Estate of Leon Israel, Jr., Barry W. Gray, and Audrey H. Israel v. Commissioner , 108 T.C. No. 13 ( 1997 )

108 T.C. No. 13
UNITED STATES TAX COURT
ESTATE OF LEON ISRAEL, JR., DECEASED,
BARRY W. GRAY, EXECUTOR, AND AUDREY H. ISRAEL, Petitioners
v. COMMISSIONER OF INTERNAL REVENUE, Respondent
JONATHAN P. WOLFF AND MARGARET A. WOLFF, Petitioners
v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 31588-88, 13142-89. Filed April 1, 1997.
Held: Fees paid in connection with "cancellation"
of legs of commodity forward contracts treated as
capital losses, not ordinary losses. The opinion of
the U.S. Court of Appeals for the District of Columbia
Circuit in Stoller v. Commissioner, 994 F.2d 855 (D.C.
Cir. 1993) (in its treatment of losses from
cancellation and replacement, and cancellation and
termination, of legs of commodity forward contracts as
ordinary losses) not followed, and our opinion in
Stoller v. Commissioner, T.C. Memo. 1990-659, affd. in
part and revd. in part 994 F.2d 855 (D.C. Cir. 1993)
(in its treatment of losses from cancellation and
termination of legs of commodity forward contracts as
ordinary losses), modified.
2
Herbert Stoller and William L. Bricker, Jr., for
petitioners.*
Steven R. Guest, Mark J. Miller, and Edward G. Langer, for
respondent.
OPINION
SWIFT, Judge: Respondent determined deficiencies in
petitioners’ Federal income taxes and increased interest as
follows:
Estate of Leon Israel, Jr., Deceased, and Audrey H. Israel
Increased Interest
Year Deficiency Sec. 6621(c)
1977 $ 9,837 *
1979 14,442 *
1980 62,482 *
* 120 percent of interest accruing after Dec. 31,
1984, on portion of the underpayment attributable
to a tax-motivated transaction.
Jonathan P. and Margaret A. Wolff
Increased Interest
Year Deficiency Sec. 6621(c)
1979 $55,114 *
1980 82,369 *
1981 2,294 *
*
Briefs amicus curiae were filed by Joel E. Miller as
attorney for Allan D.Yasnyi, Martin B. Boorstein, and Marilyn G.
Boorstein, and by Eli Blumenfeld as attorney for Lesley Yasnyi,
other partners against whom respondent has determined income tax
deficiencies relating to the same issue involved herein. These
other partners have filed petitions in this Court, and they have
filed stipulations to be bound by the final resolution of the
instant cases.
3
* 120 percent of interest accruing after Dec. 31,
1984, on portion of the underpayment attributable
to a tax-motivated transaction.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
After settlement, the sole issue for decision is whether
losses incurred in connection with closing forward contracts in
Government securities should be treated as capital losses or as
ordinary losses.
The parties submitted these consolidated cases fully
stipulated under Rule 122. More specifically, as factual
evidence in these cases, the parties stipulated the admissibility
of the entire trial record of Stoller v. Commissioner, T.C. Memo.
1990-659, 60 T.C.M. 1554, 1990 T.C.M. (P-H) par. 90,659,
affd. in part and revd. in part 994 F.2d 855 (D.C. Cir. 1993).
That case involved Herbert Stoller (Stoller), petitioners'
counsel in the instant cases and also a partner in Holly Trading
Associates (Holly), a partnership in which Leon Israel, Jr.
(Israel), Jonathan P. Wolff (Wolff), and other petitioners herein
also invested, and the treatment, for Federal income tax
purposes, of the identical losses of Holly relating to the same
forward contracts that are at issue in the instant cases. A
number of additional issues that were addressed in Stoller v.
Commissioner, supra, are not at issue herein.
4
We expressly incorporate into our findings of fact the
background facts relating to Holly's investments in forward
contracts and commodity straddle transactions as well as the
specific facts relating to the particular commodity forward
contracts that are at issue herein as those facts were found in
our opinion in Stoller v. Commissioner, supra, with one exception
as to the ultimate finding of fact that we made in our Stoller
opinion with regard to the tax treatment of the losses incurred
on the commodity forward contracts that were closed by
cancellation and termination as explained further below.
We also attach hereto and incorporate into our findings of
fact as Appendixes A-1 and A-2, certain schedules that were
attached to our opinion in Stoller v. Commissioner, 60 T.C.M.
(CCH) at 1569-1571, 1990 T.C.M. at 90-3223 to 90-3227. (We
note that Appendixes A-1 and A-2 attached hereto were labeled
Appendixes B-1 and B-2 in our above Stoller opinion.) These
schedules, among other data, set out data relating to the three
groups of forward contracts that are at issue in the instant
cases.
The schedule below identifies lines of Appendixes A-1 and A-
2 that reflect specific information with regard to each of the
three groups of forward contracts in issue and the amount of the
losses claimed by Holly with respect thereto:
5
Transaction & Losses
Claimed Appendixes A-1 and A-2 Line Nos.
First Contracts -- ($837,500) A-1, Lines 5, 7, 9, 11, 17-24, 26, 28
Second Contracts -- ($816,219) A-2, Lines 1, 3, 5, 7-12, 24-26, 29, 30
Third Contracts -- ( $10,000) A-2, Lines 13-20
The opinion of the U.S. Court of Appeals for the District of
Columbia Circuit in Stoller v. Commissioner, supra, provides only
an abbreviated explanation of the particular forward contracts
that were the subject of the appeal of our opinion in Stoller v.
Commissioner, supra, and that are at issue herein.
We also, in light of the essentially legal nature of the
issue before us, set forth herein a somewhat abbreviated
explanation of the details of the particular forward contracts
that are at issue, but we emphasize particular aspects of these
forward contracts, the significance of which appears to have been
overlooked by the Court of Appeals in its analysis and opinion in
Stoller v. Commissioner, supra.
We believe that the aspects of these transactions that we
emphasize herein are significant and determinative of the narrow
issue before us (namely, whether the losses in question are
deductible as capital or as ordinary losses). We also note that
respondent has conceded the increased interest under section
6621(c) and makes no contention herein that the forward contracts
at issue were sham transactions or lacked a business purpose or
profit motive. Further, no issue is raised as to petitioners’
cost basis in the forward contracts in question.
6
As indicated, from 1979 to 1982, Israel, Wolff, Stoller, and
other individuals were partners in Holly, which partnership
invested nominally in interest-bearing Government securities,
such as U.S. Treasury Bonds (T-Bonds) and Government National
Mortgage Association Bonds (GNMA’s) by way of unregulated
commodity forward contracts.
Holly utilized forward contracts to conduct an arbitrage
program involving the simultaneous purchase in one market and
sale in another market with the expectation of making a profit on
price differences in the different markets. Holly's program
involved the establishment of long positions in Government
securities and the simultaneous establishment of short positions
in different Government securities, with a difference in the
interest rates, or repurchase rates, on the two positions that
was calculated to yield a nominal net profit to Holly when the
positions were liquidated.
In this instance, a long position represents a contract to
purchase a Government security in the future, and a short
position represents a contract to sell a Government security in
the future. The establishment of both long and short positions
in the same type of commodity is called a spread or a straddle.
In the minds of the partners of Holly, in actuality and in
substance, Holly’s investments in commodity forward contracts
involved nothing more than contracts to speculate in or to
7
arbitrage -- for the short length of time that the forward
contracts remained outstanding -- changes or shifts in the
interest and discount rates associated with the particular type
of Government securities to which the forward contracts were
pegged. By entering into offsetting forward contracts to
purchase and to sell these Government securities, Holly
effectively created synthetic short-term security investments by
means of the straddles, even though the underlying Government
securities to which the interest rate speculation was pegged
constituted long-term Government securities.
For example, by entering into a contract to purchase, at the
current market or other specified price, 15-year T-Bonds for
delivery in 3 months and simultaneously entering into a contract
to sell, at the current market or other specified price, 15-year
T-Bonds for delivery 6 months later, Holly "created" the economic
equivalent of a contract to purchase a 6-month T-Bond. Holly
then arbitraged these contracts against simultaneous contracts to
sell GNMA’s on the same specified date in 3 months and to
purchase GNMA’s 6 months later.
In economic terms, and as between the parties, the only
important factors in such a straddle transaction are the
initially specified price differential between the legs of the
forward contracts or straddle and changes in interest and
discount rates associated with the particular Government
8
securities to which the contracts are pegged that occur during
the period of time that the contracts remain outstanding. Those
factors will determine the entire net gain or loss whenever the
position is settled or closed out.
No actual purchase or sale of the Government securities to
which the forward contracts are pegged is ever contemplated. In
fact, no specific Government securities are identified as being
associated with the forward contracts. In actuality, the
Government securities to which the forward contracts are
associated are more accurately described as hypothetical
Government securities that, if they existed, would have the same
interest rates and other features as the type of Government
securities to which the forward contracts are pegged.
Pricing of the forward contracts entered into by Holly
occurred in the following manner. Mr. Wolff, on behalf of Holly,
negotiated with ACLI Government Securities, Inc. (AGS), a dealer
in Government securities and a broker of commodity futures
contracts, the price differential -- as of the date the contracts
were entered into -- between the long and short positions of each
straddle and, once that differential was agreed upon, left it to
AGS to assign prices to the two legs of the straddle reflecting
the initial price differential agreed upon. When Mr. Wolff
negotiated with AGS regarding offsetting positions, again he
would negotiate with AGS only the price differential as of the
date the offsetting contracts were entered into.
