When Do Foreign Currency Forward Contracts Constitute Sec. 1256 Contracts?

Multinational corporations conducting business in foreign countries often enter into foreign currency derivatives to hedge their exposure with respect to anticipated acquisition or disposition of nonfunctional currency (i.e., generally a currency other than the currency in which the corporation keeps its books). Multinationals may manage this risk between affiliates rather than entering into foreign currency derivatives with third parties.

For certain foreign currency derivatives, such as a foreign currency forward contract, Sec. 1256 provides special timing rules. Whether those rules under Sec. 1256 apply to a foreign currency derivative depends on the definition of “foreign currency contract.” The stakes for multinational corporations can be fairly high in the current market, where foreign currency values can change rapidly.

Background

Under the Sec. 1256 special timing rule, a taxpayer must determine taxable income or expense in respect of any foreign currency contract annually on a mark-to-market basis (i.e., by treating the contract as if it were sold at the end of each tax year). Sec. 1256(a)(2) further provides that a taxpayer must make proper adjustments to gain or loss subsequently recognized on the sale, disposition, or settlement of such contract. This rule generally is referred to as the “mark-on-disposition” rule. (These mark-to-market timing rules do not apply to a Sec. 1256 contract that is a hedge clearly identified before the close of the day on which the taxpayer entered into the transaction (Sec. 1256(e).)

Sec. 1256 also contains a special income characterization rule, which generally does not apply to foreign currency contracts. In general, gain or loss from foreign currency contracts is ordinary under Sec. 988, absent certain elections. However, gain or loss (including mark-to-market gain or loss) on a Sec. 1256 contract generally is treated as 40% short-term capital gain or loss and 60% long-term capital gain or loss. This overlap is resolved by the application of Sec. 988 ordinary income treatment, absent an election, to the extent that the contract is not an exchange-traded regulated futures contract. Therefore, gain or loss arising from a disposition or settlement of a foreign currency forward contract generally ought to be ordinary in character, regardless of whether the contract represents a foreign currency contract under Sec. 1256(g)(2). This item briefly examines the definition of a foreign currency contract and, in particular, whether the definition includes foreign currency forward contracts entered into between nonbank counterparties.

Foreign Currency Contract

Under Sec. 1256(g)(2)(A), a foreign currency contract is subject to the mark-to-market timing rule if:

• It requires delivery of, or its settlement depends on the value of, a foreign currency that is a currency in which positions are traded through regulated futures contracts (defined by Sec. 1256(g)(1));
• It is traded in the interbank market; and
• It is entered into at arm’s length at a price determined by reference to the price in the interbank market.

While there was some ambiguity on this point until recently, the IRS has concluded that foreign currency options ought not be considered foreign currency contracts for purposes of Sec. 1256(g)(2) (see Notices 2007-71 and 2003-81). Thus, this item focuses on foreign currency forward contracts.

A currency in which positions are traded through regulated futures contracts is often referred to as a “major” currency by practitioners, while a currency in which positions are not traded through regulated futures contracts is often referred to as a “minor” currency. Accordingly, only foreign currency contracts on major currencies may be subject to Sec. 1256 if they are traded in the interbank market.

Interbank Market

To be a “foreign currency contract” under Sec. 1256, the contract must be traded in the interbank market. The Code offers little definition of the term “interbank market,” under either Sec. 1256 or other Code sections that use analogous concepts (see Regs. Sec. 1.1273-2(f)). Sec. 1256, as enacted as a part of the Economic Recovery Tax Act of 1981, P.L. 97-34, provided rules applicable to exchange-traded regulated futures contracts on foreign currencies but did not provide rules applicable to economically similar over-the-counter contracts entered into with banks.

In 1982, Congress expressed concern that taxpayers using economically comparable contracts received different tax treatment (see H. Rep. 97-794, 97th Cong., 2d Sess. 23 (1982)). Taxpayers using exchange-traded regulated futures contracts received 60% long-term and 40% short-term capital gains regardless of the holding period. A taxpayer with an interbank foreign currency contract had entirely short-term gain unless it held a long contract for the long-term capital gains holding period. (This was before the enactment of Sec. 988, which caused gains and losses from foreign currency contracts to be treated as ordinary.)

