Forwards
Timing
A taxpayer that enters into a forward contract (i.e, a non-exchange traded contract) to buy or sell foreign currency generally does not have to recognize gain or loss on the contract until it is terminated, assigned, offset, or otherwise disposed of by the taxpayers. If a taxpayer makes or takes delivery under the forward contract, then any gain or loss is realized as if the taxpayer sold the contract for its fair market value on the delivery date.
Many of the exceptions to the option timing rules discussed will also be applicable to currency forwards. Forward contracts in the major currencies are generally subject to the straddle rules because, for example, they are also traded on the interbank market, or through a foreign exchange that operates similarly to the U.S exchange. Such contracts will therefore be subject to the loss deferral rule. In addition, a forward contract in a currency that is traded through regulated futures contracts and on the interbank market will generally be a 1256 contract. Section 1256 required that such forward contracts be marked to market at year-end. Recently, a very interesting question has arisen with respect to forwarding contracts in the Indonesian rupiah, Malaysian ringgit, and the Thai baht. The FINEX in New York originally listed these contracts for trading on its exchange. During 1997, the exchange stopped listing the currencies, but on Dec. 5, 1997, they relisted these currencies. However, for the rest of December 1997, there was virtually no trading on the FINEX in these currencies. The question arises as to what the following requirement under 1256(g)(2) mean: which requires the 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.) How much trading is required to be considered “also traded”? What if a contract on a particular currency is traded on a futures exchange at the beginning of the year, but trading ceases midway through the year? These are questions for which 1256 provides no answers and there are no regulations or ruling under 1256 to provide taxpayers any guidance either. Considering the volatility of the rupiah, ringgit, and baht in 1997, the consequences to taxpayers and the Treasury of marking to market contracts on these currencies is considerable, and for that reason, some assistance from Treasury in deciding there question would be very helpful.
Character
As in the case of foreign currency options, the character of gain or loss from currency forwards governed by 988 is ordinary. A taxpayer may elect to treat foreign currency gain or loss attributable to a forward contract that is a capital asset in the taxpayer’s hands-and not part of a straddle as described above-as capital gain or loss if the taxpayer identities the transaction on the close of the day on which the transaction is entered into.
Withholding
As discussed above, in order to determine whether income to a non-U.S person is subject to withholding tax, it has to be determined whether the income is sourced within or outside the U.S under general sourcing principles. There is no clear guidance on this of these issues will be resolved under the particular income tax treaty that governs the taxation of the parties to the transaction.
Timing
Futures contracts are, by definition, exchange-traded, and therefore, those futures contracts that are traded in the United States are 1256 contracts. Accordingly, unless the contracts are hedges for tax purposes, they must be mark-to-market at year-end and gain or loss would be taken into account at that time
Character
As in the case of foreign currency options and forwards, the character of gain or loss from currency futures governed by 988 is ordinary. A taxpayer may elect to treat foreign currency gain or loss attributable to a forward contract, futures contract, or option that is a capital asset in the taxpayer’s hands and not part of a straddle (as described about) as capital gain or loss if the taxpayer identifies the transactions on the close of the day on which the transaction is entered into
Hedging Transactions
Special rules apply to taxpayers that use financial instruments as “hedging” vehicles, as that term is understood in the tax law. Although foreign currency instruments will get ordinary income treatment whether they are used for hedging or not, the timing of inclusion of the income or loss on a hedging transaction will depend on the timing of the income or loss on the item being hedged. For these purposes, a hedging transaction is transaction that a taxpayer enters into in the normal course of its business primarily to reduce the risk: (1) Of price changes or currency fluctuation with respect to ordinary property held to be held by the taxpayer; or (2) Of interest rate or price changes or currency fluctuations with respect to borrowing made or to be made, or ordinary obligations incurred or to be incurred by the taxpayers. For this purpose ordinary property is property that, upon disposition, will never give rise to capital gain or loss.
