Tax Treatment for Swaps, Options on Swaps, Futures Swaps, and Options on ETFs Partially Consisting of Swaps

Congress incorporated into section 1256(b)(2)(B) a list of swaps that parallels the list of swaps included under the definition of a notional principal contract in §1.446-3(c) with the addition of credit default swaps. The parallel language suggests that Congress was attempting to harmonize the category of swaps excluded under section 1256(b)(2)(B) with swaps that qualify as notional principal contracts under §1.446-3(c), rather than with the contracts defined as “swaps” under section 721 of the Dodd-Frank Act. Accordingly, § 1.1256(b)-1(a) of the proposed regulations provides that a section 1256 contract does not include a contract that qualifies as a notional principal contract as defined in proposed §1.446-3(c).

Basically, if the IRS is correct, then a real estate index swap should be excluded from 1256 treatment because it's considered a notional principal contract under Regulation §1.446-3(c). We believe the IRS view is a correct interpretation of the statute and should be followed.

Options on Swaps
In the Preamble, the IRS also takes the position that an option on a notional principal contract doesn't qualify for 1256 treatment. This view is harder to fit into the language of Section 1256, though the IRS reasoning is sound.

Proposed regulations are not binding until they are made final. Nevertheless, they are statements of current IRS thinking, so taxpayers taking a contrary position could be challenged by the IRS. We strongly recommend following the IRS by excluding all “notional principal contracts” (such as real estate index swaps) from Section 1256. We also recommend following the IRS proposal with regard to options on swaps, even though it's not clear whether Section 1256 requires this conclusion.

Options on ETFs Consisting of Swaps and other Securities:
Often, ETFs consist of both swaps and other securities. See, for example, http://www.proshares.com/funds/uyg_daily_holdings.html?show=all. What is the tax treatment of such ETFs? As discussed in our March blog, income generated while holding the ETFs passes through to the holders. If, for example, 25% of the ETF's income passed-though on a Schedule K-1 is generated by Section 1256 contracts, then 25% of the income will be subject to Section 1256. If the ETF is treated as a partnership, then the gain on the sale of the ETF will not get Section 1256 treatment because the ETF itself is still a security.

What happens if you purchase an option on such an ETF? Is it treated as an option on a broad-based securities index with Section 1256 treatment, or does the presence of swaps mean it fails to qualify for Section 1256 treatment? In our March blog, we made the case for treating options on broad-based securities ETFs as Section 1256 contracts. But when swap contracts are a significant component of the underlying ETF, the answer is unclear.

Given the fact that options on swaps are not clearly covered by Section 1256, and are discussed only in proposed regulations that are non-binding, there might be an opening to be lenient where the swaps constitute a minority of the ETF. This is an area where a tax opinion from our tax attorney would be a good idea to avoid penalties if you're later challenged by the IRS.

Futures Swaps
According to Reuters, CME Group Inc. “is planning to offer a new suite of futures tied to interest rate swaps later this year, as the giant exchange operator seeks to take advantage of a regulatory push for more of the $400 trillion over-the-counter swaps market to move into clearinghouses and onto regulated trading platforms.”

This begs the following tax question: Will these futures swap contracts be taxed as regulated futures contracts (RFCs) traded on U.S. futures exchanges, which are listed in Section 1256, or will they be subject to ordinary gain or loss treatment like swap contracts in general?

According to our research, futures swaps probably have Section 1256 treatment:
Where to report swap transactions
In general, swaps are ordinary gain or loss treatment reported on line 21 “Other Income” of Form 1040 like the default treatment for forex in Section 988. Similarly like forex, you can report swaps in summary form on realized gains and losses only. Unlike with forex, you cannot file an opt-out election to treat swaps as capital gains or losses. If you have trader tax status (business treatment), you can use Form 4797 Part II (ordinary gain or loss) instead of line 21 of Form 1040.

If treated like other RFCs, futures swaps are reported on Form 6781 Part I (Section 1256 contracts). These flow to Schedule D with 60/40 treatment. If you have a large capital loss carryover to use up, you can apply it against capital gains only, which includes futures swaps but not regular swaps treated with ordinary income.

Bottom line
If you hear the term “swap” in any of the instruments you trade, be on the lookout for ordinary gain or loss treatment. Remember, even if it clears on a futures exchange, it's not allowed to have Section 1256 treatment, unless it's a new “futures swap.” A few options on ETFs with swap components may have 1256 treatment, too.

In general, if you want Section 1256 treatment, it's best to read our content and check with our tax attorney. One recent client had over $2 million in trading gains on options on ETFs. He wanted to use Section 1256 treatment on many of these ETF options and it was a challenge. Some involved swaps, too. Our tax opinion letter helped him a lot.

• Proposed Regs 1.1256-1(a) state: “A section 1256 contract does not include any contract, or option on such contract, that is a notional principal contract as defined in §1.446-3(c). A contract that is defined as both a notional principal contract in §1.446-3(c) and as a section 1256 contract in section 1256(b)(1) is treated as a notional principal contract and not as a section 1256 contract.” (A swap is considered a notional principal contract.)
  
• The preamble to those regs states: “Section 1256(b)(2)(B) raises questions as to whether an option on a notional principal contract that is traded on a qualified board or exchange would constitute a ‘similar agreement' or would instead be treated as a nonequity option under section 1256(g)(3). Since an option on a notional principal contract is closely connected with the underlying contract, the Treasury Department and the IRS believe that such an option should be treated as a similar agreement within the meaning of section 1256(b)(2)(B). Accordingly, §1.1256(b)-1(a) of the proposed regulations also provides that a section 1256 contract does not include an option on any contract that is a notional principal contract defined in §1.446-3(c) of the proposed regulations.”
  
• This seems limited to options. It is not clear whether the same reasoning would apply to futures, but so long as the Treasury doesn't explicitly include futures, we feel we're safe in not including futures.