1996 WL 33658418 (1st Cir.)

For opinion see 93 F.3d 26

United States Court of Appeals, First Circuit.

Carlos J. and Jean M. QUIJANO, Appellants,

v.

UNITED STATES OF AMERICA, Appellee.

No. 96-1053.

February 26, 1996.

On Appeal from a Judgment of the District Court for the District of Maine

Brief for the Appellants

Paula N. Singer, Paula N. Singer, BBO # 464700, Robert S. Grodberg, BBO # 212360, Vacovec, Mayotte & Singer, Two Newton Place, 255 Washington Street, Suite 340, Newton, MA 02158, (617) 964-0500.

*i TABLE OF CONTENTS TO THE BRIEF

TABLE OF AUTHORITIES ... iii

STATEMENT OF SUBJECT MATTER AND APPELLATE JURISDICTION ... 1

STATEMENT OF ISSUES PRESENTED ... 1

STATEMENT OF THE CASE ... 2

STATEMENT OF FACTS ... 4

STANDARD OF REVIEW ... 5

ARGUMENT ... 5

I. COMMISSIONER'S REVENUE RULING 54-105 REQUIRING THE PURCHASE PRICE OF THE TAXPAYERS' RESIDENCE TO BE TRANSLATED INTO U.S. DOLLAR USING THE CURRENCY EXCHANGE RATE AS OF THE DATE OF PURCHASE CREATES AN UNCONSTITUTIONAL TAX, SINCE NO U.S. DOLLARS WERE EXCHANGED FOR POUNDS STERLING ON THE PURCHASE AND NO FOREIGN EXCHANGE GAIN WAS REALIZED ... 6

II. THE IMPOSITION OF TAX ON THE UNREALIZED CURRENCY EXCHANGE GAIN ON THE SALE OF THE RESIDENCE AND THE DISALLOWANCE OF THE CURRENCY EXCHANGE LOSS ON THE MORTGAGE LOAN PAYOFF UNDER THE SEPARATE TRANSACTION RULE CREATES AN UNCONSTITUTIONAL TAX ON THE TAXPAYERS' SALE TRANSACTION ... 17

CONCLUSION ... 27

EXHIBIT I ... 29

CERTIFICATE OF SERVICE ... 30

*ii TABLE OF CONTENTS TO THE ADDENDUM

Judgment ... ADD-01

Order Affirming The Recommended Decision Of The Magistrate Judge ... ADD-02

Recommended Decision On Cross Motion For Summary Judgment... ADD-04

Stipulation Of Facts ... ADD-10

*iii TABLE OF AUTHORITIES

CASES

B.F. Goodrich Company v. Commissioner, 1 T.C. 1098 (1934) ... 19

Bowers v. Kerbaugh Empire Co., 271 U.S. 1970 (1926) ... 19

Brook, Inc., v. Commissioner, 799 F.2d 833 (2nd Cir. 1986) ... 27

CenTra, Inc., et al v. U.S., 953 F.2d 1051 (6th Cir.,1992) ... 25

Chevron, U.S.A., Inc., v. Natural Resources Defense Council, Inc., 467 U.S. 837, 104 S.Ct. 2778, 81 L.Ed. 2d 694 (1984) ... 26

Church's English Shoes, Ltd. v. Commissioner, 24 T.C. 56 (1955), aff'd, 229 F.2d 957 (2nd Cir. 1956) ... 11

Clark III v. United States, 76 AFTR 2d. 95-6091 ... 5

Commissioner v. Glenshaw Glass, 348 U.S. 426 (1955) ... 14, 15

Eisner v. MaComber, 252 U.S. 189 (1920) ... 14

Foil v. Commissioner, 920 F.2d 1196 (5th Cir. 1990) ... 26

Gillin v. the United States, 423 F.2d 309 (1970) ... 19

Helvering v. Horst, 311 U.S. 112 (1940) ... 15, 16

National Standard Co. v. Commissioner, 80 T.C. 551, 558 (1983), aff'd, 749 F.2d 369 (6th Cir. 1984) ... 22, 25

Philip Morris, Inc., v. Commissioner, 104 T.C. 61 (1995), aff'd 76 AFTR 95-5773 1995) ... 21, 24, 25

Stubbs, Overbeck & Associates, Inc., v. United States, 445 F.2d 1142, 1146- 47 (5th Cir. 1971) ... 26

United States v. Central Savings Bank FSB, 499 U.S. 573 (1991) ... 21

Willard Helburn, Inc., v. Commissioner, 20 T.C. 740, aff'd 214 F.2d 815 (1st Cir. 1954) . 23, 24, 25

*iv STATUTES

United States Statutes:

28 U.S.C. §636(c)(5) ... 1

28 U.S.C. §1291 ... 1

28 U.S.C. §1346(a)(1) ... 1

Internal Revenue Code (I.R.C.):

