n-03-81.pdf

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Part III - Administrative, Procedural and Miscellaneous

Tax Avoidance Using Offsetting Foreign Currency Option Contracts

Notice 2003-81

The Internal Revenue Service and the Treasury Department are aware of a type
of transaction, described below, in which a taxpayer claims a loss upon the assignment
of a section 1256 contract to a charity but fails to report the recognition of gain when the
taxpayer’s obligation under an offsetting non-section 1256 contract terminates. This
notice alerts taxpayers and their representatives that these transactions are tax
avoidance transactions and identifies these transactions, and those that are
substantially similar to these transactions, as listed transactions for purposes of
§ 1.6011-4(b)(2) of the Income Tax Regulations and §§ 301.6111-2(b)(2) and 301.6112-
1(b)(2) of the Procedure and Administration Regulations. This notice also alerts parties
involved with these transactions of certain responsibilities that may arise from their
involvement with these transactions.

FACTS

A taxpayer pays premiums to purchase a call option and a put option (the
purchased options) on a foreign currency. The currency is one in which positions are
traded through regulated futures contracts, and the purchased options, therefore, are
foreign currency contracts within the meaning of section 1256(g)(2)(A) of the Internal
Revenue Code and section 1256 contracts within the meaning of section 1256(b). The
purchased options are reasonably expected to move inversely in value to one another
over a relevant range, thus ensuring that, as the value of the underlying foreign
currency changes, the taxpayer will hold a loss position in one of the two section 1256
contracts. The taxpayer also receives premiums for writing a call option and a put
option (the written options) on a different foreign currency in which positions are not
traded through regulated futures contracts. Thus, the written options are not foreign
currency contracts within the meaning of section 1256(g)(2)(A), nor are they section
1256 contracts within the meaning of section 1256(b). The written options are
reasonably expected to move inversely in value to one another over a relevant range,
thus ensuring that, as the value of the underlying foreign currency changes, the
taxpayer will hold a gain position in one of the two non-section 1256 contracts.

The values of the two currencies underlying the purchased and written options (i)
historically have demonstrated a very high positive correlation with one another, or (ii)
officially have been linked to one another, such as through the European Exchange
Rate Mechanism (ERM II). Thus, as the currencies change in value, the taxpayer
reasonably expects to have the following potential gains and losses in substantially
offsetting positions: (1) a loss in a purchased option and a gain in a written option; and
(2) a gain in a purchased option and a loss in a written option. At any time, the
taxpayer’s loss in the purchased option position that has declined in value may be more

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or less than the taxpayer’s gain in the offsetting written option position that has
appreciated in value. Similarly, the taxpayer’s gain in the remaining purchased option
position may be more or less than the taxpayer’s loss in the remaining written option
position. A material pre-tax profit or rate of return, or both, on the transaction is possible
but unlikely.

The taxpayer assigns to a charity the purchased option that has a loss. The
charity also assumes the taxpayer's obligation under the offsetting written option that
has a gain. As with all written options, the amount of gain on the option is limited to the
premium received for the option. In the same tax year, the taxpayer may dispose of the
remaining purchased option and offsetting written option.

Because the purchased option assigned to the charity is a section 1256 contract,
the taxpayer relies on section 1256(c) and Greene v. United States
, 79 F.3d 1348
(2d Cir. 1996), to mark to market the purchased option when the option is assigned to
the charity and to recognize a loss at that time. In contrast, because the assumed
written option is not a section 1256 contract, the taxpayer claims not to recognize gain
attributable to the option premium. Specifically, the taxpayer claims that the charity’s
assumption of the option obligation does not cause the taxpayer to recognize gain and
that the taxpayer also does not recognize gain either at the time the option expires or
terminates or at any other time.

