U.S. Taxation of Foreign Currency Transactions: A View From

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Over the past several years, new tax laws and regulations have provided guidance that has significantly clarified the taxation of foreign currency transactions. Prior to this, U.S. taxation of many of these transactions was, at best, unclear. While the laws and underlying regulations have gone a long way towards providing necessary guidance, foreign currency traders and hedgers (e.g., multinational U.S. corporations) must work their way through complex rules. The following example provides an overview of the U.S. tax consequences to both foreign currency traders and hedgers entering into a foreign exchange forward contract.

Example: On September 30, 1991, a U.S. multinational corporation, XYZ Corp., a calendar-year taxpayer, enters into a forward contract with ABC Bank to sell five million pounds on March 31, 1992, at $1.90/pound (or $9,500,000). XYZ Corp. will use the forward contract to hedge its investment in its U.K. subsidiary. Also, on September 30, 1991, U.S. individual A, a foreign currency commodity futures trader enters into a forward contract with ABC Bank to buy five million pounds on March 31, 1992 at $1.90/pound. A is also a calendar-year taxpayer. Assume that December 31, 1991 the exchange rate for the pound is $1.95 and, on March 31, 1992 it is $2.

Tax Consequences to XYZ Corp. (The Hedger)

Assuming that XYZ Corp.'s business activities typically generate ordinary income or loss, XYZ Corp.'s goal from a tax standpoint would be for the character of any gain or loss on the forward contract to result in ordinary income rather than capitai gain or loss. As under U.S. tax rules capital losses cannot offset ordinary income. Under the general rule of IRC Sec. 988, any gain or loss on a forward contract will be treated as ordinary. In addition, because the forward contract is a Sec. 1256 contract, the gain or loss will be marked to market on December 31, 1991. Any additional change in the contract's value after Decmeber 31, 1991 will be recognized as gain or loss on March 31, 1992, when the contract is closed. Based upon the currency movements presented in this example, XYZ Corp. will recognize a $250,000 ordinary loss on December 31, 1991 ($9,500,000 less $9,750,000). XYZ Corp also will recognize an additional $250,000 loss on March 31, 1992 ($9,500,000 less $10,000,000 = $500,000 less $250,000 previously recognized). Although the value of XYZ Corp.'s investment in its U.K. subsidiary has increased by $500,000 due to movement in the exchange rate, that increase will not be taxable until the investment is sold.

Under a special rule in Sec. 988, if XYZ Corp. used a regulated futures contract or a nonequity option to hedge its foreign currency exposure, the instrument would be marked to market at December 31, 1991, and treated as 60% long-term and 40% short-term capital loss. However, XYZ Corp. could make an election under Sec. 988 to treat gains or losses on Sec. 1256 futures contracts and foreign currency options as ordinary, thereby achieving the same tax treatment as achieved with a forward contract of the type described in the example. however, once this election is made, it may only be revoked with the consent of the IRS and then applied to all such futures contracts and options held by the taxpayer. …