1. As mentioned above, investing in foreign currencies has become increasingly popular, especially since the multi-year decline of the U.S. dollar against most major currencies. In addition, many holdings in foreign currencies provide higher rates of interest on cash than U.S. cash.
2. Traditionally, investments in foreign currencies have been in currencies of the major developed countries, namely the British pound sterling, Euro, Japanese yen, Australian dollar, Canadian dollar, Swiss franc, New Zealand dollar, Norwegian krone, and Swedish krone. Increasingly, however, with the rapid economic development of countries like South Korea, Brazil, Russia, India, and China, investment in “emerging market” debt and currency have become more popular.
3. The price of a foreign currency vis-à-vis the U.S. dollar is a function of many factors, including:
a. Debt level and trade deficit;
b. Inflation rates (and investor expectations of the same);
291 Rev. Rul. 2008-1, 2008-2 I.R.B. 248.
292 IRS Notice 2008-2, 2008-2 I.R.B. 252.
c. Interest rates (and investor expectations of the same);
d. Investment and trading activities of hedge funds, mutual funds, currency funds, etc. in each of the currencies; and
e. Global and regional political, economic and financial events and situations.
B. Investing in Foreign Currency
1. Foreign currency returns can be accessed in a number of ways, both simple and complex. One of the simplest ways of investing in a foreign currency is to simply buy the foreign currency, and if the U.S. dollar depreciates against the foreign currency, the investor can convert the foreign currency to more U.S. dollars than originally invested, thereby making a gain. This is essentially what foreign currency ETFs (discussed above) do. Another way is to purchase the foreign bonds (for example, sovereign bonds of a foreign country), particularly one that provides a significantly higher interest rate than offered on U.S. debt obligations, for example. In fact, buying the stock of a foreign corporation in the same foreign currency is also a way of generating foreign currency gains (and losses) since the ultimate conversion to U.S. dollars will invariably have a currency exchange component.
2. The more sophisticated foreign currency investment strategies require the active management of currencies through the use many of the financial derivatives mentioned earlier in this outline. Typically, these investment strategies are accessed through “hedge funds” (which are discussed in more detail below), and require the investment manager to take “long” or “short” positions against the foreign currency against a base currency like the U.S. dollar.
3. There are three major kinds of transactions in the traditional foreign currency exchange markets. “Spot”293 trades are foreign exchange transactions that typically settle within 2 business days with the counterparty to the trade. “Forward” trades are transactions that settle on a date beyond the spot. “Swap” transactions are transactions in which two parties exchange two currencies on one or more specified dates over an agreed period and exchange them again when the period ends.
4. In addition to the traditional foreign exchange markets, there are also currency options, which trade both over-the-counter and, in the U.S., on the Philadelphia Stock Exchange. Currency futures also exist. Currency futures are traded in a number of regulated markets, including the International Monetary Market division of the Chicago Mercantile Exchange, the Singapore Exchange Derivatives Trading Limited, and the London International Financial Futures Exchange.
5. A currency swap is a form of NPC. The market for currency swaps is estimated to be in the trillions of dollars each year. A currency swap typically is an agreement between two parties to exchange one currency for a second currency at the contract's maturity and to make periodic exchanges of the same currencies throughout the term of the agreement. The exchange at maturity is an exchange of the
“notional” principal amounts of the swap in the respective currencies and the conversion rate used to determine the amount to be exchanged is the spot rate at the inception of the contract. Some currency
293 The Treasury Regulations provide that the “spot” rate is an exchange rate that will reflect a fair market rate of exchange available to the public and involving representative amounts. Examples of the foregoing are exchange rates published in the International Financial Statistics or successor publication of the International Monetary Fund, rates published by the Board of Governors of the Federal Reserve System pursuant to 31 U.S.C. § 5151, rates published in newspapers, financial journals or other daily financial news sources, or rates quoted by electronic financial new services. Treas. Reg. § 1.988-1(d).
swaps may be “in the money” and as such may require an initial exchange of the notional principal amounts in the respective currencies, which amounts are also based on the spot rate at the inception of the contract. The periodic exchanges typically reflect the market interest rates in the respective currencies and thus such exchanges take into account the interest rate differential between the two currencies.
6. Cross-currency interest rate swaps are often referred to as “circuses,” an acronym for
“combined interest rate and currency swap.” A cross-currency interest rate swap is a basic currency swap modified so that the periodic payments with respect to one of the currencies fluctuates based upon an external interest rate index. Thus, a cross-currency interest rate swap is an interest rate swap combined with a currency swap. The usual motivation for entering into a cross-currency interest rate swap is for a taxpayer to transform both its interest rate exposure and nonfunctional currency exposure.