9
In the context of the straddle transactions of the type
involved in these cases, commodity forward contracts (as with
futures commodity contracts) are not consummated by actual sale
or purchase and delivery of the underlying securities or
commodity. Actual delivery of the underlying securities is not
contemplated. Rather, forward contracts are generally closed by
offset, that is by entering into opposite forward contracts in
the same commodity with the same or similar settlement dates.
When such opposite forward contracts in the same commodity are
entered into, the rights and obligations of the investor in the
initial contracts are simply regarded as terminated.
The parties agree that in the above situation the
termination by offset of the investor's respective positions
constitutes a capital transaction. We emphasize that all that
has happened in closing the transaction by way of offset is that
the investor (at whatever time during the length of the contract
the investor chooses to terminate or lock in the gain or loss
that has occurred with respect thereto as a result of changes in
the price differential and in interest and discount rates
relating to the relevant Government securities from the day the
forward contracts were first entered into until the day the
contracts are closed) simply notifies the other party of the
investor’s desire to close the transaction by offset and, in
effect, the contracts or positions are terminated as of that
point in time.
10
Occasionally, an investor may wish to terminate or "lock in"
the gain or loss on only a particular leg of a commodity forward
contract or straddle. The procedure is essentially the same, and
the transaction is essentially the same, regardless of which of a
number of available methods is utilized to lock in the gain or
loss on a particular leg of a commodity straddle transaction that
has occurred up until that point in time.
True cancellations of forward contracts, where the
transaction or contracts are vitiated ab initio, only occur when
forward contracts contain errors.
When interest rates change at any time during the period of
time that forward contracts are open, the value of the straddle
increases or decreases, but that increase or decrease is
moderated by the fact that as one leg of the straddle increases
in value, the other leg decreases in value by a similar amount.
Although the change in value of a given straddle remains fairly
constant, one particular leg of a straddle may reflect a large
loss and the other leg may reflect a large gain when interest
rates fluctuate widely and when the other leg of the straddle is
not considered. It was at such a point in time that Holly, for
income tax purposes, occasionally would close by offset or by
"cancellation" only a loss leg of a straddle and simultaneously
replace the loss leg with a new contract for a slightly different
delivery date, thereby locking in the loss on the first leg and
the gain on the second leg of the straddle that had occurred from
11
the day the contracts had initially been entered into until the
day the initial loss leg of the contract is closed.
In the above scenario, when the loss leg is closed by
“cancellation” and simultaneously replaced with a new forward
contract, the purpose of going through the formality of
“canceling” the loss leg of the forward contract and replacing it
(instead of directly “offsetting” the loss leg) was to attempt to
convert the capital loss that petitioners concede would have been
associated with the offset procedure into an ordinary loss that
Holly claims is associated with a “cancellation.”
When a loss leg of a straddle is closed by cancellation and
terminated (i.e., no replacement or offset contract is
purchased), as well as when a loss leg of a straddle is closed
and a replacement contract is purchased (as distinguished from
closing by offset), the loss leg of the contract is closed or
terminated as of the date of the closing, and the parties have
effectively locked in the "loss" on that leg of the straddle,
reflecting simply the change, due to shifts in the interest
rates, in the nominal value of that leg from the day the leg was
entered into until the day of the closing of the leg.
When Holly closed a loss leg of a straddle and no
replacement or offset contract was purchased, Holly paid AGS what
was referred to as a “cancellation” fee equal to and representing
the loss that had been realized on just that leg of the straddle.
When Holly closed a loss leg and replaced it, Holly also
12
paid AGS a “cancellation” fee equal to and representing the loss
that had been realized on just that leg of the straddle (and
without taking into account the offsetting gain that also was
realized and locked in as of that point in time via the
replacement leg of the straddle), which cancellation fee
represented the loss realized on the loss leg that was closed.
The closing or liquidation of loss legs of forward contracts
by way of offset or by way of "cancellation" (and whether or not
"cancellation" is followed by replacement contracts) is
economically the same. Where "cancellation" of loss legs is
followed by replacement contracts, the replacement contracts
simply serve to lock in the offsetting gain on other legs of the
straddle that has occurred from the day the straddle was first
entered into until the day the loss legs are closed. The
replacement contracts simply relate to the need to lock in the
large gain in order to offset the large loss that is going to be
claimed for tax purposes. The replacement contracts in no way
alter the character of the loss realized on the legs that are
closed.
Holly typically, in the following year, closed the gain legs
of the straddle transactions by offset in order to qualify the
gain as capital gain.
The so-called cancellation fees that were due on closing the
loss legs of forward contracts (at least with regard to the first
and second groups of forward contracts in issue) were not paid by
13
Holly at the time the investors' loss positions were locked in.
Mere bookkeeping entries were made to reflect the so-called
cancellation fees.
Just prior to the end of each year, the individual partners
of Holly obtained bank loans and made contributions to their
partnership capital accounts in Holly in amounts sufficient to
pay the cancellation fees owed by Holly. Holly then used such
funds to pay the cancellation fees to AGS and treated the fees as
ordinary losses at the partnership level and passed through the
claimed ordinary losses to the individual partners.
Just after the first of each year, AGS paid to Holly an
amount essentially equivalent to the cancellation fees that Holly
had paid AGS at the end of the prior year -- reflecting the gains
that were locked in on the straddle transactions. Holly then
distributed these funds to the individual partners as a return of
capital, and the partners used these funds to repay their bank
loans approximately 1 to 2 weeks after having been loaned the
funds.
On its Federal income tax returns for the years in issue,
Holly treated losses arising from forward contracts closed by
offset as capital losses. Holly, however, reported losses
arising from forward contracts closed by “cancellation”
(regardless of whether or not replacement contracts were
purchased) as ordinary losses.
14
In 1979, Holly reported a capital gain of $1,875 from
trading in commodity forward contracts and an ordinary loss of
$837,500 relating to the "cancellation" of the first group of
forward contracts in issue.
In 1980, Holly reported capital gains in the amount of
$850,000 (relating to the straddle the above loss leg of which
was closed in 1979 to produce the $837,500 loss claimed in 1979)
and an ordinary loss of $826,219 relating to "cancellation" of
the second and third forward contracts in issue that were
"canceled" in 1980 (an $816,219 loss relating to the second group
of forward contracts closed by "cancellation" and replacement,
and a $10,000 loss relating to the forward contract "canceled"
and terminated).
In 1981, Holly reported a cumulative net short-term capital
loss of $349,468 from trading in forward contracts. The record
is not clear as to the amount of the capital gain Holly reported
in 1981 with respect to closing in 1981 the replacement contracts
that Holly acquired in 1980.
On audit, insofar as is pertinent to the sole issue before
us in the instant cases, respondent determined that Holly’s
claimed ordinary losses (relating to the forward contracts
"canceled" and replaced and to the forward contracts "canceled"
and terminated) should be treated as capital losses.
15
Discussion
The parties herein agree on two important points: (1) That
the commodity forward contracts that Holly entered into and
created with AGS constituted capital assets; and (2) that locking
in, by offset -- at any point in time during the duration or
length of forward contracts -- the gain or loss relating to the
overall straddle transaction (or the gain or loss relating to a
leg of the straddle transaction) constitutes the sale or exchange
of a capital asset.
The issue in the instant cases is whether locking in -- at
any point in time during the duration or length of a forward
contract -- a loss relating to a leg of a straddle transaction by
two methods slightly different from the offset method (namely, by
cancellation and replacement and by cancellation and termination)
also constitutes a sale or exchange of a capital asset, as
respondent contends, or whether the taxpayers can convert the
capital loss into an ordinary loss by the use of either of such
two different methods, as petitioners contend.
As is often the case, critical to resolution of the issue
before us is the statement of the issue. If the industry label
and nomenclature are accepted at face value, and if the issue
herein is stated simply in terms of whether "cancellation" of a
leg of a forward contract gives rise to capital gain or loss, as
distinguished from ordinary gain or loss, one is directed quickly
to certain case authority (discussed below) that addresses tax
16
consequences of unexpected "cancellations" of commercial
contracts, which cases generally turn on whether property rights
relating to or arising out of the original contract survived the
cancellation and whether all rights relating to the contract
"vanished" with the cancellation. As explained below, we believe
such "cancellation" cases do not control the cancellation of
commodity forward contracts by which investors simply settle or
close out their position in a straddle or in a leg of a straddle
transaction.
As stated, the parties agree that forward contracts in
commodity markets held for investment constitute capital assets
under section 1221. Commissioner v. Covington, 120 F.2d 768 (5th
Cir. 1941), affg. in part and revg. in part 42 B.T.A. 601 (1940);
Vickers v. Commissioner, 80 T.C. 394 (1983); Hoover Co. v.
Commissioner, 72 T.C. 206 (1979). Although no delivery or
physical exchange of the underlying commodity is contemplated,
the monetary settlements that occur between the respective
parties holding the contra positions in forward contracts have
long been recognized to constitute "sales or exchanges" under the
tax laws.
As we explained in Vickers v. Commissioner, supra at 409,
involving futures contracts, for our purposes not significantly
different from forward contracts --
both the Supreme Court and the Congress have had occasions
to deal with commodity futures transactions, have treated
17
them as capital transactions thus presupposing a "sale or
exchange," and have never questioned our [Commissioner v.]
