The approval of perpetual futures contracts in the US may expose traders to unforeseen tax and regulatory risks if these products are ultimately classified as swaps rather than futures, a concern that has received little attention, CME Group Chairman and CEO Terry Duffy warned in an interview. The ambiguity surrounding the tax implications for US participants arises from the periodic funding payments exchanged between long and short positions in perpetual contracts, which Duffy believes should be legally treated as swaps due to these recurring payment exchanges. This classification discrepancy could significantly impact how the Internal Revenue Service (IRS) taxes these contracts, with potential consequences for institutional traders who may face uncertainty about how to report their positions to the IRS.
According to Duffy, the main issue stems from the mismatched designation of perpetual contracts, which could qualify for blended tax treatment under Section 1256 of the US tax code if classified as futures, but would be taxed under ordinary taxation if deemed swaps. However, legal experts argue that the issue is more complex, involving a substance-over-form question where the economic function of perpetual futures resembles that of traditional futures, despite their structural similarity to swaps. The definition of swaps is extremely broad, leaving considerable room for interpretation regarding its application to new financial products like perpetual futures.
The outcome of the ongoing legal challenge between CME and the Commodity Futures Trading Commission (CFTC) over the regulator's approval of perpetual futures contracts in the US will significantly influence the tax treatment of these contracts, with the Supreme Court's 2024 Loper Bright decision potentially playing a crucial role in deciding how existing derivatives laws apply to novel crypto products.