The US approval of perpetual futures contracts 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 stated in an interview. 'There's an unaddressed consequence,' Duffy said, highlighting the ambiguity surrounding the tax implications for US participants. The comments come as CME continues its legal challenge against the Commodity Futures Trading Commission (CFTC) regarding the regulator's approval of perpetual futures contracts in the US. A federal court decision is pending, and its outcome could significantly influence how the US approaches the rapidly growing market of perpetual futures, particularly in terms of how the Internal Revenue Service (IRS) will tax these contracts.
The dispute centers on whether perpetual futures should be legally categorized as futures or swaps, with Duffy arguing they should be considered swaps due to the periodic funding payments exchanged between long and short positions, satisfying the statutory definition of a swap under US law. Unlike traditional futures, perpetual contracts do not expire and involve periodic funding payments to keep the derivative's price aligned with the underlying asset.
If perpetual contracts are classified as futures, institutional traders may receive a blended tax treatment under Section 1256 of the US tax code, treating gains and losses as 60% long-term and 40% short-term capital gains. However, if they are deemed swaps, they will be subject to 'ordinary' taxation, given the IRS has not issued specific guidance on the tax treatment of perpetual futures.
This could lead to uncertainty for market participants who have been treating these contracts as futures for tax purposes. Legal experts consider the issue complex, pointing out that while perpetual futures structurally resemble swaps, they function economically like futures, posing a 'substance-over-form' question.
The definition of swaps is broad, leaving considerable room for interpretation, especially regarding novel financial products like perpetual futures. The outcome will depend on the court's interpretation, and the process is likely to be lengthy and involve considerable litigation. Ultimately, tax treatment may require separate guidance from the IRS, which is not obligated to follow the CFTC's interpretation, potentially leading to further uncertainty for large institutions trading in perpetual futures.