The IRS has published Proposed Regulations clarifying that for purposes of the mark-to-market rules under section 1256, foreign currency contracts include only foreign currency forward contracts, and that the definition does not include foreign currency options. The proposed regulations do not affect the status of foreign currency options otherwise qualifying as section 1256 contracts, such as foreign currency options trading on certain exchanges; however, holders of over-the-counter currency options that previously treated the options as foreign currency contracts under the mark-to-market rules may need to reassess their treatment of these options.

Only certain investments such as foreign currency contracts are subject to section 1256, which requires annual recognition of gains and losses as capital gains and losses using a ratio of 40% short-term and 60% long-term. Other foreign currency transactions are subject to tax at ordinary income tax rates under section 988. In a series of cases involving over-the-counter foreign currency options, the Tax Court held that foreign currency options did not constitute foreign currency contracts under section 1256, relying largely on legislative history, but was reversed by the Sixth Circuit’s finding that the statutory provision was broad enough to cover foreign currency options. The IRS has now refined the definition of section 1256 foreign currency contracts to include only forward contracts in an attempt to resolve uncertainty created by the Sixth Circuit’s decision and in line with prior Tax Court decisions interpreting section 1256 that distinguished between options and forward contracts on the basis that forward foreign currency contracts require settlement at expiration whereas foreign currency options do not require settlement thereof.

The proposed regulations would be effective 30 days after final regulations are published.