Opinion ID: 608070
Heading Depth: 2
Heading Rank: 1

Heading: The Taxpayers' Appeal

Text: 9 The Commissioner relies upon a line of cases best exemplified by C.I.R. v. Ferrer, [301 U.S.App.D.C. 310] 304 F.2d 125 (2d Cir.1962), in which the court, applying the substance over form doctrine, determined that contract cancellation was in essence a sale and thus resulted in a capital gain. See also Bisbee-Baldwin v. Tomlinson, 320 F.2d 929 (5th Cir.1963). The Stollers rely primarily upon the so-called disappearing asset cases such as Leh v. Commissioner, 260 F.2d 489 (9th Cir.1958), which hold that a loss incurred from a contract cancellation should be treated as an ordinary loss because the underlying contract, or asset, disappeared when it was cancelled. In other words, because the asset was neither sold nor exchanged, there could be no capital loss. 10 Neither party comes fully to grips with the other's line of cases. Nor are there any cross-references in the leading cases. Doctrinal conflicts tend to sprout like mushrooms in such dark corners of the law, but here we think there is none. 11 In Ferrer, the estimable Judge Friendly held that the gain realized by a contract should be treated as a capital or an ordinary gain depending upon the nature of the interest sold. In that case Jose Ferrer had purchased from Pierre LaMure the rights to produce a stage play and a motion picture based upon LaMure's novel Moulin Rouge. John Huston later became interested in the movie rights. Ferrer and LaMure then agreed to cancel this contract for a consideration to be paid to Ferrer by Huston's company, Moulin. 12 The Ferrer court expressly rejected any distinction between this termination of the taxpayer's contract right and its outright sale, reasoning that the nature of the transaction in both instances was the same. 13 In the instant case we can see no sensible basis for drawing a line between a release of Ferrer's rights to LaMure for a consideration paid by Moulin and a sale of them, with LaMure's consent, to Moulin or to a stranger who would then release them.... Tax law is concerned with the substance, here the voluntary passing of property rights allegedly constituting capital assets, not with whether they have been passed to a stranger or to a person already having a larger estate. 14 Id. at 131. 15 After the cancellation of Ferrer's contract, there was still an extant contract for the movie rights with essentially the same terms but a different signatory. Therefore, the court held, the substance over form doctrine applied. See also Bisbee-Baldwin, 320 F.2d 929 (where, in substance, the taxpayer transferred a servicing contract to a third party, the court looked to the underlying contract to determine whether the cancellation fee should be treated as ordinary income or a capital gain). Because the consideration for the cancellation came from a third party, it was in substance a sale. Here, however, the underlying contracts were cancelled in substance as well as in form. When a contract was cancelled, it did not merely change hands; it ceased to exist altogether. 16 The Tax Court adopted its own approach reminiscent of the substance over form reasoning in Ferrer (which it did not cite). The court determined that the contracts Holly cancelled should be treated as having generated ordinary or capital losses depending upon whether or not, after the cancellation, any rights or property interests created by the contract remained. Stoller v. Commissioner, 60 T.C.M. (CCH) 1554, 1567, 1990 WL 212864 (1990). The Tax Court found that, insofar as cancelled contracts were replaced by contracts between the same parties for the same commodities (albeit with new prices and delivery dates), [t]he substance of the transactions, although called forward contracts closed by cancellation, was in reality forward contracts closed by offset. Id. at 1566. In contrast, where a contract was cancelled and no replacement contract was made, the court held that the Stollers had properly reported an ordinary loss because the cancellation was a complete termination of both parties' rights to the straddle transaction. Id. at 1567. 17 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 [301 U.S.App.D.C. 311] effect until the date for delivery. The Tax Court, implicitly recognizing that offset and cancellation are indeed distinct, found that cancellation amounted to offset only where Holly purchased a replacement contract. The court reasoned that in such cases, the essentials of the transaction lived on because the replacement contract was in most respects identical to the cancelled contract. The subsequent purchase of a replacement contract cannot, however, transform a cancellation into an offset. Therefore, the Stollers properly treated the losses incurred in cancelling the contracts as ordinary losses. 18 This interpretation of the law prior to the 1981 amendment to the Code is reflected in the legislative history of that amendment. The Congress amended the Code specifically to provide that the gain or loss resulting from the cancellation of a contract is a capital gain or loss for tax purposes. See 26 U.S.C. § 1234(A). While that amendment does not govern this case (because the transactions at issue here took place before the effective date of the amendment), the Senate Finance Committee Report on the amendment is informative with respect to the preexisting law: Present Law 19 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.... Reasons for Change 20 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.... 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. 21 S.Rep. 97-144 (1981) (emphasis added). See also H.Rep. 97-215 (1981) U.S.Code Cong. & Admin.News p. 105. Clearly the Congress thought that it was changing the law so that a cancellation would no longer necessarily result in an ordinary loss. 22 We recognize that at best subsequent legislative history is a 'hazardous basis for inferring the intent of an earlier' Congress. Pension Benefit Guaranty Corp. v. LTV Corp., 496 U.S. 633, 650, 110 S.Ct. 2668, 2678, 110 L.Ed.2d 579 (1990) (quoting United States v. Price, 361 U.S. 304, 313, 80 S.Ct. 326, 331, 4 L.Ed.2d 334 (1960)). See also United States v. Texas, --- U.S. ----, ---- n. 4, 113 S.Ct. 1631, 1635 n. 4, 123 L.Ed.2d 245 (1993). We refer to the background understanding upon which the 97th Congress acted not because it is authoritative with respect to the intent of the 83rd Congress, but because it is a careful and contemporaneous account of the state of the law--i.e., the statute as interpreted by the courts--as of the time that the 97th Congress sought to change it. We simply agree with the 97th Congress that prior to the 1981 amendment the prevailing rule was that the cancellation of a contract resulted in an ordinary loss for tax purposes. 23 In light of this conclusion, there is no basis for finding that Stoller either was negligent or intentionally disregarded Internal Revenue Service rules and regulations in treating the losses incurred from contract cancellations as ordinary losses. Accordingly, no penalty could properly be imposed upon him under § 6653.