Section 1256 — No model of clarity

Section 1256 provides for special treatment of qualifying contracts, termed “Section 1256 contracts.” Gain or loss is 60-percent long term and 40-percent short term, regardless of the trader’s holding period for the contract. At current rates, this is a 23-percent federal rate, as opposed to a 35- percent federal rate for net gains from short-term trading or from ordinary income (such as wages and interest).

You have to factor in your own state (and local, if applicable) income tax rates. (State and local usually tax all income at the same rate, but there are divergences from the general rule.) If you are lucky enough to be a tax resident of Nevada, you will have a 23-percent maximum effective tax rate; if you live in New York City, it’s around 35 percent. Regardless, the 12-percent savings at the federal tax level can count for a lot if you are a successful trader.

Section 1256 states that Section 1256 contracts include “foreign currency contracts.” There are three requirements:

1. Contracts in foreign currency for which there are also positions traded through regulated futures contracts must require delivery or cash settlement;

2. The contract is traded in the interbank market;

3. The contract is entered into “at arm’s length” at a price determined by reference to the interbank market price.

What does Congress mean by arm’s length? Prices are determined to be at arm’s length if they are based on the prices that would be paid in a transaction between unrelated parties, neither of whom is under a compulsion to act.

For example, prices are determined at arm’s length if they are based on prices posted by a large, reputable financial institution for similar transactions. As you can see, requirement three is the easiest to satisfy because all spot forex contracts are entered into at arm’s length.

The first requirement is satisfied for all of the major currencies and many lesser currencies. For all of the currencies that are traded in the spot forex market, there is usually at least one regulated futures contract for that currency.

So, the second requirement has to be considered. The issue is whether the statute can be interpreted in a way that does justice to the intent — there is an active market for these contracts, so pricing can be determined objectively. This requirement was imposed by Congress because it was fighting tax shelters using manipulated forex contract prices. If objective pricing is the requirement, then the huge amount of trading in the spot forex market would certainly generate the type of objective prices the statute insists upon. A notice about a recent type of foreign currency tax shelters issued by the IRS in 2003 seems to indicate that the interbank market requirement should not be taken literally. The IRS’s interpretation of the law is that the taxpayer’s actual contract does not have to be entered into in the interbank market, but only that similar contracts are traded in the interbank market. Given the gigantic size and diversity of contracts in the interbank market, it is safe to conclude that any contract entered into the retail spot forex market has an equivalent contract traded in the interbank market. The IRS has yet to rule on the tax treatment of spot forex contracts under Section 1256. However, given the IRS’s very broad reading of the statute in the 2003 notice, some tax practitioners have taken the view that the statute’s reach extends to the spot forex contract, as long as requirement one (that there has to be at least one regulated futures contract for that same currency) is met. The IRS has indicated that they have this question under review and may issue guidance on it. However, in most cases the wheels of the Internal Revenue Service grind exceedingly slowly. Until then, it appears that a spot forex contract should be treated as a Section 1256 contract.