Section 988 Transactions
The International Revenue Code has special rules for “988 transactions.” These are transactions in which the amount the taxpayer is entitled to receive or required to pay is denominated in terms of a nonfunctional currency or determined by reference to the value of one or more nonfunctional currencies. Transactions covered by 988 include entering into or acquiring any forward contracts, futures contracts, options,s or similar financial instruments. Timing of recognition of gain or loss under these contracts generally follows the normal recognition principles of the Code, but there are several exceptions. In addition, 988 has a special regime covering character and source.
Options
Timing
Generally, a taxpayer does not realize taxable income upon the receipt of an option premium. If the option expires unexercised, the premium income, less fees, and commissions become income to the grantor on the date of expiration and is included in income in the year in which the options expire. In the case of a cash-settled option, the amount of income realized by the option grantor upon the exercise of an option is the amount of the premium less commission and fees, adjusted by any payment between the parties. If the option is settled by delivery of property, the option grantor reduces its proceeds by its basis in such property.
The treatment of an option purchaser mirrors that of an option grantor. The mere payment of a premium for an option does not trigger immediate tax consequences. If the option expires unexercised, the taxpayer is treated as if it disposed of the option on the expiration date. The taxpayer will therefore have a loss for the amount of the option premium, plus commissions and fees, in the years in which the option expires. If a cash-settle option is exercised, the option purchaser will have gain equal to the difference between the premium paid, plus fees and commissions, and the amount of cash received on settlement. If a property is delivered in settlement, the purchaser’s basis in the property received will be the exercise price plus the premium, as well as the fees and commissions paid.
Under a special rule for foreign currency contracts, if a taxpayer makes or takes delivery under the contract, then any gain or loss is realized as if the taxpayer has sold the contract for its fair market value on the delivery date. The exceptions to these general timing rules are numerous, and include the following:
Options that become part of a tax straddle. The U.S tax law provides special treatment for “offsetting positions in personal property.” These rules override the general 988 timing rules described above. Most particularly, as taxpayer may not deduct a loss on one of the positions in a straddle to the extent of unrealized gains in any other offsetting positions; it must capitalize all expenses associated with carrying positions that are part of a straddle; its holding period on any position that is part of a straddle does not begin to run until the position ceases to be part of the straddle.
For these purposes, a taxpayer will be considered to hold an “offsetting position in personal property” if holding one of the positions substantially diminishes the taxpayer’s risk of loss from holding any other position. “Persona; property” is any personal property of a kind that is actively traded. Actively traded properly includes any property traded on (1) a national securities exchange; (2) An interdealer quotation system sponsored by a national securities association (such as Nasdaq); (3) A domestic board of trade; (4) A foreign securities exchange or board of trade that satisfies analogous regulatory requirements under the law of the jurisdiction in which it is organized (5) an interbank market; (6) An interdealer market, i.e, a system of general circulation that provides a reasonable basis to determine fair market value by disseminating recent price quotations.
An example of a straddle in the current context would be writing an option to sell Japanese yen and holding the Japanese yen currency in an account. Since the value of the option to the writer will move in the opposite direction from the value of the Japanese yen, a loss on the option would be deductible only to the extent it exceeded the unrealized foreign exchange gain in the Japanese yen.
Transactions that are hedging transactions for tax purposes are excluded from the straddle provisions. Options that are “1256 contracts.” are subject to special rules. The main timing impact of the application of 1256 is that the option will be subject to a mark-to-market regime. Two types of 1256 contracts could govern currency options: (1) Nonequity options, i.e, currency options listed on a qualified board or exchange; or (2) Foreign currency contracts, i.e, contracts (i) that require the delivery of, or the settlement of which depends on the value of, a foreign currency that is a currency in which positions are also traded through regulated futures contracts, (ii) that are traded on the interbank market, and (iii) that are entered into at arm’s length at the price determined by reference to the price in the interbank market.
