Section 988 — No model of clarity, either

For the purposes of this discussion, assume a spot forex contract in a currency for which there is at least one regulated futures contract qualifies as a Section 1256 contract. Next, we analyze Section 988, which deals exclusively with the tax treatment of foreign exchange contracts. Section 988 provides a general rule (laced with exceptions) that income or loss from foreign currency contracts is ordinary. Section 988 has specific rules for Section 1256 forex contracts that are either regulated futures contracts or regulated options (that is, forex options listed on CFTC regulated exchanges). These retain their 60/40 treatment unless the taxpayer affirmatively elects out. This specific exception does not apply to spot forex contracts.

However, another rule in Section 988 provides that a taxpayer may elect out of ordinary treatment for “a forward contract, a futures contract, or option” if they are forex contracts. (The reference to futures is regarding futures traded on non-U.S. exchanges, as U.S. regulated futures are covered by the rule discussed immediately above.) This election is supposed to be made for each contract, which is obviously impossible in today’s active forex trading world. In practice, an election is made in the taxpayer’s books and records, covering all future spot forex contracts traded by the taxpayer, until the election is revoked by the taxpayer (through a notation in the books and records).

The issue is whether a spot forex contract is similar enough to forwards, futures, and options to afford the same tax treatment. The IRS’s 2003 notice has been interpreted by some tax practitioners as authorizing a very broad view of the statute’s scope, presumably allowing economically similar contracts to receive the same tax treatment. It is hard to differentiate a forward that settles in one week from a spot contract that settles in two days. Nonetheless, they would arguably be given very different tax treatment (35-percent rate vs. 23-percent rate for net gains).