I.R.C. § 61(a) ... 6

I.R.C. § 61(a)(3) ... 6

I.R.C. § 108 ... 21

I.R.C. § 162 ... 8

I.R.C. § 165(a) ... 20, 28

I.R.C. § 165(c) ... 20, 23, 28

I.R.C. § 212 ... 8

I.R.C. § 985(a) ... 7, 9

I.R.C. § 988 ... 17

I.R.C. § 1001(a) ... 6

I.R.C. § 1011 ... 6

I.R.C. § 1012 ... 6

I.R.C. § 1016(a)(1) ... 6

TREASURY REGULATIONS

Treas. Reg. § 1.989(a)-1(c) (1989) ... 8

REVENUE RULINGS AND PROCEDURES

Revenue Procedure 89-14, 1989-1 C.B. 814 ... 25

Revenue Ruling 54-105, 1954-1 C.B. 12 ... passim

Revenue Ruling 74-7, 1974-1 C.B. 198 ... 10, 19

*v Revenue Ruling 74-222, 1974-1 C. B. 21 ... 8

Revenue Ruling 78-281, 1978-2 C.B. 204 ... 18, 22

Revenue Ruling 90-79, 1990-2 C.B. 188 ... passim

MISCELLANEOUS

S. Rep. No. 999-313, 2d Sess., 99th Cong. (1986), reprinted in 1986-3 C.B. 1, 433 ... 9, 22

Stephen J. McGarry, The Taxation of Exchange Gains and Losses: A Road Map, The International Tax Journal, 26, Vol 14:7 (1988) ... 11

The American Bar Association, Report on the U.S. Treasury Department Discussion Draft on Taxing Foreign Exchange Gains and Losses, 36 Tax L. Rev. 425 (1981) ... 9

Lewis Carroll, Through the Looking Glass, and What Alice Found There, 34-35, (Alfred A. Knopf, Inc., 1984) (MacMillan and Co., London, 1872) ... 5

*1 STATEMENT OF SUBJECT MATTER AND APPELLATE JURISDICTION

The District Court had subject matter jurisdiction of the cause of action, the recovery of federal income tax erroneously or illegally assessed or collected, alleged in the Complaint under 28 U.S.C. § 1346(a)(1).

The taxpayers noticed their appeal on January 4, 1996, from the December 19, 1995 final judgment of the District Court for the District of Maine, entered in accordance with the Order Affirming Recommended Decision of the Magistrate Judge, Carter, C.J. The appeal was timely under Appellate Rule 4(a)(1) in that it was taken within 30 days from entry of judgment in an action in which the United States is a party. This Court's jurisdiction is predicated on 28 U.S.C. § 636(c)(5) and upon 28 U.S.C.. § 1291.

STATEMENT OF ISSUES PRESENTED

I. WHETHER COMMISSIONER'S REVENUE RULING 54-105 REQUIRING THE PURCHASE PRICE OF THE TAXPAYERS' RESIDENCE TO BE TRANSLATED INTO U.S. DOLLAR USING THE CURRENCY EXCHANGE RATE AS OF THE DATE OF PURCHASE CREATES AN UNCONSTITUTIONAL TAX, SINCE NO U.S. DOLLARS WERE EXCHANGED FOR POUNDS STERLING ON THE PURCHASE AND NO FOREIGN EXCHANGE GAIN WAS REALIZED.

*2 II. WHETHER THE IMPOSITION OF TAX ON THE UNREALIZED CURRENCY EXCHANGE GAIN ON THE SALE OF THE RESIDENCE AND THE DISALLOWANCE OF THE CURRENCY EXCHANGE LOSS ON THE MORTGAGE LOAN PAYOFF UNDER THE SEPARATE TRANSACTION RULE CREATES AN UNCONSTITUTIONAL TAX ON THE TAXPAYERS' SALE TRANSACTION.

STATEMENT OF THE CASE

This is an action for the refund of an overpayment of the taxpayers' 1990 federal income tax. The taxpayers assert that Revenue Ruling 54-105 imposed a tax upon an unrealized foreign exchange gain as a result of their purchase, financing and sale of a personal residence in the United Kingdom.

The taxpayers timely filed a joint tax return for the 1990 tax year reporting the gain on the sale of their United Kingdom residence. The gain reported included a tax on the exchange gain that resulted from the application of Revenue Ruling 54-105 requiring that the purchase price of the residence be translated into U.S. dollars using the currency exchange rate as of the date of purchase, even though there was no actual exchange of U.S. dollars for pounds sterling for the purchase.

On December 2, 1991, within the time allowed for filing an amendment to the original tax return, the taxpayers filed an amended joint federal income tax return for the year 1990 *3 with the Internal Revenue Service. The amended return sought a refund of the overpayment of $30,610, the amount of taxes on the unrealized exchange gain. On January 14, 1994, after a review of the taxpayers' amended return, the Commissioner of the Internal Revenue Service (the "Commissioner") refused to remit to the taxpayers the $30,610 overpayment.

On December 5, 1994 the taxpayers filed a complaint against the Commissioner in the District Court for the District of Maine. In the complaint the taxpayers sought recovery of the $30,610 they overpaid. The taxpayers filed a motion for Summary Judgment. The Commissioner filed a motion for Partial Summary Judgment, which acknowledged an adjustment of $2,668 in favor of the taxpayers. The adjustment resulted from the Commissioner recomputing the basis using the respective exchange rate as of the date of payment for each payment for improvements on the property. On November 14, 1995, the United States Magistrate Judge, the Honorable David Cohen, recommended that judgment be entered for the taxpayers in the amount of $2,668. The taxpayers objected to the Magistrate Judge's recommendation.

On December 15, 1995, the Chief Judge, the Honorable Gene Carter, issued an Order Affirming the Recommended Decision of The Magistrate Judge. On December 19, 1995, Judgment was entered in accordance with the Order Affirming the Recommended Decision of the Magistrate Judge.

