(1) Section 988 transaction (A) In general The term “ section 988 transaction” means any transaction described in subparagraph (B) if the amount which the taxpayer is entitled to receive (or is required to pay) by reason of such transaction— (i) is denominated in terms of a nonfunctional currency, or (ii) is determined by reference to the value of 1 or more nonfunctional currencies. (B) Description of transactions For purposes of subparagraph (A), the following transactions are described in this subparagraph: (i) The acquisition of a debt instrument or becoming the obligor under a debt instrument. (ii) Accruing (or otherwise taking into account) for purposes of this subtitle any item of expense or gross income or receipts which is to be paid or received after the date on which so accrued or taken into account. (iii) Entering into or acquiring any forward contract, futures contract, option, or similar financial instrument. The Secretary may prescribe regulations excluding from the application of clause (ii) any class of items the taking into account of which is not necessary to carry out the purposes of this section by reason of the small amounts or short periods involved, or otherwise. (C) Special rules for disposition of nonfunctional currency (i) In general In the case of any disposition of any nonfunctional currency— (I) such disposition shall be treated as a section 988 transaction, and (II) any gain or loss from such transaction shall be treated as foreign currency gain or loss (as the case may be). (ii) Nonfunctional currency For purposes of this section, the term “nonfunctional currency” includes coin or currency, and nonfunctional currency denominated demand or time deposits or similar instruments issued by a bank or other financial institution. (D) Exception for certain instruments marked to market (i) In general Clause (iii) of subparagraph (B) shall not apply to any regulated futures contract or nonequity option which would be marked to market under section 1256 if held on the last day of the taxable year. (ii) Election out (I) In general The taxpayer may elect to have clause (i) not apply to such taxpayer. Such an election shall apply to contracts held at any time during the taxable year for which such election is made or any succeeding taxable year unless such election is revoked with the consent of the Secretary. (II) Time for making election Except as provided in regulations, an election under subclause (I) for any taxable year shall be made on or before the 1st day of such taxable year (or, if later, on or before the 1st day during such year on which the taxpayer holds a contract described in clause (i)). (III) Special rule for partnerships, etc. In the case of a partnership, an election under subclause (I) shall be made by each partner separately. A similar rule shall apply in the case of an S corporation. (iii) Treatment of certain partnerships This subparagraph shall not apply to any income or loss of a partnership for any taxable year if such partnership made an election under subparagraph (E)(iii)(V) for such year or any preceding year. (E) Special rules for certain funds (i) In general In the case of a qualified fund, clause (iii) of subparagraph (B) shall not apply to any instrument which would be marked to market under section 1256 if held on the last day of the taxable year (determined after the application of clause (iv)). (ii) Special rule where electing partnership does not qualify If any partnership made an election under clause (iii)(V) for any taxable year and such partnership has a net loss for such year or any succeeding year from instruments referred to in clause (i), the rules of clauses (i) and (iv) shall apply to any such loss year whether or not such partnership is a qualified fund for such year. (iii) Qualified fund defined For purposes of this subparagraph, the term “qualified fund” means any partnership if— (I) at all times during the taxable year (and during each preceding taxable year to which an election under subclause (V) applied), such partnership has at least 20 partners and no single partner owns more than 20 percent of the interests in the capital or profits of the partnership, (II) the principal activity of such partnership for such taxable year (and each such preceding taxable year) consists of buying and selling options, futures, or forwards with respect to commodities, (III) at least 90 percent of the gross income of the partnership for the taxable year (and for each such preceding taxable year) consisted of income or gains described in subparagraph (A), (B), or (G) of section 7704(d)(1) or gain from the sale or disposition of capital assets held for the production of interest or dividends, (IV) no more than a de minimis amount of the gross income of the partnership for the taxable year (and each such preceding taxable year) was derived from buying and selling commodities, and (V) an election under this subclause applies to the taxable year. An election under subclause (V) for any taxable year shall be made on or before the 1st day of such taxable year (or, if later, on or before the 1st day during such year on which the partnership holds an instrument referred to in clause (i)). Any such election shall apply to the taxable year for which made and all succeeding taxable years unless revoked with the consent of the Secretary. (iv) Treatment of certain currency contracts (I) In general Except as provided in regulations, in the case of a qualified fund, any bank forward contract, any foreign currency futures contract traded on a foreign exchange, or to the extent provided in regulations any similar instrument, which is not otherwise a section 1256 contract shall be treated as a section 1256 contract for purposes of section 1256. (II) Gains and losses treated as short-term In the case of any instrument treated as a section 1256 contract under subclause (I), subparagraph (A) of section 1256(a)(3) shall be applied by substituting “100 percent” for “40 percent” (and subparagraph (B) of such section shall not apply). (v) Special rules for clause (iii)(I) (I) Certain general partners The interest of a general partner in the partnership shall not be treated as failing to meet the 20-percent ownership requirements of clause (iii)(I) for any taxable year of the partnership if, for the taxable year of the partner in which such partnership taxable year ends, such partner (and each corporation filing a consolidated return with such partner) had no ordinary income or loss from a section 988 transaction which is foreign currency gain or loss (as the case may be). (II) Treatment of incentive compensation For purposes of clause (iii)(I), any income allocable to a general partner as incentive compensation based on profits rather than capital shall not be taken into account in determining such partner’s interest in the profits of the partnership. (III) Treatment of tax-exempt partners Except as provided in regulations, the interest of a partner in the partnership shall not be treated as failing to meet the 20-percent ownership requirements of clause (iii)(I) if none of the income of such partner from such partnership is subject to tax under this chapter (whether directly or through 1 or more pass-thru entities). (IV) Look-thru rule In determining whether the requirements of clause (iii)(I) are met with respect to any partnership, except to the extent provided in regulations, any interest in such partnership held by another partnership shall be treated as held proportionately by the partners in such other partnership. (vi) Other special rules For purposes of this subparagraph— (I) Related persons Interests in the partnership held by persons related to each other (within the meaning of sections 267(b) and 707(b) ) shall be treated as held by 1 person. (II) Predecessors References to any partnership shall include a reference to any predecessor thereof. (III) Inadvertent terminations Rules similar to the rules of section 7704(e) shall apply. (IV) Treatment of certain debt instruments For purposes of clause (iii)(IV), any debt instrument which is a section 988 transaction shall be treated as a commodity.