Code Sec. 1234A was enacted in 1981 as part of Title V Tax Straddles of

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1 The Schizophrenic World of Code Sec. 1234A By Linda E. Carlisle and Sarah K. Ritchey Linda Carlisle and Sarah Ritchey analyze the Tax Court s decision in Pilgrim s Pride and offer their observations on how the Fifth Circuit should rule. Code Sec. 1234A was enacted in 1981 as part of Title V Tax Straddles of the Economic Recovery Tax Act of 1981 (ERTA) to prevent taxpayers from recognizing ordinary losses from the cancellation of forward contracts. 1 Because Code Sec defines capital gain and capital loss to mean gain or loss from the sale or exchange of a capital asset, taxpayers were entering into offsetting forward contracts, waiting for the long-term holding period and then selling the gain leg of the straddle to generate long-term capital gain, while cancelling the loss leg to generate an ordinary loss. In the legislative history, Congress expressed concern that dispositions which are economically equivalent to a sale or exchange of a capital asset could give rise to ordinary gain or loss. 2 Since 1981, the derivative contract world has expanded to include futures, forwards, swaps and options referencing property that is not personal property that is actively traded (as defined in Code Sec. 1092(d)(1)) and nonproperty items, such as interest rate indices. Congress has amended Code Sec. 1234A numerous times to address such new products. However, these amendments and the administrative interpretations of Code Sec. 1234A have made the scope of Code Sec. 1234A uncertain for both taxpayers and the IRS. Indeed, this uncertainty has led to a recent Tax Court case, Pilgrim s Pride Corp., which is currently being appealed to the Fifth Circuit. 3 I. Pilgrim s Pride LINDA E. CARLISLE is a Member, and SARAH K. RITCHEY is a Counsel at Miller & Chevalier Chartered in Washington, D.C. In Pilgrim s Pride, Pilgrim s Pride Corporation (the Taxpayer ) held preferred stock and trust preferred securities. The issuing corporation made an offer to redeem the securities, but the Taxpayer determined that the Code Sec. 165(a) ordinary loss deduction on abandonment provided a better after-tax return than the redemption. Code Sec. 165(a) provides that any loss sustained during a tax VOLUME 12 ISSUE L.E. CARLISLE, S.K. RITCHEY 13

2 THE SCHIZOPHRENIC WORLD OF CODE SEC. 1234A year will be allowed as a deduction. The IRS disallowed the loss because it determined that the securities were worthless within the meaning of Code Sec. 165(g). Code Sec. 165(g) provides that if a security held as a capital asset becomes worthless, any resulting loss is treated as resulting from the sale or exchange of a capital asset. Pilgrim s Pride was submitted fully stipulated to the Tax Court in May 2011 and briefed under Code Sec The case, however, was reassigned twice before Judge Dawson considered it in April of 2013 and asked the parties to brief the application of Code Sec. 1234A. Code Sec. 1234A is also a deemed sale of a capital asset rule and provides: Gain or loss attributable to the cancellation, lapse, expiration, or other termination of (1) a right or obligation (other than a securities futures contract, as defined in section 1234B) with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer, or (2) a section 1256 contract (as defined in section 1256) not described in paragraph (1) which is a capital asset in the hands of the taxpayer, shall be treated as gain or loss from the sale of a capital asset. The preceding sentence shall not apply to the retirement of any debt instrument (whether or not through a trust or other participation agreement). The IRS argued that the abandonment of the securities terminated all of the Taxpayer s rights in the securities, and since the securities were capital assets in the Taxpayer s hands, Code Sec. 1234A requires that the loss be treated as a loss from the sale or exchange of capital assets. The Taxpayer argued that based on the legislative history to Code Sec. 1234A, the court must conclude that a right or obligation with respect to property refers only to a contractual or other derivative right to property and not inherent property rights in stock. 4 In December of 2013, the Tax Court held that based on the plain meaning of Code Sec. 1234A, such provision applies to terminations of all rights and obligations with respect to property that is a capital asset in the hands of the taxpayer or would be if acquired by the taxpayer, including not only derivative contract rights but also property rights arising from the ownership of the property. 