ANALYSIS

Rev. Rul. 58-234, 1958-1 C.B. 279, clarified by
Rev. Rul. 68-151, 1968-1 C.B.
363, holds that an option writer does not recognize income or gain with respect to a
premium received for writing an option until the option is terminated, without exercise, or
otherwise. Accord
Rev. Rul. 78-182, 1978-1 C.B. 265; Koch v. Commissioner, 67 T.C.
71 (1976), acq. 1980-2 C.B. 1. Rev. Rul. 58-234 explains that this is the treatment for
the option writer because the option writer assumes a burdensome and continuing
obligation, and the transaction therefore stays open without any ascertainable income or
gain until the writer’s obligation is finally terminated. When the option writer’s obligation
terminates, the transaction closes, and the option writer must recognize any income or
gain attributable to the prior receipt of the option premium.

In some cases, the option writer’s obligation under the option contract may
terminate on the charity’s assumption of the written option obligation. In other cases,
the writer will have a continuing obligation because the writer may be called upon to
perform if the charity fails to perform or to reimburse the charity for any losses or
expenses it may incur if called upon to perform. If an assumption terminates the option
writer’s obligation under the option contract, the option writer must recognize gain when
the option obligation is assumed. If the assumption does not terminate the option
writer’s obligation under the option contract, the option writer must recognize the
premium when the option writer’s obligation under the option contract terminates (other
than through an exercise of the option against, and performance by, the option writer).

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These general principles remain applicable even if the assumption of the option
writer’s obligation is part of what the taxpayer claims is a donative transaction. Cf
.
Diedrich v. Commissioner
, 457 U.S. 191 (1982) (noting that if a donee pays a gift tax
obligation arising from a donative transfer, the donative nature of the transaction does
not preclude income recognition by the donor on the obligation assumed). Here, the
taxpayer has made a transfer to the charity of the purchased option, and the charity has
assumed the burden of the written option. No aspect of the taxpayer’s transfer or the
charity’s assumption (or their combination) relieves the taxpayer from its duty under the
Code to account for the gain attributable to the premium originally received by the
taxpayer for assuming the burden of writing the option. See
Lucas v. Earl, 281 U.S.
111 (1930) (holding that a taxpayer may not avoid inclusion of future earned income by
making a gratuitous transfer of the right to receive the income).

Finally, if the taxpayer has any unrecognized gain on the written option at the end
of the year in which the assumption occurs (e.g., the assumption did not terminate the
option writer’s obligation under the option contract), the mark-to-market loss on the
offsetting contributed section 1256 contract will be deferred under section 1092.

Transactions that are the same as, or substantially similar to, the transactions
described in this notice are identified as “listed transactions” for purposes of §§ 1.6011-
4(b)(2), 301.6111-2(b)(2) and 301.6112-1(b)(2) effective December 4, 2003, the date
this notice was released to the public. Variations on these transactions may include
positions in other section 1256 and non-section 1256 contracts. Independent of their
classification as “listed transactions” for purposes of §§ 1.6011-4(b)(2), 301.6111-
2(b)(2), and 301.6112-1(b)(2), transactions that are the same as, or substantially similar
to, the transaction described in this notice may already be subject to the disclosure
requirements of section 6011 (§ 1.6011-4), the tax shelter registration requirements of
section 6111 (§§301.6111-1T, 301.6111-2), or the list maintenance requirements of
section 6112 ( § 301.6112-1). Persons who are required to register these tax shelters
under section 6111 but have failed to do so may be subject to the penalty under
section 6707(a). Persons who are required to maintain lists of investors under
section 6112 but have failed to do so (or who fail to provide those lists when requested
by the Service) may be subject to the penalty under section 6708(a). In addition, the
Service may impose penalties on parties involved in these transactions or substantially
similar transactions, including the accuracy-related penalty under § 6662.

The Service and the Treasury recognize that some taxpayers may have filed tax
returns taking the position that they were entitled to the purported tax benefits of the
type of transaction described in this notice. These taxpayers should consult with a tax
advisor to ensure that their transactions are disclosed properly and to take appropriate
corrective action.

The principal author of this notice is Clay Littlefield of the Office of Associate
Chief Counsel (Financial Institutions and Products). For further information regarding
this notice, contact Mr. Littlefield at (202) 622-3920 (not a toll-free call).