C. Principles of Taxation
1. Subpart J294 of the Code provides the framework for determining the taxation of foreign currency transactions. It is predicated on the concept that each taxpayer has a base currency by which all transactions and investments must be measured and determined, known as a “functional currency.”295 Thankfully, for our purposes, the determination of the functional currency of U.S.
individual taxpayers and their investments is simply the U.S. dollar.296
2. Foreign currency is personal property. As such, when it is acquired it takes a cost basis,297 and when the currency is disposed of or exchanged in a taxable event, gain or loss is recognized at that time.298 Broadly, these are referred to as “Section 988” gains or losses. In contrast, the holding and exchange of U.S. dollars (the functional currency) by a U.S. individual is not a recognition event. As such, if a U.S. taxpayer exchanges U.S. dollars to acquire a nonfunctional currency or goods, that exchange is not a transaction that gives rise to a currency gain. However, if the U.S. taxpayer used non-functional currency to purchase U.S. dollars or goods, then currency gain or loss must be calculated.
3. Currency transactions within a functional currency are not taxable events. For example, there is no currency gain or loss if the functional currency is used to purchase property denominated in the functional currency. But, since nonfunctional currency is considered to be property, its disposition is a realization event if it is exchanged other than for different units of the same currency or for a deposit account or bank certificate of deposit denominated in such currency. For example, gain or loss occurs if there is an exchange of nonfunctional currency for functional currency or an exchange of one nonfunctional currency for another nonfunctional currency; on the other hand, the withdrawal of nonfunctional currency from a deposit account at a financial institution or maturity of a bank CD denominated in nonfunctional currency is not a realization event.
4. An individual U.S. taxpayer is not subject to most of the Subpart J rules to the extent that he or she engages in foreign currency transactions for personal (as contrasted to business or investment) purposes. For example, nonfunctional foreign currency expended for foreign goods and
294 §§ 985-989.
295 § 985(b).
296 § 985(b)(1)(A).
297 § 1012.
298 § 1001(a),
services while on vacation does not give rise to exchange gain or loss. Section 988 only applies to the extent the expenses of the transaction would otherwise be deductible under Sections 162 or 212.299
5. For purposes of this outline, Section 988 will apply to determine the foreign currency gain or loss arising from transactions in which foreign currency is involved which include:
a. Dispositions of any nonfunctional currency;
b. The acquisition of a debt instrument; and
c. Entering into or acquiring any forward or futures contract, option, or similar financial instrument
6. Investments in the stock of a foreign corporation do not trigger foreign currency gains.
The Tax Court has ruled that foreign currency exchange gain attributable to the sale of stock valued in a nonfunctional currency may not be treated as gain on a separate transaction but must be aggregated with the gain attributable to the appreciation in the stock.300
D. Section 988 Gains or Losses
1. Section 988(a) of the Code provides that any foreign currency gain or loss attributable to a “Section 988 Transaction” must be computed separately and treated as an ordinary income or loss.301 Effectively, taxpayers will be required to calculate the gain or loss attributable to changes in the exchange rate form the gain or loss in the underlying transaction. That being said, gain or loss on the underlying transaction and on the currency are netted against each other and if there is any excess amount of currency loss or gain, then only that is reported separately.302
2. A Section 988 Transaction is any transaction (listed below) if the amount which the taxpayer is entitled to received (or is required to pay) by reason of the transaction is denominated in terms of a non-functional currency (or determined by reference to one or more non-functional currencies). The
“functional” currency of U.S. investors is the U.S. dollar.303 The listed Section 988 Transactions that are important for our purposes are:304
a. The acquisition of or becoming the obligor under a debt instrument.305
b. Entering into or acquiring any forward contract, futures contract, option or similar financial instrument.306
299 § 988(e) and Treas. Reg. § 1.988-1(a)(9) (without reference to the 2% on certain miscellaneous deductions).
300 Mariani Frozen Foods, Inc. V. Commissioner, 81 T.C. 448 (1983), aff’d Melinda L. Gee Trust v. Commissioner, 761 F.2d 1410 (9th Cir. 1985).
301 § 988(a)(1)(A).
302 See Treas. Reg. 1.988-2(b)(8).
303 §§ 985(b) and 988(c)(1)(A).
304 § 988(c)(1)(B).
