Foreign currency straddles and transactions present complex tax issues.

• Author: Knight, Ray A.

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PREVIEW

* Foreign currency straddles can carry hidden and complex tax issues involving timing and character of gains and losses.

* A number of Code sections must be considered in determining the correct tax treatment of foreign currency straddles.

* An example of a foreign currency straddle that might be used in an arbitrage trading strategy is analyzed. The U.S. dollar has risen in recent years against many other currencies. This in turn has squeezed the overseas profits of, and otherwise created negative foreign currency exposure for, U.S.-based multinationals, while providing a lucrative playing field for foreign currency trading specialists.

Hedging strategies and derivatives may be used to manage foreign currency exposure. One such strategy is foreign currency straddles, which, however, may carry hidden tax issues. Under the Internal Revenue Code, straddles are not viewed per se as a tax-avoidance strategy but rather as investments that can be entered into with the intent to earn profits as part of legitimate business transactions. Because of the potential for abusive transactions, however, Congress has enacted specific rules governing the tax consequences of entering into straddles. These provisions (Sec. 1092) govern certain aspects of the timing and character of income or loss recognized through straddle transactions. Foreign currency transactions raise complex tax issues that taxpayers must address to withstand an IRS challenge. With a focus on a foreign currency straddle transaction example, this article discusses the scope and application of Secs. 1092,1256, and 988.

Not all straddles are designed to shield investors from economic consequences. In fact, an investor can construct a straddle that will yield a profit if the investor has correctly predicted future price movements. For example, a commodity futures straddle may involve simultaneously holding a long position in a commodity for one delivery month and a short position in the same commodity for a different month. The "spread" refers to the difference in price between the commodity futures contracts for the two delivery months. How the spread widens or narrows affects the profit or loss of a commodity futures straddle. Whether the spread widens or narrows depends on the relative movements of the prices between the two delivery months of the straddle.

Several factors can affect the movement of the spread. A significant factor that affects the amount of the spread between delivery months is the estimated carrying charges, or the costs associated with taking delivery of a commodity in the nearby month and holding it until the distant month. Other factors in the commodities futures markets that affect the movement of a spread include economic conditions, expectations of the size of a pending crop, weather conditions, political factors, demand, and merchandising considerations. These factors can cause a spread to be wider or narrower than the amount of the estimated carrying charges. (1)

Investors also can use straddle transactions as part of a larger trading strategy. For example, an arbitrage is the simultaneous purchase in one market and sale in another with the expectation of making a profit on price differences in the different markets. An arbitrage of a U.S. Treasury bond (T-bond) straddle against a straddle involving bonds of the Government National Mortgage Association, or Ginny Mae, involves the purchase of Ginny Mae contracts and simultaneous sale of T-bond contracts for settlement on the same date, entered into simultaneously with the sale of Ginny Mae contracts and purchase of T-bond contracts for settlement a given number of months later. Fluctuations in the spreads between these two markets will result in a net gain or loss in the entire position. (2) Because a loss on one leg of a straddle is accompanied by a gain on the other leg, a straddle has less risk than an individual, or open, position. Similarly, a balanced straddle has less risk than an unbalanced straddle. Due to the differences in risk, the margin requirements for straddles are frequently less than those for open positions.

Arbitrage Trading Strategies in Foreign Currencies

Every taxpayer and virtually every separate business enterprise will be regarded as operating in a principal currency, called the "functional currency." Sec. 985(b)(1)(A) states the general rule that the functional currency for tax purposes will be the dollar. The special rules in Secs. 985-989 provide rules for dealing with various circumstances in which a taxpayer or business enterprise acquires or uses currencies other than the functional currency in some way. The rules provide methods for determining when a taxpayer will recognize gains and losses with respect to nonfunctional currencies for tax purposes and for determining the character and source of any such gains and losses.

Arbitrage trading strategies typically call for the purchase and sale of very large notional amount derivative contracts where the risk of loss is reduced (but not eliminated) by entering into positions in a manner that substantially reduces outright foreign exchange risks. Such positions generally are referred to in the financial markets as straddles. A foreign currency...