Covington, [supra] or Battelle [v. Commissioner, 47 B.T.A.
117 (1942)] cases in which we found a "sale or exchange" in
the "netting" or "offsetting" mechanism of the commodity
exchanges. * * *
We went on in Vickers v. Commissioner, supra at 409, to explain
further:
In the landmark Corn Products [Refining Co. v. Commissioner,
350 U.S. 46 (1955)] case in 1955, the Supreme Court even
then was facing a consistent 20-year practice by respondent
and the lower courts, whereby speculative transactions in
commodity futures received capital treatment * * *. The
Supreme Court cited our Battelle [v. Commissioner, supra,]
case as part of that consistent practice. 350 U.S. at 53
n.8. Moreover, the Congress, too, has assumed that gains
and losses from speculative commodity futures transactions
are capital in nature as shown by the 1950 legislative
history of the predecessor of section 1233 dealing with
short sales of property and by the legislative history of
the recent legislation dealing with commodity futures and
eliminating certain abusive practices involving commodity
tax straddles. [Fn. refs. omitted.]
In Commissioner v. Covington, supra at 769-770, an early
opinion of the Court of Appeals for the Fifth Circuit, involving
a taxpayer's losses from commodity futures contracts, the
fundamentals of such transactions, from a tax standpoint, were
explained, and it was concluded that such transactions in essence
constitute sales or exchanges, as follows:
[The taxpayer argues that the investor] doesn't, by its
dealing, become the owner of any property, it merely enters
into executory contracts which are executed, not by transfer
of property, but by closing them out at a profit or loss,
under the rules of the exchange, without a sale or exchange
of property being involved. * * * [T]he clearing house of
18
the exchange to which all contracts are transferred,
extinguish[es] offsetting contracts and makes a money
settlement of the price difference. There is then neither
the sale nor exchange of the commodity or of the contract.
There is only the extinguishment of a contract to buy and a
contract to sell, and a money settlement for the price
difference. This, says the * * * [taxpayer], is not a
selling or buying of property. Speaking plainly [the
taxpayer argues], it is simply an arrangement or device by
which gains or losses are chalked up and settled for,
between speculators who have taken opposite positions in a
rising and falling market.
It is difficult to see how, if * * * [the taxpayer] is
right in this naive reduction to fundamentals, of the
transactions in which it has been engaged, its activities
can be distinguished from mere wagering or to be equally
naive, betting or gambling. But they are so distinguished
in law and in business contemplation, and they are so
distinguished, because implicit in the transactions is the
agreement and understanding that actual purchases and sales,
and not mere wagering transactions, are being carried on.
[Commissioner v. Covington, 120 F.2d at 769-770; emphasis
added.]
We believe the above statement from this early opinion is
apropos to the facts of the transactions before us in this case
and succinctly distills the essence of what is going on --
namely, the "purchase and sale" of forward contracts or
"positions" in a particular market (in this case the market for
interest-sensitive Government securities). Whenever the investor
(during the length or duration of the forward contracts that have
been purchased) elects to settle, close out, extinguish, or
cancel the contracts or positions, or one of the legs thereof,
and to realize the gain or loss associated with the contracts, or
with one of the legs thereof, and regardless of whether the
19
investor "closes out" or "locks in" the gain or loss by way of
offset, by way of cancellation and replacement contracts, or by
way of cancellation and termination, the transaction is exactly
the same -- in purpose, in effect, and in substance -- and
produces exactly the same type of taxable gain or loss -- in the
instant cases capital gain or capital loss.
As the U.S. Court of Appeals for the Fifth Circuit stated,
implicit in the realization or "lock in" of the gain or loss
associated with straddle transactions or with legs thereof
(whether the lock in is effected by way of offset, cancellation
and replacement, or cancellation and termination) is the
agreement and understanding that actual purchases and sales have
occurred with respect to the price-differential and interest-
sensitive risk for T-Bonds and GNMA’s that each party accepted
when the commodity straddle transaction was first entered into.
In each case, the investor assumed the risk of swings in the
price of such Government securities for whatever time each leg of
the contract was outstanding.
Regardless of when and how a loss position in a commodity
forward contract is extinguished, closed, settled, terminated, or
canceled, at any one point in time during the length or duration
of the contract, the investor in fact has participated in exactly
the transaction for which the investor contracted from the time
the transaction was first entered into until the day the investor
chooses to close or terminate that leg. The investor got exactly
20
what was bargained for (participation in this interest-sensitive
risk transaction for a period of time) and when the investor
closed the leg or the position (by whichever of the various
"alternative liquidation techniques" that are made available to
investors in commodities forward contracts (see Ewing v.
Commissioner, 91 T.C. 396, 418 (1988), affd. without published
opinion 940 F.2d 1534 (9th Cir. 1991)), the investor effectively
sold off or extinguished and exchanged that right to participate
and realized the gain or loss associated therewith up to that
point in time.
When the investor chooses to dispose of or terminate that
risk, or any part thereof, and to lock in the gain or loss that
has occurred on any leg of the straddle, because of swings in
interest rates on Government securities that have occurred, the
investor elects a method to do so, but each method produces
exactly the same economic event and consequence, only nominal
differences in form, and certainly, as between the parties to the
forward contracts, a sale or exchange of the respective price-
differential and interest-sensitive risk positions that their
contracts represented from the time they first entered into the
forward contracts up until the time that the risk is terminated
and the gain or loss is locked in.
As we stated in Hoover Co. v. Commissioner, 72 T.C. 206, 249
(1979), in analyzing payments labeled as "compensating" payments
21
and in concluding that offsetting forward contracts in foreign
currency constituted capital transactions:
These offsets clearly constitute both "closure" under
section 1233 and a sufficient sale or exchange under the
general capital provisions to mandate capital treatment
here. * * * [Id.]
As use of the term "compensate" was not controlling in
Hoover Co. v. Commissioner, 72 T.C. 249, use of the term
"cancellation" by petitioners in connection with the settlement
of loss legs of their forward contracts is not controlling and
should not mislead us here.
Respectfully, we believe that the Court of Appeals for the
District of Columbia Circuit in Stoller v. Commissioner, 994 F.2d
855, 856-857, erred in not recognizing the above case authority
and holdings that establish the "closure" or "sale or exchange"
nature of the termination of offsetting forward contracts. Upon
closing by offset of forward contracts, the transaction is
terminated and extinguished, settlement between the parties
occurs at that time, and no contracts remain in effect. This is
illustrated clearly in Appendix A-1 hereto under the caption
"Straddles Opened And Closed -- 1980". The four forward
contracts under this caption were opened on June 20, 1980, and
were settled and closed 10 days later on June 30, 1980, by four
offsetting forward contracts. After June 20, 1980, in spite of
the fact that four offsetting forward contracts were entered into
22
with specified settlement dates in 1981 and 1982, the offsetting
contracts extinguished each other. The transactions were
settled, terminated, and closed. Nothing survived as between the
parties to these particular forward contracts into 1981 and 1982.
Whether 6-months’ offsetting forward contracts, all of the
legs of an entire straddle, or simply one leg thereof, are
settled or closed 1 week or 1 month after they are entered into,
or not until the initially specified settlement date, and by
whatever method used to settle or close the contracts (in the
instant cases, by offset, by cancellation and replacement, and by
cancellation and termination), in each situation the capital
transaction that the parties entered into through the forward
contracts, the straddle, and the legs thereof, has been closed
and the payment received (if a gain is realized) or made (if a
loss is realized) represents exactly the same type of income or
loss earned with regard to the contracts, the straddle, or the
legs thereof, for the length of time the forward contracts were
outstanding.
Other legs of the straddle may remain open, and the parties
may continue to be exposed to continuing shifts in interest rates
and in price fluctuations of Government securities for the
duration or length of time that other legs of the straddle remain
open, but with regard to the leg that has been closed, or
canceled, or offset, the transaction is closed, and a completed
sale or exchange has occurred under section 1221 with regard to
23
the rights of the parties associated with that portion of the
straddle that was closed.
With the benefit of further analysis, it is our conclusion
that our opinion in Stoller v. Commissioner, T.C. Memo. 1990-659,
affd. in part and revd. in part 994 F.2d 855 (D.C. Cir. 1993) (in
its treatment of a cancellation and termination of a leg of a
straddle transaction) and the opinion of the Court of Appeals for
the District of Columbia Circuit in Stoller v. Commissioner (in
its treatment of both cancellation and replacement and
cancellation and termination of legs of straddle transactions)
erred in not recognizing the fundamental sale or exchange nature
of these transactions in which, simply stated, the gain or loss
-- at a certain point in time -- is locked in with regard to the
portion of the straddle that is closed.
As the Court of Appeals for the Fifth Circuit early
recognized in Commissioner v. Covington, 120 F.2d at 769-770,
"closing" of the contracts at a profit or loss is the sum and
substance of the transactions before us. We perceive no
difference, for income tax purposes and in determining the
character of the gain or loss, between closing a leg of a
straddle and closing the entire straddle. Both events lock in
the gain or loss on the interest rate shift that has occurred as
of the point in time that a leg or legs of the straddle are
closed.