5 Accordingly, the abandonment loss claimed by the Taxpayer was a capital loss because the abandonment was deemed to be a loss from the sale or exchange of a capital asset under Code Sec. 1234A. In rendering its opinion, the Tax Court reviewed the legislative history of Code Sec. 1234A and determined that the 1997 amendment to Code Sec. 1234A extended the statute s application to property rights arising from the ownership of capital property. 6 Prior to 1997, Code Sec. 1234A applied only to actively traded personal property as defined in Code Sec. 1092(d)(1). Following the decision, the Taxpayer asked the court for a full court review, but such request was denied. The Taxpayer filed a timely notice of appeal with the Fifth Circuit. In its brief to the Fifth Circuit, the Taxpayer again argues that Code Sec. 1234A does not apply to the abandonment of securities because Code Sec. 1234A(1) only applies to derivative rights or obligations and not inherent property rights. 7 The Taxpayer asserts that the Tax Court s interpretation of Code Sec. 1234A(1) makes Code Sec. 1234A(2) redundant and is contrary to legislative intent and the government s historical position that Code Sec. 1234A does not apply to the abandonment of certain types of property. 8 In its reply, the IRS maintains that the Tax Court correctly concluded that Code Sec. 1234A applies to the abandonment of securities and associated rights and that the scope of the statute is not limited to derivatives contracts. 9 The IRS argues that its interpretation of Code Sec. 1234A(1) does not render Code Sec. 1234A(2) redundant, and because the statute is unambiguous, the Fifth Circuit need not consider the legislative history. 10 The IRS also asserts that administrative rulings on which the Taxpayer relies are not inconsistent with the broader scope of Code Sec. 1234A. Set forth below is a discussion of the legislative history and administrative pronouncements that the Fifth Circuit will need to consider in reaching its decision. II. Legislative History of Code Sec. 1234A Code Sec. 1234A was enacted in 1981 as part of a comprehensive tax package designed to prevent tax-avoidance straddle transactions. 11 As described above, taxpayers would rely on the extinguishment doctrine to selectively recognize ordinary losses from the cancellation of certain derivatives contracts. The legislative history describes [s] ome of the more common tax-avoidance transactions as involving cancellations of forward contracts for currency or securities and gives as an example a taxpayer entering into offsetting forward contracts for the sale and purchase of German marks which could simultaneously produce capital gain on the sale of the gain leg and ordinary loss on the cancellation of the loss leg. 12 The legislative history provides that Code Sec. 1234A was enacted to address the cancellation of a contract to deliver a capital asset that 14 JOURNAL OF TAXATION OF FINANCIAL PRODUCTS VOLUME 12 ISSUE

3 is economically equivalent to the sale or exchange of the contract [emphasis added]. 13 In 1983, Congress made a technical correction to Code Sec by amending the definition of a regulated futures contract in Code Sec. 1256(b)(1) to include cash-settled futures contracts and to Code Sec. 1234A by extending the deemed sale rule to all Code Sec contracts. This technical amendment to Code Sec. 1234A resulted in the addition of Code Sec. 1234A(2) which provided that: Gain or loss attributable to the cancellation, lapse, expiration, or other termination of... (2) a regulated futures contract (as defined in section 1256) not described in paragraph (1) which is a capital asset in the hands of the taxpayer, shall be treated as gain or loss from the sale of a capital asset. 14 Since Code Sec. 1234A(2) was added as a technical correction to ERTA, Congress intended in 1981 for Code Sec. 1234A to apply to the cancellation, lapse, expiration or other termination of a right or obligation with respect to personal property which is or would be a capital asset in the hands of the taxpayer, and the ownership of all regulated futures contracts held as capital assets regardless of whether such contracts required the delivery of personal property that is a capital asset. If the plain meaning of Code Sec. 1234A was that the right with respect to personal property included the property right arising from the ownership of a futures contract, there would have been no reason to add Code Sec. 