Congress did not, however, intend that all foreign currency forward contracts be characterized as Sec. 1256 contracts. Specifically, Congress noted that

[c]ontracts traded in the interbank market generally include not only contracts between a commercial bank and another person but also contracts entered into with a futures commission merchant who is a participant in the interbank market. A contract between two persons neither of whom is a futures commission merchant or similar participant in the interbank market is not a foreign currency contract under this provision. (Emphasis added.) (H.R. Conf. Rep. 97-986, 97th Cong., 2d Sess. 4213 (1982).)

The IRS, in administrative guidance, has concluded that the interbank market refers to the over-the-counter market maintained by banks to purchase and sell foreign currency and financial products. Specifically, the IRS stated that the interbank market is not a formal market but rather a group of banks holding themselves out to the general public as being willing to purchase, sell, or otherwise enter into certain transactions (see FSA 200025020).

The IRS also broadly interprets interbank market to include all banks and investment banks (as the terms are generally used in the marketplace). Due to the IRS’s seemingly broad interpretation of the term “interbank market,” taxpayers must consider whether a foreign currency forward contract negotiated between two private parties, neither of which is a bank or provides bank-like services to customers, qualifies as a foreign currency contract within the meaning of Sec. 1256(g)(2).

While the IRS may take a broad view of the definition of “foreign currency contract,” it is not clear that its view trumps Congress’s expressed intent that the term not include contracts entered into by private parties where neither party is a bank, futures commission merchant, or other “similar participant” in the interbank market. Accordingly, a privately negotiated currency forward contract between two parties, neither of which is a bank (in the broadest sense), arguably would not appear to be subject to Sec. 1256.

However, for many multinational companies, this conclusion may not be the end of the analysis. If a large multinational company has one or more treasury centers that perform bank-like functions for the parent company’s affiliates, it seems difficult to draw the line between a foreign currency forward contract between two “private” parties and a bank foreign currency forward contract. Could such a treasury center be viewed as a “similar participant in the interbank market”? This might require a facts-and-circumstances analysis to determine the level of participation of these treasury centers in the interbank market, the frequency of dealings in the interbank market, and the nature of the specific terms of the contract between the parties.

Collateral Issues

If it is determined that particular foreign currency forward contracts are not subject to Sec. 1256 (because neither affiliate of the multinational company is a participant in the interbank market), such contracts ought to give rise to gain or loss based on realization-based timing principles. Note that resolving the potential application of Sec. 1256 does not by itself resolve the overall timing treatment of foreign currency forward contracts. Rules such as the straddle rules (under Sec. 1092), the hedging rules (under Sec. 1221 and Regs. Sec. 1.446-4), and the specific elective foreign currency integration rules (under Regs. Sec. 1.988-5) each might affect the timing of gain or loss on a foreign currency forward contract. However, to understand the potential application of each of these provisions, the potential application of Sec. 1256 to the foreign currency contract first must be determined.

From Rebecca Lee, J.D., LL.M., and Wei-Chin (Michael) Mou, J.D., LL.M., Washington, DC

A company organized under the laws of a foreign country that does not conduct business in the United States still may be “relevant” for purposes of U.S. taxation. Therefore, it may be necessary to select a federal tax classification to minimize U.S. tax. The tax affairs of a foreign entity may create a disclosure or information reporting obligation, such as Form 8858, Information Return of U.S. Persons with Respect to Foreign Disregarded Entities, or Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. A foreign entity also may create subpart F income for its U.S. owners if proper entity classification planning is overlooked.

Classification Election

As with eligible domestic entities, a classification election for an eligible foreign entity is made by filing Form 8832, Entity Classification Election. Regs. Secs. 301.7701-1 through -3 (the check-the-box regulations) contain the entity classification rules that should be reviewed before an election is filed. In filing Form 8832, the electing entity must specify whether the election is an “initial classification by a newly formed entity” or a “change in current classification.” Determining which option applies depends on whether the election is made effective as of the date of relevance (or before) or as of a later date.