24
Courts often must address taxpayers' "artful devices" to
convert ordinary gain into more favorable capital gain or to
convert capital loss into more favorable ordinary loss. See
Commissioner v. P.G. Lake, Inc., 356 U.S. 260, 265 (1958) (citing
Corn Prods. Ref. Co. v. Commissioner, 350 U.S. 46, 52 (1955)).
That task should be accomplished on the basis not of the
"cancellation" label used by the parties but on the realities of
the transactions and expectations of the parties.
We reiterate what we stated in Stoller v. Commissioner,
supra, when presented with the identical facts as in the instant
cases, that to call the closing transactions in issue
"cancellations" is a misnomer and is misleading.
As stated earlier, we believe that cases involving
unexpected and true cancellations of commercial contracts and
"vanishing" or "disappearing assets" are not particularly
helpful. See Leh v. Commissioner, 260 F.2d 489 (9th Cir. 1958),
affg. 27 T.C. 892 (1957); Commissioner v. Pittston Co., 252 F.2d
344, 347-348 (2d Cir. 1958), revg. 26 T.C. 967 (1956); General
Artists Corp. v. Commissioner, 205 F.2d 360, 361 (2d Cir. 1953),
affg. 17 T.C. 1517 (1952); Commissioner v. Starr Bros., 204 F.2d
673, 674 (2d Cir. 1953), revg. 18 T.C. 149 (1952).
Those cases involve regular commercial contracts for the
provision of goods or services and the unexpected cancellation of
the contracts in midstream due to unusual circumstances not
consistent with the continuation of the original contracts that
25
had been entered into. Leh v. Commissioner, supra (termination
of petroleum supply contract); Commissioner v. Pittston Co.,
supra (termination of exclusive coal purchase contract); General
Artists Corp. v. Commissioner, supra (cancellation of performance
contract); Commissioner v. Starr Bros., supra (termination of
exclusive pharmaceutical sales contract).
It seems obvious to us that the cancellations involved in
the above cases are fundamentally different from the
"cancellations" of forward contracts that are involved herein
where the "cancellations", lock in, settlement, or closing that
occurred are exactly what the parties contemplated when they
entered into the forward contracts (namely, Holly and AGS
contemplated that Holly would have the risk of price fluctuations
on each leg of the straddle from the day the straddle was first
opened until whatever day Holly chooses to lock in the gain or
loss). Holly received the benefit of that contract and now
becomes liable for the burden (namely, the loss incurred on the
legs Holly chose to close). Holly received exactly what it
contracted for. AGS did likewise. In this sense, the
transactions in question with respect to the loss legs do not
represent cancellations. They represent consummations. The
cases, therefore, involving unexpected cancellations of
commercial contracts are of limited applicability.
In a number of cases, taxpayers and respondent have sought
to invoke the "disappearing asset" theory, but that theory was
found to be inapplicable where a close scrutiny of the substance
26
and reality of the transaction in issue indicated that much more
was involved than mere "vanishing assets." In Commissioner v.
Ferrer, 304 F.2d 125, 131 (2d Cir. 1962), revg. and remanding 35
T.C. 617 (1961), the cancellation of a contract entitling the
taxpayer to produce the play "Moulin Rouge" (so that rights to
produce the play could be transferred to another producer) was
treated as a sale or exchange.
In Bisbee-Baldwin Corp. v. Tomlinson, 320 F.2d 929, 931-932
(5th Cir. 1963), a cancellation fee was treated as arising from a
sale or exchange where, in substance, the underlying mortgage
servicing contract was transferred to a third party.
That is the situation before us. Particularly with regard
to the loss legs that were "canceled" and immediately replaced,
little, if anything, "vanished" upon Holly’s closing or settling
the loss legs. To the contrary, Holly and the Holly partners
stayed around, continued to participate in the straddle
transactions, postponed even paying the loss until the very end
of the year with funds borrowed by Holly, closed or settled the
offsetting gain leg of the forward contracts just after the new
year, and used the gain to repay the bank. The last thing the
investors would have wanted -- upon the "cancellations" in
question -- is to vanish or disappear from the rest of these
straddle transactions, the consequence of which is that the
investors might actually have had a real loss to pay.
27
More than anything else, the investors wanted to stay
around, to be a part of the straddle transactions as they came to
their predictable, inevitable, intended, and planned closing. We
agree with the analysis set forth in our prior opinion in Stoller
v. Commissioner, 60 T.C.M. at 1566, 1990 T.C.M. (P-H) at
90-3220 --
the substance of the alleged cancellation transactions [will
be determined] by looking to the entire spread arbitrage
transaction and the economic consequences sought by the
parties. * * * When * * * [the taxpayer] requested the
cancellation of a contract or series of contracts, it was
part of an ongoing straddle and was for the purpose of
changing Holly's window of risk. He did not want to
terminate Holly's straddle with AGS, he just wanted to
change the delivery date of one leg and accelerate the loss
to be recognized by Holly and its partners. * * * [Citation
omitted.]
Respectfully, we also believe that in Stoller v.
Commissioner, 994 F.2d at 858, the Court of Appeals for the
District of Columbia Circuit erred in its interpretation of the
1981 legislative history accompanying the addition of section
1234A to the Internal Revenue Code. Id. The legislative history
concerning section 1234A states the following:
Present Law
The definition of capital gains and losses in
section 1222 requires that there be a "sale or
exchange" of a capital asset. Court decisions have
interpreted this requirement to mean that when a
disposition is not a sale or exchange of a capital
asset, for example, a lapse, cancellation, or
abandonment, the disposition produces ordinary income
or loss. * * * [See Leh v. Commissioner, 260 F.2d 489
 28
(9th Cir. (1958) and Commissioner v. Pittston Co., 252
F.2d 344 (2d Cir. 1958); fn. ref. omitted.]
Reasons for Change
The committee believes that the change in the sale
or exchange rule is necessary to prevent tax-avoidance
transactions designed to create fully-deductible
ordinary losses on certain dispositions of capital
assets, which if sold at a gain, would produce capital
gains. * * *
Some taxpayers and tax shelter promoters have
attempted to exploit court decisions holding that
ordinary income or loss results from certain
dispositions of property whose sale or exchange would
produce capital gain or loss. * * *
* * * * * * *
Some of the more common of these tax-oriented
ordinary loss and capital gain transactions involve
cancellations of forward contracts for currency or
securities.
The committee considers this ordinary loss
treatment inappropriate if the transaction, such as
settlement of a contract to deliver a capital asset, is
economically equivalent to a sale or exchange of the
contract. * * * [S. Rept. 97-144, at 170-171 (1981),
1981-2 C.B. 412, 480.]
According to the Court of Appeals for the District of
Columbia Circuit, the above language from the legislative history
indicates that Congress thought that it was changing the law and
that this change in the law is strong evidence that
"cancellation" of commodity forward contracts before the change
in the law produced ordinary losses. Stoller v. Commissioner,
994 F.2d at 858.
29
We respectfully disagree with the Court of Appeals for the
District of Columbia Circuit's analysis of the above legislative
history. See our explanation of the above legislative history in
Stoller v. Commissioner, 60 T.C.M. at 1565, with which we
agree. It suffices here to reiterate what we stated in Vickers
v. Commissioner, 80 T.C. 394, 410-411 (1983) (in the context of
commodity futures contracts), with regard to section 1234A:
Whether new section 1234A is viewed as a change in the law
in some areas or as merely removing all doubt that sales or
exchange treatment is to be accorded to certain dispositions
of property, we think Congress clearly did not intend to
upset the sale or exchange treatment that had long been
accorded to speculative commodity futures transactions of
the type involved in the present case. [Citation omitted.]
Petitioners argue that the proper venue for appeal of these
cases is to the U.S. Court of Appeals for the District of
Columbia Circuit and therefore that under Golsen v. Commissioner,
54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971), we are
bound to follow the opinion of the U.S. Court of Appeals for the
District of Columbia Circuit in Stoller v. Commissioner, supra.
At the time the respective petitions in these cases were
filed, however, petitioners resided as follows:
Petitioners Residence
Audrey H. Israel New Jersey
Barry W. Gray, Executor representing
the Estate of Leon Israel, Jr.* New York
Jonathan P. and Margaret A. Wolff New York
30
* Leon Israel, Jr., died a resident of New Jersey.
Petitioners' counsel argues that docket No. 31588-88,
involving the Estate of Leon Israel, Jr., is appealable to the
U.S. Court of Appeals for the District of Columbia Circuit
because petitioners' counsel, Herbert Stoller, is also a co-
executor of the Estate of Leon Israel, Jr., and resided in
Bermuda at the time the petition was filed. In this regard, we
note that the petition in docket No. 31588-88 was filed not by
Herbert Stoller, as executor of the Estate of Leon Israel, Jr.,
but by Barry W. Gray, as executor of the Estate of Leon
Israel, Jr.
Section 7482(b)(1)(A) provides that decisions of the Tax
Court may be reviewed by the U.S. Court of Appeals for the
circuit in which is located:
(A) in the case of a petitioner seeking
redetermination of tax liability other than a
corporation, the legal residence of the petitioner,
Because Herbert Stoller is not a petitioner in docket No.
31588-88, it is unclear whether said docket would be appealable
to the U.S. Courts of Appeals for the Second and/or Third Circuit
or to the U.S. Court of Appeals for the District of Columbia
Circuit. Accordingly, we are not bound by the opinion of the
31
U.S. Court of Appeals for the District of Columbia Circuit in
Stoller v. Commissioner, supra.
