The opinion
T.C. Memo. 1996-293
UNITED STATES TAX COURT
WALLY FINDLAY GALLERIES INTERNATIONAL, INC. AND SUBSIDIARIES,
Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15292-94. Filed June 24, 1996.
W's foreign subsidiary F was insolvent for many
years. When economic instability greatly exacerbated
F's financial problems, W wrote off F's intercompany
debt and its investment in F's stock, but continued to
operate F for 3 more years in the hope that F could be
sold as a going concern or that its assets would
increase in value. Held: Deductions for bad debts and
worthless stock on the consolidated return of W's
affiliated group were properly disallowed.
John J. Quinlisk, Anne Showel Quinn, and Patrick J. Bitterman,
for petitioners.
Russell D. Pinkerton, for respondent.
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MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: Petitioners sought redetermination of
deficiencies in their Federal income tax for the taxable years
ended September 30, 1981 (FY 1981) and September 30, 1982 (FY
1982) in the amounts of $620,347 and $85,612, respectively. The
deficiencies are attributable to the carryback of a net operating
loss arising from two deductions claimed on petitioners'
consolidated return for FY 1984. We must decide: (1) Whether
petitioners are entitled to a deduction under section 166(a)(1)1
with respect to accounts payable by a foreign subsidiary that
were canceled in FY 1984; and (2) whether petitioners are
entitled to a deduction under section 165(g) for loss of their
investment in the foreign subsidiary. We hold that neither
deduction was proper.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulations of fact and attached exhibits are incorporated
herein by this reference. Petitioners are an affiliated group of
corporations of which Wally Findlay Galleries International, Inc.
(WFGI), is the parent. At the time the petition was filed WFGI's
principal office was located in Chicago, Illinois. During FY
1
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the taxable years at issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
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1981 through FY 1984 (taxable years at issue) WFGI was engaged in
the acquisition and sale of works of fine art through art
galleries located in New York City, Palm Beach, Chicago, Beverly
Hills and Paris, France. Operations in Paris were conducted in
the form of a French limited liability company, Wally Findlay
Galleries International, S.A.R.L. (French subsidiary), of which
WFGI owned 99 percent and a domestic subsidiary owned the
remaining 1 percent. The French subsidiary commenced operations
in 1971. The French subsidiary performed a number of functions
for the corporate group (Wally Findlay Group). It operated two
Paris art galleries for exhibition and sale of paintings from
WFGI's inventory. The advantages of the Paris location and a
series of highly celebrated exhibitions in the early years served
to enhance WFGI's international reputation. The French
subsidiary also served as the international buying office for the
Wally Findlay Group. The WFGI annual report for the first year
of the French subsidiary's operations explained the benefits
expected from this arrangement:
Working from this office in the midst of the European
art market, our ability to acquire important French
Impressionist and Post-impressionist paintings, a vital
factor in our sales, has been greatly improved. At the
same time, our contacts with contemporary artists have
been expanded. For the first time, we are in a
position to work closely year-round with the European
based artists whom we represent exclusively and to
review new artists. This makes it possible to control
our inventory and to schedule a more far-reaching
program of exhibitions for all our galleries.
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The French subsidiary also handled shipping and customs
clearance for paintings acquired in Europe for the U.S. art
galleries. Although a resident manager oversaw operations, all
major decisions concerning the French subsidiary were made by the
officers of WFGI.
The principal asset of the French subsidiary was a long-term
lease for the premises it used for its business. The premises
comprised a handsome 18th-century townhouse at 2, Avenue
Matignon, and space in the basement and first floor of an
adjoining building at 48, Avenue Gabriel. The leased property
was located in a prestigious district of the city and enjoyed
high security owing to the proximity of the French president's
residence. Although the stated term of the lease was 9 years,
owing to restrictions under French law on the landlord's ability
to withhold his consent to renewal, it was effectively renewable
indefinitely at the lessee's option. The rent was adjusted once
in every 3-year period, or trimester, according to a statutory
formula based on the cost of living. Presumably because of legal
restrictions on the rental market, the fair-rental value of
desirable commercial space in Paris tended substantially to
exceed the rent. Thus, to acquire its premium lease in 1969, the
French subsidiary paid the prior tenant FF 1,445,250, or $262,773
at the then-current exchange rate of 5.5 francs per U.S. dollar.
The French subsidiary made extensive renovations and structural
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improvements to the property at great expense. These investments
would likely have enhanced the premium value of the lease. Not
long after the opening of its gallery at the Avenue Matignon
address, the French subsidiary entered into a second lease for
the use of display space in the Hotel George V. The record does
not disclose the terms of this lease or the amount of any costs
that the French subsidiary may have incurred for acquisition or
improvements.
Most of the paintings offered for sale at the Paris gallery
had been acquired from WFGI on consignment. During the years at
issue, when one of these paintings was sold, the parent would
record a sale of the painting to the subsidiary at 65 percent of
the net retail price, and the subsidiary would record this amount
as its cost for the painting. Amounts due WFGI on account of the
subsidiary's sales were payable in U.S. dollars translated at the
exchange rate prevailing at the time of sale. On the other hand,
amounts earned by the subsidiary as commissions for purchasing,
shipping, and export services on behalf of the parent were
payable in francs. The cost of sales account payable to the
parent and the commissions account payable to the subsidiary were
the two major components of the overall intercompany account
during the years at issue.
