CME's Duffy Highlights Overlooked Tax Risk Associated with US Perpetual Futures

The approval of perpetual futures contracts in the US may expose traders to unforeseen tax and regulatory uncertainty if these products are ultimately classified as swaps rather than futures, according to CME Group Chairman and CEO Terry Duffy. In an interview, Duffy emphasized that there is ambiguity from a tax perspective for all US participants due to the potential for these contracts to be deemed swaps. This ambiguity stems from the periodic funding payments exchanged between long and short positions in perpetual futures, which Duffy argues aligns with the statutory definition of a swap under US law. Unlike traditional futures, perpetual contracts do not expire and involve recurring funding payments to keep the derivative's price close to the underlying asset's price.

Duffy believes this mechanism satisfies the definition of a swap. The main concern with the current designation of perpetual contracts as futures is that many institutional traders could receive a blended tax treatment under Section 1256 of the US tax code, which treats gains and losses as 60% long-term and 40% short-term capital gains. If these contracts are classified as swaps, they would be subject to 'ordinary' taxation.

Given the novelty of perpetual futures, the IRS has not provided specific guidance on their tax treatment. Legal experts note that the issue is complex, with the textual structure of perpetual futures resembling swaps but their economic performance akin to futures, making it a 'substance-over-form' question.

The definition of swaps is extremely broad, leaving room for interpretation regarding its application to new financial products like perpetual futures. The outcome of the court decision could significantly influence how the US approaches perpetual futures, with the possibility of extensive litigation and the need for separate IRS guidance on tax treatment.

Until there is clarity from regulators, tax authorities, or courts, large institutions may face uncertainty over reporting trades involving perpetual futures, potentially leading to tax disputes.