305 A debt instrument includes a bond, certificate, note, debenture, or other evidence of indebtedness. § 988(c)(4) and Treas. Reg. § 1.988-1(a)(2)(i).
c. The disposition of a nonfunctional currency.307
3. The phrase “forward contracts, futures contracts, option, warrant, or similar financial instrument” for Section 988 purposes will only be subject to Section 988 if the underlying property of the financial instrument is the nonfunctional currency.308
a. As such, the following would not be considered Section 988 Transactions: a forward contract to purchase wheat denominated in a nonfunctional currency, an option to enter into a forward contract to purchase wheat denominated in a nonfunctional currency, or a warrant to purchase stock denominated in a nonfunctional currency.309
b. However, under that same logic, the following would be considered Section 988 Transactions:a forward contract to purchase a nonfunctional currency, an option to enter into a forward contract to purchase a nonfunctional currency, an option to purchase a bond denominated in or the payments of which are determined by reference to the value of a nonfunctional currency, or a warrant to purchase nonfunctional currency.310
4. The Code provides that a taxpayer may elect to treat any foreign currency gain or loss attributable to a forward contract, a futures contract, or option which is a capital asset in the hands of the taxpayer and which is not a part of a straddle as capital gain or loss (as the case may be) if the taxpayer makes such election and identifies such transaction before the close of the day on which such transaction is entered into.311
5. Disposition of Nonfunctional Currency
a. A disposition of a nonfunctional currency can occur in a number of ways from an investment standpoint.
(1) For example, a U.S. investor could purchase 100 Euros for $130. After holding it for a year, if the exchange rate has changed such that the U.S. dollar has depreciated against the Euro, the U.S. investor could convert the Euros to $170 U.S. dollars. There would be $40 of gain, which will be treated as ordinary income.
(2) Using nonfunctional currency for property (shares of stock for example) is treated as an exchange of nonfunctional currency for units of functional currency at the spot rate on the date of the exchange, and then a purchase or sale of the property for those units of functional currency.312
306 “Similar financial instrument” includes a notional principal contract only if the payments required to be made or received under contract are determined with reference to a non-functional currency. Treas. Reg. § 1.988-1(a)(2)(iii)(B).
307 While not technically considered a listed Section 988 Transaction, the disposition of a nonfunctional currency, the Code provides a special rule that treats the disposition as a Section 988 Transaction. § 988(c)(1)(C).
308 Treas. Reg. § 1.988-1(a)(2)(iii)(A).
309 Id.
310 Id.
311 § 988(a)(1)(B).
312 Treas. Reg. §1.988-2(a)(2)(ii)(B).
The Treasury Regulations provide if an individual taxpayer purchases or sells securities traded on an established securities market and pays for them in nonfunctional currency, then the taxpayer must compute the amount realized with respect to the stock or securities, as determined on the trade date, by translating the units of nonfunctional currency received into functional currency at the spot rate on the settlement date of the sale.313
(3) In addition, the Treasury Regulations clarify that the use of nonfunctional currency in the settlement of a forward, futures or option contract, or other similar financial instrument, is considered to be a sale or disposition of the nonfunctional currency.314
(4) The Treasury Regulations also provide that the exchange of one nonfunctional currency for a different nonfunctional currency (Euros for UK pounds) is not a like-kind exchange and will be considered a recognition event.315
b. The Treasury Regulations provide the follow exceptions to the general rule that any exchange of a nonfunctional currency will be a taxable event:316
(1) An exchange of units of nonfunctional currency for different units of the same nonfunctional currency;
(2) The deposit of nonfunctional currency in a demand or time deposit or similar instrument, including a certificate of deposit, issued by a bank or other financial institution if such instrument is denominated in such currency;
(3) The withdrawal of nonfunctional currency from a demand or time deposit or similar instrument issued by a bank or other financial institution if such instrument is denominated in such currency;
(4) The receipt of nonfunctional currency from a bank or other financial institution from which the taxpayer purchased a certificate of deposit or similar instrument denominated in such currency by reason of the maturing or other termination of such instrument; and
(5) The transfer of nonfunctional currency from a demand or time deposit or similar instrument issued by a bank or other financial institution to another demand or time deposit or similar instrument denominated in the same nonfunctional currency issued by a bank or other financial institution.
6. Foreign Currency Debt Instruments
a. The “acquisition of a debt instrument or becoming the obligor under a debt instrument,”317 is subject to Section 988, provided that the debt instrument is denominated in or determined by reference to a nonfunctional currency.