*4 This Appeal from the final judgment and from the December 19, 1995 order, was noticed on January 4, 1996. The case was entered here on January 23, 1996.

STATEMENT OF FACTS

The taxpayers bought a residence in London, England on September 30,1986 for 297,500 Pounds Sterling ("pounds") (ADD-11). They financed the purchase in full with a mortgage loan in pounds (ADD-11). While they owned the residence, the taxpayers made capital improvements totalling 45,647 pounds (ADD-11). At no time did they use United States dollars to purchase or improve the residence (ADD-12). They refinanced the mortgage loan for 330,000 pounds on October 12, 1988, and again for 330,180 pounds on March 27, 1990 (ADD-11). On July 27, 1990, the taxpayers sold the residence for a net price of 453,374 pounds (ADD-12).

The taxpayers included $308,811 in capital gain from the sale of the residence in their original federal tax return for 1990 (ADD-11). To determine the gain on the sale, the taxpayers translated their cost and selling price of the residence into U.S. dollars using the currency exchange rate as of the date of purchase and date of sale, respectively (ADD-12). The taxpayers thereafter filed a timely amended federal return for 1990 claiming a reduction in the capital gain from $308,811 to $199,491 resulting in a tax refund claim of $30,610 (ADD-11). To translate the cost *5 of the residence into U.S. dollars for the amended return, the taxpayers used the currency exchange rate as of the date of sale (ADD-12). On January 14, 1994, after reviewing the taxpayers' amended return, the Commissioner refused to remit to the taxpayers the $30,610 they claim to have overpaid. (ADD-12).

STANDARD OF REVIEW

This Court reviews district court grants of summary judgment de novo. Clark III v. United States, 76 AFTR 2d. 95-6091. This standard of review is the same for both issues presented in this case.

ARGUMENT

"... [A]fter looking everywhere for the Queen... [Alice] thought she would try the plan, this time, of walking in the opposite direction.

It succeeded beautifully. She had not been walking a minute before she found herself face to face with the Red Queen, and full in sight of the hill she had been so long aiming at."

Lewis Carroll, Through the Looking Glass, and What Alice Found There, 34-35, (Alfred A. Knopf, Inc., 1984) (MacMillan and Co., London, 1872)

The Commissioner, like Alice, has stepped through the Looking-Glass. The Commissioner has concluded as a matter of law, that, because the taxpayers must translate the gain on the sale of their residence into U.S. dollars using the Commissioner's rule, the taxpayers have an economic gain *6 resulting from the translation. The taxpayers argue that there must first be a real economic gain. Congress and the Commissioner can then decide when and how the real economic gain shall be taxed.

I. COMMISSIONER'S REVENUE RULING 54-105 REQUIRING THE PURCHASE PRICE OF THE TAXPAYERS' RESIDENCE TO BE TRANSLATED INTO U.S. DOLLARS USING THE CURRENCY EXCHANGE RATE AS OF THE DATE OF PURCHASE CREATES AN UNCONSTITUTIONAL TAX, SINCE NO U.S. DOLLARS WERE EXCHANGED FOR POUNDS STERLING ON THE PURCHASE AND NO FOREIGN EXCHANGE GAIN WAS REALIZED.

A. THE CAPITAL GAIN FROM THE SALE OF A CAPITAL ASSET IS THE AMOUNT REALIZED OVER THE ADJUSTED BASIS.

Sections 61(a) and (a)(3) of the Internal Revenue Code (the "Code") provide that gross income includes "gains derived from dealings in property." Section 1001(a) of the Code defines the gain from the sale of property as "the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain." Section 1012 provides that "the basis of property shall be the "cost of such property..." Section 1016(a)(1) provides that adjustment shall be made in all cases for "expenditures, losses, or other items properly chargeable to capital...."

The "amount realized" from the sale of the residence by the taxpayers was 453,374 pounds. (ADD-12). The "cost of the property" was the purchase price of 297,500 pounds. (ADD-11). The cost of capital improvements totalled 45,647 *7 pounds. (ADD-11). The total "cost of such property" was 343,147 pounds. The taxpayers realized a gain of 110,227 pounds from the sale of the residence, the "amount realized" of 453,374 less the "cost" of 343,147 pounds. (ADD-11). Viewing the transaction in the foreign currency in which it was transacted, the taxpayers "derived a gain from dealings in property" of 110,227 pounds, ($199,491 as translated into U.S. dollars in the Amended Return. (ADD-11). The tax on the actual appreciation realized is not in dispute.

B. FOR PURPOSES OF DETERMINING THEIR U.S. TAX CONSEQUENCES, THE TRANSACTIONS IN ISSUE MUST BE TRANSLATED INTO U.S. DOLLARS

Prior to the collapse of the Bretton Woods Agreement in the early 1970's the value of all currencies were fixed in terms of gold. Following the collapse of the Agreement, the U.S. dollar was allowed to fluctuate against foreign currencies creating a need to determine how best to account for transactions involving foreign currencies for U.S. tax purposes. In the Tax Reform Act of 1986, Congress codified the rules applicable to U.S. taxation of transactions involving foreign currencies by adding Subpart J, "Foreign Currency Transactions", to the Code.

