EDUCATION CENTER
GTT RESOURCES: FOREIGN FUTURES

Futures traded on Foreign Futures Exchanges:

A foreign futures exchange only receives Section 1256 (lower 60/40) tax treatment on selected instruments if the IRS expressly approves Section 1256 treatment in an official IRS pronouncement. See examples in Revenue Ruling 2009-4 and 2007-26 below.

A no-action letter from the CFTC - allowing a foreign futures exchange to offer futures contracts in the U.S. under Rule 30.10A - may be a starting point for achieving this tax-advantaged treatment, but it's not enough on it's own. Recent IRS rulings and guidance have indicated that the IRS pronouncement itself is the deciding factor.

Revenue Ruling 2009-04 holds that Dubai Mercantile Exchange, a United Arab Emirates Authorized Market Institution, is a qualified board or exchange within the meaning of section 1256(g)(7)(C) of the Internal Revenue Code. This ruling is effective for Dubai Mercantile Exchange Contracts (commodity futures contracts and futures contract options) entered into on or after Feb. 1, 2009. Revenue Ruling 2009-04 will be IRB 2009-5, dated February 2, 2009.

IRS Revenue Ruling 2007-26 "holds that ICE Futures, which is a United Kingdom Recognised Investment Exchange, is a qualified board or exchange within the meaning of section 1256(g)(7)(C) of the Code."

Our older content below laid out a “reasonable basis” argument that a foreign futures exchange will constitute a qualified board or exchange if it receives a no-action letter from the CFTC allowing it to offer futures contracts in the U.S. under Rule 30.10. A “reasonable basis” means that we do not necessarily believe that a court would rule in favor of this position.

Reference William R. Pomierski, “Code Sec. 1256 Considerations for ICE Futures and Beyond,” JOURNAL OF TAXATION OF FINANCIAL PRODUCTS Volume 6 Issue 4 2007 writes:

CFTC Rule 30.10 permits a foreign regulatory or self-regulatory organization to petition the CFTC for an order allowing member firms to conduct business from locations outside of the United States for United States persons without registering under the CEA. In light of the fact that ICE Futures had previously received a no-action letter from the CFTC allowing it to offer futures contracts (and options thereon) in the U.S. under Rule 30.10, the IRS seems to have made it clear in Rev. Rul. 2007-26 that Rule 30.10 status does not result in an exchange being considered a qualified board or exchange for Code Sec. 1256 purposes under Category 1 or Category 2. As such, financial positions that trade on a foreign exchange operating in the U.S. under Rule 30.10 should not be considered Section 1256 Contracts absent a ruling or other determination letter from the IRS specifically designating any such exchange as a Category 3 exchange.

The fact that this is the IRS position does not mean that it is binding on a taxpayer. Nevertheless, to the extent that prior ambiguity on the IRS position allowed a taxpayer to argue that he had a reasonable basis position, we feel that ambiguity no longer exists.

We also note that the highly regarded Keyes treatise (2007 version) states:

In contrast to domestic futures exchanges, a foreign futures exchange by definition cannot qualify as a domestic board of trade designated as a contract market by the CFTC. Accordingly, a foreign futures exchange will constitute a qualified board or exchange only if the Treasury determines that the exchange has rules adequate to carry out the purposes of Section 1256.

Also, COMREP ¶ 12,561.02 ('81 Economic Recovery Tax Act, , PL 97-34, 8/13/81), the legislative history to Section 1256, states:

. . . traded on or subject to the rules of a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or of any board of trade or exchange which the Secretary determines operates under rules adequate to carry out the purposes of the mark- to-market provisions.

This is in line with the actual rule of 1256(g)(7):

(7) Qualified board or exchange.
The term “qualified board or exchange” means—

(A) a national securities exchange which is registered with the Securities and Exchange Commission,

(B) a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or

(C) any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of this section.

We find it very difficult to continue to argue that a foreign exchange qualifies under Section 1256(g)(7)(A) or (B) unless the foreign exchange is treated as an extension of a domestic exchange, which is what happened in Rev. Rul. 87-43-- the CME and the SIMEX entered into an agreement to establish the Mutual Offset System,which provides an inter-exchange clearing process by which customers can establish new positions or offset existing positions on one exchange, during hours in which that exchange is closed for trading, by the execution of a contract on the other exchange. As we understand it, that is not the case for an exchange which receives a no-action letter from the CFTC allowing it to offer futures contracts in the U.S. under Rule 30.10.

Old 2003 Content:

Foreign Exchange Traded Futures - Old Content

The following question was asked on our GTT Message Board: "Are futures trades done on foreign exchanges also taxed at 60/40 for U.S. citizens, or does 60/40 only apply to futures listed on US exchanges."

Here was our old answer.

There is a reasonable basis in fact and law to conclude that futures traded on certain foreign contract markets with either a CFTC Rule 30.10 exemption or No Action Letter (defined below) are entitled to classification as Section 1256 contracts (e.g., commodities) with the result that “60/40” tax treatment is appropriate.