1234A(2). This technical correction, therefore, supports the view that Congress intended Code Sec. 1234A to apply only to derivative rights or obligations with respect to personal property which is or would be a capital asset and not to property rights arising from the ownership of personal property. In 1984, Code Sec. 1234A was amended to exclude its application since enactment in 1981 to the retirement of any debt instrument by the addition of a second sentence stating that The preceding sentence shall not apply to the retirement of any debt instrument (whether or not through a trust or other participation arrangement). This second technical correction provides no insight regarding how the first sentence of Code Sec. 1234A should be interpreted. In 1997, Congress again amended Code Sec. 1234A(1). This amendment is the foundation of the Tax Court s opinion in Pilgrim s Pride. The legislative history discusses the considerable amount of litigation dealing with whether modifications of legal relationships between taxpayers is to be treated as a sale or exchange and notes that because the Supreme Court in Douglass Fairbanks 15 held that the redemption of a bond before maturity was not a sale or exchange, many courts have determined that the lapse, cancellation or abandonment of a bond is not a sale or exchange of a capital asset. 16 In discussing the Reasons for Change, the legislative history states that the bill treats the cancellation, lapse, expiration or other termination of a right or obligation which is (or on acquisition would be) a capital asset in the hands of the taxpayer to all types of property as a sale or exchange. 17 In explaining the amendment, the legislative history states that the extension of Code Sec. 1234A will only affect property that is not personal property which is actively traded on an established exchange. Thus, the Committee bill will apply to (1) interests in real property and (2) nonactively traded personal property. 18 As examples, the legislative history provides that the first expansion will treat amounts received on a lease termination as capital gain, and the second expansion will treat the loss realized on the forfeiture of a down payment under a stock purchase contract as a capital loss. The Tax Court relies upon Congress s reference to the redemption of a bond as not giving rise to sale or exchange treatment to conclude that the 1997 amendment to Code Sec. 1234A expanded its scope to apply to property rights. Both examples of the results of the expansion given in the legislative history, however, reference gain or loss with respect to derivative rights in property, i.e., a lease and a forward contract. In 2000, Congress again amended Code Sec. 1234A(1) to provide that a right or obligation with respect to property did not include a securities futures contract, as defined in Code Sec. 1234B. At the same time, Code Sec. 1234A(3) was added to the Code to provide deemed sale treatment to [g]ain or loss attributable to the cancellation, lapse, expiration or other termination of (3) a securities futures contract (as so defined) which is a capital asset in the hands of the taxpayer. 19 Thus, following the 2000 amendment, deemed sale treatment applied to: a right or obligation (other than a securities futures contract) with respect to property which is or would be a capital asset under Code Sec. 1234A(1); the ownership right in a Code Sec contract that was a capital asset under Code Sec. 1234A(2) even though it was not a right with respect to property which would be a capital asset; and the ownership right in a securities futures contract that was a capital asset under Code Sec. 1234A(3). The addition of Code Sec. 1234A(3) indicates that the termination of property rights in a securities futures VOLUME 12 ISSUE

4 THE SCHIZOPHRENIC WORLD OF CODE SEC. 1234A contract would not be covered by Code Sec. 1234A(1). As with Code Sec. 1234A(2), Code Sec. 1234A(3) would have been necessary only if Code Sec. 1234A(1) was limited to derivatives contracts where the underlying personal property is a capital asset. The last amendment to Code Sec. 1234A occurred in 2002 when Congress determined that the treatment of all gain or loss attributable to the sale, exchange or termination of securities futures contracts would be dealt with under the look-through rule of Code Sec. 1234B, not Code Sec. 1234A, and deleted Code Sec. 1234A(3) in its entirety. III. Tax Treatment of Worthless Securities If a security which is a capital asset becomes worthless, Code Sec. 165(g)(1) treats