Foreign Currency Option Transaction Lacked Profit Motive; Losses Are Not Deductible

(Parker Tax Publishing November 2024)

On remand from the Sixth Circuit, the Tax Court agreed with the IRS that a married couple was not entitled to a $3 million short-term capital loss on their assignment of a foreign currency option to a charitable organization. The court concluded that, even if the assignment caused the couple to recognize a loss under Code Sec. 1256, Code Sec. 165(c) limits loss deductions to transactions entered into for profit and the court found that the transaction at issue was not entered into for profit. Wright v. Comm'r, T.C. Memo. 2024-10.

Background

Terry Wright and his wife, Cheryl, are co-owners of Cyber Advice, LLC, an investment company that is taxed as a partnership. The Wrights formed Cyber Advice to hold stock. In 2002, Mr. Wright calculated his net worth as $6.1 million, which included $3.5 million of capital gains from stock sales. Consequently, the Wrights' estate planning attorney and their accountant proposed a tax strategy involving major-minor foreign currency option transactions as a way of generating tax losses to reduce the Wrights taxable income.

Observation: A major-minor transaction refers to a currency whose positions are traded through regulated futures contracts (e.g., euros) and a currency that is considered minor because there is not a regulated futures contract for the currency (e.g., the Danish krone).

In 2002, Cyber Advice purchased a euro put option for a premium of approximately $36.2 million, which gave Cyber Advice the right to sell 1.2 billion euros to Beckenham Trading Company (Beckenham) for $1.3 billion on the expiration date of the option. Cyber Advice also purchased a euro call option from Beckenham with terms that were the mirror image of the euro put option. Cyber Advice also sold a krone call and krone put to Beckenham on mirror-image terms. Three days later, Cyber Advice assigned the euro put option and krone put option to a charitable organization, the Foundation for an Educated America (the Foundation). Cyber Advice also sold the euro call option to Beckenham and repurchased the krone call option from Beckenham.

Under Code Sec. 1256, special rules apply to a "foreign currency contract." An investor who holds certain types of derivatives at the close of the tax year, including a foreign currency contract, is required under Code Sec. 1256(a) to mark to market those derivatives by treating them as having been sold for their fair market value on the last business day of the tax year. A foreign currency that an investor must mark to market at the end of the tax year is called a "Section 1256 contract." A foreign currency contract is defined under Code Sec. 1256(g)(2)(A) as a contract (1) which requires delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts, (2) which is traded in the interbank market, and (3) which is entered into at arm's length at a price determined by reference to the price in the interbank market.

On its 2002 income tax return, Cyber Advice did not report any gain from the krone put transactions. It reported a total net short-term capital loss of approximately $3 million. On their 2002 tax returns, the Wrights took the position that they did not need to recognize any gain from the assignment of the krone put option to the Foundation because over-the-counter options on minor foreign currencies such as the krone are not Section 1256 contracts to which the mark-to-market accounting rules applied. The Wrights also took the position that recognition of a short-term capital loss from the assignment of the euro put option to the Foundation was proper because (1) the assignment of the euro put option resulted in a termination of their rights under Code Sec. 1256(c), and (2) because the euro put option was a "foreign currency contract" subject to Code Sec. 1256. The IRS determined that the Wrights had improperly claimed an almost $3 million net capital loss in relation to the "major-minor" transactions. The IRS also assessed a penalty under Code Sec. 6662 for substantial understatement of income tax.

In Wright v. Comm'r, T.C. Memo. 2011-292, the Tax Court held that the Wrights were not entitled to a loss on the assignment of the euro put option to the Foundation because their option was not a "foreign currency contract" under Code Sec. 1256. According to the Tax Court, the foreign currency option did not meet the "delivery" or "settlement" requirement in Code Sec. 1256(g)(2) because it did not require delivery or settlement "unless and until" the holder exercises the option. The Tax Court said that it was clear that the statute, as originally enacted, applied only to forward contracts which require delivery of the foreign currency. The Wrights appealed to the Sixth Circuit.

