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In Wright v. Commissioner, No. 15-1071 (6th Cir. Jan. 7, 2016), the US Court of Appeals for the Sixth Circuit has reversed the Tax Court and held that an over-the-counter (OTC) euro foreign currency option is subject to the mark-to-market rules of Section 1256, based upon the plain language of the statute. This holding contradicts prior Tax Court decisions and IRS guidance and may enable or require certain taxpayers to mark OTC options over major foreign currencies to market under Section 1256.

Background

In December 2002, through a wholly owned partnership, the Wrights entered into a "major-minor foreign currency option transaction" whereby they purchased mirror-image euro put and call options and simultaneously sold mirror-image Danish krone put and call options. (The euro is a "major" foreign currency because there are actively traded regulated futures contracts in the euro. The Danish krone reportedly was a "minor" foreign currency because there were no actively traded regulated futures contracts in the krone at that time.) The values of the euro and krone moved together. The partnership subsequently assigned the depreciated euro put option and the appreciated krone put option to a charity.

On their 2002 income tax returns, the Wrights contended that they need not recognize the gain from the assignment of the krone put option to the charity, because OTC foreign currency options on minor foreign currencies are not Section 1256 contracts to which mark-to-market accounting applies. They contended, however, that it was proper to recognize loss on the assignment of the euro put option because an OTC foreign currency option on a major currency is a foreign currency contract subject to Section 1256, and such contract must be marked immediately prior to the disposition of the contract.

The IRS disallowed the claimed loss, asserting that the Wrights could not claim a loss on the euro put option assignment because the OTC currency options are not "foreign currency contracts" within the scope of Section 1256.¹ The Tax Court agreed with the IRS that the euro put option was not a foreign currency contract under Section 1256 and therefore not subject to mark-to-market accounting. The Tax Court cited Summitt v. Commissioner, 134 T.C. 248 (2010), and Garcia v. Commissioner, T.C. Memo 2011-85, two recent cases in which the Tax Court had held that a major foreign currency OTC option was not subject to Section 1256, and noted that the Wrights did not attempt to distinguish their facts from those cases (see Tax Alert 2011-697).

Sixth Circuit decision

The Sixth Circuit reversed the Tax Court's holding and remanded the case for further proceedings. The Sixth Circuit concluded that, while the Tax Court's reasoning was supported by sound tax policy, it conflicted with the plain language of Section 1256.

Section 1256(g)(2) provides, in part, that a "foreign currency contract" is 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" [emphasis added]. The Sixth Circuit concluded that the use of the word "or" between the "delivery" and "settlement" phrases indicates that these phrases describe two independent ways by which a contract may qualify as a "foreign currency contract." Therefore, a contract "the settlement of which depends" on the value of a major foreign currency is a "foreign currency contract," even if that contract is an option that does not mandate that any settlement occur.

The legislative history to Section 1256(g)(2)(A)(i) indicates that Congress added the settlement prong in 1984 only to allow for cash settlement of forward contracts. The concern was that forward contracts that could be cash settled, rather than settled only through delivery of the underlying currency, would not otherwise fall within Section 1256. The Sixth Circuit dismissed the Commissioner's reliance on this legislative history, however, on the basis that the plain language of Section 1256 is clear and that the Wrights' euro put option met the "settlement" prong of Section 1256(g)(2)(A)(i). The Sixth Circuit added that the fact that tax policy may support disallowing the claimed loss is not sufficient for the court to reform the plain language of the statute. The Sixth Circuit acknowledged that its interpretation of Section 1256 allows the Wrights to engineer a large tax loss with minimal economic outlay or risk, but noted that the economic substance doctrine may apply to disallow the claimed losses. The Sixth Circuit also noted that the IRS could issue regulations reversing its result.

The Wright decision is somewhat surprising because it conflicts with prior Tax Court decisions, IRS guidance and the legislative history to Section 1256. In light of this conflict, the IRS may petition for an en banc review.

Implications

Prior to this decision, many practitioners believed that OTC foreign currency options likely were not subject to Section 1256, and therefore generally need not be marked to market. Pending further judicial action, the Wright decision indicates that, for taxpayers in the Sixth Circuit, major foreign currency options are subject to Section 1256. For taxpayers who have taken the opposite position, however, an accounting method change may be needed to accomplish this, and it is unclear that the IRS would be willing to grant such change.

Taxpayers in the Sixth Circuit should also be aware that if, they were willing to pay any tax deficiency and sue for a refund in the Court of Federal Claims, the Wright decision would not be binding authority in that Court.² Outside the Sixth Circuit, taxpayers should be aware of the position that OTC major foreign currency options might have to be marked to market under Section 1256 although, here again, method change issues need to be considered.

The Sixth Circuit's decision will generally not affect the character of an FX option, which would be determined under Section 988 and would generally be ordinary unless Section 988(a)(1)(B) applies. Moreover, the Sixth Circuit's decision should not cause a foreign currency swap on a major currency to be subject to mark-to-market accounting because Section 1256(b)(2)(B) explicitly provides that such contracts are not Section 1256 contracts, at least for tax years beginning after July 21, 2010. Practitioners also should consider whether treating FX options as Section 1256 contracts might create or enlarge a mixed straddle.

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ENDNOTES

¹ None of the other categories of contracts subject to Section 1256 would apply to an OTC foreign currency option.

² Appeal from a decision of the Court of Federal Claims would lie to the United States Court of Appeal for the Federal Circuit, where a decision of the Sixth Circuit would be persuasive, but not binding precedent.