Some of the term under the definition of “foreign currency contract: require . A “regulated futures contract” is one with respects to which the amount required to be deposited and the amount that may be withdrawn depends on a system of marking to market, and that is traded on or subject to the rules or a qualified board or exchange. The term “qualified board or exchange” means: (A) a national securities exchange that is registered with the Securities and Exchange Commission; (B) A domestic board of trade designated as a contract market by the Commodities Futures Trading Commission (CFTC); or (C) Any other exchange board of trade or other markets that the Secretary of the Treasury determines has rules adequate to carry out the purposes of 1256. Thus far, the Treasury Department has ruled only three times under (C), as follows: (1) Futures and options contracts established under Mutual Offset Systems between the Chicago Mercantile Exchange and the Singapore International Monetary Exchange are considering traded on or subject to rules of exchange adequate for 1256 purpose. (2) The International Futures Exchange (Bermuda) Ltd. is a qualified board or exchange for purpose of 1256. (3) The Mercantile Division of the Montreal Exchange is a qualified board or exchange for purposes of 1256.
The key concept under 1256 is the system of marking to market. When a party enters into a futures or options contract on an exchange that party (or its agent) will be required to put up a “margin,” which served to assure the exchange that the party will be able to fulfill its side of the contract when the time comes due. If the price of a derivative contract moves on any trading day, every party with an open contract in that market will either make a gain or a loss. That loss is not merely a book lass, as it would be for a forward contract or an over-the-counter option, but actually realized through the adjustment of the margin account. Those parties with contracts that appreciated in value compared with the previous trading day will have their accounts increased, and parties whose contracts decline in value will have their accounts decreased. This was the reason Congress believed that taxpayers holding exchange-traded instruments should have a recognizable tax event at year-end, even if they did not dispose of their derivative contracts.
Congress extended the mark-to-market requirement to those foreign currency contracts that have sufficiently similar features to the exchange-traded instruments-namely those traded on the interbank market. The legislative history to 1256 indicates that contracts traded on the interbank market include contracts between a commercial bank and another person and contracts entered into with a futures commission merchant who is a participant in the interbank market. A “futures commission merchant” (FCM) is an entity that fulfills a number of functions as an intermediary between customers and brokers in the pit. The CFTC requires registration of all FCMs, which it defines as entities.
…engaged in soliciting or accepting orders for the purchase or sale of any commodity for future delivery on or sale of any commodity for future delivery on or subject to the rules of any contract market and that, in or in connection with such solicitation or acceptance of such order, accepts any money, securities, or property…to margin, guarantee, or secure any trades or contracts that results…therefore.
The Application of 1256 to the foreign exchange option is somewhat anomalous. Although a foreign exchange option may technically meet the three-prong test required for a foreign currency contract, the policy basis for requiring the contract to be marked to market for tax purposes does not exist. As a result of asymmetry in the economics of the underlying contracts, there is no real gain or loss until the option is exercised, sold, or expires. There is no accumulation of profits or loss over the life of the contracts and options positions are not marked either under 1256(g)(1) or (g)(2). Transactions that are hedging transactions for tax purposes are excluded from this mark-to-market requirement.
Character
The character of gain or loss from transactions governed by 988 is generally ordinary. If a foreign currency option falls under the definition of a non-equity option, however, its character will be capital unless the taxpayer elects ordinary treatment. In addition, a taxpayer may elect to treat a foreign currency forward contract, futures contract, or option that is a capital; asset in the taxpayer’s hands and that is not part of a straddle (as defined above) as capital gain or loss if the transaction is identified on the close of the day on which the transaction is entered into
Withholding
To the extent that an option contract is acquired from, or sold to, a foreign entity, the need to withhold U.S tax on any income must be considered. There is no authority as to whether income received by a foreign person upon sale or cash settlement, of an option, constitutes fixed or determinable, able or periodical (FDAP) income and is therefore subject to withholding tax under 871(a)(1). Moreover, there are no specific rules relating to the sourcing of income realized with respect to an option. There U.S Treasury has the authority to issue sourcing rules for options forwards, and futures contracts, but this authority has not been exercised. Therefore, income realized under option, forwards, and futures contracts are sourced under the general sourcing provisions of the Internal Revenue Code, and there is no clear authority on point.
For many taxpayers, the question of withholding is resolved by treaty rather than domestic law. Under the 1996 U.S Model Treaty, income from financial instruments not specifically covered by another treaty article will be covered by “Other Income” in Article 21 and will be subject to income tax only in the country of residence of the recipient. For taxpayers with options gains or losses generated by a business in dealing in such instruments, the income or loss may be covered by the “Business Profits” articles of the model or other relevant treaty.
If the transaction in question is not covered by a treaty, additional analysis must be made to build the position that no withholding is required.