The 60/40 Question

Section 1256 requires certain types of contracts to be marked to market at year-end, regardless of the taxpayer's status. Gain or loss, under Section 1256(a)(3), is 60% long-term capital gain and 40% short-term capital gain. Long-term capital gains are taxed at a maximum rate of 15% for all sales after May 5, 2003. Short term capital gains are taxed at the normal tax rate. The maximum short term ordinary rate is 35%, effective January 1, 2003.

Commodities receive preferential tax treatment over securities (e.g., stocks, stock options, narrow based indices, single stock futures, mutual funds, Exchange Traded Funds (e.g., QQQs) and bonds).

Section 1256 Contracts

Section 1256 was introduced into law by the Economic Recovery Tax Act of 1981, Pub. L. 97-34, 95 Stat. 172 (effective date June 23, 1981). Section 1256 contains special rules for reporting gains and losses from "section 1256 contracts."

Section 1256(b) defines the term "section 1256 contract" (e.g., commodities) as including any regulated futures contract, any foreign currency contract, any non-equity option, any deal equity option and any dealer securities futures contract. The Commodities Futures Modernization Act of 2000 (CFMA) established that broad based indices are also considered commodities.

Section 1256(g)(1) provides that the term "regulated futures contract" means a contract (A) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (B) which is traded on or subject to the rules of a qualified board or exchange.

A futures contract is not defined in Section 1256. The CFTC defines a futures contract as "an agreement to purchase or sell a commodity for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) which obligates each party to the contract to fulfill the contract at the specified price; (3) which is used to assume or shift price risk; and (4) which may be satisfied by delivery or offset."

Only a futures contract that has actually been traded on a CFTC designated contract market or subject to its rules is a regulated futures contract for purposes of § 1256(g)(1).

A regulated futures contract can be traded by either a taxpayer as a principal or by a third party acting on the taxpayer's behalf as an agent. Futures contracts that have been traded by two private parties "over the counter" ("OTC") are not traded on a contract market and are not regulated futures contracts for purposes of Section 1256(g)(1). See Revenue Ruling. 87-43, 1987-1 C.B. 252.

A futures contract that does not meet these terms may be a non-regulated futures contract. The difference between forward contracts and futures contracts is that the parties to a forward contact generally intend to make and take delivery. Parties to a futures contract are speculators who intend to close out their positions by offset before delivery.

Section 1256(g)(7) provides that the term "qualified board or exchange" means (A) a national securities exchange which is registered with the Securities and Exchange Commission; (B) a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or (C) any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of this section.

While the Secretary of the Treasury has not taken up its congressional mandate to create legislative certainty in this area, it can be argued that the CFTC, by default, has filled the interstitial legislative gap.

Why 60/40 Treatment is Viable

Since the enactment of Section 1256 in 1981, a number of contract markets throughout the world have implemented adequate rules and could be determined to be a "qualified board or exchange" within the meaning of Section 1256(g)(7). The Treasury Department's recognition of the appropriate extension of 60/40 tax treatment to foreign exchanges, boards of trade, and other markets pursuant to Section 1256(g)(7)(C) is long overdue and is not likely to be forthcoming anytime soon.

While a formal designation as such by the Treasury would expressly make futures contracts traded on these foreign exchanges eligible for treatment as a Section 1256 contract (e.g., eligible for 60/40 capital gain or loss treatment, the lack of such designation by the Secretary does not necessarily preclude 60/40 tax treatment.

Operative Analysis

For purposes of determining the tax consequences of a transaction, it is necessary to ascertain the legal relationships that exist between the parties to the transaction. In the typical exchange clearing process for a futures or option contract, an exchange clearing house is interposed between the original parties to the transaction, namely, the clearing members who represent the purchaser and seller under the contract.

Although there are a series of steps involved in the typical exchange clearing process, the step transaction doctrine provides that these steps are not analyzed separately but are viewed as component parts of a single transaction.

In the typical exchange clearing process, the legal relationship between the investor and the broker remains unchanged notwithstanding the fact that an exchange clearing house is interposed between the original parties to the transaction.

Relying on this type of analysis, in Revenue Ruling 85-72,
1985- 1 CB 286, the IRS determined that International Futures Exchange (Bermuda) Ltd. was a qualified board or exchange.

The Tax Court, in Johnson v. CIR, T.C. Memo (1993-178), stating that the purpose of Section 1256 is to provide the system of taxation based on marking to market of regulated futures contracts, held the taxpayer’s trading in futures contracts and in futures transactions on the London Metal Exchange were conducted subject to the rules of a board of trade or commodity exchange within the meaning of Section 1256(g)(7).

However, in Revenue Ruling 87-43, 1987-1 CB 252, the IRS ruled that Singapore International Monetary Exchange Limited (SIMEX) was a foreign board of trade that was not a qualified board or exchange. In that ruling, the Chicago Mercantile Exchange (CME) and the SIMEX established the Mutual Offset System (System) to provide a process by which customers could establish new positions or offset existing positions on one exchange, during hours in which that exchange is closed for trading, by the execution of a contract on the other exchange.