Section 985(a) of Subpart J of the Code provides: "Unless otherwise provided in regulations, all determinations under this subtitle shall be made in the taxpayer's functional currency." The "functional currency" *8 of an individual taxpayer is the United States dollar if the taxpayer's transactions do not meet the definition of a "qualified business unit." An activity is not a "qualified business unit" if it does not generate expenses deductible as trade or business expenses under section 162 of the Code or production of income expenses under section 212. See Treas. Reg. § 1.989(a)-1(c). The taxpayers' transaction generated neither section 162 (trade or business) nor section 212 (production of income) expenses and, therefore, is not a "qualified business unit". The taxpayers' functional currency for the sale of their residence is the U.S. dollar since the regulations do not provide otherwise.

The sale of the residence is a closed transaction. For United States tax purposes, U.S. taxpayers' [FN1] must account for their transactions in United States dollars. When transactions are denominated in a foreign currency, a U.S. taxpayer must translate the transactions into U.S. dollars for purposes of determining the U.S. tax consequences of those transactions. See Rev. Rul. 74-222, 1974-1 C.B. 21.

FN1. U.S. taxpayers include all U.S. citizens wherever they reside and foreign nationals who become resident aliens by meeting either the U.S. lawful permanent resident test or the substantial presence test of section 7701(b).

The statutory scheme of Subpart J of the Code requiring that transactions be accounted for in the taxpayer's functional currency does not give guidance on how these transactions are to translated into U.S. dollars. Although *9 section 985(a) allows the Commissioner to promulgate regulations giving guidance to individual taxpayers on how these transactions are to be accounted for, regulations have been neither promulgated nor proposed. In the absence of both statutory and regulatory guidance, the source of the principles relevant to transactions involving foreign currency of individuals are embodied in a series of court cases and revenue rulings issued by the Internal Revenue Service ("IRS"). [FN2]

FN2. See S. Rep. No. 999-313, 2d Sess., 99th Cong. (1986), reprinted in 1986-3 C.B. 1, 433. In general no pre-1986 studies or treatises discuss transactions of individuals involving foreign currency in any depth. See, e.g., The American Bar Association, Report on the U.S. Treasury Department Discussion Draft on Taxing Foreign Exchange Gains and Losses, 36 Tax L. Rev. 425 (1981) which states: "In general, the draft applies to business transactions of business taxpayers, but not to dealers, investors, or employees." Id. at 428.

C. THE APPLICATION OF REVENUE RULING 54-105 TO TRANSLATE THE GAIN CREATES A TAX ON AN UNREALIZED GAIN.

As a general principle of taxation, the taxation of transactions involving foreign currencies should theoretically be no different from the taxation of other transactions. Confusion results, however, when general tax principles and the various sections of the tax code applicable to domestic transactions are applied to transactions involving foreign currencies. This is particularly the case in the *10application of Revenue Ruling 54-105 to translate the gain derived from the sale of assets involving foreign currency. Revenue Ruling 54-105 provides:

"For the purposes of determining the gain, the cost and selling price of the property should be expressed in American currency at the rate of exchange prevailing as of the date of the purchase and the date of the sale, respectively." [FN3] Rev. Rul. 54-105, 1954-1 C.B. 12.

FN3. The ruling applies specifically to "gains realized on the sale of items of personal property, which are the personal property of the taxpayer, such as personal automobiles or television sets, in a foreign country by a United States citizen living abroad." The rule is applied by the Commissioner to all transactions involving taxpayers whose functional currency is the U.S. dollar. The rule is applied to U.S. citizens who reside in the United States and have transactions abroad involving foreign currency. The rule also applies to transactions involving foreign currency of resident aliens wherever they reside. The rule, which may have been correct in the context in which it was issued, has become unreasonable in the context in which it applies more than 40 years later.

For purposes of determining U.S. taxes, Revenue Ruling 54-105 applies to foreign currency translations regardless of whether or not the taxpayers engaged in a foreign currency transaction.

For U.S. tax purposes, foreign currency is not money; it is a fungible commodity treated as personal property. See, e.g. Rev. Rul. 74-7, 1974-1 C.B. 198 superseding I.T. 3810, 1946-2 C.B. 55, in which a U.S. citizen converted U.S. dollars into foreign currency and then subsequently converted the foreign currency back into U.S. dollars following travel abroad. As personal property, foreign currency has a fair market value in U.S. dollars that *11 changes daily. A foreign currency transaction occurs whenever foreign currency is purchased, sold, or exchanged in the form of cash or other cash equivalents, but the translation of foreign currency into U.S. dollars is not a foreign currency transaction.

The gain resulting from a foreign currency transaction should be different from a situation involving only foreign currency translations. For example, had the taxpayers converted U.S. dollars to pounds for the purchase of their residence they would have been engaged in a foreign currency transaction. For a foreign currency transaction, the basis of foreign currency purchased is determined using the exchange rate as of the date of the purchase of the currency in accounting for any profit or loss resulting from the subsequent payment of the foreign currency. See Church's English Shoes, Ltd, 24 T.C. 56 (1955), aff'd 229 F. 2d 957 (2nd Cir. 1956) in which the taxpayer was speculating in foreign currency. See Stephen J. McGarry, The Taxation of Exchange Gains and Losses: A Road Map, The International Tax Journal, page 26, Vol 14:7, (1988) for further explanation of foreign currency translations and transactions.

