U.S. taxation of foreign currency transactions: a view from traders' and hedgers' perspectives. (International Taxation)by Tannenbaum, Elliot
Example: On September 30, 1991, a U.S. multinational corporation, XYZ Corp., a calendar-year taxpayer, enters into a forward contract with ABC Bank to sell five million pounds on March 31, 1992, at $1.90/pound (or $9,500,000). XYZ Corp. will use the forward contract to hedge its investment in its U.K. subsidiary. Also, on September 30, 1991, U.S. individual A, a foreign currency commodity futures trader enters into a forward contract with ABC Bank to buy five million pounds on March 31, 1992 at $1.90/pound. A is also a calendar-year taxpayer. Assume that on December 31, 1991 the exchange rate for the pound is $1.95 and, on March 31, 1992 it is $2.
Tax Consequences to XYZ Corp.
Assuming that XYZ Corp.'s business activities typically generate ordinary income or loss, XYZ Corp.'s goal from a tax standpoint would be for the character of any gain or loss on the forward contract to result in ordinary income rather than capital gain or loss. As under U.S. tax rules capital losses cannot offset ordinary income. Under the general rule of IRC Sec. 988, any gain or loss on a forward contract will be treated as ordinary. In addition, because the forward contract is a Sec. 1256 contract, the gain or loss will be marked to market on December 31, 1991. Any additional change in the contract's value after December 31, 1991 will be recognized as gain or loss on March 31, 1992, when the contract is closed. Based upon the currency movements presented in this example, XYZ Corp. will recognize a $250,000 ordinary loss on December 31, 1991 ($9,500,000 less $9,750,000). XYZ Corp. also will recognize an additional $250,000 loss on March 31, 1992 ($9,500,000 less $10,000,000 = $500,000 less $250,000 previously recognized). Although the value of XYZ Corp.'s investment in its U.K. subsidiary has increased by $500,000 due to movement in the exchange rate, that increase will not be taxable until the investment is sold.
Under a special rule in Sec. 988, if XYZ Corp. used a regulated futures contract or a nonequity option to hedge its foreign currency exposure, the instrument would be marked to market at December 31, 1991, and treated as 60% long-term and 40% short-term capital loss. However, XYZ Corp. could make an election under Sec. 988 to treat gains or losses on Sec. 1256 futures contracts and foreign currency options as ordinary, thereby achieving the same tax treatment as achieved with a forward contract of the type described in the example. However, once this election is made, it may only be revoked with the consent of the IRS and then applied to all such futures contracts and options held by the taxpayer.
IF XYZ Corp. acquired the forward contract to hedge an ordinary asset such as pound denominated trade receivable, then XYZ Corp. could possibly make a Sec. 1256(e) election. This would enable XYZ to defer all ordinary gain or loss recognition on the forward contract at December 31, 1991 until the contract was closed on March 31, 1992. However, it should be noted that the ability to utilize the Sec. 1256(e) election for assets other than inventory is somewhat clouded by the Arkansas Best court case.
Tax Consequences to A (The
In contrast to XYZ Corp.'s business operations, A's trading activities typically will result in capital gain or loss treatment. If A incurs capital losses trading other commodities, then these losses may only offset capital gains. Therefore, A's goal from a tax standpoint would be to have any gain on the forward contract treated as capital gain. Alternatively, if A only trades forward currency contracts, then A may also desire capital gain treatment if the capital gain/ordinary rate differential is attractive.
As indicated, under Sec. 988 gain or loss from trading a forward currency contract is generally treated as ordinary. However, Sec. 988 provides another special election to treat the gain or loss as capital if certain requirements are met. First, the forward contract must be a capital asset in the hands of a trader. Second, the contract may not be part of a tax straddle. Finally, the trader must meet IRS identification and reporting requirements. At present, the temporary regulations under Sec. 988 require substantial documentation to be filed with a trader's tax return. Hopefully, the final regulations will ease these reporting requirements.
Returning to the example, if A made the election to treat the gain or loss as capital, then on December 31, 1991, A will recognize a $250,000 capital gain ($9,750,000 value at December 31 less $9,500,000). On March 31, 1992, when A closes out the contract, an additional $250,000 capital gain will be recognized ($10,000,000 value at March 31, less $9,500,000, less $250,000 gain previously recognized). With respect to the capital gain recognized at December 31, 1991, and March 31, 1992, under Sec. 1256 sixty percent of the gain will be long-term capital gain and forty percent will be short-term capital gain.
Also, as previously discussed, Sec. 988 treats gains and losses from Sec. 1256 regulated futures contracts and currency options as capital, unless a special election is made to treat them as ordinary. Therefore, to the extent A trades regulated futures contracts or foreign currency options, the gain or loss will be sixty percent long-term and forty percent short-tem capital gain or loss.
As this overview illustrates, while the IRS provides U.S. taxpayers with rules for the taxation of foreign currency transactions, the guidance and the decisions to be made on a relatively straightforward business transaction can be quite complex. Accordingly, forward contract activity should be reviewed in terms of the available elections to ensure that the most tax efficient position can be taken.
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