Are OTC major foreign currency options now subject to sec. 1256?

• Author: Fu, Kenneth
• Position: Over-the-counter

Before the Sixth Circuit issued its decision in Wright, 809 F.3d 877 (6th Cir. 2016), on Jan. 7, few tax practitioners would have suggested that over-the-counter (OTC) foreign currency options on "major" currencies should be accorded Sec. 1256 treatment as "foreign currency contracts."

Sec. 1256(g)(2)(A)(i) defines a foreign currency contract in part 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." Wright brought a fresh perspective on the subject, particularly via a renewed focus on contract settlement as it relates to this definition.

Previous case law stipulated that OTC currency options are not foreign currency contracts, generally interpreting the definition above to require actual settlement of the contract. Since settlement is not required with options, a foreign currency option would therefore not meet the definition of a foreign currency contract. Prior cases (Summitt, 134 T.C. 248 (2010), and Garcia, T.C. Memo. 2011-85) support the assertion that a major foreign currency OTC option is not a foreign currency contract. Furthermore, many regard the language in the statute as intended to apply to forward contracts that require actual delivery of foreign currencies. Notably, the clause "or the settlement of which depends on the value of" was added by Congress in 1984 merely to allow cash-settled forward contracts to still qualify as foreign currency contracts under Sec. 1256, not to broaden the definition to include any contract simply on the basis of its relation to foreign currencies. Finally, Notice 2007-71 clarified that purchased foreign currency options are not foreign currency contracts.

Wright Case

In 2002, Terry and Cheryl Wright entered into a series of options transactions involving major and minor currencies through their partnership interests in Cyber Advice LLC. The IRS identified this type of arrangement in Notice 2003-81 as a fisted transaction subject to Sec. 6011 disclosure requirements, Sec. 6111 tax shelter registration requirements, and Sec. 6112 list maintenance requirements. The Wrights purchased substantially offsetting put and call options on the euro (a major currency under Sec. 1256) and also wrote offsetting put and call options on the krone (a minor currency), which had a strong positive correlation with the euro.

Purchased put and call options give...