the resulting loss as a loss from the sale or exchange of a capital asset. Reg (i), adopted in 2008, expands upon the statutory rule. It provides that an abandonment of a security by a taxpayer is treated as if the security has become wholly worthless and, thus, the resulting loss is also treated as a loss from the sale or exchange of a capital asset, if the security is a capital asset in the hands of the taxpayer. Reg (i) does not reference Code Sec. 1234A, which if applicable to ownership rights in all personal property, would make the regulation redundant for the abandonment of securities held as capital assets. The Taxpayer in Pilgrim s Pride argued that this omission means the Treasury did not believe that Code Sec. 1234A applied to the abandonment of securities in The Tax Court, however, disagreed and stated that Reg was consistent with Code Sec. 1234A. 20 IV. Administrative Guidance Interpreting Code Sec. 1234A In 2004, proposed regulations under Code Sec. 1234A were promulgated providing that any gain or loss arising from a termination payment with respect to a notional principal contract is treated as gain or loss from the termination of a notional principal contract. 21 In addition, gain or loss derived from the settlement of obligations under a bullet swap or forward contract is treated as gain or loss from the termination of such contracts. These proposed regulations, which have not been finalized, would apply to ownership rights in personal property because there is no underlying asset for bullet swaps and notional principal contracts. In Technical Advice Memorandum , 22 the IRS discussed the application of Code Sec. 1234A to the surrender of a life insurance contract and determined that Code Sec. 1234A would not apply to ordinary income accretions to the contract s value because such components of the payment amount were not property that is a capital asset. Similarly, the IRS ruled in Revenue Ruling , 23 that a taxpayer s surrender of a life insurance contract would not produce capital gain under Code Sec. 1234A because Code Sec. 61(a)(10) provides that gross income from life insurance policies is treated as gross income. The IRS has also applied Code Sec. 1234A to the redemption of units issued by a charitable remainder unitrust against a pool of investment assets, ruling that such redemption generates capital gain or loss. 24 In each situation, the IRS is applying Code Sec. 1234A to property rights arising from the ownership of a capital asset, not a derivative contract with respect to a capital asset. In contrast, other administrative guidance addressing the tax treatment of gain or loss with respect to the termination of contract rights does not apply Code Sec. 1234A(1) to ownership rights in personal property. In Revenue Ruling 93-80, 25 the IRS determined that a partner who abandons its partnership interest, does not receive any distributions upon its withdrawal from the partnership, and is not relieved of any partnership liabilities, recognizes an ordinary loss because there is no sale or exchange of property. The ruling was published before Code Sec. 1234A(1) was amended in 1997 to apply to rights and obligations with respect to all types of property (rather than just publicly traded property) and does not reference Code Sec. 1234A. The IRS, however, cited the ruling in Chief Counsel Advisory for the proposition that a loss incurred on the abandonment or worthlessness of a partnership interest gives rise to an ordinary loss. 26 V. Foreign Currency Contracts Statutory Language or Congressional Intent In another provision of the Code enacted as part of ERTA, the IRS followed Congressional intent in interpreting the plain words of the statute. Code Sec. 1256(g)(2)(A) defines a foreign currency contract as a contract that requires delivery of, or the settlement of which depends on the value of, certain foreign currencies. In Notice , the IRS concluded that foreign currency options are not foreign currency contracts, whether or not the underlying currency is one in which positions are traded through regulated futures contracts. 27 In the Notice, the IRS states that Code Sec. 1256(g)(2)(A), as enacted in 1984, did not allow for cash settlement and required actual delivery of the underlying foreign currency in all circumstances. As previously 16 JOURNAL OF TAXATION OF FINANCIAL PRODUCTS VOLUME 12 ISSUE

