax shelter.  The shelter involved two pair of options that were designed to offset each other, but due to the requirement that §1256 options be marked to market, the taxpayer recognizes the loss inherent in that loss (which is a major currency OTC option) but not the gain inherent on the offsetting option (the minor option).

As the Tax Court described the transaction in the original opinion:

The major-minor tax shelter was designed to manipulate the mark-to-market rules as follows. Notice 2007-71, 2007-2 C.B. 472-73. See, e.g., [ Summitt v. Commissioner, 134 T.C. 248, 249-54 (2010)]. The taxpayer arranges with a counterparty for four OTC options. The taxpayer buys from the counterparty a euro call and a euro put on mirror-image terms. The taxpayer also sells to the counterparty a krone call and a krone put on mirror-image terms. The premiums paid to and received from the counterparty mostly offset each other. Because the call and put for each currency are mirror images of each other, one will rise while the other will fall. Because the krone is closely tied to the euro, both calls should largely offset each other, as should both puts.

The taxpayer and the counterparty then retain their premiums, but the taxpayer assigns to a charity his rights and obligations under the depreciated euro option and the appreciated (and offsetting) krone option (i.e., the charity receives both calls or both puts). The taxpayer asserts that the assignment of the losing euro option is a recognition event under § 1256(c)(1), and he invokes the mark-to-market rules to claim a loss. See Greene v. United States, 79 F.3d 1348, 1353-58 (2d Cir. 1996) (donation of regulated futures contract to charity is a recognition event). Because [the taxpayer takes the position that] the krone option is not a § 1256 contract, the taxpayer recognizes gain, if ever, when his obligation to perform is terminated by the closing or lapse of the option. The taxpayer and the counterparty then terminate the unassigned options so that the gain on one offsets the loss on the other. If the taxpayer's reading of § 1256 is correct, he receives a large tax loss with minimal economic risk or out-of-pocket expense. Moreover, because the options are offsetting and can be settled in dollars, the nominal amounts of foreign currency can be set well beyond the means of the parties, so as to generate the tax loss desired by the taxpayer.

A major currency OTC option exists if the currency in question is also traded through regulated futures contracts (which the euro is), while a minor currency is one which is not traded through regulated futures contracts (which is true of the krone).  The major market option would arguably fall under the rules since it effectively “duplicates” the regulated contract (and thus would provide a way to skirt the rules meant to capture such transactions).

So the question becomes—was the taxpayer’s view of what is and is not a §1256 contract correct.

The key issue is what is meant by the clause found at IRC §1256(g)(2)(A) that defines a type of §1256 contract known as a “foreign currency contract.”  The law provides:

(A) Foreign currency contract. -- The term “foreign currency contract” means a contract --

(i) 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,

The real question arose regarding the “settlement of” clause.

The Tax Court had held that a contract could not meet this clause unless it required a settlement in cash, not simply allowed for such to take place.

As the Sixth Circuit opinion notes:

It is true that "[a]n obligation to settle [the Wrights' euro put option] may never arise if the holder does not exercise its rights under the option" because a "foreign currency option is a unilateral contract that does not require delivery or settlement unless and until the option is exercised by the holder." Summitt, 134 T.C. at 264. Thus, whether a foreign currency option such as the Wrights' euro put option is exercised and at what date exercise occurs will not necessarily depend on the value of the foreign currency in which the option is denominated because the holder of the option could decide whether to settle the option for reasons that are unrelated to the value of the foreign currency.

The Court also admits that reading the provision the way the taxpayers do advances no conceivable tax policy objective, noting:

We see no conceivable tax policy that supports this interpretation of the plain language of § 1256, and none has been suggested to us by the parties. To the contrary, this interpretation of § 1256 seems to allow the Wrights to engineer a desired tax loss by paying only a minimal cash outlay and by engaging in major-minor transactions that subject the Wrights to little actual economic risk. Although these transactions involve large sums of dollars, euros, and krones, these transactions appear to have subjected the Wrights to little actual economic risk because the four options in the major-minor transactions offset each other. Further, when the premium payments are netted against each other, the transactions subjected the Wrights to a short-term capital loss of only $25,200. Accordingly, the Wrights were able to pay $50,200 out of pocket -- based upon the Wrights' short-term capital loss of $25,200 and payment of $25,000 to a tax attorney for a tax opinion -- in order to reduce their taxes by at least the $603,093 deficiency upheld by the Tax Court. Moreover, the Wrights did not plausibly explain how engaging in transactions involving transfers of offsetting foreign currency options that opened and closed over the course of three days could accomplish the Wrights' stated goals of investment diversification and realization of a significant economic return. Accordingly, the Wrights appear to have engaged in the major-minor transactions primarily to generate the desired tax loss.

