Appeal from the United States Tax Court.
Posner, Flaum, and Manion, Circuit Judges.
The eternal tension between form and substance is the topic of this tax appeal. In Glass v. Commissioner, 87 T.C. 1087 (1986), following massive consolidated pretrial and trial proceedings, the Tax Court upheld the Internal Revenue Service's disallowance of deductions (aggregating some $100 million) claimed by more than 1,400 taxpayers for losses allegedly incurred trading option straddles and hedges on the London Metal Exchange. Four of these taxpayers petition us to reverse Glass. Other taxpayers have filed similar petitions in nine other circuits; and we are told that cognate issues involving losses incurred in options and futures trading (not all on foreign exchanges) are involved in some 25,000 other cases wending their way through the IRS and the Tax Court.
To understand the legal issues, one must understand the transactions. (For background see Black & Scholes, The Pricing of Options and Corporate Liabilities, 81 J. Pol. Econ. 637 (1973); Black, Fact and Fantasy in the Use of Options, 31 Fin. Analysts J., July-August 1975, at 36.) A call option is a right, for a limited time, to buy a commodity at the price fixed in the option (the "strike price"). In the first stage of the transactions involved in this case, the investor sold an option, receiving as consideration what is called a premium; it is the price of the option, as distinct from the strike price. The sale (or, as it is sometimes called, the grant) of an option is a risky business. If the price of the commodity rises above the strike price, the buyer will exercise the option and the seller will be out the difference between the market price and the strike price, minus the premium. If the price of the commodity declines or stays the same, or even if it rises but not above the strike price, the option will not be exercised and the seller of the option will therefore profit to the full extent of the premium.
The seller can limit his risk. See Tamari v. Bache & Co. (Lebanon) S.A.L., 838 F.2d 904 (7th Cir. 1988). In an option straddle--the only type of transaction made by the particular taxpayers before us--he does this by buying an option equal in quantity and strike price to the option he is granting, but expiring at a different date; the premium he pays will differ, therefore, from the premium he received for his granted option. If the price of the commodity does not rise above the strike price, he will not exercise his option, but neither will the buyer of the option that he granted exercise his option. Therefore if the premium that the seller received for granting the option was greater than the premium he paid for the option that he bought but is not exercising, he will have made money. If the price of the commodity does rise above the strike price, he will exercise his option in order to cover his loss on the granted option (which his buyer will exercise), and again his profit (or loss) will be measured by the difference between the premium on the option he granted and the premium on the option he sold. Market risk will be minimized but not eliminated, for the difference in delivery dates will expose the investor to the risk that a gap will open between the market prices of the underlying commodities (e.g., of July silver and October silver).
The investor need not close out the transaction by exercising his option and waiting for the buyer to exercise his option, or by waiting for the options to expire. In the transactions in this case, shortly after the option straddle was put on it was closed out by the purchase and sale of identical offsetting positions. The investor was shown as buying an option for the same quantity, strike price, and delivery date as the option he had sold and as selling an option for the same quantity, strike price, and delivery date as the option he had bought, and these offsetting positions were cancelled on the books of the broker handling the transactions.
Why would anyone engage in such a roundabout transaction? The beginning and in this case perhaps the end of the answer is that at the time these transactions occurred, the Treasury Department took the position that any loss incurred on a granted option was a loss deductible from ordinary income, while any loss incurred on a purchased option was a capital loss; and so with the gains on these transactions. So if the premium that the investor paid to buy an option that would close out his granted option was greater than the premium he had received for the grant, the resulting loss was deductible from the investor's ordinary income. This loss would imply a corresponding gain from granting an option to close out his purchased option, a gain resulting from the rise in the premium after the option straddle had been put on, and realized by closing the second "leg" of the straddle, the purchase leg. And this gain would be capital gain. Congress has since eliminated the disparate tax treatment of granted and purchased options. See 26 U.S.C.A. § 1234 (West Supp. 1984).
The next step was to convert the short-term capital gain on the second "leg" of the straddle into a long-term capital gain in order to take advantage of the fact that long-term capital gains were at the time taxed at a lower rate than short-term capital gains (which were taxed as ordinary income); hence a deduction from ordinary income equal in amount to a capital gain would yield a net tax saving. This conversion was done as follows. At the same time that the option straddle was put on, a forward contract straddle was also put on. A forward contract is a contract to buy or sell goods for delivery in the future at a price fixed in the contract. (On the mechanics of forward and futures contracts see United States v. Dial, 757 F.2d 163, 164-65 (7th Cir. 1985).) As with an option straddle, depending on the movement of the market price one leg would have a gain, the other a loss. When the option straddle was closed out, the loss leg of the forward straddle (ordinarily the sale leg, because commodity prices were rising during the relevant period) would be closed out too, yielding a short-term capital loss that would offset the short-term capital gain. Thus the net result of the taxpayer's trading in the first year would be a loss to set off against ordinary income. Several months later the taxpayer would close the gain leg of the forward contract straddle and realize the gain. If it was too soon to be a long-term capital gain (which required that the asset be held for at least six months) he would put on another forward straddle, to move the gain forward.
Well, what is wrong with all this? It is not clear that anything is wrong--so far. There is no rule against taking advantage of opportunities created by Congress or the Treasury Department for beating taxes. "Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes." Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934) (L. Hand, J.), aff'd, 293 U.S. 465, 79 L. Ed. 596, 55 S. Ct. 266 (1935). "[N]obody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant." Commissioner v. Newman, 159 F.2d 848, 850-51 (2d Cir. 1947) (L. Hand, J., dissenting). The Treasury Department had decided that while a loss or gain incurred on the purchase of an option was capital in nature--the right being a capital asset owned by the holder--a loss or gain incurred on the sale of an option was not. Why the seller's gain or loss should be thought different in character from the buyer's beats us, but there it is, and taxpayers were entitled to take advantage of this curiously asymmetrical treatment of the different legs of a straddle before Congress eliminated the asymmetry.
