Writer Seeks Clarification of Proposed Mark-to-Market Accounting Regs

May 13, 1999

[1] I am writing in response to your request for comments on the proposed regulations for dealers in commodities and traders in securities or commodities regarding the election to use the mark-to- market method of accounting for their businesses (REG 104924-98) (the "Proposed Regulations").

[2] I commend the Internal Revenue Service (the "Service") for recognizing that there are uncertainties in the tax treatment of traders and dealers who use the mark-to-market method of accounting. I agree with the approach of the Proposed Regulations, which is to treat taxpayers that elect mark-to-market treatment like dealers, and to explain the restrictions on the use of mark-to-market accounting for non financial customer paper. I believe, however, that certain clarifications will enhance the Proposed Regulations substantially.

[3] The preamble to the Proposed Regulations requests comments on whether there are circumstances under which a specific rule that is applicable' to a securities dealer should not apply to electing securities traders. Two examples of such circumstances are when traders that have elected mark-to-market treatment apply the rules of sections 864 and 988. ¹ For the purposes of applying those sections, the gain or loss of a trader that is treated as ordinary solely by reason of electing mark-to-market treatment should continue to be treated as gain or loss from a capital asset.

[4] Section 475(d)(3)(A) characterizes a dealer's mark-to- market gain or loss as ordinary. Section 475(f)(1)(D) states that rules similar to the rules of subsection 475(d) should apply to electing traders, except for purposes of applying sections 1402 and 7704. Furthermore, Proposed Regulation section 1.475(f)-2(c) states that the principles of the rules under section 475 for dealers also apply to electing traders, and Proposed Regulation section 1.475(f)- 2(b) affirms that the gain or loss from a security that is marked-to- market by a trader is ordinary. The problem arises, however, because several other Code sections treat gain or loss from trading activities by referring to the underlying property as a capital asset. The effectively connected income rules of section 864 and the foreign currency gain or loss rules of section 988 are illustrative of this statutory drafting technique. Sections 64 and 65, however, require that any gain or loss from a sale or exchange of property that other provisions treat as ordinary income or loss be treated as gain or loss from the sale or exchange of property that is not a capital asset. Therefore, the unintended result of treating an electing trader's income as ordinary is that Code sections 864 and 988 treat the trading income differently solely because a trader elects mark-to-market treatment.

[5] Congress recognized the problems caused by changing the character of an electing trader's income when it added the exception to section 475(f)(1)(D) for the purposes of sections 1402 and 7704 in the 1998 Restructuring and Reform Act. The Joint Committee on Taxation's explanation of this provision confirms that Treasury can apply the same limitation "for purposes of any other Code provision specified by Treasury in regulations." ² Accordingly, as explained below, the Service should clarify that, for a trader electing mark- to-market treatment, the ordinary character of section 475 gain or loss should not apply for purposes of sections 864(c)(2) and 988(a)(1)(B).

[6] Section 864(c)(3) provides that all U.S. source income (other than income to which section 864(c)(2) applies) is treated as effectively connected trade or business income. Section 864(c)(2) applies to U.S. source gain from the sale of capital assets. Without the requested clarification, if a trader inadvertently engages in a non-safe harbor business, all of the trader's income subject to a section 475 mark-to-market election could automatically be treated as effectively connected with the trade or business, including income that would otherwise fall under the safe harbors of sections 864(b)(2)(A)(ii) and 864(b)(2)(B)(ii) (the "Securities Trading Income"). This result occurs because the Securities Trading Income would be treated as ordinary as the result of the election and, therefore, would not be described in section 864(c)(2).

[7] Securities Trading Income should continue to be tested under section 864(c)(2) when necessary to determine whether it is effectively connected. Such income was never meant to be subject to tax under section 864(c)(3) solely because a trader elects mark-to- market treatment. In fact, Congress enacted the exemption for Securities Trading Income to encourage foreign investment in the U.S. capital markets. The mark-to-market election was not intended to change this treatment in such a dramatic fashion.

[8] The Service, therefore, should clarify that a foreigner's income from trading for its own account will not cease being tested (if necessary) under section 864(c)(2) solely by reason of the trader's election of mark-to-market treatment. Without such clarification, traders that elect to mark to market their securities may not be able to attract foreign investors. Furthermore, traders that would otherwise elect mark-to-market treatment will be discouraged from making such an election because they would have to liquidate some of their positions because foreign investors will withdraw as a result of the election being made.

[9] Section 988 deals with the tax treatment of gain or loss from fluctuations in the value of a foreign currency. In general, foreign currency gain or loss attributable to a "section 988 transaction" is characterized as ordinary income under section 988(a)(1)(A). A trader is permitted, however, to elect to treat foreign currency gain or loss attributable to a forward contract, futures contract, or option that is a capital asset and not part of a straddle as capital gain or loss under section 988(a)(1)(B). According to section 988(a), the rules under section 988(a) apply "notwithstanding any other provisions of this chapter," which includes section 475.

[10] In its definition of security, section 475 includes foreign currency forwards contracts and options that could be section 988 transactions subject to an election under both section 475 and section 988(a)(1)(B). In such a case, a trader electing mark-to- market treatment might treat gain or loss attributable to those contracts and options as ordinary. It is unclear, however, whether any foreign currency gain or loss on those contracts or options could also be treated as capital gain or loss under the section 988(a)(1)(B) election. The Service should clarify, therefore, that foreign currency gain or loss can qualify for capital treatment under section 988(a)(1)(B), even if it is section 475 gain or loss.

[11] Thank you for your careful attention to these issues. I look forward to responding to any questions that you may have.

Respectfully submitted,

² Joint Committee on Taxation, general explanation of tax legislation enacted in in 1998, p. 185.