Applicable Guidance

The applicable rules on the classification of foreign entities and the date a foreign entity becomes relevant for U.S. tax purposes have evolved since the advent of the check-the-box regime in 1996. The Internal Revenue Manual states that, for foreign entities formed after 1996 and before October 21, 2003, a foreign entity has a U.S. tax classification even if that entity is not relevant (see IRM Section 4.61.5.3.1). In other words, the entity had a classification regardless of whether the entity affected what was reported on a U.S. income tax or information return.

That rule was modified by an October 2003 clarification to the regulations. Today, the concept of relevance for a foreign entity is delineated in Regs. Sec. 301.7701-3(d)(1)(i), which provides that a foreign eligible entity’s classification is relevant when its classification affects the liability of any person for federal tax or information purposes.

Under this current regulatory provision, a foreign entity is not deemed to have a federal tax classification until the entity is relevant for U.S. tax purposes. In addition, a foreign entity can become relevant for U.S. tax purposes even if the acquiring entity (e.g., a U.S. company) takes no action with regard to the entity after it is acquired.

Unless the foreign eligible entity elects otherwise, Regs. Sec. 301.7701-3(b)(2) states that the entity will default to:

• A partnership if it has two or more members and at least one member does not have limited liability with respect to the entity’s debts;
• An association (taxable as a corporation) if all members have limited liability; or
• A disregarded entity (not separate from its owner) if it has a single owner that does not have limited liability.

A foreign eligible entity that otherwise is not relevant nevertheless can make itself relevant by affirmatively filing Form 8832 and electing its federal tax classification. The election will stay in place, regardless of whether the electing entity is ever reported on a U.S. return, for five years (see Regs. Secs. 301.7701-3(d)(2) and (3)).

Relevance Issues

1.  How is the date when a foreign entity becomes relevant for U.S. tax purposes determined?

The date is determined by looking to the date the foreign entity will affect what is reported on a U.S. income tax or information reporting return, or the date elected on a Form 8832 filed by the entity, whichever date is earlier. If no Form 8832 is filed, the foreign entity will be deemed to have defaulted to its classification as of the date the entity becomes relevant. This default classification will affect what is reported on a U.S. income tax or information reporting return.

2. What if the foreign entity making the election is not newly formed but was acquired recently as a shelf company?

Assuming that the entity was formed after October 21, 2003, the foreign entity has 75 days following the date it becomes relevant (i.e., the date the entity defaults to its federal tax classification) to file Form 8832 and elect a classification other than its default classification (Regs. Sec. 301.7701-3(c)(1)). This election will constitute an initial election, despite its not being effective as of the date of formation, because the foreign entity had no classification before that date. Note that Rev. Proc. 2002-59, which allows a late-filed Form 8832 to be treated as timely in certain limited situations, cannot be invoked to make the election for a shelf company after the 75-day period because that revenue procedure applies only if the election is effective as of the date the company was formed. Compare Rev. Proc. 2002-59, §4.01(1), with Regs. Secs. 301.7701-3(c)(1)(i) and (ii).

3. What if the foreign entity never has been relevant for U.S. tax purposes but the entity’s owner must start filing a U.S. income tax return for which the entity’s federal tax classification is relevant?

Whether an effective Form 8832 can be filed will depend on the taxpayer’s particular facts and circumstances. If, for example, a foreign individual is physically in the United States for a set number of days during the tax year, the individual may become liable for filing a U.S. tax return for that full tax year. This outcome means that it might be determined only late in the year (after the foreign individual has been present in the United States for the requisite number of days) that a foreign entity owned by the foreign individual effectively became relevant as of the first day of the year.

Under some circumstances, the foreign entity may qualify for “9100 re-lief” under Regs. Sec. 301.9100-3 to make an initial election effective as of the date of formation or as of the date the entity became relevant for U.S. tax purposes. If 9100 relief is not available, other alternatives, including liquidating or restructuring the foreign entity before it otherwise would become relevant, should be considered.