The principle the taxpayer must follow when taking into account income and loss under a hedging transaction is a “clear reflection of income.” To clearly reflect income, the accounting method chosen by the taxpayer must reasonably match the timing of income, deduction, gain, or loss from the hedging transaction with the timing of income, deduction, gain, and loss from the item being hedged. The IRS is flexible in this regard and acknowledges that there may be more than one method of accounting that satisfies the clear reflection of income principle. However, once a method of accounting is adopted by the taxpayer, it must be used consistently and can be changed only with the consent of the commissioner. A taxpayer’s books and records must contain a description of the accounting method used for each type of hedging transaction and the description must be sufficient to show how the clear reflection requirement is satisfied.
A taxpayer is permitted to hedge aggregate risk but still is required to comply with the clear reflection of the income requirement. In such a situation, the taxpayer must match the timing of income, etc., of the aggregate item being hedged. There are special rules for hedging transactions that take place within a consolidated group.
In order to avoid having to mark to market 1256 contracts that are used as hedging transactions and to avoid loss deferral under the straddle provisions, taxpayers must identify the foreign exchange derivative contract as a hedging transaction. To do this, the taxpayer must identify the contract as a hedging transaction before the close of the day on which the transaction is entered into. The taxpayer also must identify the item being hedged within 35 days of entering into the hedging transaction. The identification must state the item, items, or aggregate risk being hedged by identifying the transaction that creates risk and the kind of risk the transaction creates. The identification must be included in the taxpayer’s books and records and must be unambiguous. An identification for accounting or regulatory purposes is not sufficient unless there is a clear indication that the identification is for tax purposes as well and contains all the relevant information required by the tax identification rules.
Securities Held by a Dealer
Ta[ayers that are considered “dealers in securities” are subject to mark-to-market treatment on their securities portfolio. A “dealer” is very broadly defined as a taxpayer that regularly purchases securities from or sells securities to customers in the ordinary course of trade or business, or regularly offers to enter into, assume, offset, assign, or otherwise terminate position in securities with customers in the ordinary course of a trade or business. A security includes stock, evidence of indebtedness, swap, or other derivative instruments. A currency option, for example, could be part of a dealer’s portfolio, and unless the option is held by the taxpayer as an investment, or is a hedge or property or liabilities not subject to the mark-to-market requirement, the taxpayer treats the option as if sold for its fair market value on the last business day of the taxable year and take the resulting gain or loss into account for that year.
Even those taxpayers that generally would not consider themselves to be”dealers” may find that they in fact are dealers under 475. For example, a trading or hedging subsidiary that generally enters into financial transactions with other members of its consolidated or affiliated group may be considered a dealer in securities. Taxpayers with “customers” that are limited to members of their own consolidated group are governed by special rules may be able to elect out of dealer status in the right circumstances. Under the Taxpayer Relief Act of 1997 (P.L. 105-34). a taxpayer that is engaged in a trade or business as a trader in securities and makes an appropriate election will also be able to mark to market any security held in connection with the taxpayer’s trade or business.
Summary
Foreign currency contracts generally produce ordinary income or loss (or do so at the election of the taxpayer for regulated futures and non-equity options). In certain circumstances, a taxpayer may elect capital treatment on some derivative foreign exchange securities. The timing for taking into account gains and losses on these transactions will be determined by the type of instruments and the use to which it is put by the taxpayers. For example, a hedging transaction generally will be subject to a timing regime that matches the income, gain, deduction, or loss from the hedging transactions with those items from the hedged item. In addition, if a taxpayer is a dealer in securities under 475, mark-to-market accounting is generally required on all securities. No clear guidance exists with respect to the appropriate treatment, for withholding tax purposes, of amounts paid pursuant to foreign currency contracts to nonresidents. To the extent, no covered by the treaty, a separate analysis of each type of transaction will be required to determine the necessity for withholding payments to nonresidents.