It is important to note that the instant case involves a foreign currency translation and not a foreign currency transaction. Foreign currency translations involve the translation of the events of taxpayers' transaction, the *12 sale of their residence, into U.S. dollars for purposes of determining their U.S. tax on the transaction in accordance with Revenue Ruling 54-105. The relevant events of taxpayers' transaction were: 1) the borrowing of a mortgage loan in pounds, 2) the purchase a residence for their personal use, the purchase price of which was paid in pounds with the loan proceeds, 3) the payment of each individual cost of improvement in pounds (See Exhibit A in (ADD-13)), 4) the refinancing of the taxpayers' mortgage loan in pounds, 5) the sale of the residence, the sale price of which was paid in pounds, and 6) the payoff of the mortgage loan in pounds with proceeds from the sale.

The taxpayers derived a gain on the sale of their residence of 110,227 pounds. In order to determine the capital gain from the sale of a capital asset purchased and sold in a foreign currency, a taxpayer is required by Revenue Ruling 54-105, to first translate the purchase price and cost of improvements into U.S. dollars using the currency exchange rate prevailing as of the date of purchase and date of payment for each respective cost of improvement. The ruling requires that the selling price be translated separately into U.S. dollars using the currency exchange rate as of the date of sale. The taxpayer must determine the gain by subtracting the purchase price and costs of improvements in U.S. dollars from the selling price in U.S. dollars. If there has been a change in the currency *13 exchange rate between the date of the purchase, or the date of payment of any respective cost of improvement, and the date of sale, the resulting gain will include an exchange gain or loss, as the case may be.

The Commissioner has imposed a tax on an unrealized exchange gain by requiring the taxpayers to translate the gain on the sale of their residence in accordance with Revenue Ruling 54-105. Using the Commissioner's rule, the gain on the sale of the property is $308,811, the gain as reported on the original return (less the adjustment allowed by the Commissioner that resulted in a tax refund of $2,668 (ADD-01)). The difference between the gain of $308,811 (as adjusted) determined under Revenue Ruling 54-105 and the net gain in pounds as submitted of $199,491 in the Amended Return is the unrealized gain caused by the application of Revenue Ruling 54-105. [FN4]

FN4. Had the taxpayers sold their house for 343,147 pounds, their purchase price plus the cost of improvements, the Commissioner would have nevertheless imposed a tax on the sale. The taxable gain under Rev. Rul. 54-105 would have been an unrealized exchange gain of over $100,000 (343,147 pounds times 1.82, the date of sale exchange rate, less 343,147 pounds times 1.49, the date of purchase exchange rate, less the Commissioner's adjustments.)

D. THE TAX IMPOSED ON THE UNREALIZED GAIN RESULTING FROM APPLYING REVENUE RULING 54-105 TO THE TAXPAYERS' SALE IS UNCONSTITUTIONAL.

The Sixteenth Amendment to the Constitution declares that "Congress shall have the power to lay and collect taxes *14 on income, from whatever source derived...." In determining what constitutes income substance rather than form is controlling. Eisner v. MaComber, 252 U.S. 189 (1920). The Court in MaComber in attempting to define the ordinary meaning of income declared: "Income may be defined as the gain derived from capital, from labor or from both combined, provided it be understood to include profit gained through a sale or conversion of capital assets.... The Macomber Court elaborated further:

"Here we have the essential matter; not a gain accruing to capital, not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value proceeding from the property, severed from the capital however invested or employed, and coming in, being 'derived.' that is received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal;-that is income derived from property. Nothing else answers the description." Id. at 207.

Although subsequent Supreme Court and lower court decisions have somewhat narrowed the scope of Macomber, it is still useful in distinguishing gain from capital and its language deserves careful consideration.

In Commissioner v. Glenshaw Glass, 348 U.S. 426 (1955), the Supreme Court articulated a judicial definition of gross income which complements Congress' statutory definition of income from whatever source derived as found in code section 61(a). The court in Glenshaw Glass said:

"Here we have instances of undeniable ascensions to wealth, clearly realized, and over which the taxpayer's have complete dominion. [The circumstances of the acquisition] cannot detract from their character as taxable income to the recipients." Id. at 431.

*15 As defined in Glenshaw Glass, the term gain clearly reflects the notion that an accession to wealth occurs if the taxpayer gains economically from the transaction.

In the instant case the application of Revenue Ruling 54-105 to the taxpayers' sale results in the imposition of a tax upon events (i.e. the change in the value of the pound relative to the U.S. dollar) on which the taxpayers did not derive an undeniable ascension to wealth, clearly realized, and over which they had complete dominion. The taxpayers argue that, in fact, they received no gain, profit or economic benefit from the unrealized exchange gain resulting from the translation of their sale into U.S. dollars on which they paid a tax. The taxpayers acknowledge that they did receive an economic benefit from the sale of the property of 110,227 pounds ($199,491 as translated into U.S. dollars in the Amended Return (ADD-11)). The tax on that gain is not at issue.

It is well established that a taxpayer does not necessarily need to receive cash or property in order to realize income. The courts generally hold that realization occurs when the taxpayer takes the last step by which the economic gain comes to fruition. Helvering v. Horst, 311 U.S. 112 (1940). In Horst, the taxpayer attempted to avoid income by detaching interest coupons from underlying bonds and giving them to his son. The court said:

"But the rule that income is not taxable until realized has never been taken to mean that the taxpayer, even on *16 the cash receipts basis, who has fully enjoyed the benefit of the economic gain represented by his right to receive income, can escape taxation because he himself has not received payment of it from his obligor. The rule, founded on administrative convenience, is only one of postponement of the tax to the final event of enjoyment of the income, usually the receipt of it by the taxpayer, and not one of exemption from taxation where the enjoyment is consummated by some event other than the taxpayer's personal receipt of money or property. This may occur when he has made such use or disposition of his power to receive or control the income as to procure in its place other satisfactions which are of economic worth." Id. at 116.