Decisions will be entered
under Rule 155.
Reviewed by the Court.
COHEN, CHABOT, JACOBS, GERBER, PARR, WELLS, RUWE, COLVIN,
BEGHE, LARO, FOLEY, VASQUEZ, and GALE, JJ., agree with this
majority opinion.
APPENDIX A-1
CHRONOLOGY OF HOLLY’S STRADDLE TRANSACTIONS
Explanation of Columns:
ACLIX # = ACLI Contract # Trade Date = Date Position Settlement Date = Delivery Date
Face = Face Value of Security Established Scrty. = Government Security
Rate = Rate of Security L/S = Long or Short G/L Disp = Gain or Loss on
O/C = Closed by Offset or Price - Purchase or Sale Price Disposition When Position
Canceled Line Tr. Beg/Cl = Line # Closes
Transaction Begins or Closes
Other Abbreviations:
MM = Millions of $ GNMA = Ginnie Mae Certificate TBond = US Treasury Bond
CAN = Canceled
1979-1980 STRADDLE TRANSACTIONS
Trade Settle Line Tr.
ACLIX # Line # Date Date Face L/S Scrty. Rate Price G/L O/C Beg/Cl
929772 1 10/12/79 9/16/81 3MM L GNMA 779/32 2,318,437.50 O 14
929773 2 10/12/79 3/18/81 3MM S GNMA 7730/32 (2,338,125.00) O 13
918904 3 10/12/79 3/81 3MM L TBond 8311/32 2,500,312.50 O 16
918903 4 10/12/79 9/81 3MM S TBond 831/32 (2,490,937.50) O 15
929768 5 10/12/79 9/16/81 5MM L GNMA 777/32 3,860,937.50 C 17
929770 6 10/12/79 3/18/81 5MM S GNMA 7728/32 (3,893,750.00) O 25
929769 7 10/12/79 9/16/81 5MM L GNMA 778/32 3,862,500.00 C 18
929771 8 10/12/79 3/18/81 5MM S GNMA 7729/32 (3,895,312.50) O 25
918907 9 10/12/79 3/81 5MM L TBond 8312/32 4,168,750.00 C 19
918905 10 10/12/79 9/81 5MM S TBond 832/32 (4,153,125.00) O 27
11
918908 11 10/12/79 3/81 5MM L TBond 83 /32 4,167,187.50 C 20
918906 12 10/12/79 9/81 5MM S TBond 831/32 (4,151,562.50) O 27
020094 13 10/23/79 3/18/81 3MM L GNMA 7330/32 2,218,125.00 120,000.00 O 2
020093 14 10/23/79 9/16/81 3MM S GNMA 7317/32 (2,205,937.50) (112,500.00) O 1
020053 15 10/23/79 9/81 3MM L TBond 7916/32 2,385,000.00 105,937.50 O 4
020052 16 10/23/79 3/81 3MM S TBond 7920/32 (2,388,750.00) (111,562.50) O 3
CAN929768 17 10/24/79 9/16/81 5MM L GNMA (200,000.00) C 5
CAN929769 18 10/24/79 9/16/81 5MM L GNMA (201,562.50) C 7
CAN918907 19 10/24/79 3/81 5MM L TBond (218,750.00) C 9
CAN918908 20 10/24/79 3/81 5MM L TBond (217,187.50) C 11
020073 21 10/24/79 6/17/81 5MM L GNMA 7314/32 3,671,875.00 O 26
020074 22 10/24/79 6/17/81 5MM L GNMA 7314/32 3,671,875.00 O 26
020050 23 10/24/79 6/81 5MM L TBond 7830/32 3,946,875.00 O 28
020051 24 10/24/79 6/81 5MM L TBond 7830/32 3,946,875.00 O 28
25
105623 25 1/23/80 3/18/81 10MM L GNMA 77 /32 7,778,125.00 10,937.50 O 6 & 8
105622 26 1/23/80 6/17/81 10MM S GNMA 7721/32 (7,765,625.00) 421,875.00 O 21 & 22
105625 27 1/23/80 9/1/81 10MM L TBond 7913/32 7,940,625.00 364,062.50 O 10 & 12
105624 28 1/23/80 6/1/81 10MM S TBond 7915/32 (7,946,875.00) 53,125.00 O 23 & 24
STRADDLES OPENED AND CLOSED -- 1980
147848 1 6/20/80 12/16/81 6MM L GNMA 3010/32 4,818,750.00 O 6
147847 2 6/20/80 6/19/82 6MM S GNMA 7626/32 (4,788,750.00) O 5
147349 3 6/20/80 6/1/82 6MM L TBond 838/32 4,995,000.00 O 8
147350 4 6/20/80 12/1/81 6MM S TBond 8320/32 (5,017,500.00) O 7
150081 5 6/30/80 6/16/82 6MM L GNMA 765/32 4,569,375.00 219,375.00 O 2
150082 6 6/30/80 12/16/81 6MM S GNMA 7615/32 (4,588,125.00) (230,625.00) O 1
150083 7 6/30/80 12/1/81 6MM L TBond 7914/32 4,766,250.00 251,250.00 O 4
150084 8 6/30/80 6/1/82 6MM S TBond 7912/32 (4,762,500.00) (232,500.00) O 3
APPENDIX A-2
1980-1982 STRADDLE TRANSACTIONS
Trade Settle Line Tr.
ACLIX # Line # Date Date Face L/S Scrty. Rate Price G/L O/C Beg/Cl
164941 1 8/29/80 9/16/81 10MM L GNMA 706/32 7,018,750.00
C 8
164940 2 8/29/80 3/17/82 10MM S GNMA 706/32 (7,018,750.00) O 21,22,31
164943 3 8/29/80 3/01/82 10MM L TBond 7220/32 7,262,500.00 C 9
164942 4 8/29/80 9/18/81 10MM S TBond 7210/32 (7,231,250.00)
O 27 & 28
178424 5 10/22/80 9/16/81 2.9MM L GNMA 7023/32 2,050,843.75
C 7
178425 6 10/22/80 3/17/82 2.9MM S GNMA 7022/32 (2,049,937.50)
O 31
CAN178424 7 10/28/80 9/16/81 2.9MM L GNMA (100,593.75) C 5
CAN164941 8 10/28/80 9/16/81 10MM L GNMA (293,750.00) C 1
CAN164943 9 10/28/80 3/82 10MM L TBond (421,875.00) C 3
180286 10 10/28/80 12/16/81 2.9MM L GNMA 678/32 1,950,250.00 O 24,25,26
180285 11 10/28/80 12/16/81 10MM L GNMA 678/32 6,725,000.00 O 24,25,26
180287 12 10/28/80 12/16/81 10MM L TBond 6810/32 6,831,250.00 O 29 & 30
181467 13 11/05/80 12/80 1MM L TBond 68 680,000.00 C 17
181466 14 11/05/80 3/81 lMM S TBond 6820/32 (686,250.00) C 18
182250 15 11/07/80 12/80 lMM L TBond 67 670,000.00 C 19
182251 16 11/07/80 3/81 1MM S TBond 6720/32 (676,250.00) C 20
CAN181467 17 11/25/80 12/80 1MM L TBond 10,000.00 C 13
CAN181466 18 11/25/80 3/81 1MM S TBond (15,000.00) C 14
CAN182250 19 11/25/80 12/80 1MM L TBond 20,000.00 C 15
CAN182281 20 11/25/80 3/81 1MM S TBond (25,000.00) C 16
390801 21 9/18/81 3/17/82 2.5MM L GNMA 581/32 1,450,781.25 O 2
390800 22 9/18/81 3/17/82 .9MM L GNMA 58 522,000.00 413,593.751 O 2
390799 23 9/18/81 6/16/82 9.5MM L GNMA 532/32 5,515,937.50 O 32
390802 24 9/18/81 12/16/81 5.6MM S GNMA 5725/32 (3,235,750.00) O 10 & 11
390803 25 9/18/81 12/16/81 2.4MM S GNMA 5726/32 (1,387,500.00) O 10 & 11
390804 26 9/18/81 12/16/81 4.9MM S GNMA 5727/32 (2,834,343.75) (1,217,656.25)2 O 10 & 11
390805 27 9/18/81 9/18/81 5.1MM L TBond 59 3,009,000.00 O 4
390806 28 9/18/81 9/18/81 4.9MM L TBond 5824/32 2,878,750.00 1,343,500.003 O 4
390808 29 9/18/81 12/1/81 4.9MM S TBond 5911/32 (2,907,843.75) O 12
34
391075 30 9/18/81 12/1/81 5.1MM S TBond 5916/32 (3,034,500.00) (888,906.25)4 O 12
436789 31 3/4/82 3/17/82 9.5MM L GNMA 635/32 5,999,843.75 682,468.755 O 2 & 6
436790 32 3/4/82 6/16/82 9.5MM S GNMA 6213/32 (5,928,593.75) 412,656.25 O 23
1
Gain figure represents gain realized by offsetting $3.4 million of Contract # 164940 (line 2) by lines 21 and 22.
2
Loss figure represents total loss realized on closing transactions on lines 10 and 11 by transactions shown on lines 24
through 26.
3
Gain figure represents total gain realized by offsetting transaction shown on line 4 by transactions shown on lines 27 and
28.
4
Loss figure represents total loss realized by offsetting transaction shown on line 12 by transactions shown on lines 29 and
30.