From Daniel Wiles, J.D., and Kevin Curran, J.D., LL.M., Washington, DC

In February 2008, the IRS issued proposed regulations (REG-124590-07) intended to clarify the manufacturing exception in the context of foreign base company sales income (FBCSI) under Sec. 954(d)(1). Among other things, the proposed regulations address the application of the manufacturing exception where a controlled foreign corporation (CFC) does not satisfy the physical manufacturing test but the CFC (or its branch) is involved in the manufacturing process. Until the regulations are finalized, taxpayers may follow the existing final regulations or elect to apply the proposed rules.

“Substantial Contribution” Standard

The IRS recognized that due to business considerations in the global marketplace, property may be produced under a contract manufacturing arrangement under which a CFC engages in manufacturing-related activities but does not itself manufacture the property. Thus, the proposed regulations introduce a new test of a CFC’s nonphysical “substantial contribution” to manufacturing. Under this new approach, a CFC principal may be deemed the manufacturer of a product—and thus qualify for the manufacturing exception—if its employees conduct activities that constitute a substantial contribution to the manufacturing process, even if the principal itself does not physically manufacture the product. Whether a CFC principal has satisfied the substantial contribution test is based on facts and circumstances.

The regulations offer a nonexclusive list of factors to consider in determining whether a CFC principal makes a substantial contribution:

• Oversight and direction of the activities or process (including management of the risk of loss). The regulations emphasize the CFC principal’s substantive activities, rather than mere contractual rights.
• Performance of manufacturing activities that are considered in, but would not satisfy, the “physical manufacturing” tests of Regs. Sec. 1.954-3(a)(4). The IRS reiterated its intent to consider nonphysical manufacturing activities as well as those that are physical but do not qualify as “substantial transformation” under the existing subpart F regulations, such as minor assembly.
• Control of raw materials, work in process, finished goods, material selection, vendor selection, and logistics. The proposed regulations would not explicitly require ownership of inventory by the CFC principal to be considered to have control. Rather, the regulations focus on the substantive control activities in the supply chain during the manufacturing process.
• Management of manufacturing profits. Such profits may relate to the impact on the overall profitability contributed by manufacturing.
• Quality control. Relevant activities may include exercising oversight and control rights over the quality of the products manufactured and providing guidelines and remediation decisions when a quality control threshold is breached.
• Direction of development, protection, and intellectual property used in manufacturing the product. This standard focuses on manufacturing-related intellectual property.

The regulations specifically use the word “employee” to ensure that only the activities performed by the employees of the CFC principal would be considered in determining whether a substantial contribution has been made to the manufacturing process by the CFC principal. The proposed regulations also would not distinguish between buy-sell and toll (consignment) contract manufacturing arrangements, although the examples appear to center on a toll arrangement.

Dismissing the “Its” Argument

In the preamble and, implicitly, in the language of the proposed regulations themselves, the IRS dismissed the “its” argument, under which taxpayers take the position that no FBCSI would result when a CFC sells different property than the property it buys. Taxpayers have argued that because Sec. 954(d)(1) refers to the purchase of personal property from a related person and “its” sale to any person, the provision applies only when the same property is sold. The regulations also implicitly reject the approach of “attributing” the contract manufacturer’s activities to the CFC principal.

Observations

Although the proposed regulations were intended to reduce controversy and provide clarification on certain contract manufacturing arrangement issues, taxpayers have expressed many concerns about the proposed rules. The proposed facts-and-circumstances test for substantial contribution could result in both flexibility and uncertainty. For example, the weight given to any activity (whether or not listed above) varies with the circumstances of a particular business. The presence or absence of any of the above activities, or of a particular number of activities, is not determinative.

In addition, the regulations provide examples to illustrate both the substantial contribution standard and other issues. Some of the other examples may have unintended implications for the substantial contribution standard. Questions have been raised about the interaction of these examples and how the IRS might use them during an examination. IRS officials have urged taxpayers to focus on the rules themselves rather than on the examples. Therefore, it is unclear to what extent taxpayers may rely on the examples.

Multinational corporations may need to reevaluate existing structures in light of the proposed regulations. Some companies may find it preferable to avoid contract manufacturing arrangements in favor of other structures, while others may find it advantageous to enter into new contract manufacturing arrangements.

From Irene Pik-Wah Hui, CPA, Washington, DC