The approval of perpetual futures contracts in the US could lead to unforeseen tax and regulatory challenges for traders if these products are ultimately classified as swaps rather than futures, a matter that has received minimal public attention, as stated by CME Group Chairman and CEO Terry Duffy. "There's an overlooked consequence," Duffy mentioned in an interview with CoinDesk.
"From a tax perspective, there's ambiguity for all US participants." Duffy's comments come amidst CME's ongoing legal dispute with the Commodity Futures Trading Commission (CFTC) regarding the regulator's approval of perpetual futures contracts in the US. The outcome of the federal court decision could significantly impact how the US approaches the rapidly growing area of perpetual futures, including how the Internal Revenue Service (IRS) taxes these contracts. The disagreement stems from whether perpetual futures should be legally categorized as futures or swaps.
Duffy argues that perpetual futures should be classified as swaps due to the periodic funding payments exchanged between long and short positions, which he believes satisfies the statutory definition of a swap under US law. Unlike traditional futures, perpetual contracts do not expire and instead involve periodic funding payments to maintain the derivative's price close to the underlying asset.
Duffy contends that these recurring payment exchanges meet the definition of a swap. The main issue with this mismatched designation, according to Duffy, is that if perpetual contracts are classified as futures, many institutional traders may receive a blended tax treatment under Section 1256 of the US tax code. However, if these contracts are deemed swaps, they will be taxed under ordinary taxation.
The IRS has not provided guidance on the tax treatment of perpetual futures, given their relatively new status. If regulators or courts ultimately conclude that perpetual contracts are swaps rather than futures, market participants who have been treating them as futures for tax purposes may face uncertainty when reporting these positions to the IRS.
Legal experts, however, consider the issue more complex. "The challenge is that perpetual futures structurally resemble swaps but function like futures," said Rustin Diehl, a tax attorney.
"It's a substance-over-form question, focusing on function versus text." The definition of swaps is extremely broad, leaving room for interpretation regarding its application to new financial products like perpetual futures. The outcome will depend on the court's interpretation, particularly given the Supreme Court's 2024 Loper Bright decision, which reduced federal courts' deference to agencies' interpretations of ambiguous statutes. The process is likely to be lengthy, with potential litigation and the need for separate IRS guidance on tax treatment.
Until there is greater clarity from regulators, tax authorities, or courts, large institutions may face uncertainty over reporting trades involving perpetual futures.