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 ■€©■ CO 00 CO <1
1979 H-1 £*• to
Estate of Leon Israel, Jr., Deceased, and Audrey H. Israel — Continued
Increased interest Year Deficiency sec. 6621(c)
1980 62,482 1
Jonathan P. and Margaret A. Wolff
Year Deficiency Increased interest sec. 6621(c)
1979 $55,114 1
1980 82,369 1
1981 2,294 1
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.
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 appendix A-l 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 appendix A-l and A-2 attached hereto were labeled appendix B-l 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 appendix A-l 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:
Transaction & losses claimed Appendixes A-l and A-2 line Nos.
First contracts — ($837,500) A-l, 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.
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 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 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.
In the context of the straddle transactions of the type involved in these cases, commodity forward contracts (as with commodity futures 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.
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 the day the contracts had initially been entered into until the day the initial loss leg of the contract was 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) is 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 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 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.
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.
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 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 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 the exchange to which all contracts are transferred, [extinguishes] 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, supra at 769-770; emphasis added.]
We believe the above statement from this early opinion is apropos 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 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 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” are made available to investors in commodity 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 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 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. * * *
As use of the term “compensate” was not controlling in Hoover Co. v. Commissioner, supra 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 at 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-l 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 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-month 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 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.
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 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 chose 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 the Commissioner have sought to invoke the “disappearing asset” theory, but that theory was found to be inapplicable where a close scrutiny of the substance 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.
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. 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 (9th Cir. 1958); 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. * * *
% ‡ ^ ‡ if:
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.
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, 1990 T.C.M. (P-H) at 90-3219, with which we agree. It suffices here to reiterate what we stated in Vickers v. Commissioner, 80 T.C. at 410-411 (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 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.1 New York
Jonathan P. and Margaret A. Wolff New York
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 appeal-able 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 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.[[Image here]]
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120 percent of the interest accruing after Dec. 31, 1984, on the portion of the underpayment attributable to a tax-motivated transaction.
120 percent of the interest accruing after Dec. 31, 1984, on the portion of the underpayment attributable to a tax-motivated transaction.
Leon Israel, Jr., died a resident of New Jersey.