Unpublished Disposition, 931 F.2d 59 (9th Cir. 1991)

No. 89-70136.

United States Court of Appeals, Ninth Circuit.

Before BEEZER and KOZINSKI, Circuit Judges, and KLEINFELD^* , District Judge.

MEMORANDUM^** 

This is an appeal from a Tax Court decision. The parties have stipulated that David Cook, the petitioner-appellant, was a commodities dealer at all relevant times. They have further stipulated that he entered into a number of straddles on the London metals exchange in 1976 and 1977, which were economic shams, but not factual shams. The Commissioner disallowed approximately $1.5 million in capital loss deductions for the first leg of these straddles. The question on appeal is whether the Commissioner was bound, by certain 1986 modifications to section 108 of the Deficit Reduction of 1984, to allow the deductions. We decide that the Commissioner was correct.

The mechanics of these straddles are explained with precision in Dewees v. Commissioner, 870 F.2d 21, 23-24 (1st Cir. 1989), and Glass v. Commissioner, 87 T.C. 1087, 1107-1117 (1986). In oversimplified form, a straddle is a bet that the price of a commodity will rise, hedged with another bet made at the same time that the price will fall. The investor buys at one time, options both to buy and sell the same commodity in different future months. As the price of the commodity changes, one of these options will become more valuable, and the other less valuable. The two options are called the legs of the straddle. One leg will always show a loss, and the other a gain, if the price of the commodity changes by more than the commissions. A leg is usually closed out by purchasing an offsetting position. Profit can be made as the spread between the legs changes.

Mr. Cook's options, though, were not designed to generate a trading profit. Instead, they were designed to generate short-term loss in the first calendar year, and long-term capital gain in the second year of approximately equal magnitude. Competex, the broker Cook used, gave an example in its promotional literature of trades designed to generate a $100,000 first year tax deduction for a $12,000 investment, followed by an $88,000 long term capital gain in the second year. This would produce a tax saving of $28,000 for the 50% bracket taxpayer. The investor's entire $12,000 would be absorbed for premiums and commissions, so he would get no money back, only paper, but his economic advantage from tax savings would still be a net of $16,000. Glass v. Commissioner, 87 T.C. 1087, 1110 (1986).

To say that these options were not factual shams, as the parties stipulate, means that the paperwork for the purchases and sales of the options actually took place. To say, as the stipulation does, that the arrangement was an economic sham, means that it was designed never to make a trading profit. The Tax Court found that the straddles were designed to delay income tax obligations by one year, and to convert ordinary income into capital gains.

This description on its face suggests that no taxable event occurred during the first year, that is, no loss which can be recognized for tax purposes occurred. See Gregory v. Helvering, 293 U.S. 465, 469 (1935). Since the straddle had no business purpose, and was purely an artifice to generate a tax benefit without any change in the taxpayer's economic position, Gregory prohibits any recognition of loss. Analysis of the complexities of the 1984 and 1986 statutory changes results in no different conclusion.

The Deficit Reduction Act of 1984 has a section written just for pre-1982 straddles, section 108. The section breaks the straddle down into its separate legs, called positions. Before the 1986 retroactive change, which is the basis for Cook's petition, subsection (a) said that "in the case of any disposition" of a pre-1982 position, "any loss from such disposition shall be allowed for the taxable year of the disposition if such position is part of a transaction entered into for profit." Deficit Reduction Act of 1984, Pub. L. 98-369, Sec. 108(a) 98 Stat. 494, 630. This provision allowed the loss to be taken when the first leg was sold, even though the first leg was part of a straddle transaction which would not be fully closed out until the other leg was sold. The critical qualification in this provision was the phrase, "if such position is part of a transaction entered into for profit." This language plainly excluded transactions lacking economic substance from the benefit of subsection (a). Subsection (b) of the 1984 Act said that "for purposes of subsection (a), any position held by a commodities dealer ... shall be rebuttably presumed to be part of a transaction entered into for profit." This provision shifted the burden of proof regarding economic substance from the taxpayer to the Commissioner, if the taxpayer was a commodities dealer, but still plainly kept the "for profit" qualification in the statute as a condition of taking the tax benefit of the loss in year one.