In this case the taxpayers received neither cash nor property on the foreign currency translation. Nor did they dispose, receive, control or otherwise exercise any power over the unrealized exchange gain as a result of the foreign currency translation. In fact, the currency exchange rates that the taxpayers are compelled to use under Revenue Ruling 54-105 are fortuitous. They are completely outside the control of the taxpayers and are not subject to manipulation by the taxpayers. The only economic result to the taxpayers due to the foreign currency translation is the tax imposed by the Commissioner on the unrealized gain.

The taxpayers received no economic benefit from the unrealized currency exchange gain produced by translating the sale of their residence in accordance with Revenue Ruling 54-105. The Commissioner exceeds Constitutional authority by imposing a tax on such an unrealized gain. Gain that is "derived" from a translation rule cannot be subject to tax.

*17 II. THE IMPOSITION OF TAX ON THE UNREALIZED CURRENCY EXCHANGE GAIN ON THE SALE OF THE RESIDENCE AND THE DISALLOWANCE OF THE CURRENCY EXCHANGE LOSS ON THE MORTGAGE LOAN PAYOFF UNDER THE SEPARATE TRANSACTION RULE CREATES AN UNCONSTITUTIONAL TAX ON THE TAXPAYERS' SALE TRANSACTION.

A. THE APPLICATION OF REVENUE RULING 90-79, TO TRANSLATE THE BORROWING RESULTS IN AN UNREALIZED EXCHANGE LOSS.

Section 988 of Subpart J of the Code added by the 1986 Tax Reform Act describes the rules for determining foreign currency gain or loss. In discussing Section 988 of the Code, the Senate Report stated:

"[S]ection 988 is inapplicable to exchange gain or loss recognized by a U.S. individual resident abroad upon repayment of a foreign currency denominated mortgage on the individual's principle residence. The principles of current law would apply to such transaction."

In 1990, the Commissioner issued Revenue Ruling 90-79 based on pre-1986 law. Revenue Ruling 90-79 provides:

"An individual may not offset the gain (or loss) realized [emphasis added] on the repayment of a nonfunctional currency denominated mortgage loan used to finance the purchase of the residence. Rev. Rul. 90-79, 1990-2 C.B. 188."

Revenue Ruling 90-79 analyzes the U.S. tax consequences of the purchase and sale of a residence via a foreign currency loan similar to the facts of the taxpayer's transactions. In Revenue Ruling 90-79, an individual purchased a foreign personal residence financed by a foreign currency denominated loan and sold it for a gain several years later after the value of the foreign currency had increased in relation to the U.S. dollar. Although the *18 individual realized a gain on the sale of the residence, a loss resulted in the translation of the loan using the currency exchange rates as of the time of the initial loan borrowing and the time of the loan payoff, respectively.

The taxpayers' borrowing only involve a foreign currency translation as discussed previously. The first mortgage loan of 297,500 pounds was borrowed on September 30, 1986. (Add-11). The mortgage loan was transferred to BNP Mortgages Limited and the loan amount increased by 32,500 pounds on October 12, 1988. (ADD-11). As to the second mortgage loan refinancing, the loan was transferred to the Halifax Building Society and the amount of the loan increased by 180 pounds on March 27, 1990. (ADD-11,12). Applying Revenue Ruling 90-79 translation rule for the mortgage loans to the taxpayers' borrowing, the taxpayers had a net currency exchange loss on the borrowing of $101,736 as illustrated by Exhibit I. [FN5]

FN5. A literal application of Rev. Rul. 78-281, 1978-2 C.B. 204 results in an unrealized loss in 1988 on the refinancing of the first mortgage, an unrealized gain on the refinancing of the mortgage loan on March 27, 1990 and an unrealized loss on the mortgage loan payoff on July 27, 1990. Taking this rule to the extreme, had the taxpayers made monthly principle payments on their mortgages, they would have had a unrealized gain or loss, each time they made a monthly principle payment, even though they were living in a pounds economy making payment in pounds. See Rev. Rul. 78-281, Id. This rule would require U.S. taxpayers purchasing a residence in a foreign country to secure a mortgage loan denominated in U.S. dollars, thereby passing the risk of exchange gain or loss to the mortgagor, a risk few, if any, banks would assume.

*19 B. TAXPAYERS REALIZED NO ECONOMIC INCOME OR ECONOMIC LOSS AT ALL ON THE REPAYMENT OF ITS BORROWING

As discussed, foreign currency is considered property for tax purposes. Rev. Rul. 74-7, Id. Early cases involving borrowing in foreign currency recognized that the borrowing and subsequent return of the same property generally did not give rise to taxable income or loss. See, e.g. Bowers v. Kerbaugh-Empire Co. 271 U.S. 1970 (1926), and B.F. Goodrich Co. v. Commissioner, 1 T.C. 1098 (1943), acq. 1943-1 C.B. 10 (withdrawn), nonacq. 1974-2 C.B. 5. Gain or loss is realized and recognized when the taxpayer converts U.S. dollars into foreign currency and foreign currency to U.S. dollars in connection with the foreign currency borrowing and payoffs. See, e.g. Gillin v. the United States 423 F. 2d 309 (1970).