The panel finds, nevertheless, that the actual language in the statute passed by Congress can only be interpreted in the way the Wrights do.  The Court notes:

The Wrights' euro put option meets the "settlement" prong of § 1256(g)(2)(A)(i) because the Wrights' euro put option is a contract the settlement of which depends on the value of a foreign currency. The Wrights' euro put option is a "contract" because an option is "a promise which meets the requirements for the formation of a contract and limits the promisor's power to revoke an offer." Restatement (Second) of Contracts § 25 (1981). …any settlement of such an option that does occur will necessarily depend on the value of the foreign currency in which the option is denominated because if the option is exercised, the amount the seller of the foreign currency must pay the buyer will depend on the value of that foreign currency at the time the option is exercised. Accordingly, the Wrights' euro put option meets the "settlement" prong of § 1256(g)(2)(A)(i) because the Wrights' euro put option is a contract "the settlement of which depends on the value of" the euro, which is a foreign "currency in which positions are also traded through regulated futures contracts."

While this might not have been Congress’s intent, the Court finds that with clear language Congressional intent doesn’t come into play:

Because the plain language of § 1256 clearly provides that the Wrights' euro put option meets the "settlement" prong of § 1256(g)(2)(A)(i), we need not resort to legislative history to interpret § 1256. The Tax Court concluded that a foreign currency option does not fall within the meaning of a "foreign currency contract" in part because the Tax Court determined that Congress added the "settlement" prong to § 1256 in order to allow cash-settled forward contracts to come within the definition of "foreign currency contract" only if these cash-settled forward contracts required, "by their terms at inception, settlement at expiration." Wright, 2011 WL 6440420 at *3 (citing Summitt, 134 T.C. at 264-65). Similarly, the Commissioner contends that Congress added the settlement prong to the definition of a "foreign currency contract" not to remove "the delivery of a foreign currency requirement" but to allow "that requirement to be met with a cash settlement." However this may be, the plain language of § 1256, as stated above, clearly establishes that the Wrights' euro put option meets the "settlement" prong of § 1256(g)(2)(A)(i).

But it should be made clear that the panel doesn’t conclude that the transaction actually will generate a tax benefit, specifically noting that the IRS has other ways to attack the transaction.

Congress provided two escape hatches to guard against the type of adverse tax policy outcome at issue here. In particular, Congress allows the Secretary of the Treasury to prescribe regulations to exclude any type of contract from the "foreign currency contract" definition if the inclusion of this type of contract would be "inconsistent" with the purposes of § 1256. I.R.C. § 1256(g)(2)(B). The Secretary therefore could prevent future taxpayers from relying on § 1256 to mark to market foreign currency options by issuing a regulation that excludes foreign currency options from the definition of a "foreign currency contract." Further, Congress also allows the Commissioner to prevent taxpayers from claiming tax losses based upon transactions involving offsetting foreign currency options by challenging specific transactions under the economic substance doctrine, as lacking in economic substance. See I.R.C. § 7701(o) (providing that a transaction shall be treated as having economic substance only if "the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position" and "the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction").

In a footnote, the Court does note that “We do not address specifically, however, the applicability of these provisions to the Wrights' transactions.”  But clearly it would seem that, given the Court’s view that the transaction was entered into solely for the tax benefit and the taxpayers faced no real risk of economic loss, there’s a significant risk the IRS would prevail by challenging such a transaction under the economic substance provision.

Advisers should also note that that the Tax Court has ruled against this transaction in multiple cases and that the Sixth Circuit’s view of this issue might not be adopted should the taxpayer’s appeal end up being heard by another Circuit.  As well, if the Sixth Circuit view is upheld by other Circuits, the opinion tells the IRS how to shut down the shelter by regulation even if for some reason the economic substance challenge was not found to be effective.