Cook obviously had no claim to a deduction for the loss leg under the 1984 statute, and made none. His theory arises out of a change in the language, in the Tax Reform Act of 1986, Pub. L. 99-514, Sec. 1808(d) 100 Stat. 2085, 2817, Sec. 1808(d). The 1986 Act struck out the language in subsection (a), "if such position is part of a transaction entered into for profit." It substituted "if such loss is incurred in a trade or business, or if such loss is incurred in a transaction entered into for profit though not connected with a trade or business." Id., Sec. 1808(d) (1). Subsection (a) provided, after the change, that with respect to any disposition of a position entered into before 1982 and forming part of a straddle, "any loss from such disposition" must be allowed for the tax year of the disposition, if the loss was incurred in a transaction entered into for profit, or in the alternative, if the loss was incurred in a trade or business. Subsection (b) was also amended. The new provision eliminated the "rebuttably presumed" language for commodities dealers, and provided instead that " [f]or purposes of subsection (a), any loss incurred by a commodities dealer in the trading of commodities shall be treated as a loss incurred in a trade or business." The relevant portion of section 108 of the 1984 Act, as amended by section 1808 of the 1986 Act, now reads:

(a) GENERAL RULE.--For purposes of the Internal Revenue Code of 1954, in the case of any disposition of 1 or more positions--

(1) which were entered into before 1982 and form part of a straddle, and

(2) to which the amendments made by title V of such Act do not apply,

any loss from such disposition shall be allowed for the taxable year of the disposition if such loss is incurred in a trade or business, or if such loss is incurred in a transaction entered into for profit though not connected with a trade or business.

(b) LOSS INCURRED IN A TRADE OR BUSINESS.--For purposes of subsection (a), any loss incurred by a commodities dealer in the trading of commodities shall be treated as a loss incurred in a trade or business.

Plugging the equation of subsection (b) into the conditions of subsection (a), we wind up with a 1986 law that says that in the case of a disposition of a position entered into before 1982 and forming part of a straddle, any loss from the disposition must be allowed for the taxable year of the disposition, if the loss was incurred by a commodities dealer in the trading of commodities. With the statute in this form, Cook has a position with some appeal. He is stipulated to be a commodities dealer, and the London trades were of commodities futures, so the statute seems to say that losses from the dispositions of the loss legs are allowable for the year of the loss. The "for profit" clause does not apply to commodities dealers, so he argues with some force that his paper losses in the first year are entitled to recognition.

The customers who were not commodities dealers lost their case in the Tax Court in Glass v. Commissioner, 87 T.C. 1087 (1986), because the transactions lacked economic substance. The Tax Court held that "the relevant transaction was petitioner's entire commodity tax straddle scheme." Id. at 1163. The Tax Court looked to the regulation at Regs. Sec. 1.165-1(b) allowing only a "bona fide" loss, with determination of loss to be governed by " [s]ubstance and not mere form." This analysis precluded focusing solely upon the losses in year one to the exclusion of the equivalent gain locked in for year two. Glass at 1163. The Tax Court noted the parallel between the revised language on straddles and the general provision on deductibility of losses:

The amended section 108(a) expressly distinguishes between a loss incurred by a commodities dealer in the trade or business of trading commodities and a loss incurred in a commodities transaction entered into for profit though not connected with a trade or business. Thus, the language of section 108(a) is now completely harmonized with that of section 165(c) (1), which allows losses incurred in a trade or business, and section 165(c) (2), which allows losses incurred in any transaction entered into for profit, though not connected with a trade or business.

Glass at 1166. We determined that "it is the overall scheme which taints the deductibility of the year one losses." Id. at 1174. It concluded that the "multiple and complex tax straddle scheme encompassing prearranged results--lacked economic substance and was a sham," so the petitioners could not deduct the losses in year one. Id. at 1177.

This court affirmed Glass in Keane v. Commissioner, 865 F.2d 1088 (9th Cir. 1989). Glass involved some fourteen hundred taxpayers' claims, and has been affirmed in numerous other circuits and reversed in none. See Dewees v. Commissioner, 870 F.2d 21 (1st Cir. 1989), Friedman v. Commissioner, 869 F.2d 785 (4th Cir. 1989), Killingsworth v. Commissioner, 864 F.2d 1214 (5th Cir. 1989), Ratliff v. Commissioner, 865 F.2d 97 (6th Cir. 1989), Yosha v. Commissioner, 861 F.2d 494 (7th Cir. 1988), Kirchman v. Commissioner, 862 F.2d 1486 (11th Cir. 1989).