Many transactions are largely or even entirely motivated by the desire to obtain a tax advantage. But there is a doctrine that a transaction utterly devoid of economic substance will not be allowed to confer such an advantage. In the Gregory case, cited above, the owner of a corporation that had certain assets which she wished to sell created a new corporation, transferred the assets in question from the old corporation to the new one, and three days later dissolved the new corporation, with the result that she received the assets as a liquidating dividend; she then sold them. She claimed that the transfer of the assets from the old to the new corporation was a "reorganization" within the meaning of the tax statute and that the liquidating dividend was therefore a distribution "in pursuance of a plan of reorganization." If so, her gain from the sale of the assets would be taxable as a capital gain, whereas if the old corporation had distributed the assets to her directly, the distribution would have been a simple dividend, taxable to her as ordinary income in an amount equal to the full value of the assets. See Blum, The Importance of Form in the Taxation of Corporate Transactions, 54 Taxes 613, 615-16 (1976). The Tax Court accepted Mrs. Gregory's position but the Second Circuit reversed and was affirmed by the Supreme Court. In Judge Hand's words, "the transactions were no part of the conduct of the business of either or both companies; so viewed they were a sham, though all the proceedings had their usual effect." 69 F.2d at 811.
Gregory v. Helvering is different from the myriad instances where the taxpayer times the sale of an asset to offset a capital gain or to take advantage of a capital loss. See, e.g., Doyle v. Commissioner, 286 F.2d 654, 659-60 (7th Cir. 1961). In such a case there is an arm's length transaction. The transfer of assets from one corporation owned wholly by Mrs. Gregory to another newly created solely to be the vessel for the assets was a pure paper shuffle, having no potential consequences for the business in which the corporations engaged. The new corporation engaged in no business--it was merely a device for the avoidance of taxes. "The substance-over-form doctrine is invoked by the government with greatest success when the transaction under examination entails self-dealing." 1 Bittker, Federal Taxation of Income; Estates and Gifts para. 4.3.3, at p. 4-38 (1981); see also id. at pp. 4-39 to 4-40. The new corporation, as Judge Hand later noted, "was not created or used for some business purpose, but as a screen for another corporation which, or an individual who, was conducting the business. In Gregory v. Helvering the taxpayer had organized a corporation only to serve as a means of transfer; it was used once and only for that purpose, and was dissolved as soon as it had done so. The Court held that it was not a 'corporation' within the meaning of that term, as Congress must be understood to have used it, because in common speech, it means a jural person created to conduct industry, commerce, charity or some other commonly practiced activity, and not to serve merely as an escape from taxation." Commissioner v. National Carbide Corp., 167 F.2d 304, 306 (2d Cir. 1948). (Alternatively, Mrs. Gregory's "plan of reorganization" was not the sort of plan that Congress had contemplated in using those words.) If Mrs. Gregory had won, either Congress would have had to amend the statute (which it did anyway, however) or there would have been a flurry of sterile reorganizations--reorganizations not only motivated solely by a desire to avoid taxes but having no consequences other than to avoid taxes. Such "reorganizations" do not add to social wealth. They do not impinge on the world of business at all. They merely transfer wealth from one group of taxpayers to another.
In another well-known case the Second Circuit upheld the denial of an interest deduction where the taxpayer had "borrowed funds in order to engage in a transaction that has no substance or purpose aside from the taxpayer's desire to obtain the tax benefit of an interest deduction: and a good example of such purposeless activity is the borrowing of funds at 4 percent in order to purchase property that returns less than 2 percent and holds out no prospect of appreciation sufficient to counter the unfavorable interest rate differential." Goldstein v. Commissioner, 364 F.2d 734, 741-42 (2d Cir. 1966); see also Knetsch v. United States, 364 U.S. 361, 5 L. Ed. 2d 128, 81 S. Ct. 132 (1960). Goldstein was a more difficult case than Gregory because the transactions were at arm's length, whereas the shuffle that ended in the profit to Mrs. Gregory was the result of transactions internal to the corporate enterprise owned by her. But deliberately to incur an expense greater than the expected gain--to pay 4 percent for the chance to make 2 percent--is the antithesis of profit-motivated behavior; such a transaction lacks economic substance. Compare our Levin v. Commissioner, 832 F.2d 403, 406-07 (7th Cir. 1987), and Milbrew v. Commissioner, 710 F.2d 1302, 1305 (7th Cir. 1983).
The economic substance doctrine is sharply criticized in Isenbergh, Musings on Form and Substance in Taxation, 49 U. Chi. L. Rev. 859, 863-84 (1982). The author argues that not only the doctrine's articulation (the focus of the criticism by Gunn, Tax Avoidance, 76 Mich. L. Rev. 733 (1978)), but also the outcomes of such classic "form-substance cases as Gregory and Goldstein, are incorrect--the consequence of judicial ambition or impatience. Yet in both cases (Gregory more clearly than Goldstein) the taxpayer was trying to take advantage of a loophole inadvertently created by the framers of the tax code; in closing such loopholes the courts could not rightly be accused of having disregarded congressional intent or overreached. Nor were they cases like Crane v. Commissioner, 331 U.S. 1, 91 L. Ed. 1301, 67 S. Ct. 1047 (1947), where plugging one ...