1. DC Bar Association Financial Products Panel: Was Wright Wrong? A Discussion of Section 1256, OTC FX Options/Swaps & the 6 th Circuit’s 2015 Decision in Wright Jeffrey Dorfman, PricewaterhouseCoopers LLP Viva Hammer, Joint Committee John Kaufman, Greenberg Traurig David H. Shapiro, PricewaterhouseCoopers LLP March 9, 2016 1

2. Section 1256(g)(2)(A) Defines “foreign currency contract” as a contract: 2 (i) which requires delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts, (ii) which is traded in the interbank market, and (iii) which is entered into at arm's length at a price determined by reference to the price in the interbank market. ***Consider OTC FX options & swaps – are they “foreign currency contracts,” as defined above?***

3. 3 Summary Of Legislative History 1. Technical Corrections Act of 1982. The term “foreign currency contract” was added to section 1256 by the Technical Corrections Act of 1982 by expanding the definition of “regulated futures contact” to include a “foreign currency contract.” “Foreign currency contract” was defined as a contract which: (A) which requires delivery of a foreign currency which is a currency in which positions are also traded through regulated futures contracts, (B) which is traded in the interbank market, and (C) which is entered into at arm’s length at a price determined by reference to the price in the interbank market. Why did the statute provide that the contract must “require delivery?” The legislative history indicates that Congress intended to include in section 1256 contracts “that are economically comparable to regulated futures contracts in the same currencies and that are used interchangeably with regulated futures contracts by traders.” See the House and Senate Reports to the Technical Corrections Act of 1982. Thus, the intent was to limit the term to certain bank forward contracts. 2. Deficit Reduction Act of 1984. The Deficit Reduction Act of 1984 amended the definition of “foreign currency contract” by adding a clause to (A) above as follows: (A) which requires delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts, Why did Congress add this clause? It added the clause to include cash settled forward contracts. The House Report and the Bluebook provide as follows: Because certain contracts may call for a cash settlement by reference to the value of the foreign currency rather than actual delivery of the currency, the bill provides that the delivery of a foreign currency requirement is met where the contract provides for a settlement determined by reference to the value of the foreign currency. (Emphasis added.) Did the legislative history indicate that the clause “or the settlement of which depends on the value of” was intended to broaden the scope of the definition of “foreign currency contract” to include such instruments as options? No, it indicates only that the “delivery” requirement is met where there is cash settlement.

4. Informal IRS Guidance: 4 PLR 8818010 – FX Swaps are NOT section 1256 contracts A review of the legislative history underlying section 1256(g)(2)(A) indicates that Congress intended to include within the definition of foreign currency contract bank forward contracts in currencies traded through regulated futures contracts because they are economically comparable to and used interchangeably with regulated futures contracts. … Currency swap contracts are significantly different than bank forward contracts in the way interest rates differentials in the currencies which are the subject of the contracts are accounted for. Currency swap contracts typically account for interest rate differentials through a present and continuing exchange of notional interest payments over the life of the contracts while bank forward contracts account for such difference upon maturity. Given this significant difference between bank forward contracts and currency swap contracts and the failure by Congress in the legislative history of the Technical Corrections Act of 1982 and the Tax Reform Act of 1986 (the 1986 Act) to indicate its intention to include currency swaps within the definition of foreign currency contract, we conclude that the currency swap agreements fail to satisfy the requirements of section 1256(g)(2)(A)(ii) and (iii). Accordingly, we hold that the currency swap agreements are not section 1256 contracts. FSA 200025020 – OTC FX Options are NOT section 1256 contracts Although the definition of a foreign currency contract provided in §1256(g)(2) may be read to include a foreign currency option contract, the legislative history of the Technical Corrections Act of 1982 (“TCA”)… which amended § 1256 to include foreign currency contracts, indicates that the Congress intended to extend § 1256 treatment only to foreign currency forward contracts that are traded on the interbank market. There is no indication that foreign currency option contracts were contemplated for inclusion in the statutory definition of a forward currency contract in § 1256(g)(2)(A). Sections 1256(g)(3) and (4) deal comprehensively with options listed on a qualified board or exchange. These provisions were added to the Code by …the Tax Reform Act of 1984 ("TRA"), …. They provide that only dealer equity options (i.e., listed stock options) and listed options (other options listed on exchanges) are § 1256 contracts. The legislative history to these provisions is silent regarding whether the failure to separately include a provision addressing the treatment of foreign currency options was due to their having been included within §1256(g)(2)(A). The legislative history to …the TRA, however, which amended §1256(g)(2), indicates that only "certain" foreign currency contracts were treated as regulated futures contracts under that provision. …. This, coupled with the previously referenced provisions of the legislative history to the TCA, and our view that reading §1256(g)(2) expansively to apply generally to foreign currency options would effectively override the limitations of §1256(g)(3) and (4), leads us to conclude that foreign currency option contracts are not foreign currency contracts pursuant to §1256(g)(2)(A).

