Foreign Exchange Tax In The US

Foreign exchange (or Forex) is traded in two ways: as currency futures on regulated commodities exchanges, which fall under the tax rules of IRC Section 1256 contracts, or as cash foreign exchange on the unregulated interbank market, which fall under the special rules of IRC Section 988. Many foreign exchange traders are active in both markets.

Because futures and cash foreign exchange are subject to different tax and accounting rules, it is important for foreign exchange traders to know which category each of their trades fall into so that each trade can be reported correctly to receive optimum tax advantage.

Currency futures and options listed on U.S. commodities and futures exchanges are by default treated as 1256 contracts. There is no confusion in the tax code about it and traders or investors get lower 60/40 tax-treatment by default.

But for these U.S. listed foreign exchange futures and options, few traders know they may also elect out of IRC 1256 for IRC 988 (foreign currency transaction) ordinary gain or loss treatment. But this is not a big problem in the real world since very few individual traders would want to exchange lower 60/40 tax-treatment for higher ordinary gain tax-treatment? This election is very strict and it must be made on January 1 or the start of trading later in the year, and once made can only be revoked with IRS consent.

You can't cherry pick the election after-the-fact, when you know you have losses. This election is mostly used by corporations and hedgers to avoid capital loss treatment. Don’t panic about foreign exchange futures losses, IRC 1256 losses may be carried back 3 tax years; but only applied against IRC 1256 gains in those years.

Currency futures and options listed on foreign (non-U.S. exchanges) are treated differently by default, but possibly in the same manner after doing some leg work. IRC 1256 contracts include not only contracts listed on U.S. exchanges but certain non-exchange traded contracts also. Two things can help you get foreign currency futures treated as IRC 1256 contracts.

First, we have argued recently that foreign futures are similar to U.S. futures and should be afforded IRC 1256 treatment. Otherwise, the U.S. may be in contravention of tax treaties with many other countries.

Second, on spot foreign exchange taxation, we argue that a trader or investor may elect out of IRC 988 for IRC 1256 on foreign currency futures listed on foreign exchanges. Therefore, we believe that like spot foreign exchange discussed below, you may claim IRC 1256 treatment on for foreign currency futures listed on foreign exchanges, providing you also timely elect out of IRC 988.

Over-the-counter currency options are a huge marketplace. They are not futures or options contracts listed on U.S. or foreign exchanges; nor are they interbank-traded spot or forward currency contracts. OTC currency options are a breed apart and traded often by sophisticated traders. Even though the IRS never cleared up duelling and conflicting older tax law code sections IRC 1256 and IRC 988 in connection with spot foreign exchange taxation, the IRS did make the tax rules clear for OTC foreign exchange options in their 2003 tax notice (2003-81). In the notice, the IRS clearly states that OTC foreign exchange options are IRC 1256 contracts, but if you want 60/40 treatment, you still have to elect it.

Notice a trend developing here. IRC 1256 recognises some foreign currency contracts as being 1256, while duelling IRC 988 also recognises those same contracts as being IRC 988. Which tax code section wins and applies?

It’s reasonable to conclude that the trend shows you can claim 1256 treatment, but you should also elect out of IRC 988. Join the 60/40 lower tax club, but also get permission first to leave the higher-taxing IRC 988 club.

Here’s the skinny on IRC 988 foreign currency transactions. They are ordinary gain or losses reported in summary form on line 21 of Form 1040. Conversely, IRC 1256 foreign currency futures are reported on Form 6781; where they are split 60/40 before being moved over to Schedule D (Capital Gain or Losses).

IRC 988 interbank foreign exchange includes spot foreign exchange, forward foreign exchange and other types of foreign exchange contracts. Spot foreign exchange differs from forward foreign exchange contracts in that spot settles in cash in no more than 2 days, and forward contracts settle in more than 2 days.

IRC 988 clearly states that a trader or investor (holding a capital asset versus a hedger or regular business) may elect out of IRC 988 for the more tax-beneficial IRC 1256 on foreign exchange forward contracts and foreign exchange futures.

IRC 988(a)(1)(B) requires that if you want 60/40 treatment for a foreign exchange future (meaning foreign exchange listed), options or forward, you have to elect it (which we recommend using the global good till cancelled type of election).

Here is where the big tax uncertainty comes into play. Notice that IRC 988 does not specifically mention that you may elect out of 988 on spot foreign exchange. This glaring omission unfortunately leads many tax professionals to short-sightedly concur that spot foreign exchange may only be treated with ordinary gain or loss treatment.

We argue that you can dig deeper to find a way to treat spot foreign exchange as IRC 1256, as long as you play it safe and also elect out of IRC 988 on spot foreign exchange too.

Here is how it works and how you can do it:

Although it is not widely known by the foreign exchange trading marketplace, IRC 1256 recognises many types of spot foreign exchange contract currencies as 1256 contracts.

Again, the problem is that IRC 988 also specifically recognises spot foreign exchange contracts as IRC 988 transactions. Again, these two tax code sections conflict and cause uncertainty and risk for return positions on spot foreign exchange.

Does IRC 988 trump 1256 or does IRC 1256 trump 988 or must they co-exit? The prudent answer seems to be they must co-exist.

