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, according to CME Group Chairman and CEO Terry Duffy. This issue has received little attention, despite its potential consequences. Duffy's comments come as CME challenges the Commodity Futures Trading Commission's (CFTC) approval of perpetual futures contracts, with the outcome potentially influencing the US approach to these rapidly growing financial products. A key concern is how the Internal Revenue Service (IRS) will tax these contracts, with Duffy arguing that they should be treated as swaps due to the periodic funding payments exchanged between long and short positions.
Unlike traditional futures, perpetual contracts do not expire and instead involve recurring funding payments to keep the derivative's price close to the underlying asset's price. This mechanism, Duffy contends, aligns with the statutory definition of a swap under US law. The mismatch in designation could lead to institutional traders receiving a blended tax treatment under Section 1256 of the US tax code if the contracts are considered futures, but they would be taxed under 'ordinary' taxation if classified as swaps.
Given the lack of IRS guidance on the tax treatment of perpetual futures, market participants may face uncertainty in reporting these positions to the IRS if the contracts are ultimately deemed swaps. Legal experts, however, note that the issue is complex, with the structure of perpetual futures resembling swaps but functioning like futures, posing a 'substance over form' question. The broad definition of swaps and the recent elimination of the Chevron doctrine, which reduces deference to agencies' interpretations of ambiguous statutes, add to the uncertainty.
This could lead to a lengthy litigation process, with tax treatment potentially requiring separate IRS guidance. Until there is clarity from regulators, tax authorities, or the courts, large institutions may face uncertainty over reporting trades involving perpetual futures, highlighting the need for careful consideration of the tax implications of these financial products.