5. Notice 2003-81 – The Transaction Taxpayer executed 2 pairs of OTC (non-exchange-traded) options: Pair 1: (A) Purchased Put on “Major” Currency X (e.g., Euro) + (B) Written Put on correlated/pegged “Minor” Currency Y (e.g., Danish krone) Pair 2: (A) Purchased Call on “Major” Currency X (e.g., Euro) + (B) Written Call on correlated/pegged “Minor” Currency Y (e.g., Danish krone) (“Major” currencies trade via regulated futures contracts; “minor” currencies do not.) The combined economic exposure of each pair nets to zero. In all cases, over time, the transaction would ‘mature,’ such that ONE of these pairs will contain: (A)a purchased option on a “major” currency with a built-in loss, and (B)a written option on a “minor” currency with a built-in gain. - This was the point: to create this ‘special option pair,’ with no economic risk. - The other pair would be discarded with no net tax effect, and no economic risk. Taxpayer would contribute this ‘special option pair’ to charity, and take the position that: (1)It was entitled to MTM the built-in loss on the purchased put option under section 1256(c) (because the purchased put was a “section 1256 contract”) **THE TECHNICAL ISSUE** (2) It had no gain recognition on the written option with built-in gain (because it was a donative transaction and the option is not a “section 1256 contract”) 5

6. Notice 2003-81 – The IRS Position & Immediate Aftermath The Notice identifies the transaction as a “listed transaction,” and targets the taxpayer’s ability to defer gain on the contribution to the charity. The Notice does NOT suggest that the taxpayer cannot MTM its loss on the contribution of the purchased option to the charity. To the contrary: -The Notice explicitly states as a “fact” that because the “currency [underlying the purchased options] is one in which positions are traded through regulated futures contracts … the purchased options, therefore, are foreign currency contracts within the meaning of section 1256(g)(2)(A) … and section 1256 contracts within the meaning of section 1256(b).” -The Notice continues: “Because the purchased option assigned to the charity is a section 1256 contract, the taxpayer … marks to market the purchased option when the option is assigned to the charity…” The tax bar immediately observed: -Inconsistent with the legislative history of section 1256. -A departure from prior IRS guidance (albeit informal guidance) (PLR 8818010 & FSA 200025020) -Potential for whipsaw. Taxpayers had authority for either position. -Asked for more definitive guidance. -See Feder, Harter & Shapiro, “Notice 2003-81: Are OTC Currency Options Section 1256 Contracts?,” 101 Tax Notes 1470 (December 22, 2003); Tax Notes Today, December 19, 2003, 2003 TNT 246-33, Doc. 2003-26876. 6

7. Notice 2007-71 – The Reversal of Notice 2003-81 This is a quote from Notice 2007-71: Although as a general matter the “Facts” portion of Notice 2003-81 correctly describes the transaction at issue, it includes an erroneous conclusion of law. The second sentence in the “Facts” portion of Notice 2003-81 states: “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 § 1256(g)(2)(A) of the Internal Revenue Code and §1256 contracts within the meaning of §1256(b).” This sentence should have stated “The taxpayer takes the position that the purchased options are foreign currency contracts within the meaning of §1256(g)(2)(A) of the Internal Revenue Code and §1256 contracts within the meaning of §1256(b).” The Service and Treasury do not believe that foreign currency options, whether or not the underlying currency is one in which positions are traded through regulated futures contracts, are foreign currency contracts as defined in §1256(g)(2), and intend to challenge any such characterization by taxpayers. 7

8. The Tax Court Weighs In Summit (2010). After a full discussion of various “plain meaning” theories and consideration of the legislative history: [Taxpayer] views the legal distinction between a forward and an option to be insignificant. We disagree. A forward foreign currency contract is a bilateral contract between a seller and a buyer that obligates the seller, at the time of signing, to settle his obligation to perform by either delivering the currency or making cash settlement. …. A foreign currency option is a unilateral contract that does not require delivery or settlement unless and until the option is exercised by the holder. An obligation to settle may never arise if the holder does not exercise its rights under the option. It is clear that, as originally enacted in 1982, section 1256(g)(1) applied only to forward contracts. The statute referred to a contract which required delivery of the foreign currency, not to a contract in which delivery was left to the discretion of the holder. It is also clear that the 1984 amendment “or the settlement of which depends on the value of” was inserted to allow a cash- settled forward contract to come within the term “foreign currency contract”. Foreign currency contracts can be physically settled or cash-settled, but they still must require, by their terms at inception, settlement at expiration. The statute's plain language is dispositive. There is no evidence in the legislative history that a literal reading of the statute will defeat Congress' purpose in enacting it. “we hold that under section 1256, the major foreign currency option assigned by [taxpayer] to the charity is not a foreign currency contract as defined in section 1256(b)(2) and (g)(2), and the marked-to market provisions of section 1256 do not apply to the transfer of the call option to the charity.” Garcia (2011). Tax Court follows its decision in Summit. Barrier features in option do not change result. Wright (2011). Tax Court follows its decisions in Summit & Garcia. 8