According to Revenue Ruling 90-79, the translation of the events of the taxpayers' purchase, sale and mortgage loans and payoffs in pounds results in unrealized gains and losses. The taxpayers neither gained nor lost economically from the change in the loan principal from one bank to another. [FN6] Nor did they suffer an economic loss on the loan payoff. The loss was "derived" from the Commissioner's Revenue Ruling 90-79 translation rule. The translation of the taxpayers' repayment of the mortgage loan resulted in an *20 unrealized exchange loss in the same manner that the Revenue Ruling 54-105 created an unrealized exchange gain as applied to the sale of the residence.

FN6. They may have gained economically from a reduction in the interest rates but those facts are not part of the record and the statement is mere conjecture.

C. SECTION 165(a) AND (c) DO NOT APPLY TO NON-ECONOMIC LOSSES.

Section 165(a) provides a deduction for any loss sustained during the taxable year and not compensated for by insurance or otherwise. I.R.C. § 165(a). Subsection (c) of Section 165, however, limits the deduction available to individuals 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; and (3) casualty and theft losses. I.R.C. § 165(c).

In allowing deductions for losses to individuals, the Code and Treasury regulations thereunder apply to real economic losses, i.e. losses "sustained" during the taxable year. Deductions are allowed to individuals for losses incurred in entered into to generate income, "a trade or business" or "any transaction entered into for profit." Additionally, individuals are allowed deductions for losses from events causing real economic loss: "fire, storm, shipwreck, or other casualty." Nothing in the regulations suggest that this section was intended to apply to a situation in which no economic loss was "sustained" in the first place. This argument is analogous to the holding of *21 Philip Morris v. Commissioner 104 T.C. 61 (1995), aff'd 76 AFTR 95-5773 (1995) where the court relied on the holding of United States v. Central Savings Bank FSB, 499 U.S. 573 (1991), in which the legislative intent did not allow the application of the tax deferral mechanism of section 108 to losses resulting from tax payer's foreign currency borrowing.

The taxpayers did not "sustain" an economic loss as a result of the payoff in pounds of their mortgage loans denominated in pounds. In applying section 165(c) to the payoff of a mortgage loan, Revenue Ruling 90-79 states: "An individual may not offset the gain (or loss) realized [emphasis added] on the repayment of a nonfunctional currency denominated mortgage loan used to finance the residence." As discussed above the taxpayers realized neither a gain nor a loss on the borrowing and loan payoffs. The unrealized loss was "derived" from Commissioner's translation rule. Taxpayers argue that section 165(a) was never intended to and does not apply to the unrealized exchange gains and losses.

D. THE APPLICATION OF THE SEPARATE TRANSACTION PRINCIPLE IN COMBINATION WITH THE COMMISSIONER'S TRANSLATION RULE RESULTS IN THE IMPOSITION OF AN UNCONSTITUTIONAL TAX ON TAXPAYERS' SALE TRANSACTION.

In the Tax Reform Act of 1986, Congress codified the rules applicable to U.S. taxation of transactions involving *22 foreign currencies. The Senate Report of the Act discussed the principles relevant to borrowing of taxpayers whose functional currency is the U.S. dollar:

"Foreign exchange gain or loss can arise in the course of a trade or business or in connection with an investment transaction. Exchange gain or loss can also arise where foreign currency is acquired for personal use. Under the so-called 'separate transactions principle,' both the courts and the IRS require that exchange gain or loss be separately accounted for, apart from any gain or loss attributable to an underlying transaction." [FN7]

FN7. S. Rep. No. 999-313, 2d Sess., 99th Cong. (1986), reprinted in 1986-3 C.B. 1, 433 (footnotes omitted).

The taxpayers' transaction (the sale of their residence, and the related mortgage transactions) are neither related to a trade or business nor connected with an investment transaction. Neither did they acquire foreign currency for personal use. The taxpayers borrowing did not involve a foreign currency transaction, i.e. the taxpayers did not exchange U.S. dollars for pounds or pounds for U.S. dollars.

The "separate transaction principle" referred to in the Senate Report was developed in the context of business transactions of business taxpayers. see, e.g. Rev. Rul. 78-281 Id., National Standard Co. v. Commissioner, 80 T.C. 551, 558 (1983), aff'd 749 F.2d 369 (6th Cir. 1984). However, the separate transaction principle was incorporated into Revenue Ruling 90-79. In that ruling, the individual *23 realized a gain on the sale of the residence that included both an appreciation gain and an unrealized currency exchange gain. However, an unrealized loss resulted from the repayment of the loan. Since the loss was not of a type described in section 165(c), the taxpayer was not allowed to deduct it. The Service held: "An individual may not offset the gain (or loss) realized [emphasis added] on the repayment of a nonfunctional currency denominated mortgage loan used to finance the purchase of the residence." Rev. Rul. 90-79, 1990-2 C.B. at 188.

As support of Revenue Ruling 90-79 the Service cites the case of Willard Helburn v. Commissioner, 20 T.C. 740, aff'd 214 F.2d 815 (1st. Cir. 1954). In Helburn, the taxpayer purchased lambskins at a fixed price in pounds. The price in pounds was paid at the exchange rate which was in effect during the negotiations and at time of the sale. To pay for the lambskin the taxpayer borrowed pounds. The loan was for a period of 120 days. During this 120 day period the U.S. dollar appreciated. Accordingly, to repay the borrowed pounds, the taxpayer was able to convert less U.S. dollars to pounds then the taxpayer would have had when the loan was granted. As a result, the taxpayer received an economic benefit from the loan transaction.

