Where Securities Trade Dictates Tax Treatment

Section 1256 of the Internal Revenue Code 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 indices, options on futures, nonequity options, certain off-exchange foreign currency contracts and a few other items.

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. 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deemed RFCs if the contract "(A) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (B) is traded on or subject to the rules of a qualified board or exchange."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.)

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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.

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 (Rev. Rul. 87-43). A partnership between Chicago Mercantile Exchange and Singapore International Monetary Exchange Limited

• ICE Futures Rev Rul 2007-26

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 Rev. Rul. 2009-4

• ICE Futures Canada Rev. Rul. 2009-24

• London International Financial Futures and Options Exchange (LIFFE) Rev. Rul. 2010-3

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 Rev. Rul. 2013-5