Listed Transaction #25 (Foreign Currency Option Contract)
Abusive Offsetting Foreign Currency Option Contract Transactions
IRS Notice 2003-81
In this IRS Notice, the IRS indicates that it has become aware of transactions in which taxpayers claim a loss on an assignment of a Section 1256(g) foreign currency contract to charity, but then fail to report the recognition of gain when the taxpayer's obligation under an offsetting non-Section 1256 contract terminates.
Taxpayer's Investments in 1256 Contracts-Ensuring a Loss Position. The taxpayer in the IRS Notice pays a premium to purchase a call option and a put option on a foreign currency. The currency trades through regulated foreign currency contracts (within the meaning of Section 1256(g)(2)(A) of the Internal Revenue Code and Section 1256 contracts under Section 1256(b) of the Code). These purchased options are reasonably expected to move inversely in value to one another over a relevant range, thus ensuring that as the value of the foreign currency changes, the taxpayer will hold a loss position in one of the two section 1256 contracts.
Taxpayer's Investments in Non-1256 Contracts-Ensuring a Gain Position. The taxpayer also receives premiums for writing call option and a put option on a different foreign currency in which positions are not traded through regulated futures contracts. Thus, these contracts do not qualify as 1256 contracts under the Code. These written options are reasonably expected to move inversely in value to one another over a relevant range, thus ensuring that, as the value of the underlying foreign currency changes, the taxpayer will hold a gain position in one of the two non-1256 contracts.
The IRS noted how the taxpayer took advantage of the fact that because the purchased option assigned to the charity is a Section 1256 contract, the taxpayer can mark-to-market the purchased option at the point of assignment and recognize a loss at that time, relying on Section 1256(c) and Greene v. U.S., 79 F.3d 1248 (2d Cir. 1996). However, in contrast, because the assumed written option is not a Section 1256 contract, the taxpayer claims not to recognize gain attributable to the option premium. The taxpayer claims that the charity's assumption of the option obligation does not cause the taxpayer to recognize gain, nor does the taxpayer have to recognize gain at the time the option expires or terminates or at any other time.
The IRS disagrees. According to the IRS, the taxpayer has made a transfer to the charity of the purchased option, and the charity has assumed the burden of the written option. No aspect of the taxpayer's transfer or the charity's assumption (or their combination) relieves the taxpayer from its duty to account for the gain attributable to the premium originally received by the taxpayer for assuming the burden of writing the option. The IRS states that if the taxpayer has any unrecognized gain on the written option at the end of the year in which the assumption occurs (e.g., the assumption did not terminate the option writer's obligation under the option contract), then the mark-to-market loss on the offsetting contributed Section 1256 contract will be deferred under Section 1092 of the Code.
If you believe that you may have engaged in a transaction that is the same or substantially similar to the transaction described above, Federal law may require you to disclose your and other parties' participation in any such "listed transaction" on IRS Form 8886. For more information about Federal law requirements, please contact us.
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