In Notice 2026-62 (Notice), the Treasury Department and IRS identify several derivative strategies that are used by so-called tax-aware investment managers and may potentially be abusive transactions, as they generate capital gain and ordinary loss through selective terminations, elections or identifications.

The Notice separately identifies and seeks comments on several investment fund strategies involving exchange-traded funds that are regulated investment companies for tax purposes. Treasury and the IRS believe these strategies produce results inconsistent with the purpose and proper application of IRC Section 852(b)(6). (A Tax Alert on these investment strategies is forthcoming.)

Overview

The Notice identifies transactions in which "tax-aware" funds or managed investment accounts engage. The transactions use multi-position strategies that seek to generate capital gain and ordinary loss in equivalent amounts from economically offsetting transactions or allow taxpayers to effectively elect their character. According to the Notice, these strategies may use taxpayer elections in ways that are inconsistent with their purpose.

The Notice acknowledges that taxpayers may use long-standing, well-established techniques to reduce federal income tax liability in a manner consistent with congressional intent and specifies that these strategies are inconsistent with the purpose of the Code sections under which the unbalanced results are generated.

Possible responses to these strategies include regulations, notices, revenue rulings, and the possible designation of a transaction as a transaction of interest or listed transaction. However, the Notice itself does not designate any transaction as a listed transaction or transaction of interest but requests information and comments while Treasury and the IRS consider further guidance or other action.

Mixed-character identified straddles

The first strategy identified involves pairing a foreign-currency forward contract producing ordinary income or loss under IRC Section 988 with an offsetting regulated futures contract that is in the same currency and produces capital gain or loss under IRC Section 1256. The fund is therefore taking economically offsetting long and short positions in the same foreign currency and identifies the contracts as an identified straddle under IRC Section 1092(a)(2).

Regardless of which position has appreciated, the fund terminates the futures contract first. If the futures contract is in a gain position, the fund reports IRC Section 1256 capital gain (i.e., reports 60% of the gain as long-term capital gain and 40% of the gain as short-term capital gain) and subsequently reports a corresponding ordinary loss under IRC Section 988 when the forward contract settles. If the futures contract is in a loss position, the fund capitalizes that loss into the basis of the forward contract under the identified-straddle rules of IRC Section 1092(a)(2). The basis adjustment thus reduces the ordinary income, or may produce an ordinary loss, when the forward contract settles. Through this sequencing, the fund takes the position that favorable capital gain and ordinary loss can result when the futures position appreciates, while only a relatively small amount of net ordinary income or loss results when the futures position declines.

The Notice also describes a similar strategy involving an equity-index notional principal contract and an offsetting futures contract on the same equity index. Treasury and the IRS describe these arrangements as using a timing rule intended to address selective loss recognition to produce inconsistent character from economically offsetting positions.

The Notice excludes from its discussion straddles that produce consistent character and holding-period results regardless of whether a position has gain or loss.

Same-day foreign-currency forward transactions

This second strategy involves foreign-currency forward contracts that expire or are disposed of or terminated on the same day that taxpayers enter into them. After completing its trading for the day, but before the end of the day (as required by IRC Section 988(a)(1)(B) and its regulations), the fund determines which contracts generated gains and elects capital treatment under IRC Section 988(a)(1)(B) only for those contracts. The fund does not make the election for contracts generating losses, allowing the losses to retain their default ordinary character.

Because the contracts have already terminated or otherwise produced a known result by the time the election is made, the fund has the benefit of hindsight when deciding whether the election is advantageous. Economically identical instruments consequently receive different tax characteristics depending on whether they generated gain or loss. The strategy purports to deliver capital gains and ordinary losses to investors, with the ordinary losses potentially available to offset unrelated ordinary income.

The Notice explains that the election was intended to allow taxpayers trading foreign currency through regulated futures contracts and forward contracts to obtain consistent capital gains treatment for gains and losses from the two types of instruments. Treasury and the IRS view the selective election practices described in the Notice as contrary to this purpose.