Since Glass involved customers who were not commodities dealers, they were plainly bound by the "for profit" language in section 108(a). For commodities dealers, a distinction can be drawn, because the statute makes loss incurred by a commodities dealer equivalent to loss incurred in a trade or business, and commands the Commissioner to allow loss in the case of any disposition of a position of a pre-1982 straddle by a commodities dealer, regardless of whether the transaction was entered into for profit.

The Tax Court decided against Cook, in Cook v. Commissioner, 90 T.C. 975 (1988). The Court explained that in Glass "the putatively incurred losses were central to transactions lacking economic substance and were therefore shams. In effect, then, no losses were incurred." Cook at 985. Even though a commodities dealer did not need to satisfy the "for profit" requirement under the 1986 Act, he still needed a "loss," and there was none. A concurring opinion took the position that losses had to be recognized for year one, where the transaction was an economic but not a factual sham, for section 108 to mean anything for commodities dealers, but that the provision applied only to trades on the domestic exchange, not on an unregulated foreign exchange. Id. at 989-993. An additional concurrence suggested that both the implied domestic exchange requirement, and also the lack of economic substance, precluded deductibility of the first year putative losses.

We agree with the Tax Court majority that where the transaction was an economic sham, there was no "loss," even in year one. We think that this result is compelled by our previous decision in Keane v. Commissioner, 865 F.2d 1088 (9th Cir. 1989). Although Keane is factually distinguishable, because it involved investors who were not commodities dealers, nevertheless the ratio decidendi prevents the loss which is part of an economic sham transaction from being recognized at all. We do not reach the issue of trades on foreign commodities exchanges, discussed by the concurring Tax Court opinions.

This Circuit has already committed itself to several principles governing commodities straddles. Sochin v. Commissioner, 843 F.2d 351 (9th Cir. 1988), a case arising out of straddles not on the London metals exchange, determined that "the 'reasonable expectation of profit' standard is not applied until the court determines that the transaction is itself bona fide, i.e. that it is not a sham.... Thus, the Tax Court in the present case never reached section 108." Sochin at 354, n. 6. Though there was disagreement on some other points, all the judges in Sochin agreed that section 108 of the 1984 act did not apply to transactions which were not bona fide.

In Keane v. Commissioner of Internal Revenue, 865 F.2d 1088 (9th Cir. 1989), we affirmed the Tax Court's decision in Glass. There, the Tax Court held that individuals who were not commodities dealers could not deduct losses caused by their straddles as the transactions lacked economic substance. See pp. 4-5, supra. We found that the Tax Court "correctly considered the entire two-year sequence of transactions when it determined that the London option transactions lacked economic substance and were designed merely to create deductible losses." Id. at 1091. In Keane, our ratio decidendi was the principle stated in Sochin, that "the 'reasonable expectation of profit' standard is not applied until the court determines that the transaction is itself bona fide, i.e., that it is not a sham." Keane v. Commissioner, 865 F.2d 1088, 1092 (9th Cir. 1989); Sochin v. Commissioner, 843 F.2d 351, 354, n. 6 (9th Cir. 1988).

This analysis compels the result in the case at bar. The logic of our analysis in the Sochin footnote and in Keane is that one must ask, first, was there a bona fide loss, and then, only if the answer is yes, does one ask whether the loss was incurred in a trade or business or alternatively, incurred in a transaction entered into for profit. When we apply this logic to Mr. Cook's transactions, we get the same result as the Tax Court, because he had no bona fide loss. Without a bona fide loss from the disposition, there is nothing to allow.

Cook argues that this reading makes a nullity of the commodities dealer provision in section 108. He argues that so long as the transaction is not a factual sham, the commodities dealer provision in Sec. 108 must be designed to allow deductibility of losses in economic sham transactions, because otherwise the provision would be a nullity. This argument challenges us to imagine a transaction by a commodities dealer which generates a recognizable loss, yet the loss is not incurred in a transaction entered into for profit.