5
Gain figure represents gain realized by offsetting $6.6 million of Contract # 164940 (line 2) and line 6 by line 31.
35
BEGHE, J., concurring: Having joined the majority opinion, I
write separately to respond to some of the strictures in the
dissenting opinion.
With all due respect, the author of the dissenting opinion and
the Court of Appeals for the District Columbia Circuit in Stoller
v. Commissioner, 994 F.2d 855 (D.C. Cir. 1993), revg. in part
T.C. Memo. 1990-659, have not paid proper heed to the body of
judge-made law in the Second and Third Circuits, as well as this
Court, that treats even true cancellations of some types of
contracts as capital gain or loss transactions; this is just
another area in which the capital character of the asset and
other circumstances properly focus the analysis upon the nature
of the contract rights in question, rather than merely upon the
structure of the transaction as a "sale or exchange", as opposed
to a cancellation, termination, or relinquishment. See, e.g.,
Commissioner v. Ferrer, 304 F.2d 125 (2d Cir. 1962), revg. in
part and remanding 35 T.C. 617 (1961); Commissioner v. McCue
Bros. & Drummond, Inc., 210 F.2d 752 (2d Cir. 1954), affg. 19
T.C. 667 (1953); Commissioner v. Golonsky, 200 F.2d 72 (3d Cir.
1952), affg. 16 T.C. 1450 (1951); see also Sirbo Holdings, Inc.
v. Commissioner, 509 F.2d 1220 (2d Cir. 1975), affg. 61 T.C. 723
(1974); Maryland Coal & Coke Co. v. McGinnes, 225 F. Supp. 854
(E.D. Pa. 1964), affd. 350 F.2d 293 (3d Cir. 1965).
Other special circumstances present in the cases at hand
provide a principled basis for looking beyond the conceded facts
36
that the transactions in question were bona fide, had economic
substance, and were entered into for profit--all of which only go
to the economics of the amount of gain or loss--to recognize the
also inescapable facts that Holly and AGS were related parties
with no adverse interests insofar as the treatment of the closing
transactions as offsets or cancellations was concerned. The
custom or usage of the trade among dealers and traders in forward
contracts and the underlying commodities, which Holly and AGS
arbitrarily ignored, is that true cancellations are only employed
to correct mistakes, not to close out forward contracts entered
into and disposed of in the ordinary course of business.1 See
Brown v. Commissioner, 85 T.C. 968, 994 (1985), affd. sub nom.
Sochin v. Commissioner, 843 F.2d 351 (9th Cir. 1998); Stoller v.
Commissioner, T.C. Memo. 1990-659, 60 T.C.M. 1554, 1566,
1990 T.C.M. (P-H) par. 90,659, at 3220-90; majority op. p. 10.
1
Another fact, shown in the stipulated record, that points up the
arbitrary treatment of the transactions between Holly and AGS,
insofar as the choice of tax consequences was concerned, is that,
in the case of offsetting transactions, Holly and AGS agreed to
recognize both gains and losses as of the trade date of the
offset. This would seem to be contradicted by the fact that both
contracts remain in existence, and a net profit or loss is locked
in, but remains unrealized until the settlement date when the
securities are deemed delivered and received pursuant to both
contracts, and the net profit or loss debited or credited to the
trader's account. I don't understand how agreement of the
parties could change the tax consequences. If such an agreement
were efficacious, the validity of short sales against the box in
not only locking in gain but also postponing realization would
seem to be thrown into doubt.
37
In these circumstances, the analysis in the majority opinion of
the forward contracts in question and the ways in which they were
handled by Holly and AGS is consistent with and supported by
Judge Friendly's analysis in Commissioner v. Ferrer, supra, and
its ancestors and descendants. The cases at hand, then, are the
latest ones in which it is appropriate to observe that "the
'formalistic distinction' between two-party and three-party
transactions that was criticized in Ferrer is fast becoming a
footnote to history." Bittker & McMahon, Federal Income Taxation
of Individuals par. 32.1[5] at 32-5, 6 (1995).
CHABOT, JACOBS, and PARR, JJ., agree with this concurring
opinion.
38
HALPERN, J., dissenting:
I. Introduction
I dissent because I believe that the majority is not justified
in disregarding the actual transactions engaged in by Holly (the
partnership) in favor of hypothetical transactions that yield the
largest tax for the Government. The majority justifies treating
a cancellation as a sale on the ground that cancellations and
offsets are economically equivalent. Even were I to accept that
proposition, the majority has failed to persuade me that a common
“reality” of the two transactions is a sale. In searching for
that reality, it is important to keep in mind that respondent has
made the following concession:
Respondent concedes for purposes of these cases that
Holly Trading Associates’ transactions in forward contracts
with ACLI Government Securities, Inc. during the years at
issue were bona fide, had economic substance, and were entered
into for profit. [Emphasis added.]
I cannot join in an opinion that taxes a cancellation as a sale
without specific statutory authority and under what I consider a
drastic extension of the doctrine of substance over form.
II. Anticipatory Commodities Transactions
I believe that, in part, the majority misunderstands some of
the complex arrangements by which persons arrange for the future
purchase or sale of a commodity. A certain amount of detail is
necessary to appreciate what I believe the majority
misunderstands. Many of the factual details of the various
39
anticipatory arrangements for the purchase or sale of a commodity
can be found in our opinion in Stoller v. Commissioner, T.C.
Memo. 1990-659, affd. in part and revd. in part 994 F.2d 855
(D.C. Cir. 1993).1 Following are pertinent terms and concepts.
A. Regulated Futures Contracts
A regulated futures contract (RFC) is a standardized executory
contract to buy or sell a designated commodity at a specific
price on a fixed date in accordance with the rules of a commodity
exchange. The date the contract is to be performed is normally
identified by its delivery month, e.g., “a January 1997
contract”. All RFCs start out as a contract between a buyer and
seller. At the end of each trading day, the exchange’s clearing
organization substitutes itself as the “other side” of each
contract, so the clearing organization becomes the buyer to each
seller and the seller to each buyer. The agreement made by or on
behalf of the two parties on the floor of the exchange is thus
broken down into a “long” RFC, in which one party is the buyer
and the clearing organization is the seller, and a “short” RFC,
1
My research has also led me to two helpful articles dealing
with both the mechanical and tax aspects of anticipatory
commodities transactions, at least as those matters stood in
1981, which is about the date of the transactions involved
herein. Donald Schapiro, Commodities, Forwards, Puts and Calls--
Things Equal to the Same Things Are Sometimes Not Equal to Each
Other, 34 Tax Lawyer 581 (1980-81); Donald Schapiro, Tax Aspects
of Commodity Futures Transactions, Forward Contracts and Puts and
Calls, 39th Annual N.Y.U. Institute 16-1 (1981).
40
in which the other party is the seller and the clearing
organization is the buyer.
Trading in RFCs for a specific commodity and delivery month
continues until the day of the month set by the exchange on which
trading in contracts for that delivery month stops. Thereafter,
delivery of the commodity is made by holders of open short RFCs
to holders of open long RFCs on the matched-up basis established
by the clearing organization.
Up until the date trading stops, the holders of both long and
short RFCs can close out their contracts without making or taking
delivery of the commodity by entering into inverse purchase or
sale contracts on the exchange. Thus, the holder of a long RFC
can eliminate the risk of, or “offset”, his obligation to
purchase and pay for the commodity by acquiring from another the
promise to purchase and pay for the same commodity on the same
exchange for the same delivery month, that is, by entering into
an inverse, short RFC. Such a transaction has been held to meet
the Code requirement of a “sale or exchange”, which can give rise
to capital gain or loss, on the ground that a “fictional”
delivery is made on the offsetting inverse, short RFC with the
commodity “acquired” under the long RFC. Commissioner v.
Covington, 120 F.2d 768, 770, 772 (5th Cir. 1941), affg. in part
and revg. in part 42 B.T.A. 601 (1940). The holder of a short
RFC can, likewise, offset his obligation to sell the commodity at
the agreed price by acquiring from another a commitment to sell
41
and deliver the same commodity on the same exchange for the same
delivery month, that is, by entering into an inverse, long RFC.
The commodity to be delivered under the long RFC is deemed
received and used to satisfy the delivery obligation under the
short RFC, thus satisfying the sale or exchange requirement
necessary for capital gain or loss treatment. Id. The special
short sale rules of section 1233 are applicable to RFCs. Unless
certain exceptions apply, the gain or loss is capital. Sec.
1233(a).
It appears that, under the usual exchange rules applicable to
RFCs, the offsetting contracts, which are both with the exchange,
immediately cancel and are terminated, with a money settlement
for the difference in value. Commissioner v. Covington, supra at
769. Gain or loss is, thus, realized on that (the offset) date.
B. Forward Contracts
A forward contract is also an executory agreement calling for
future delivery of a commodity. Forward contracts, however, are
privately negotiated; they are not traded on commodity exchanges
or subject to the rules of any board of trade. If the parties to
any particular forward contract agree, the contract can be
canceled before the delivery date. Normally, any unrealized gain
or loss in the contract would then be accounted for because the
party on the profitable end of the contract would demand payment
for giving up a valuable right. The character of that gain or
loss is the question in this case. A party may fix the amount of
42
unrealized gain or loss in a forward contract by entering into an
inverse contract to buy or sell the same commodity for delivery
on the same date (the settlement date), but at the then current
market price for delivery on such date. In Hoover Co. v.
