An Option Isn’t a Contract

In Uncategorized on 04/14/2011 at 16:53

When it comes to mark-to-market foreign currency deals.

The issue for Tax Court in Ricardo A. and Tari Scurlock Garcia, T.C. Mem. 2011-85, filed 4/13/11, is whether the foreign exchange options Ricardo contributed to the Holy Innocents Building Fund were in fact Section 1256 foreign exchange contracts.  If so, the $3,000,000 loss that Ricardo claimed was valid. If not, Ricardo owes much tax, interest and penalties.

Note that facts are not found in a summary judgment motion like this one; they are assumed from the pleadings, as there is no substantial question of fact for the Court to determine. See Fed R. Civ. P. 52(a).

The deals were made between Ricardo’s sole member-sole manager LLC (disregarded entity) and  Montgomery Global Advisors V LLC, based in San Francisco. Ricardo lived in Texas and his LLC was Georgia-domiciled. While the options had “knock-in” and “knock-out” barriers, meaning the rate of exchange during the option period had either to hit or miss a certain level before the option could be exercised, Tax Court held that this feature did not convert the option to a contract.

The good news for taxpayers is that Section 1256(a)(1) generally permits certain financial instruments to be marked to market on the last business day of the taxable year and any gain or loss on those contracts to be included on the taxpayer’s Federal income tax return. And gain or loss is recognized immediately upon contribution to a Section 501(c)(3) entity, as Holy Innocents presumably was.  Any gain or loss with respect to a “section 1256 contract” is treated as a short-term capital gain or loss to the extent of 40 percent of such gain or loss and a long-term capital gain or loss to the extent of 60 percent of such gain or loss. Section 1256(a)(3).

The bad news for Ricardo and Tari is that Section 1256(b) excludes from the definition of a “section 1256 contract” any option on a currency futures contract unless the option is subject to the regulations of, and traded on, a regulated exchange, like a national securities exchange which is registered with the Securities and Exchange Commission, a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of section 1256. See Section 1256(g) and Section 1256(g)(7).

First, Tax Court held an option is not a contract for Section 1256 purposes. Relying on Summitt v. Commissioner, 134 T.C. 248 (2010), Tax Court holds that Section 1256 (a)(1) does not apply, because the option allows Ricardo to walk away rather than be required to settle, whether in cash or by physical delivery of currency, at expiry of the option. The plain words of the statute require a binding contract, says Judge Haines, not what Sam Goldwyn called a “definite maybe”.

Second, Tax Court held that Section 1256(b) requires the contracts be subject to regulation by, and be traded on, a regulated exchange, and these non-contracts weren’t so regulated or traded.

The game here, as in Summitt, is to straddle a currency position with offsetting puts and calls. The puts are written in “major currencies” (yen, euros, sterling), the calls in “minor” currencies (Danish kroner). The major put was claimed to fall within Section 1256 mark-to-market and take-the-loss rules when assigned to Holy Innocents (how innocent in fact was Holy Innocents is not explored in the decision); the minor call was not, so the offsetting gain on the minor currency call didn’t have to be marked or reported. And the barrier was claimed to qualify an otherwise disqualified deal. No go, says Judge Haines; the deals are not subject to the rules of, nor traded on, a regulated exchange, and besides, there is no requirement to settle in cash or kind at maturity, so barrier or no barrier, Section 1256 does not apply.

Ricardo and Tari argued that testimony of a foreign currency exchange expert was necessary to determine this case. No, says Judge Haines. “The testimony suggested by petitioners is nothing more than the legal conclusions of a supposed industry expert. We made our legal determination on the section 1256 issue in Summitt.” 2011 T.C. Mem. 83, at p.13.

Takeaway? As Job said, “He disappointeth the devices of the crafty, so that their hands cannot perform their enterprise.” Job 5:8. Don’t be too clever.


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