Rev. Rul. 87-43

1987-1 C.B. 252, 1987-22 I.R.B. 13.

FUTURES AND OPTION CONTRACTS ESTABLISHED UNDER THE MUTUAL OFFSET SYSTEM

Published: June 1, 1987

Section 1256.-Section 1256 Contracts Marked to Market

  Futures and option contracts established under the Mutual Offset System. Futures and option contracts established under the Mutual Offset System existing between the Chicago Mercantile Exchange Limited are considered traded on or subject to the rules of the exchange that ultimately assumes the contracts for purposes of the sourcing rules and section 1256 of the Code.

ISSUES

  (1) Whether futures contracts or option contracts that are established pursuant to the Mutual Offset System existing between the Chicago Mercantile Exchange and the Singapore International Monetary Exchange Limited are considered traded on or subject to the rules of the exchange that assumes the contract for purposes of section 1256 of the Internal Revenue Code.

  (2) Whether the use of the Mutual Offset System will affect the sourcing of gains or losses from futures and option contract transactions.

FACTS

  The Chicago Mercantile Exchange (CME) is a 'qualified board or exchange' within the meaning of section 1256(g)(7)(B) of the Code. The Singapore International Monetary Exchange Limited (SIMEX) is a foreign board of trade that is not a 'qualified board or exchange' because there has not been a determination by the Secretary under section 1256(g)(7)(c).

  In September 1984, the CME and the SIMEX entered into an agreement to establish the Mutual Offset System (System). The System provides an inter- exchange clearing process by which customers can establish new positions or offset existing positions on one exchange, during hours in which that exchange is closed for trading, by the execution of a contract on the other exchange. The System was designed to provide investors with the economic benefits of extended trading hours while reducing the price risks and transaction costs inherent in trading on two autonomous exchanges.

  Under the System, a customer initially places an order to execute a futures or option contract with a clearing member of the exchange to which the contract will ultimately be transferred (Origination Exchange). The Clearing member for the Origination Exchange then transfers the order to a clearing member of the exchange where the trade will be executed (Execution Exchange). After the contract is cleared on the Execution Exchange, the contract is transferred to the Origination Exchange through an inter-exchange clearing process. The Origination Exchange automatically assumes the transferred contract, usually before the next trading day of the Execution Exchange. Thereafter, the contract is subject to and treated under the rules of the Origination Exchange as if it had been originally executed on that exchange without using the System. Once an order to execute a futures or option contract is placed in the System, it cannot be removed from the System except in situations when the contract cannot be cleared successfully.

LAW AND ANALYSIS

  Section 1256 of the Code prescribes special rules for reporting gains and losses from 'section 1256 contracts.'

  Section 1256(b) of the Code defines the term 'section 1256 contract' as including any regulated futures contract and any nonequity option.

  Section 1256(g)(1) of the Code provides that the term 'regulated futures contract' means a 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) which is traded on or subject to the rules of a qualified board or exchange.

  Section 1256(g)(3) of the Code provides that the term 'nonequity option' means any listed option which is not an equity option.

  Section 1256(g)(5) of the Code provides that the term 'listed option' means any option (other than a right to acquire stock from the issuer) which is traded on or subject to the rules of a qualified board or exchange.

  Section 1256(g)(7) of the Code provides that the term 'qualified board or exchange' means   (A) a national securities exchange which is registered with the Securities and Exchange Commission

  (B) a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or

  (C) any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of this section.

  For purposes of determining the federal income tax consequences of a transaction, it is necessary to ascertain the legal relationships that exist between the parties to the transaction. In the typical exchange clearing process for a futures or option contract, an exchange clearing house is interposed between the original parties to the transaction, namely, the clearing members who represent the purchaser and seller under the contract. Although there are a series of steps involved in the typical exchange clearing process, the step transaction doctrine provides that these steps are not analyzed separately but are viewed as component parts of a single transaction. In the typical exchange clearing process, the legal relationship between the investor and the broker remains unchanged notwithstanding the fact that an exchange clearing house is interposed between the original parties to the transaction.

  The inter-exchange clearing process constitutes no more than an additional step in the normal clearing process. Under the System, the inter-exchange clearing process is automatic and, generally, once an order is placed in the System, it cannot be removed therefrom. With respect to the original parties to the transaction, the legal relationships that result after the contracts are transferred under the System are no different from those that would exist if the trade had taken place on the Origination Exchange without using the System. Consequently, the step transaction doctrine applies to the System and the inter-exchange clearing process has no independent significance for federal income tax purposes.

HOLDINGS

  (1) Futures contracts or option contracts established under the System are treated as traded on or subject to the rules of the Origination Exchange for purposes of section 1256 of the Code. Thus, contracts executed on the SIMEX and assumed by the CME under the System are treated as traded on or subject to the rules of a qualified board or exchange within the meaning of section 1256(g)(1)(B) and section 1256(g)(5) of the Code. By contrast, contracts executed on the CME and assumed by the SIMEX under the System are not treated as traded on or subject to the rules of a qualified board or exchange within the meaning of section 1256(g)(1)(B) or section 1256(g)(5).

  (2) Gains or losses from contracts executed on the SIMEX and assumed by the CME under the System have the same source as gains or losses, respectively, of contracts that are executed on the CME without using the System. Conversely, gains or losses from contracts executed on the CME and assumed by SIMEX under the System have the same source as gains or losses, respectively, of contracts that are executed on the SIMEX without using the System.

  No holding is provided herein regarding whether such gains or losses are U.S. or foreign source under sections 861 through 863 of the Code.