Commissioner, 72 T.C. 206, 249-250 (1979), we described the
consequence of entering into offsetting forward contracts.
Finally, we note that the most common method of settling
a forward sale contract has traditionally been to enter into a
purchase contract and to offset the contractual obligations to
sell and purchase. Meade v. Commissioner, T.C. Memo. 1973-46;
Muldrow v. Commissioner, 38 T.C. 907, 910 (1962); Sicanoff
Vegetable Oil Corp. v. Commissioner, 27 T.C. 1056, 1059, 1063
(1957), revd. 251 F.2d 764 (7th Cir. 1958). Offset of the
contractual obligations by the seller has been held to be
delivery under the sale contract (Chicago Bd. of Trade v.
Christie Grain & Stock Co., 198 U.S. 236, 248 (1905); Lyons
Milling Co. v. Goffe & Carkener, Inc., 46 F.2d 241, 247 (10th
Cir. 1931)), satisfying the sale or exchange requirement on
the date the contract is settled. See Covington v.
Commissioner, 42 B.T.A. 601 (1940), affd. in part 120 F.2d
768 (5th Cir. 1941), cert. denied 315 U.S. 822 (1942).
There is, thus, an important distinction between the operation
of offset in the contexts of RFCs and forward contracts. By
exchange rules, offsetting RFCs cancel and are terminated on the
offset date, with a money settlement then for any difference in
values. Offsetting forward contracts, being privately
negotiated, do not automatically cancel and terminate on the
offset date but, unless the parties agree to the contrary,
coexist until the settlement date, when both contracts are deemed
to have been executed, with delivery taken (on the long contract)
and delivery made (on the short contract). Although not
perfectly clear on that point, Hoover suggests that, unless the
43
parties earlier agree to settle up, the settlement date, not the
offset date, is the date that gains and losses are realized with
respect to forward contracts settled by offset. In Hoover, there
were 13 forward contracts in issue that were settled by entering
into inverse forward contracts. Of that number, a debit or
credit (settlement payment) was made after the offset date, on
the settlement date, in nine situations. In one situation, a
settlement payment was made after the offset date, but in advance
of the settlement date, and, in one situation, a settlement
payment was made after the settlement date. In two situations, a
settlement payment was made on the offset date. In one
situation, it is clear that the settlement payment was made in a
year beginning after the offset date. Nothing indicates that the
taxpayer did not report, and both the Commissioner and the Court
accepted, the date of the settlement payment as the date that
gain or loss was realized. Indeed, the Court calculated the
holding period with respect to those transactions from the offset
date; those calculations seem to belie any assertion that the
offset date is the date of realization. Hoover Co. v.
Commissioner, supra at 250-251.
C. Straddle
A person who has entered into either a RFC or a forward
contract (when no distinction is intended, an “anticipatory
contract”) assumes the risk that the market price for delivery of
the commodity on the agreed date will change. Changes in the
44
market price for delivery of the commodity will result in changes
in the value of an anticipatory contract for delivery in that
month. An anticipatory contract holder is described as being in
a “naked” position when he bears the unalloyed risk of changes in
the market price for delivery of the commodity (market risk).
A “straddle”, in its simplest terms, is the simultaneous entry
into two anticipatory contracts with respect to the same
commodity; one is a long contract, to buy a given amount of the
commodity for delivery at a specific time, and the other is a
short contract, to sell the same amount of the commodity for
delivery at a different time. A straddle reduces market risk
because, as the value of one leg decreases, the value of the
other leg increases. Because the legs are for deliveries at
different times, the value changes will not necessarily be
exactly offsetting. There is, thus, the potential for profit or
loss in a straddle.
D. Replacing a Leg
A participant in a straddle may replace one leg of the straddle
with another contract of the same kind (i.e., long or short) for
a different delivery date (such replacement of one leg being
referred to as a switch). For example, here, in Stoller v.
Commissioner, T.C. Memo. 1990-659, with respect to the
cancellations in question (except for one group, the
November 25th group), we found that the partnership wished to
45
change delivery dates in order to shorten the window of risk of
the straddle.
In the case of a straddle built on RFCs, the mechanics of a
switch would involve the taxpayer simultaneously entering into
(1) an inverse contract with respect to the long or short RFC
being switched and (2) a like (long or short) RFC to replace the
RFC being switched. Except perhaps in the case of certain tax-
motivated straddles, see, e.g., Smith v. Commissioner, 78 T.C.
350 (1982), gain or loss on the long RFC component of the
offsetting pair would immediately be realized and recognized.
Commissioner v. Covington, 120 F.2d 768 (5th Cir. 1941). In the
case of a straddle built on forward contracts, the parties to the
contract to be switched may agree to cancel that contract,
settling up with respect to any gain or loss in the contract. To
avoid being naked with respect to the remaining leg of the
straddle, the straddling party would immediately enter into a
contract to replace the canceled contract and complete the
switch. The character of any gain or loss to be accounted for on
the cancellation is the issue in this case, but there seems to be
no disagreement that cancellation is an event giving rise to an
allowable loss. In the case of a switch made by first entering
into an inverse contract with the same party, the suggestion of
Hoover Co. v. Commissioner, 72 T.C. 206 (1979), is that gain or
loss is realized upon the hypothetical delivery under the short
46
contract of the offsetting pair on the settlement date or on any
earlier date that the parties consummate a cash settlement. That
suggestion as to timing, however, is thrown into doubt by the
majority. There seems to be no disagreement, however, that the
gain or loss is realized from a sale or exchange. The second
step in the switch would be exactly the same as if the switch
were initiated by canceling the to-be-switched-leg, i.e.,
entering into a replacement contract.
E. Canceling Both Legs
The majority has not made clear that what it has called the
Third Contract, see majority op. p. 5 (the November 25th group),
involved straddles consisting of contracts that were all closed
by cancellation on the same date. There was no switch of any leg
and, consequently, no continuing straddle investment after the
cancellations, all of which took place on November 25, 1980.
III. Majority’s Theory of Equivalence
I believe that the key to understanding the majority’s error is
contained in the following sentence:
Whenever the investor (during the length or duration of the
forward contracts that have been purchased) elects to settle,
close out, extinguish, or cancel the contracts or positions,
or one of the legs thereof, and to realize the gain or loss
associated with the contracts, or with one of the legs
thereof, and regardless of whether the investor “closes out”
or “locks in” the gain or loss by way of offset, by way of
cancellation and replacement contracts, or by way of
cancellation and termination, the transaction is exactly the
same -- in purpose, in effect, and in substance -- and
produces exactly the same type of taxable gain or loss -- in
the instant cases capital gain or capital loss. [Majority op.
pp. 18-19; emphasis added.]
47
That sentence follows almost immediately after the majority’s
citation to, and quotation from, Commissioner v. Covington,
supra. The majority emphasizes those parts of the court’s
opinion (1) describing the taxpayer’s argument that, pursuant to
exchange rules, offsetting RFCs are extinguished and a money
settlement made and (2) finding that implicit in an exchange
regulated offset is the “agreement and understanding” that an
actual purchase and sale of the underlying commodity has taken
place. Majority op. p. 19. The majority finds that the
agreement and understanding implicit in the exchange rules
governing offsets of RFCs is apropos to the cancellations of the
forward contracts here in issue. Id.
The majority states:
Courts often must address taxpayers’ “artful devices” to
convert ordinary gain into more favorable capital gain or to
convert capital loss into more favorable ordinary loss. * * *
That task should be accomplished on the basis not of the
“cancellation” label used by the parties but on the realities
of the transactions and expectations of the parties.
[Majority op. pp. 24; emphasis added.]
The majority obviously concludes that the common reality of
(1) exchange regulated offsets, (2) the bilateral relationship of
the two parties to offsetting forward contracts, and (3) the
terminated relationship of the parties to a canceled forward
contract is a sale or exchange. Indeed, the majority states
that, in Stoller v. Commissioner, T.C. Memo. 1990-659, affd. in
part and revd. in part 994 F.2d 855 (D.C. Cir. 1993), both this
Court and the Court of Appeals for the District of Columbia
48
Circuit erred in not recognizing “the fundamental sale or
exchange nature” of cancellations of forward contracts. Majority
op. p. 22.
The majority’s perception of fundamental reality is bottomed on
the treatment accorded RFCs settled by offset, as articulated in
Covington v. Commissioner, supra. There, the taxpayer argued
that the reality of an exchange regulated offset is the lack of
any actual sale or exchange because there is an extinguishment of
the RFC settled by offset. The Court of Appeals for the Fifth
Circuit, however, forced the taxpayer to abide by the form of the
transaction he had chosen (as sculpted by the exchange rules
dealing with offsets) and held that, in effect, he had entered
into two contracts and realized a gain on closing the short
contract. That is a perfectly appropriate result. See, e.g.,
Legg v. Commissioner, 57 T.C. 164, 169 (1971), affd. 496 F.2d
1179 (9th Cir. 1974), in which we stated: “A taxpayer cannot
elect a specific course of action and then when finding himself
in an adverse situation extricate himself by applying the age-old
theory of substance over form.”
