Treasury and IRS Flag Certain "Tax-Aware" Fund Strategies as Problematic

At a Glance

• The explicit reservation of retroactive authority under Section 7805(b)(3) means that transactions already completed could be affected by future guidance. Even without new guidance, the IRS may challenge these strategies on audit under existing judicial doctrines.
• Funds and investors with separately managed accounts that utilize any of the "tax-aware" strategies outlined in the Notice should carefully consider such investments in light of the concerns raised by the Notice and monitor further guidance.

On September 28, 2026, the Treasury Department and the IRS issued Notice 2026-62, which included a warning aimed at investment fund strategies that exploit technical differences among economically similar financial products to manufacture favorable tax results. While most press attention has focused on the Notice's ETF-specific provisions — discussed in "Exchange-Traded Fund (ETF) Transactions Come under IRS Scrutiny" — the Notice also separately focuses on issues with "tax-aware" strategies used primarily by investment partnerships and separately managed accounts.

Notice 2026-62 identifies the government's concerns with these tax-aware strategies, indicates that additional guidance may be forthcoming (potentially including retroactive guidance under section 7805 of the Code), and requests comments. The notice says the IRS may also challenge these strategies on examination under existing law, including substance-over-form, step-transaction, and other judicial doctrines, without waiting for new guidance.

The identified tax-aware strategies consist of certain multi-position strategies where taxpayers may use technical differences among certain similar products or payments, or timing and identification rules, to generate capital gains and ordinary losses. The Notice points out that these strategies appear to be primarily tax-motivated rather than aimed at achieving an economic return through genuine investment activity.

1. Mixed-Character Identified Straddles (Section 1092(a)(2) / Section 988 / Section 1256)

   In one strategy described in the Notice, a fund enters into a pair of contracts that are long and short on the same foreign currency. The Notice says a similar tax result is also achieved by pairing a notional principal contract (NPC) that is an equity index swap and a futures contract on that same index.

   In the currency-related strategy, one leg is a forward contract that produces ordinary income or loss under Section 988(a)(1)(A). The other leg is a regulated futures contract that produces a 60/40 capital gain or loss under Section 1256(a)(3). The fund identifies the pair as an "identified straddle" under Section 1092(a)(2).

   The fund terminates the futures contract first.

   • If the futures contract is in a gain position, the fund recognizes capital gain on that leg and ordinary loss on the forward contract when it settles.
   • If the futures contract is in a loss position, the fund takes the position that the loss is capitalized into the basis of the forward contract under Section 1092(a)(2)(A), reducing ordinary income (or creating an ordinary loss) on the forward contract at settlement.

   The ordinary losses can then be used by investors to reduce unrelated ordinary income. The IRS views this strategy as generating gross capital gain and ordinary loss from offsetting positions in a way that is inconsistent with congressional intent.




2. Same-Day Section 988(a)(1)(B) Elections on Foreign-Currency Forwards

   A second strategy identified in the Notice utilizes the timing of the capital-gain election available for foreign-currency forward contracts. A fund enters into foreign-currency forward contracts that expire or are disposed of on the same day they are entered into. Section 988(a)(1)(B) permits a taxpayer to elect capital gain or loss treatment for foreign-currency gain or loss on a forward contract, provided the taxpayer identifies the transaction before the close of the day on which it is entered into. In the absence of such an election, the foreign-currency forward contract results in ordinary gain or loss.

   After trading is complete for the day, the fund elects Section 988(a)(1)(B) treatment only for forward contracts that expired at a gain, converting that gain to capital gain. No election is made for contracts that expired at a loss, leaving those losses as ordinary. Because the contracts expire or are disposed of on the same day they are entered into, the fund already knows the results of the contracts when it decides whether to elect.

   The requirement that Section 988(a)(1)(B) treatment be elected on the day that a foreign-currency forward contract is entered into was intended to prevent taxpayers from using hindsight in deciding whether to make the election. The termination or disposition of such a contract on the very day it is entered into frustrates the legislative intent of that identification requirement.




3. Selective NPC Terminations

   The Notice identifies a third strategy that exploits the difference in character between periodic or nonperiodic payments under a notional principal contract (e.g., certain total return swaps) and termination payments. Under Treasury Regulation Section 1.446-3, periodic and nonperiodic payments on an NPC are accrued ratably and generally are ordinary in character. A termination payment (made to extinguish or assign all or a proportionate part of the remaining rights and obligations under an NPC) is recognized in the year of termination and can produce capital gain or loss.

   In this strategy, a fund enters into multiple NPCs, then terminates (before scheduled payments are made) only those NPCs that are in a gain position, claiming capital gain treatment on the termination payments although the terminated NPC payment may be based primarily on the value of the underlying equity (e.g., akin to the factor used for the scheduled payment, but changing the tax character). NPCs that are in a loss position are held to maturity, producing ordinary expense or loss treatment through the scheduled payment rules.

   The government views this strategy as selectively producing capital gains and ordinary losses from economically similar or offsetting positions, using the form of termination or expiration to dictate character rather than reflecting genuine economic distinctions.

Implications

The explicit reservation of retroactive authority under Section 7805(b)(3) means that transactions already completed could be affected by future guidance. Even without new guidance, the IRS may challenge these strategies on audit under existing judicial doctrines, including the economic substance doctrine and the substance-over-form doctrine.

A future designation as a transaction of interest (or listed transaction) would trigger disclosure obligations under Section 6011 and the associated penalty regime under Sections 6662A and 6707A. The Notice stops short of making such designations now but expressly contemplates doing so. Funds and investors with separately managed accounts that utilize any of the "tax-aware" strategies outlined in the Notice should carefully consider such investments in light of the concerns raised by the Notice and monitor further guidance. The Notice also invites comments from interested parties.

ETF Strategies Identified in the Notice

The Notice also identifies strategies employed by some exchange-traded funds that rely on what the government calls "atypical usage" of Internal Revenue Code section 852(b)(6) to achieve a tax result not intended under the Code. We discuss these in "Exchange-Traded Fund (ETF) Transactions Come under IRS Scrutiny."