5 described, Code Sec was amended in 1984 to include cash settled futures contracts. The IRS determined in the Notice, however, that there is no indication that Congress intended by this addition to extend the definition of foreign currency contract to foreign currency options. The IRS reached this conclusion even though the plain meaning of the statute would make foreign currency options, which are contracts the settlement of which depends upon the value of foreign currencies, a foreign currency contract. As support, the IRS referenced legislative history relating to an amendment to Code Sec. 988(c)(1)(E) made two years after the enactment of Code Sec. 1256(g)(2)(A) which indicates that a foreign currency option is not a foreign currency contract as defined in 1256(g)(2). 28 Conclusion Although the Tax Court states that the plain meaning of Code Sec. 1234A is clear, both taxpayers and the IRS have read it to mean different things at different times. Code Sec. 1234A was enacted to address the use of derivative contracts to generate selectively realized capital gains and ordinary losses. Throughout its many amendments, Code Sec. 1234A continues to apply to the use of derivatives to selectively change the character of gains and losses with respect to certain transactions that are the equivalents of sales or exchanges. Code Sec. 1234A, however, is not the only provision that deems sale or exchange treatment, e.g., See Code Sec. 165(g). The question that the Fifth Circuit will have to resolve in the appeal of Pilgrim s Pride is whether a right with respect to property is limited to a derivative right or includes property rights. As the IRS did with the definition of foreign currency contracts, in our view, the Fifth Circuit should look to the intent of Congress when Code Sec. 1234A was enacted, conclude that Code Sec. 1234A applies only to derivative rights with respect to personal property, and remand the case for further consideration under Code Sec. 165(g). ENDNOTES 1 All Code Sec. references are to the Internal Revenue Code of 1954, as amended, and all post-1986 section references are to the Internal Revenue Code of 1986, as amended. 2 S. Rep. No , at 170 (1981); see also H.R. Rep. No , at 212 (1981). 3 Pilgrim s Pride Corp., 141 TC 533, Dec. 59,715 (Dec. 11, 2013). 4 Id. at Id. at Id. at Brief of Appellant, Pilgrim s Pride Corp. at 15, Pilgrim s Pride Corp., No , CA-5 (June 30, 2014). 8 Id. at Brief of Appellee, Commissioner of Internal Revenue at 16-17, Pilgrim s Pride Corp., No , CA-5 (Aug. 15, 2014). 10 Id. at ERTA, Title V Tax Straddles (P.L ), 501, 95 Stat. 323 (1981), defining the term straddle to mean offsetting positions with respect to personal property. 12 S. Rep. No , at 171; see also H.R. Rep. No , at Id. at ; see also H.R. Rep. No , at In 1984, Congress changed the definition of a regulated futures contract to a section 1256 contract and expanded the types of contracts subject to market-to-market treatment. As a result, it also changed the reference to a regulated futures contract in Code Sec. 1234A(2) to a section 1256 contract. See Deficit Reduction Act of 1984 (P.L ), 102, 98 Stat. 624 (1984). 15 Douglass Fairbanks, SCt, 306 US 436 (1939). 16 H.R. Rep. No , at 451 (1997); see also S. Rep. No , at (1997). 17 Id. at 454; see also S. Rep. No , at Id. 19 Omnibus Consolidated and Emergency Supplemental Appropriations for Fiscal Year 2001 Act (P.L ), 401, 114 Stat. 2763A-649 (2000). 20 Supra note 3, at Terminations of bullet swaps and forward contracts are also included in the proposed regulations under Code Sec. 1234A. A bullet swap is defined as a financial instrument that is not an excluded contract as defined in (c)(1)(ii), that provides for the computation of an amount or amounts due from one party to another by reference to a specified index upon a notional principal amount, and that provides for settlement of all the parties obligations at or close to maturity of the contract. Prop. Reg A-1(c) (2), 69 FR 8898 (Feb. 26, 2004). 22 TAM (Dec. 24, 2004). 23 Rev. Rul , CB LTR (June 27, 2008). 25 Rev. Rul , CB See CCA (Sep. 15, 2006). 27 Notice , CB Id. citing Technical and Miscellaneous Revenue Act of 1988 (P.L ), 6130, 102 Stat (1988). This article is reprinted with the publisher s permission from the Journal of Taxation of Financial Products, a quarterly journal published by Wolters Kluwer. Copying or distribution without the publisher s permission is prohibited. To subscribe to the Journal of Taxation of Financial Products or other Wolters Kluwer Journals please call or visit CCHGroup. com. All views expressed in the articles and columns are those of the author and not necessarily those of Wolters Kluwer. VOLUME 12 ISSUE