The fiction imposed on a taxpayer that settles RFCs by offset,
however, is not a ground to conclude that, in reality, a taxpayer
not engaging in an exchange regulated offset (indeed, not
engaging in an offset at all) entered into a hypothetical
contract to complete the purchase and sale of a commodity that he
never owned. Assume, for instance, that the taxpayer has
49
constructed a straddle in X commodity, entering into a long May
forward contract and a short September forward contract. Assume
further that there is an unrealized loss in the short contract,
and, for legitimate business reasons, the taxpayer wishes to
switch the short contract to a December forward contract. The
taxpayer cancels the short September contract, makes a cash
settlement payment, and enters into a short December contract.
The reality that the majority would impose is that the taxpayer
entered into a long September contract under which,
hypothetically, he took delivery of the commodity, which was used
to satisfy the short September contract. To me, that is not
reality; it is a fiction built upon a fiction.
As a matter of tax policy, perhaps the cancellation of a
forward contract should be treated as a zero dollar sale so as to
satisfy the sale or exchange requirement of section 1222.
Congress thinks so and has added section 1234A, which, however,
is not effective with respect to the facts of this case.
The majority’s understanding of the “nature of the termination
of offsetting forward contracts”, majority op. p. 20, is
illustrated by certain forward contracts in this case. That
perspective is set forth as follows: “Upon closing by offset of
forward contracts, the transaction is terminated and
extinguished, settlement between the parties occurs at that time,
and no contracts remain in effect.” Id. If that is intended as
a general statement of fact or of legal consequence, it is
50
unsupported by any authority and is in apparent contradiction to
our findings and opinion in Hoover Co. v. Commissioner, 72 T.C.
206 (1979). Certainly, it is in contradiction to the
understanding of the facts in this case by the Court of Appeals
for the District of Columbia Circuit. In reversing us in part,
the court said:
The problem with the Tax Court’s reasoning is that
cancellation and offset are different in substance as well as
in form. When a contract is cancelled it simply ceases to
exist. When a contract is offset, both the original contract
and the offsetting contract remain in effect until the date
for delivery. * * * [Stoller v. Commissioner, 994 F.2d at
857-858; emphasis added.]
The majority may be misled by the way the partnership accounted
for offset transactions. It appears that the partnership
accounted for unrealized gains and losses in forward contracts as
of the offset date, the date of the inverse contract. That may
or may not have been correct, but it is not evidence that the
contracts were, by agreement, terminated on the offset date.
More to the point, it is not evidence of general industry
practice.
In addition, the majority suggests that, since “little, if
anything, `vanished' upon Holly's closing or settling the loss
legs”, sale or exchange treatment of those contract cancellations
is appropriate. Majority op. p. 25. The majority recognizes
that some contracts were not replaced (the November 25th group).
Nevertheless, the majority explains that what remained after the
contract cancellations was Holly's continued participation in
51
straddle transactions: “The last thing the investors would have
wanted -- upon the `cancellations' in question -- is to vanish or
disappear from the rest of these straddle transactions, the
consequence of which is that the investors might actually have
had a real loss to pay.” Id.
By juxtaposing cases involving “unexpected and true
cancellations” of “regular commercial contracts for the provision
of goods or services” (true cancellations) with the forward
contract cancellations in issue, the majority purports to discern
a fundamental difference that distinguishes true cancellations
and explains the capital loss treatment appropriate for the
contracts in issue. Id. at 23-24. The majority rejects true
cancellation treatment for the contracts in issue by invoking
what it considers Judge Friendly's “substance and reality”
analysis in Commissioner v. Ferrer, 304 F.2d 125 (2d Cir. 1962),
revg. and remanding 35 T.C. 617 (1961). Believing that the
“situation” here is the same as in the Ferrer case, the majority
slaps together the whole of the partnership's straddle activities
into a unitary endeavor that justifies disregarding (partially)
each individual step.
I believe that the majority has failed to appreciate the
significance of Judge Friendly's analysis in the Ferrer case and,
therefore, may not seek its blessing. In that case, involving
the purported termination of certain dramatic production contract
rights, Judge Friendly stated:
52
Tax law is concerned with the substance, here the voluntary
passing of “property” rights allegedly constituting “capital
assets,” not with whether they are passed to a stranger or to
a person already having a larger “estate.” So we turn to an
analysis of what rights Ferrer conveyed. [Id. at 131.]
Judge Friendly then engaged in an examination of the nature of
the various rights in issue in that case. He believed that the
principal distinction between a termination of contract rights
that gives rise to capital gain and a termination that does not
is the existence of an “equitable interest” in the holder of the
rights being terminated, which interest is evidenced by the
availability of equitable relief in the enforcement of the
contract rights. Id. at 131-134.2 It is, thus, insufficient for
the majority to consider all of the partnership's straddle
investments, each straddle transaction, or even each forward
contract and to pronounce baldly that the partnership “received
exactly what it contracted for.” Majority op. p. 25. Nor is it
sufficient to rely on the parties' stipulation that the forward
contracts in issue constitute capital assets. What is required
is a careful consideration of the partnership’s property
interests in the subject matter of the contracts in question, in
light of Congress’ admittedly indistinct purpose in providing for
2
That understanding of Judge Friendly’s analysis has been
stated by two commentators: Marvin A. Chirelstein, Capital Gain
and the Sale of a Business Opportunity: The Income Tax Treatment
of Contract Termination Payments, 49 Minn. L. Rev. 1, 20-23
(1964); James S. Eustice, Contract Rights, Capital Gain, and
Assignment of Income--the Ferrer Case, 20 Tax L. Rev. 1, 7-9
(1964).
53
the exceptional treatment of capital gains and losses. In sum,
the majority has failed to examine the nature of the contract
rights terminated by the cancellations of the forward contracts
in issue in the manner contemplated by Judge Friendly and,
therefore, is foreclosed from relying on Commissioner v. Ferrer,
supra, to support its substance and reality analysis.
Another difficulty with the rationale of the majority is the
majority’s failure to explain the steps by which it proceeded to
conclude that the cancellation losses were losses from the sale
or exchange of capital assets. Section 1001 addresses the
determination of gains and losses on the disposition of property.
The sale or exchange requirement for capital gain or loss
treatment is introduced in section 1222. The majority has failed
to explain exactly what property was disposed of when a forward
contract was canceled, how the partnership’s adjusted basis in
the disposed-of property was determined, or what amount was
realized on such disposition. I must admit that I am puzzled by
those questions, as I am puzzled by how Judge Friendly’s
“equitable interest” analysis could be applied to find a capital
loss in a situation where the last thing the partnership intended
was actual delivery of the underlying securities that were the
subject of the forward contracts in question. Given Congress'
enactment of section 1234A, I see no reason to engage in an
analysis that may result in consequences we cannot foresee.
54
IV. Conclusion
Professors Bittker and Lokken, in their treatise on Federal
income, gift, and estate taxation, address the principle that
substance must govern over form in taxation. Bittker & Lokken,
Federal Taxation of Income, Estates and Gifts, par. 4.3.3, at 4-
33, (2d ed. 1989). They begin their discussion by noting that
the substance-over-form principle has been referred to as “the
cornerstone of sound taxation” (quoting Estate of Weinert v.
Commissioner, 294 F.2d 750, 755 (5th Cir. 1961), revg. and
remanding 31 T.C. 918 (1959)). Id. In the course of their
discussion, they state (without citation of authority, but none
is needed): “If a transaction is consummated in a form that
fairly reflects its substance, it ordinarily passes muster
despite the conscious pursuit of tax benefits; in this case, the
choice of form resembles an election provided by statute.” Id.
at 4-38. They caution, however:
A rogue offshoot of the substance-over-form doctrine
suggests that when a taxpayer selects one of several forms
that have identical practical consequences in the real world,
the government can disregard the chosen form and tax the
transaction as though the most costly of the alternatives had
been employed. * * * [Id. at 4-41.]
They continue: “On close inspection, the most-costly-alternative
theory turns out to be a drastic extension, rather than a mere
restatement, of the substance-over-form doctrine.” Id. at 4-42.
The majority has not invoked much of the substance-over-form
jurisprudence. It has, however, looked for the “realities of the
55
transactions” and raised the specter of “artful devices”. I
believe that it is fair to say that the majority has looked to
tax the cancellation transactions on the basis of what it
considers to be their substance. In searching for that
substance, however, the majority has dug no deeper than the
fiction that accounts for the tax treatment of exchange regulated
offsets and forward contracts settled by offset and payment.
Indeed, with respect to offsetting forward contracts, the
majority appears to conclude, wrongly, that all such contracts
cease to exist on the offset date. The reality of the settlement
of anticipatory contracts by offset is not that the contract
holder took delivery under a long contract of a commodity that he
then used to satisfy his delivery obligation under a short
contract. That is a fiction imposed on the taxpayer because of
the way he chose to cast his transaction. To impose that fiction
on a taxpayer who, for whatever reason, chose not to cast his
transaction that way seems to me to be wrong, at least without
some better explanation than what the majority gives. From a
policy perspective, I can sympathize with the majority’s concern
that a taxpayer should not be able to lower his tax bill simply
on the basis of which form, as between two economically
equivalent (or similar) forms, he chooses. The majority’s
concern is apparent in how, in part, it frames the issue in this
case: “whether the taxpayers can convert the capital loss into
an ordinary loss”. Majority op. p. 14 (emphasis added). That
56
statement suggests that the proper inquiry is the proper tax
characterization of the cancellations, not whether, tax questions
aside, form and substance agree. To me, that is a troublesome
inquiry for the reasons stated by Professors Bittker and Lokken.