Selective termination of notional principal contracts

The third strategy involves a fund that qualifies as a trader for federal income tax purposes but has not made an IRC Section 475(f) election. The fund enters into multiple long and short notional principal contracts, referencing different assets or indices. The contracts are generally short-term and, in some cases, may have terms as short as one week; none is part of a straddle under IRC Section 1092. They include one or more periodic or nonperiodic payments contingent on the performance of an underlying asset, such as stock.

The fund does not accrue amounts relating to the contingent payments before payment is made on the contract, or the contract is disposed of or matures, instead taking the position that contingent amounts produce ordinary income or expense when received or paid.

When a contract appreciates, the fund terminates or disposes of it shortly before a scheduled payment date and receives a termination payment from the counterparty. Although the payment may be economically attributable primarily to appreciation in the underlying equity, which also would have determined the scheduled payment, the fund characterizes the entire amount as a termination payment under Treas. Reg. Section 1.446-3(h), and as capital gain under IRC Section 1234A. The fund takes the position that none of the amount substitutes for, or assumes the ordinary character of, the expected scheduled payment.

When a contract is in a loss position, the fund holds it through the scheduled payment or expiration date and reports the resulting payment it makes as an ordinary expense, because there is no actual or deemed sale or exchange of a capital asset. The strategy therefore applies different forms of settlement to otherwise similar contracts based on whether each contract has gain or loss. Treasury and the IRS state that this selectivity purports to generate gross capital gain and gross ordinary loss, contrary to the purposes of the Code's applicable timing and character rules.

Request for comments

The Notice requests information on the identified transactions, similar transactions, and other investment fund strategies that participants may be using to produce unintended tax results. Comments are requested specifically on whether the descriptions are accurate, whether factually or economically distinguishable transactions should receive different treatment, what form and scope future guidance should take, and whether additional strategies raise comparable concerns. Written comments are due by October 28, 2026.

Implications

Although the Notice does not change existing law as it relates to the transactions it discusses, taxpayers relying on current law in this area may wish to consider what potential changes could look like. Regarding the same-day foreign-currency forward transactions and the selective application of IRC Section 988(a)(1)(B), the Notice appears to be particularly concerned about fact patterns where the currency forward contract is closed at the time that the election is made and the gain or loss position is certain. It may be the case, therefore, that any future guidance in this area would be limited to those transactions and would not extend to other similar transactions (e.g., to currency derivatives that are not closed out until after the election has been made). Alternatively, the IRS and Treasury may take a different route entirely, for example by providing that the election applies to gains arising only after it is made, or that the election must be made by the beginning, rather than the end, of the day on which the taxpayer enters into the derivative.

On the identified straddle strategy, the IRS and Treasury may consider adopting a rule that would preserve the timing of the recognition of the disallowed loss, while requiring that loss to retain the character that it would have had under the identified straddle rules. If promulgated, such a rule could be complex to administer, particularly for taxpayers with sequential or repetitive identified straddles.

While the IRS and Treasury have previously proposed regulations (which were never finalized) focusing specifically on contingent nonperiodic payments on notional principal contracts in Notice 2011-44 and REG-166012-02, Notice 2026-62 is broader in scope and deals with all contingent payments on notional principal contracts.

Finally, it is difficult to predict what guidance, if any, may ultimately be promulgated in response to the IRS and Treasury's concern about the character electivity on the termination of notional principal contracts. One potential rule could require a taxpayer to accrue ordinary income or deduction up to the termination date of the swap, which would eliminate much of the perceived electivity. Such a rule, however, could be rejected as overly burdensome for taxpayers that were not engaging in the systematic activity described in the Notice. Another potential approach could target a set of factors that the government believes, when taken together, are indicative of abuse. Other potential approaches (including taking no action) are also possible.

The Notice contemplates the potential for guidance that may be retroactive and may affect transactions that fall outside its scope. Such guidance may include designating some or all of the transactions as listed transactions or transactions of interest, possibly with retroactive effect. Taxpayers that are active in these types of transactions or similar transactions should consult with their tax advisers to determine the potential scope of future guidance.