The Section 1256 club is hard to get into: Futures on foreign exchanges often don't qualify

By Robert A. Green, CPA

Section 1256 offers up to 12% lower capital gains tax rates on short-term trading with its attractive 60/40 tax rates. It includes regulated futures contracts (RFCs), broad-based stock indices, options on those indexes, options on futures, nonequity options, certain off-exchange foreign currency contracts and a few other items. But it can be a hard club to get into. Among Section 1256 contracts, regulated futures contracts, nonequity options and securities futures contracts must be traded on or subject to the rules of a “qualified board or exchange” (QBE). U.S. exchanges make the list pretty easily, but foreign exchanges don't. Let's look at the QBE requirement in more detail.

QBE
Section 1256 includes a list of those exchanges that are considered QBEs. Imagine Section 1256 being a popular club with a bouncer at the door holding a VIP guest list. If the exchange or board of trade you trade on is not on the QBE list, then the contracts you trade are excluded from Section 1256 tax treatment — even if they are regulated futures contracts.

QBEs include national securities exchanges registered with the SEC (category 1), domestic boards of trade designated as a “contract market” by the CFTC (category 2) or any other exchange or board of trade or other market (worldwide) that the CFTC and Treasury determines has rules adequate to carry out the purposes of Section 1256 (category 3).

According to Section 1256, contracts on category 1 and 2 exchanges are deemed RFCs if the contract “(A) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (B) is traded on or subject to the rules of a qualified board or exchange.” (This doesn't include securities futures contracts.)

The first step in finding out if a product qualifies for Section 1256 is to see if its exchange is on the QBE list. Don't jump to that conclusion just because you received a 1099B reporting Section 1256 treatment. E&Y's “Updated 2013 US IRC Section 1256 qualified board or exchange list” is a handy reference.

Notice the North American Derivatives Exchange (Nadex) — a domestic board of trade — is a category 2 because it's regulated by the CFTC. In part two of this blog series, I discuss whether Nadex binary options and credit spreads are RFCs under the Section 1256 definition and requirement.

Foreign exchanges with QBE status
These category 3 foreign QBEs received a CFTC exemption (“no action letter”) and Treasury/IRS determination granting them QBE status published in a required revenue ruling:

• International Futures Exchanges (Bermuda) Ltd.(inactive)

• Mercantile Division of the Montreal Exchange (inactive)

• Mutual Offset System – partnership between Chicago Mercantile Exchange and Singapore International Monetary Exchange Limited

• ICE Futures

o Per RIA, “a United Kingdom Recognized Investment Exchange that was (1) a wholly-owned subsidiary of a U.S. parent corporation, and (2) overseen by the U.K.'s Financial Services Authority, provided that the exchange continued to comply with all CFTC conditions necessary to retain its no-action relief permitting it to make its electronic trading and matching system available in the U.S.”

• Dubai Mercantile

• ICE Futures Canada a regulated exchange of Canada

• London International Financial Futures and Options Exchange (LIFFE)

o Per RIA, “Is a regulated exchange of the United Kingdom … Exchange offered electronic trading of commodity futures contracts and other futures and options contracts. Contracts were cleared and settled by Clearing House, a CFTC-regulated Derivatives Clearing Organization. The CFTC had granted Exchange no-action relief permitting it to make its electronic trading and matching system available in the U.S.”

• Eurex Deutschland

o Per RIA, “Is a regulated exchange of Germany, as long as: either CFTC continues to allow Eurex to provide direct access to its electronic trading and order matching system from U.S. under existing no action letter, pending CFTC approval of Order of Registration, or Eurex holds valid Order of Registration as foreign boards of trade (FBOT). IRS grants consent to taxpayers to change to Section 1256 mark to market method for 1st taxable year during which taxpayer holds Eurex Deutschland Contract that was entered on or after 3/1/2013.”

CFTC looks abroad
The CFTC's reach is global — protecting customers located in the U.S. trading on foreign exchanges.

The CFTC website (international foreign products) says “These regulations are designed to carry out Congress's intent that foreign futures and foreign options products offered or sold in the U.S. be subject to regulatory safeguards comparable to those applicable to domestic transactions. As set forth in CFTC Regulation 30.4, any domestic or foreign person engaged in activities like those of a futures commission merchant (FCM), introducing broker (IB), commodity pool operator (CPO), or commodity trading advisor (CTA) must register in the appropriate capacity or seek an exemption from registration under CFTC Regulation 30.5 or CFTC Regulation 30.10.”

The first step in finding out if Section 1256 applies is to look up the CFTC no action letter with 30.5 or 30.10 exemption. The CFTC publishes current and pending no action letters at “Foreign Government Agencies and SROs that have Received CFTC Orders under CFTC Regulation 30.10” and “Pending Requests for CFTC Regulation 30.10 Exemption.”

Treasury's determination is published
The second step is to look up the IRS revenue ruling. The IRS has a two-step process for these determinations.

1. The foreign exchange must submit a private letter ruling requesting QBE status. If the IRS is satisfied that the exchange has sufficient rules for application of Section 1256, it publishes a revenue ruling. The revenue ruling applies to the commodity futures contracts and futures contract options only entered on the named exchange, and not any affiliated exchanges. For example, Section 1256 applies for futures traded on Eurex Deutschland, but not for futures traded on an affiliate of Eurex Deutschland.

2. The IRS looks to see if the exchange obtained a CFTC exemption (no action letter). Section 738 of the Dodd-Frank Act gives the CFTC authority to adopt rules and regulations that require registration of a foreign board of trade that provides U.S. participants direct access to the board of trade's electronic trading system. This proposed registration system is supposed to replace the no-action letter process.

Mergers, partnerships and cooperation lead to questions about QBE status
There have been several cross-border mergers and acquisitions, partnerships and other cooperation agreements between U.S., EU and Asian exchanges and foreign boards of trade. These mergers and affiliations are confusing brokers, who are then confusing their clients. Keep things simple and clear: make sure you see an IRS revenue ruling in the exact name of the exchange you trade on.

When a U.S. QBE has a “mutual offset agreement” with a non-QBE foreign exchange, the IRS treats trades executed on the foreign exchange that are assumed by the U.S. QBE as Section 1256. But trades executed on the U.S. QBE that are assumed by the foreign exchange are not considered Section 1256. This was the case with the CME/SIMEX Mutual Offset System 1987 revenue ruling listed above.

If a U.S. QBE acquires a foreign non-QBE, generally the foreign regulator oversees the foreign non-QBE. It seems reasonable to believe that the foreign non-QBE should not automatically inherit the U.S. exchange's QBE status without getting a CFTC exemption (no-action letter) and a formal determination by Treasury. The ICE Futures 2009 revenue ruling listed above is a similar case.

Dodd Frank rules for swaps
As of 2011, the Dodd-Frank Act requires privately negotiated derivatives contracts to clear on derivatives exchanges or boards of trade. The CFTC is trying to coordinate these rules with similar ones enacted in the EU. Among other things, the CFTC wants EU swaps exchanges to report on trading activities by Americans. Dodd-Frank law and IRS proposed regulations exclude swap contracts from Section 1256.

Many foreign exchanges don't want U.S. filings
NYC tax attorney Roger Lorence heard from Treasury and IRS officials that several foreign exchanges and boards of trade fear getting involved with the U.S. Treasury and IRS — perhaps due to controversial U.S. FATCA and FBAR reporting — so they don't want a CFTC exemption and Treasury determination granting them QBE status. But perhaps they will change their minds if Americans demanding QBE status become a major part of their business activity.