In Wright v. Comm'r, 2016 PTC 4 (6th Cir. 2016), the Sixth Circuit reversed the Tax Court and held that the Wrights' euro put option met the "settlement" prong of Code Sec. 1256(g)(2)(A) and thus qualified as a foreign currency contract. According to the Sixth Circuit, an option does not require delivery or settlement unless the option is exercised. However, the Sixth Circuit reasoned that the foreign currency option at issue was a foreign currency contract within the meaning of Code Sec. 1256(g)(2) because its settlement (if it had occurred) would have depended on the value of the euro, a foreign currency in which positions are traded through regulated futures contracts.

The Sixth Circuit observed that, while the Tax Court's disallowance of the Wrights' claimed tax loss made sense as a matter of tax policy, the plain language of the statute clearly provides that a foreign currency option can be a "foreign currency contract." The Sixth Circuit thus remanded the case back to the Tax Court for further proceedings consistent with its opinion.

Before the Tax Court, the IRS conceded that the Wrights were not liable for the Code Sec. 6662 penalty but invoked several theories to support its determination of a deficiency, including (1) that the couple had not substantiated the foreign currency option's assignment to the Foundation, and (2) that the transaction was not entered into for profit. While Code Sec. 165(c) generally allows a deduction for any bona fide loss sustained during the tax year, the loss must be incurred in a transaction entered into for profit.

Although the Wrights argued that the option transactions were intended to diversify the Wrights' portfolio and produce a positive rate of return, Mr. Wright testified that the option transactions were "more for the tax benefit" and that the diversification of their investments was through other transactions undertaken on Cyber Advice's behalf.

Analysis

The Tax Court held that, regardless of whether the Wrights substantiated the foreign currency option's assignment to the Foundation, Code Sec. 165(c) prevented the Wrights from deducting their loss because the transactions were not entered into for profit. Thus, the court said, the Wrights were liable for the deficiency determined by the IRS.

In reaching its decision, the court relied on an IRS expert who credibly showed how the Wrights' transactions would perfectly offset each other. However, even though the positions offset nearly perfectly, the court noted that Cyber Advice could expect that it would always have a loss in one component option of the euro straddle that it purchased, which it could terminate (along with the offsetting sold position in a minor currency) at its discretion to generate an artificial capital loss.

The court concluded that any profit motive Cyber Advice may have had for entering into the foreign currency option transactions was indiscernible on the record before it. Even though the positions offset nearly perfectly, the court found that Cyber Advice could expect that it would always have a loss in one component option of the euro straddle that it purchased, which it could terminate (along with the offsetting sold position in a minor currency) at its discretion to generate an artificial capital loss.

The court also rejected the Wrights' contention that Code Sec. 1211(b) (which allows capital losses only to the extent of capital gains) and Code Sec. 1256(a) override the application of Code Sec. 165 with respect to losses arising from the sale or exchange of capital assets. The court noted that under Code Sec. 165(f), losses from sales or exchanges of capital assets are allowed only to the extent permitted in Code Secs. 1211 and 1212. In the court's view, Code Sec. 1256(a) does not change this analysis. That section, the court explained, concerns the timing and character of gain or loss from the sale deemed by Code Sec. 1256(a), not the ultimate allowability of a deduction in respect of any such loss for purposes of computing taxable income. The court said that other provisions, including Code Secs. 165, 1211(b), and Code Sec. 1212(b), work together to govern the extent to which a loss arising from a Code Sec. 1256(a) deemed sale is allowable as a deduction. The court reasoned that if Congress intended to permit the deduction of a loss arising from a Code Sec. 1256(a) deemed sale without regard to any other Code provision, it could have - and should have - said so expressly.

For a discussion of Code Sec. 1256 contracts, see Parker Tax ¶116,150. For a discussion of the criteria for determining whether a transaction was entered into for profit, see Parker Tax ¶97,505.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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