Claims Court addresses Corn Products.

Following the Supreme Court's 1988 decision in Arkansas Best Corp., 485 US 212 (1988), many tax practitioners believed that claiming ordinary loss treatment under the Corn Products doctrine was precluded, except possibly in the narrowest of hedging transactions. However, a recent Claims Court decision may have breathed new life into the Corn Products doctrine, or may have at least created support for a broad view of the inventory hedging exception to capital asset treatment.

In Circle K Corp., Cl. Ct., 1991, a gas retailer purchased over time a significant amount of stock in an oil and gas company, and also received an option to purchase crude oil from the oil company. In its SEC filings, the taxpayer stated that these purchases were intended to diversify its operations and for investment purposes. According to the Claims Court, however, these representations were made primarily to ensure the taxpayer's entitlement to a depletion allowance. The court found that, in fact, the underlying objective of the taxpayer's investment was to guarantee a source of gasoline for its retail operations if future oil shortages arose.

In determining whether the taxpayer's investment was "inventory" under Sec. 1221(1), the Claims Court focused on the Supreme Court's decision in Corn Products Refining Co., 350 US 46 (1955), and Arkansas Best. In Corn Products, the issue was whether capital gains treatment was appropriate for the taxpayer's dealings in corn futures. The taxpayer's business involved converting corn into starches, sugars and other products. After droughts in the 1930s caused sharp increases in corn prices, the company implemented a program of buying corn futures to assure itself an adequate supply of corn and to protect against price increases. Depending on its needs, the company would either take delivery on the corn futures or sell them.

The Supreme Court characterized the company's dealing in corn futures as "hedging" transactions. The Court, noting that hedging transactions consistently had been treated as giving rise to ordinary gains and losses, held that the corn futures were ordinary assets. Admittedly, petitioner's corn futures do not come within the literal language of the exclusions set out in section 1221. They were not stock in trade, actual inventory, property held for sale to customers or depreciable property used in a trade or business. But the capital-asset provision of section 1221 must not be so broadly applied as to defeat rather than further the purpose of Congress. . . . Congress intended that profits and losses arising from the everyday operation of business be considered as ordinary income or loss rather than capital gain or loss. . . . Since this section is an exception from the normal tax requirements of the Internal Revenue Code, the definition of a capital asset must be narrowly applied and its exclusions interpreted broadly.

For more than 30 years after the Supreme Court's decision, lower courts applied the so-called Corn Products doctrine to find that assets acquired and sold in the ordinary course of business, including stock or other assets normally characterized as capital assets, were accorded ordinary gain or loss treatment. The courts typically examined the taxpayer's business motives underlying an asset acquisition to determine whether the taxpayer's decision was driven by investment objectives, justifying capital asset treatment, or by objectives central to the taxpayer's business operations, thus satisfying the Corn Products standard for ordinary income treatment. Meanwhile, commentators debated whether the so-called Corn Products doctrine constituted a new exception to the Sec. 1221 definition of capital asset or whether the case merely represented a broad interpretation of Sec. 1221(1)'s inventory exception.

After years of uncertainty, the Supreme Court finally readdressed Corn Products in Arkansas Best. The taxpayer in Arkansas Best was a diversified holding company that in 1968 owned 65% of a bank's stock. The taxpayer continued to purchase the bank's stock between 1968 and 1974. The pre-1972 purchases were designed to help the bank expand; the purchases from 1972 to 1974, made after federal examiners had classified the bank as a problem bank, were designed to provide the bank with needed capital to help the bank survive. In 1975, the taxpayer claimed an ordinary loss when it sold most of its bank stock. The Tax Court held, based on Corn Products, that while the loss incurred on sales of stock acquired before 1972 was clearly capital (such stock having been acquired for investment purposes), the loss realized on stock acquired after 1972 was ordinary, since it was purchased and held exclusively for the business purpose of protecting the taxpayer's reputation by attempting to prevent the bank's failure.

In affirming the Eighth Circuit's reversal of the Tax Court, the Supreme Court finally clarified that Corn Products involved an application of Sec. 1221(1)'s inventory exception to the definition of "capital asset," and that the exceptions enumerated in Sec. 1221 were exclusive. A taxpayer's motivation in purchasing an asset was not determinative of whether or not the asset was within Sec. 1221's capital asset definition. Moreover, while the corn futures in Corn Products were not actual inventory, they were nevertheless an integral part of the taxpayer's inventory purchase system, thus constituting inventory substitutes under a broad reading of the Sec. 1221(1) inventory exception.

The Claims Court in Circle K, after noting that the Supreme Court did not hold that futures contracts actually had to be exercised to qualify under Sec. 1221(1), held that a "source of supply" stock purchase could still qualify as a hedging transaction if it was an integral part of a taxpayer's inventory purchase system. The fact that Circle K never acquired oil as a result of its investment in the oil company's stock and options was not fatal. Under Arkansas Best, it was inappropriate for a court to examine, at least initially, a taxpayer's motive in acquiring an asset. Rather, the court must objectively determine whether a stock purchase had a sufficiently close connection to the taxpayer's business so that it could be fairly characterized as an integral part of the inventory purchase system. Finding that the taxpayer's investment in the oil company's stock bore the requisite close connection, the Claims Court found that the inventory exception applied to create ordinary loss treatment on Circle K's disposition of its interest in the oil company.

Arguably, Circle K fits neatly within Arkansas Best's narrow interpretation of Corn Products; i.e., hedging transactions that constitute an integral part of a business's inventory purchase system are within the Sec. 1221(1) inventory exception. However, Circle K's interpretation of what constitutes an "integral part of a taxpayer's inventory purchase system" appears to be considerably broader than that suggested by the Supreme Court in Arkansas Best. In Circle K, the taxpayer never exercised its options to acquire any crude oil (since market conditions never mandated their use), while in Corn Products, the taxpayer repeatedly exercised the futures as market conditions demanded. In finding that a "hedging transaction should not be construed so narrowly as to exclude a valid contract or agreement that gives its holder the flexibility to exercise it or not, depending on market conditions," the Claims Court may have departed from the objective standards imposed by the Court in Arkansas Best, by examining the taxpayer's subjective intent of investing to guarantee a source of oil. (Presumably, the taxpayer would not have satisfied the inventory exception if its underlying objective in investing in the oil company was diversification, as stated in its SEC filings.)

In light of Circle K, the question arises whether any acquisition by a taxpayer of an interest in a company that sells products integral to the taxpayer's inventory may be afforded ordinary treatment on the disposition of that interest. For example, might not the acquisition by an auto manufacturer of an interest in a tire manufacturer satisfy Circle K's definition of inventory? Must the acquisition be of a substantial interest in the company acquired? Just how remote can the possibility be that the interest acquired will be used to obtain inventory and still constitute a "hedge"? Must the taxpayer objectively manifest his purpose in acquiring that interest? And if so, how? It will be interesting to observe whether the Claims Court's decision in Circle K signals the beginning of another expansion of the Corn Products doctrine, such as occurred before Arkansas Best.