9. Congress Weighs In (Dodd-Frank Act of 2010) Dodd-Frank Act has sixteen titles covering 849 pages in the official printed version. On the very last of those pages, there is an amendment to §1256: The term ‘section 1256 contract’ shall not include—.. ‘‘(B) any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement.’’ The legislative history to this amendment consists of a single sentence: [Dodd-Frank Act] contains a provision to address the recharacterization of income as a result of increased exchange-trading of derivatives contracts by clarifying that section 1256 of the Internal Revenue Code does not apply to certain derivatives contracts transacted on exchanges. 9

10. The 6 th Circuit in Wright 10 “The Tax Court’s reasoning appears to be supported by sound tax policy, but nonetheless conflicts with the plain language of § 1256. Section 1256 provides that a “foreign currency contract” is a contract “the settlement of which depends” upon the value of a foreign currency even if that contract does not mandate that any such settlement occur.” “Because the plain language of § 1256 clearly provides that the Wrights’ euro put option meets the “settlement” prong of § 1256(g)(2)(A)(i), we need not resort to legislative history to interpret § 1256.” “Congress may have wanted a contract that provides for settlement in cash to fall within the “foreign currency contract” definition only if that contract mandates settlement at maturity. If Congress had wanted to expand the definition of a “foreign currency contract” to include only such contracts, Congress could have amended § 1256(g)(2)(A)(i) to provide that a “foreign currency contract” is a contract “which requires delivery of, or which requires a settlement which depends on the value of, a foreign currency.” But Congress did not amend § 1256 in this way.” Although the Sixth Circuit did not support the government’s reading of 1256(g)(2)(A)(i), it did provide two other avenues of attack in future cases, i.e. Regulations Economic Substance

11. Lessons to be Learned from Wright 11 -Context Matters -What a statute means is not always what it says – if it is read out of context. -A “textualist” reading of the tax law may yield unforeseen, or absurd, results. -What Context? -History of the statute -The statute as a whole -Legislative history -Go beyond the dictionary -Why Not Follow Legislative History? -Congress can not “intend” -Legal certainty and equal access to the law -LH is not reviewed by everyone who votes -LH may be distorted by losing party (or, worse – lobbyists) -Why Follow Legislative History? -It is the best indication of the purpose behind a statute -Legislators often read only the LH prior to vote -It is often the best summary of the historical context for the statute -Tax LH tends to be fairly complete, and written by nonpartisan professionals -Tax specialists have access to LH – legal certainty and equal access arguments are less relevant in this context

12. Pilgrim’s Pride - Textualism at Work Tax Court, 141 TC 533 (2013). A loss from the abandonment of a capital asset is a capital loss, because fee ownership is a “right or obligation with respect” to the asset under Section 1234A. Section 1234A – “Gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation (other than a securities futures contract, as defined in section 1234B) with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer…shall be treated as gain or loss from the sale of a capital asset. “ Tax Court ruled that, under the “plain meaning” of Section 1234A, a fee ownership is a “right or obligation with respect to” an asset. Fifth Circuit 779 F.3d 311 (2015) reverses Tax Court decision The appellate court and the Tax Court relied on the “plain meaning” of the statute to arrive at opposite results. The difference is the way in which they interpreted the meaning of “meaning” The Tax Court read the phrase “right or obligation with respect to property” with regard only to the sentence in which it appeared and a dictionary. The Fifth Circuit read the phrase within the historical context and purpose of the statute- The statute was originally passed in 1981 in order to prevent taxpayers from using pre-1981 extinguishment doctrine case law to realize dissimilar treatment of economically similar transactions constituting offsetting legs of a straddle To determine the historical context of the statute, the court quotes from the legislative history of the 1981 Act “Plain meaning” = “Plain meaning within appropriate context”. 12

13. Textualism – Where Will it End? 475(c)(2) (Definition of a “security” for Section 475 purposes): (A) share of stock in a corporation; (B) partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust; (C) note, bond, debenture, or other evidence of indebtedness; (D) interest rate, currency, or equity notional principal contract; (E) evidence of an interest in, or a derivative financial instrument in, any security described in subparagraph (A), (B), (C), or (D), or any currency, including any option, forward contract, short position, and any similar financial instrument in such a security or currency Is a cash position in currency a “security”? Under one reading of the plain meaning of 475(c)(2)(E), yes – because cash ownership is “an evidence of an interest in” currency – but, within the context of the statute as a whole, no. Prop. Reg. 1.864(b)-1(b)(2) (Definition of a “derivative” for safe harbor ECI purposes)- (ii) An evidence of an interest, or a derivative financial instrument (including any option, forward contract, short position and any similar financial instrument in any (A) Commodity… (B) Currency… (C) Share of stock… (D) Partnership or beneficial ownership interest in a widely held or publicly traded partnership Is a cash position in currency or a partnership interest a “derivative”? 13

14. Getting Wright Right - 1256(g)(2)(A) in Context Historical context of the 1981, 1982 and 1984 Acts Extensive, consistent, evidence from the legislative history Policy reasons – similar treatment of economically similar transactions 14