The Sixth Circuit tackled a complex question involving the interpretation and application of Internal Revenue Code Section 1256 as it applies to so-called “major-minor” currency transactions. The term “major-minor” is a reference to the fact that a currency is considered “major” if positions in it are traded through regulated futures contracts and a currency is “minor” if there is not a regulated futures contract for the currency.
In Wright, et al. v. Comm’r of Internal Revenue, Petitioners Terry and Cheryl Wright engaged in a major-minor currency transaction in which they purchased a call option (an option to buy a currency for a specified price) on the Euro, a major currency, and a call option on the Danish Krone, a minor currency, from Beckenham Trading Company. Simultaneously, the Wrights sold a Euro put option (the option to sell a currency for a specified price) and a Krone put option to Beckenham. While the transaction is complex, it is only essential to know that the call and put on the Euro and the Krone were for identical values and had mirroring terms. In this way, if the Euro appreciated in value, the call would increase in value and the put would decrease in value in the same amount, thus assuring gain on one and a loss on the other.
At the end of the year, the Wrights assigned the euro put and the Krone put (each valued at approximately $33 million) to a charity and sold the euro call and repurchased the krone call from Beckenham. Through this transaction, and others not relevant to the issue, the Wrights reported almost $3 million dollars of short term capital loss which they used to reduce their capital gains from about $3.4 million to $454,477. Upon filing their tax returns, the IRS issued a notice of deficiency for over $600,000 and assessed penalties for a substantial understatement of tax. In tax court, the relevant issue was whether the euro put option was a “foreign currency contract” as defined by Section 1256(g)(2)(A)(i) of the Internal Revenue Code. The Tax Court found that the euro put was not a foreign currency contract, reasoning that the definition requires that foreign currency contracts contain a mandate that the contract be settled. Because a put option gave the Wrights the right to execute the option (resulting in settlement), but not an obligation to do so, the put option was not a foreign currency contract. The result of this decision was that the Wrights could not recognize a short-term capital loss on the option.
On appeal, the Sixth Circuit recognized that the Tax Court’s reasoning was supported by sound tax policy, namely that artificially creating capital loss while simultaneously negating virtually any economic risk, cut against the clear intent of the drafters of Section 1256. However, when interpreting the tax code, the plain language of the code section must be ascertained; if it is clear, there is no other analysis needed. The Sixth Circuit found that the plain language of Section 1256, which defines a foreign currency contract as a contract “which requires delivery of, or settlement of which depends on the value of a foreign currency…” was clear in that it only requires that, if a settlement does occur, the settlement must be based on the value of a foreign currency. The Sixth Circuit noted that the comma following “delivery of” within the definition of foreign currency contract “establishes that the word ‘requires’ does not apply to the settlement prong [of the definition.]” The settlement of the euro put option, had it occurred, would have been based on the value of the euro; however, the obligation to settle the put option “may never arise if the holder does not execute its rights under the option[.]”
Despite the fact that the Sixth Circuit found “no conceivable tax policy that supports this interpretation of the plain language of Section 1256,” the Sixth Circuit decided that “[t]he fact that tax policy does not appear to support allowance of the Wrights’ claimed loss is not sufficient to reform statutory language[.]” The Sixth Circuit has made it clear that if this tax outcome is to be prevented, Congress will have to amend the Code.