Estate of Leon Israel, Jr., Barry W. Gray, and Audrey H. Israel v. Commissioner

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. (CCH) 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. (P-H) 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. at 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. (CCH) 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. (CCH) 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. (CCH) 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.