313 Treas. Reg. § 1.988-2(a)(2)(iv)(A).
314 Treas. Reg. § 1.988-2(a)(1)(i).
315 Treas. Reg. § 1.988-2(a)(1)(ii).
316 Treas. Reg. § 1.988-2(a)(1)(iii).
317 § 988(c)(1)(B)(i).
b. The Treasury Regulations provide that the holder of a debt instrument will realize gain or loss when principal is received from the obligor or the instrument is disposed of.318 Conversely, the obligor will realize gain or loss when principal is paid or the obligation to make payments is extinguished or transferred.319 A material change in the terms of a debt instrument (like the conversion of a nonfunctional currency debt obligation into a functional currency obligation) will be a deemed disposition of the debt obligation.320
c. With respect to income on nonfunctional currency debt obligations, the Treasury Regulations provide that the holder of a debt instrument will realize gain or loss when interest is received or the instrument is disposed of with interest accrued as of the date of disposition.321 Conversely, the obligor will realize gain or loss when interest is paid or the obligation to make interest payments is extinguished or transferred.322
d. The amount of gain or loss with respect to the principal of a foreign currency debt instrument is determined by converting the units of nonfunctional currency principal at the spot rate (into units of functional currency) on the date payment is received or the instrument is disposed of, and subtracting the amount computed by translating the units of nonfunctional currency principal at the spot rate on the date the holder acquired the instrument.323 A similar calculation as made with respect to the obligor of the obligation.324
7. Forward, Futures, Options and Other Financial Instruments
a. In this context, a forward or futures contract will be subject to Section 988 gain or loss when the contract is an agreement to buy or sell an amount of foreign currency on a future date at a specified exchange rate (the “forward rate”). The forward rate, which determines the amount payable on the contract's delivery date, is a function of the current spot exchange rate and the interest rate differential between the two currencies in their respective debt markets.
b. A foreign currency call option gives the holder the right to purchase a given amount of foreign currency at a specified exchange rate (the “strike rate”) prior to the contract's expiration date. A foreign currency put option gives the holder the right, but not the obligation, to sell a given amount of foreign currency at the strike price prior to the expiration date.
c. Other financial instruments subject to Section 988 include notional principal contracts, such as interest rate swaps, caps, floors and collars, currency swaps, and options on a futures contract.325 A NPC will fall within Section 988 provided that the payments required to be made or received under the contract are determined by reference to a nonfunctional currency.326 With the
318 Treas. Reg. § 1.988-2(b)(5).
319 Treas. Reg. § 1.988-2(b)(6).
320 Treas. Reg. § 1.1001-3.
321 Treas. Reg. § 1.988-2(b)(3).
322 Treas. Reg. § 1.988-2(b)(4).
323 Treas. Reg. § 1.988-2(b)(5).
324 Treas. Reg. § 1.988-2(b)(6).
325 Treas. Reg. § 1.988-2(a)(2)(iii).
326 Treas. Reg. § 1.988-1(a)(2)(iii)(B)(1).
exception of currency swaps, the timing of income, deduction and loss with respect to a NPC that is a Section 988 Transaction is governed by Section 446 and the Treasury Regulations thereunder (as discussed above).327 Any gain or loss from a NPC that is a Section 988 Transaction will be treated as exchange gain or loss,328 and the character will be treated as ordinary.329 The election under Section 988(a)(1)(B) discussed below for certain forward related instruments does not apply here.
d. A currency swap is a form of NPC subject to Section 988. Under the Treasury Regulations, a currency swap is a contract between two or more parties which involves different currencies and in which the parties agree to exchange periodic interim payments on or before maturity of the contract, and exchange the swap principal amount upon maturity of the contract. A currency swap contract may also require an exchange of the swap principal amount at the outset of the agreement.330
(1) In general, any income or loss with respect to a currency swap contract will be characterized as gain or loss (not as interest income or expense),331 as is any resulting gain or loss on the disposition or termination of the swap contract.332
(2) The Treasury Regulations distinguish between periodic interim payments and the swap principal amount. Periodic interim payments arise in an exchange of one or more payments in one currency specified in the swap contract for one or more payments in a different currency specified by the contract. The payments in each currency must be computed by reference to an interest index applied to the swap principal amount. The swap principal amount is an amount of two different currencies, which under the terms of the swap, is used to determine the periodic interim payments in each currency and which is exchanged upon the commencement or maturity of the contract.333
(3) The methodology used by the Treasury Regulations involves hypothetical loans and borrowings. Payments are treated as made pursuant to a hypothetical borrowing by the paying party that is denominated in the currency in which the payments are required to be made under the currency swap,334 and payments received under the swap as payments received pursuant to a hypothetical loan made by the party in the currency in which payment are received under the swap.335 In other words,
(3) The methodology used by the Treasury Regulations involves hypothetical loans and borrowings. Payments are treated as made pursuant to a hypothetical borrowing by the paying party that is denominated in the currency in which the payments are required to be made under the currency swap,334 and payments received under the swap as payments received pursuant to a hypothetical loan made by the party in the currency in which payment are received under the swap.335 In other words,