We do not need to go this far to give meaning to the statute. The words of the statute now precisely track the hoary formula of Sec. 165(c) (1) and Sec. 165(c) (2) of the Code:

(c) LIMITATION OF LOSSES OF INDIVIDUALS.--In the case of an individual, the deduction under subsection (a) shall be limited to--

(1) losses incurred in a trade or business;

(2) losses incurred in any transaction entered into for profit, though not connected with a trade or business....

Internal Revenue Code, 26 U.S.C. § 165 (1986). It is unlikely that Congress meant anything different by its use of these terms of art in Sec. 108 of the 1984 Act as amended by the 1986 Act, from what it has meant for many years in Sec. 165 of the Code. Cf. Landreth v. Commissioner, 859 F.2d 643, 648 (9th Cir. 1988) (after the 1986 amendments, "the 'entered into for profit' language in section 108 should be interpreted in the same way as the identical language in section 165(c) (2)."); Miller v. Commissioner, 836 F.2d 1274 (10th Cir. 1988); accord Glass, 87 T.C. at 1166. Tax recognition is generally denied to paper losses in transactions having no economic effect, whether they take place in a trade or business or not, without ever reaching the issue of subjective motive. See Gregory v. Helvering, 293 U.S. 465 (1935). Once Congress amended Sec. 108 in 1986 to make the language track the traditional Sec. 165 language, it eliminated the need to construe Sec. 108 in a fashion distinct from Sec. 165. The structural parallelism of the sections gives us the meaning.

A reading such as the one suggested by Mr. Cook would mean that a person who owned a seat on a commodities exchange during the relevant years would, by an economically meaningless shuffling of paper, have been relieved of any obligation to pay taxes at ordinary income rates. That would be an anomalous provision. It may be that commodities dealers occasionally have to engage in trades in which the transactions themselves are not intended to generate a trading profit, but are necessary to the business of being a commodities dealer. For example, Dewees describes a London Metal Exchange brokers' "practice of' laying off' their trades with each client, each day, by entering into offsetting transactions with other buyers or sellers. This way the brokers are exposed to no net market risk, and do not hold interests adverse to their clients'." Dewees v. Commissioner, 870 F.2d 21, 23-24 (1st Cir. 1989) The Exchange does not require this practice. Glass v. Commissioner, 87 T.C. 1087, 1097, and 1159 n. 123 (1986). Lay-off trades of this kind might be within the traditional meaning of the trade or business branch of Sec. 165, even though they would not generate deductible losses for persons not in the commodities dealer business. This would be the kind of transaction which Mr. Cook challenges us to imagine. But regardless of whether Congress went through a similar intellectual process, we think its use of the Sec. 165 language imports the traditional Gregory analysis.

The Second Circuit has reached the same conclusion in DeMartino v. Commissioner, 862 F.2d 400 (2d Cir. 1988). That case also involved a commodities dealer, and the 1986 changes to section 108 of the 1984 Act, and held that "section 108(a) does not apply to straddle transactions that are shams." Id. at 407. The decision involved transactions which were economic but not factual shams. DeMartino applies "the basic rule of law ... that taxation is based upon substance, not form," Id. at 406, citing inter alia Gregory v. Helvering, 293 U.S. 465 (1935), and Knetsch v. United States, 364 U.S. 361 (1960).

Cook suggests that we accept his reading based upon a close analysis of a snippet of legislative history. The legislative history, though, is considerably more ambiguous that the statute. Remarks on the floor by Senators and Representatives cast additional doubts on which legislative history the different actors in the process wanted courts to use. Landreth v. Commissioner, 859 F.2d 643, 646 n. 8 (9th Cir. 1988). We can more appropriately apply the words of the statute as voted upon by both Houses and signed into law by the President. See Miller v. United States, 836 F.2d 1274, 1281-1282 (10th Cir. 1988).

We interpret the word "losses" in section 108 in accord with the ordinary English meaning of the word, the structural parallel with Sec. 165 of the Code, and the 55 year old Gregory tradition, to avoid recognizing paper transactions which have no purpose or economic consequence other than tax avoidance. This results in a statutory construction which is consistent with ordinary English usage and other areas of tax law, and is economically practical as applied to the commodities industry.

Affirmed.