Commodity Futures Trading Commission
The same type of legal analysis can be extended to decisions of the CFTC with respect to foreign contract markets.
Part 30 of the CFTC's regulations establishes the regulatory structure governing the offer and sale of foreign futures and options contracts to US persons by persons acting as futures commission merchants, introducing brokers, commodity pool operators, and commodity trading advisors.
Section 30.10 of these regulations allows the CFTC to, among other things, exempt a foreign firm acting in the capacity of a futures commission merchant from compliance with certain CFTC rules and regulations. To receive such relief under Rule 30.10, the firm's home-country regulator must demonstrate that it provides a comparable system of regulation and must enter into an information-sharing agreement with the CFTC.
Once a firm receives confirmation of Rule 30.10 relief, it may engage in the offer or sale of foreign futures and options contracts to U.S. persons without registering with the CFTC on the terms specified in the Rule 30.10 Order.
The following regulatory and self-regulatory authorities have received CFTC Rule 30.10 Orders.
Australia
Sydney Futures Exchange (SFE)
ASX Futures Proprietary Limited (ASXF)
Brazil
Bolsa de Mercadorias & Futuros
Canada
Winnipeg Commodity Exchange
Montreal Exchange
Toronto Futures Exchange (TFE)
France
Marché à Terme International de France (MATIF)
Germany
Eurex Deutschland
Japan
Tokyo Grain Exchange (TGE)
New Zealand
New Zealand Futures and Options Exchange (NZFOE)
Singapore
Singapore International Monetary Exchange (SIMEX)
Spain
MEFF Sociedad Rectora de Productos Financieros Derivados de Renta Fija (MEFF Renta Fija)
MEFF Sociedad Rectora de Productos Financieros Derivados de Renta Variable (MEFF Renta Variable)
United Kingdom
Securities and Investments Board (SIB) (now Financial Services authority (FSA))
Association of Futures Brokers Dealers (AFBD)
The Securities Association (TSA)
Investment Management Regulatory Association (IMRO)
Securities and Futures Authority (SFA) (previously AFBD and TSA)

There is a reasonable basis in fact and law to conclude that futures traded on foreign contract markets with a Rule 30.10 exemption are entitled to classification as Section 1256 contracts (e.g., commodities) with the result that “60/40” tax treatment (defined below) is appropriate. All that is needed is a determination by the Treasury Secretary.

In the absence of a forward determination by the Secretary, it may be possible to develop an appropriate and reasonable tax return position in support of 60/40 tax treatment for futures contracts traded on the foregoing foreign contract markets.

The CFTC has effectively determined that the foregoing contract markets are exchanges, boards of trade and other markets qualified within the meaning of Section 1256(g)(7) as such boards and exchanges have rules adequate to support the purpose of Section 1256.

In addition, it can be posited due to the extensive review conducted by the CFTC’s Division of Market Oversight, futures traded through the foreign entities (listed below) receiving No Action Letters from the CFTC eligible for Section 1256 60/40 tax treatment, pursuant to the analysis presented above.

MEFF AIAF SENAF Holding de Mercados Financieros S.A. (MEFF) Madrid and Barcelona, Spain
Bourse de Montreal, Inc. Montreal, Quebec, Canada
London Metal Exchange Limited. (LME) London, U.K.
Eurex Zurich. (Eurex CH) Zurich, Switzerland
OM London Exchange Limited. (OM) London, U.K.
Hong Kong Futures Exchange Ltd. (HKFE) Hong Kong, China
SGX-DT. Singapore
International Petroleum Exchange of London Limited. (IPE) London, U.K.
Eurex Deutschland. (Eurex) Frankfurt, Germany
SFE Corporation Ltd. Sydney, Australia and Auckland, New Zealand
Euronext Paris. Paris, France
London International Financial Futures and Options Exchange (LIFFE). London, U.K.

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GreenTraderTax.com

Here is a follow up comment from GreenTraderTax

Note that although I am sympathetic to the argument that any foreign board or exchange that has received notification from the CFTC under Rule 30.10 is a qualified board or exchange under Section 1256(g), the IRS has not ruled on this.

The 1993 Johnson TC Memo case cited on our website holds that the London exchange was a board or exchange, under prior law dealing with the definition of a capital asset and holding periods, former Section 1222.

The court did not hold that the London exchange was a qualified board or exchange under Section 1256(g), as the case's facts arose before the enactment of Section 1256. Therefore, while Johnson is favorable, there is still a gap, as our website makes clear.

Should an aggressive taxpayer conclude that the gap should be filled in by default? Our websiste certainly gives fair disclosure, and leaves it up to the taxpayer. Certainly, I think that there is a reasonable basis for a return position. The IRS itself has acted recently to extend these interstitial gaps, in the area of "foreign currency contracts" by arguing that the term includes not just interbank traded forwards, but other OTC forex contracts as well.