The Court in Helburn, determined that there were two possible tax consequences resulting from this purchase of inventory with foreign funds. The first consequence would *24 look at the whole arrangement as an integrated transaction. The second consequence would be to look at the purchase of goods separately from the financing of these goods. The court determined that since the taxpayer had involved itself in speculation of foreign currency, the transaction should be viewed in two parts. Id. at 1836. Here taxpayers argue that since they were not involved in foreign currency speculation and, in fact, had no foreign currency transaction related to their sale, the Court should disregard the separate transaction rule and view the transaction as an integrated transaction. Viewing the transaction as an integrated transaction, the taxpayers' residence was fully financed in pounds throughout their ownership period. When the residence was sold and the underlying mortgage was paid off from the sale proceeds, the unrealized gain on the sale was offset by the unrealized loss on the mortgage payoff.

The taxpayers argue that the proper rule on realization has more recently been addressed by the Tax Court in Philip Morris, Inc. v. Commissioner, Id. Philip Morris involved the proper treatment of gains resulting from the use of foreign currency, the value of which changed in relation to U.S. dollars, between the dates of borrowing and repayment in the same currency. In finding for the Commissioner, the Court discussed the gains and losses related to foreign currency obligations as follows:

*25 "The conclusion that the occasion may differ from the reason for realization finds support in the fact that petitioner would have no taxable gain absent its conversion of the proceeds of the borrowing to, and the obtaining of the means of repayment from, U.S. dollars. If the foreign currency had not been exchanged, and instead held in its own borrowed form, petitioner would have had a loss (albeit unrealized) on the value of its currency in hand exactly offsetting the economic gain (albeit unrealized) from repayment in a devalued currency, and thus no gain or loss for tax purposes. Willard Helburn v. Commissioner, 20 T.C. 740, 743 (1953), affd. 214 F.2d 815 (1st Cir. 1954); see National Standard Co. v. Commissioner, 80 T.C. at 569 n. 4 (Tannenwald, J., dissenting) ('the value at the time of borrowing and the cost of acquisition would be the same'). Petitioner has taxable gain on the occasion of the discharge of its indebtedness but only because it exchanged the foreign currency for U.S. dollars (the reason)." Id.

Taxpayers ask the Court to find that the application of the Rulings cited are both unreasonable and unconstitutional when applied to taxpayers' transaction.

Revenue Procedure 89-14, which restates the objectives of and sets forth the standards for the publication of revenue rulings and revenue procedures in the Internal Revenue Bulletin, defines a "revenue ruling" as:

"an official interpretation by the Service of the internal revenue laws and related statutes, treaties, and regulations." Rev. Proc. 89-14, 1989-1 C.B. 814, superseding 86-15, 1986-1 C.B. 544.

As discussed by the Federal Court in CenTra, Inc. et al. v. U.S., 953 F.2d 1051 (6th Cir. 1992), "Once an agency's interpretation of a statute it administers is established, that interpretation is entitled to deference." CenTra, Inc. et al. v. U.S., Id. at 1055. In *26Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 104 S.Ct. 2778, 81 L.Ed.2d 694 (1984), the Supreme Court explained how a court should treat agency interpretation of statutes within the agency's ambit:

"When a court reviews an agency's construction of the statute which it administers, it is confronted with two questions. First, always, is the question whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress. If, however, the court determines Congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute, as would be necessary in the absence of an administrative interpretation. Rather, if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency's answer is based on a permissible construction of the statute." 467 U.S. at 842-843, 104 S. Ct. at 2781-2782.

In the case at hand, Congress did not address the precise issue of how a gain on an asset purchased and sold in foreign currency by an individual whose functional currency is the U.S. dollar should be translated for U.S. tax purposes.

As stated by the Court in Foil v. Commissioner, 920 F.2d 1196 (5th Cir. 1990), "IRS Revenue Rulings do not have the force of law, and are not binding on this court. Stubbs. Overbeck & Associates, Inc. v. United States, 445 F.2d 1142, 1146-47 (5th Cir. 1971). Accordingly, we will disregard a Ruling if the Ruling conflicts with the statute it supposedly interprets, with the statute's legislative history, or if the Ruling is otherwise unreasonable. See *27 Brook, Inc. v. Commissioner, 799 F.2d 833, 836 n.4 (2nd Cir. 1986)."

Taxpayers argue that the Court should not uphold a revenue ruling which imposes an unconstitutional tax on the taxpayers' sale of their residence.

CONCLUSION

The taxpayers received no economic gain from the unrealized currency exchange gain derived from Commissioner's translation rule as applied to the sale of their residence. The Commissioner has imposed an unconstitutional tax of $30,610 (as adjusted) on the unrealized gain derived from the translation. In addition, the taxpayers neither benefitted from nor suffered economically from their loan borrowing and payoffs. Section 165 does not apply to non-economic losses. Revenue Ruling 90-79, combining the Commissioner's translation rule, the separate transaction rule, and the application of section 165 to a non-economic loss results in an unconstitutional tax on the taxpayers' transaction.

It is time for the Commissioner to step back through the Looking-Glass.

*28 Therefore, for the reason explained above, the taxpayers request that this Court to order the Commissioner to remit the net overpaid tax of $27,942 plus interest to the taxpayers.

Appendix not available.