If 1256 trumped 988 on spot foreign exchange, then spot foreign exchange would always be 1256 and you could not even elect out of 1256 for 988 as that is allowed for U.S. exchange listed currency futures and options only. So you would be stuck with 60/40 treatment, which is not good if you have large spot foreign exchange trading losses, as you would prefer ordinary loss treatment with IRC 988. Be careful what you wish for.

So it’s a good thing that our firm and consensus professionals believe that spot foreign exchange is IRC 988 by default (sort of trumping 1256), so you start with ordinary gain or loss treatment. We explain why we believe that spot foreign exchange is sufficiently similar to forward foreign exchange contracts so you can also elect out of 988 on spot foreign exchange too.

It seems like our logic on spot foreign exchange pays good dividends. You can argue that spot foreign exchange is 1256 as long as you elect out of 988 first. Have your cake and eat it too.

Again, tax law for foreign exchange is very confusing and complex and the only thing that is certain is that there are major conflicts in the tax code with IRC 1256 and IRC 988.

A note of caution: You can have your cake and eat it too with ordinary loss treatment and 60/40 gain treatment by using internal elections wisely. But don't fool around with making these elections. If you wind up with 60/40 treatment on gains and ordinary loss treatment on losses from year-to-year, that will appear to be “cherry picking” after-the-fact, even though the elections must be made in advance of trading.

We expect IRS clarification, but possibly also a requirement for external elections like with IRC 475 mark-to-market accounting for business traders.

Foreign Exchange Tax In The UK

Up to 1993 there were no specific rules for taxing or relieving foreign exchange gains or losses and they were treated in several different ways:

·        As part of the Case I profit or loss if they were on a trading account

·        As part of the capital gain or loss on disposal of an asset

·        As 'nothings' outside the tax system altogether (nothings are gains/losses that cannot be taxed/relieved because they arose in respect of a non-trade debt, or a capital item such as a loan or non-chargeable asset).

Companies manage the risk of currency fluctuations by using certain types of financial contract. Any savings on currency costs needed to be balanced against any additional tax liabilities. However, it could be difficult to identify the precise nature of the contract, and the tax treatment before 1993 was often uncertain. To add to the difficulty, gains and losses could have been recognised on either the translation or the realisation basis.

In contrast to the tax treatment, accounting practice was relatively straightforward with exchange gains or losses either taken through the profit and loss account, or taken to reserves.

To bring tax treatment more into line with accounting practice, the department published a consultative document in 1991. This set out the department's proposals which eventually led to the rules in FA 1993.

The aim of the FA 1993 legislation was to bring the taxation of exchange gains and losses broadly into line with accounting practice, and particularly the accounting treatment set out in Statement of Standard Accounting Practice 20 (SSAP20).

This was achieved by:

• Bringing exchange gains and losses on monetary transactions in foreign currencies within specific tax rules in FA 1993.

• Recognising exchange gains and losses as they accrued, using the translation basis only

• Permitting companies to elect to take certain exchange gains and losses to reserves

• Permitting companies to calculate exchange gains and losses using the appropriate local currency. (This was amended in FA2000 to allow local currency accounts without the need for an election.)

FA 1993 allowed companies to defer unrealised exchange gains where certain conditions were met. This was usually until the disposal of the underlying asset.

New rules - FA 2002

The aim of FA 2002 is to bring the tax treatment of exchange gains and losses even closer to the accounting treatment.

Instead of using a separate legislation, FA 2002 amends FA 1996 and treats the exchange gain or loss in the same way as a profit or loss from a loan relationship for tax purposes.

However, exchange gains and losses arise in a different way to the calculations you would use for loan relationships.

In many cases, providing the company has followed correct accounting practice when drawing up accounts, the Inland Revenue will accept the company's figures unless a specific ‘anti-avoidance’ rule applies.

Matching Regulations

The rules in the 1993 legislation allowed a company to elect to take certain exchange gains and losses to reserves. These are known as the matching regulations. The 1993 matching rules have been modified in FA 2002 so that they follow the accounting treatment without the need for an election.

Currency accounts

There are still separate rules on the currency that must be used to measure profits for tax purposes.

Basic Foreign Exchange Tax Rules

The effect of FA96/S84A (introduced by FA 2002) is that debits and credits calculated under the loan relationship rules include exchange gains or losses on loan relationships.

Broadly it includes all money debts arising from the borrowing or lending of money, including overdrafts, bank loans and bank deposits.

Exchange gains and losses may arise on both the interest payable in a foreign currency, and the outstanding capital balance in the foreign currency (unless the loan relationship is a convertible security).

The exchange gains and losses are taken to the profit and loss account, whether they arise on income or capital account.

Example

Satas Ltd has placed $200,000 in a US$ account. It is worth £156,000 at the beginning of the AP and £147,000 at the end of the AP. Translation of the US$ account is required by SSAP20 at both accounting dates. The exchange loss of £9,000 is treated as a loan relationship debit for the year.

During the year interest of $1,500 arises each quarter. The interest is translated into sterling at the date it arises and again when it is either paid, or accrued on the balance sheet at the end of the year.

If the exchange rate changes from one of these valuation times to another, a gain or loss will arise on the interest credit.

The exchange rate at the accounting date on the accrual is £1 = $1.425. The rate at the date of payment has moved to £1= $1.520. The amount payable in the accounts was therefore £1,052 but the amount paid was only £988. The difference of £64 is an exchange gain and is a loan relationship credit for the year.

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