No promissory notes were executed to evidence indebtedness
on the intercompany account. There was no stated maturity date,
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no interest accrued, and no security was provided. Under the
memorandum of agreement executed in 1971, which governed their
relationship, the subsidiary was required to remit amounts
payable to the parent “as promptly as practicable.” In practice,
WFGI permitted the French subsidiary to retain WFGI's 65-percent
share of sale proceeds to pay other creditors and finance its
working capital needs generally. Although the French subsidiary
made payments from time to time, the intercompany account showed
a substantial balance due WFGI in every year from FY 1971 to
FY 1984.
Intercompany Account Balance Payable to WFGI
FY Balance FY Balance FY Balance
1971 $1,179,903 1976 $354,165 1981 $885,013
1972 629,622 1977 453,777 1982 630,466
1973 991,735 1978 348,369 1983 1,026,143
1
1974 890,779 1979 286,419 1984 1,061,425
1975 707,021 1980 990,982
1
Prior to cancellation as of September 30, 1984.
Owing to the large and persistent intercompany debt, the
French subsidiary's balance sheets showed a deficit in
shareholder's equity in every one of these years as well.
Consequently, to have caused the subsidiary to pay greater
amounts to the parent would have jeopardized the subsidiary's
ability to continue paying its debts to third parties. The
officers of WFGI believe that any action by the parent company
that caused the subsidiary's insolvency to become publicly known
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would seriously injure the reputation of the Wally Findlay Group
as a whole.
The French subsidiary suffered from a chronic insufficiency
of earnings. Between FY 1971 and FY 1984, the business was
profitable in only 2 years, FY 1973 and FY 1980. The success
achieved in the latter year was, in large part, attributable to
the patronage of Arab customers looking for ways to invest the
large cash balances that had been generated by a sharp rise in
oil prices. The emergence of this new clientele was cause for
optimism: WFGI's officer's hoped that the French subsidiary
would finally be able to sustain itself. But the high oil prices
proved unsustainable and Arab demand did not fulfill
expectations. After FY 1980 sales were uneven.
Sales by the French Subsidiary
FY FF
1980 10,878,545
1981 10,195,912
1982 6,849,060
1983 11,574,743
1984 6,177,305
The pattern of losses resumed in FY 1981. In FY 1982 the
subsidiary reported the largest loss in its history. The
subsidiary's accountants advised WFGI that in view of the large
loss experienced in FY 1982 it seemed unlikely that the deficit
in shareholder's equity would be eliminated in the next 2 years,
and warned that under these circumstances they were required by
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French law to notify the French authorities of the company's
financial situation, which could result in a judicial declaration
of insolvency and involuntary liquidation proceedings. They
recommended that WFGI capitalize the intercompany account in
order to cure the deficit.
Sales recovered in the next fiscal year, exceeding the level
attained in FY 1980. Nevertheless, the French subsidiary
reported another large loss. The consolidated financial
statements of the group for FY 1981 through FY 1983 attributed
40 percent of the cumulative losses sustained by the French
subsidiary during this period to losses in currency exchange
transactions caused by the appreciation of the U.S. dollar
against the franc.
A series of events in FY 1984 compounded the French
subsidiary's problems. For many years the company's accounts at
Banque de la Cite had been continuously overdrawn. The bank had
honored overdrafts, charging interest on the funds beginning in
1982. In February 1984 the French subsidiary was asked to
transfer a Rouault painting from its collection to the bank as
security. In March the bank announced that it would no longer
honor checks drawn on the subsidiary's accounts without a
guarantee from the parent. WFGI acceded to the bank's demand,
arranging for its own bank in the United States to issue a letter
of credit on behalf of the French subsidiary.
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In July 1984 the subsidiary's accountants discovered that
FF 108,000 (approximately $11,000 - $12,000 at then-current
exchange rates) attributable to cash transactions was missing.
WFGI's officers concluded that the funds had been embezzled by
the subsidiary's resident manager. The money was never
recovered. The manager left the company before the end of the
fiscal year, pursuant to a settlement agreement involving a
mutual release of claims and an additional payment by WFGI of
$22,000.
In July an artist doing business as Selene Ltd. filed suit
against the French subsidiary, seeking payment of $25,500
allegedly due to him as his share of the sale price of two
paintings. Having investigated the financial capacity of the
subsidiary and learned that it was technically insolvent, he
requested a declaration of insolvency and involuntary liquidation
of the company to satisfy his claim.
As the fiscal yearend approached, the officers of WFGI
expected that the results for the year would again show a large
loss. Moreover, despite payments to the parent by the subsidiary
during the years at issue totaling more than $1.5 million, the
intercompany account balance had reached its highest level since
the first year of operation. A special meeting was convened on
September 20, 1984, to consider the possibility of dissolving the
French subsidiary. For reasons that are not clearly articulated
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in the minutes, it was decided that the subsidiary should
continue business in spite of its losses. In October the
officers of WFGI traveled to Paris, where they discussed the
French subsidiary's situation with its accountants and legal
counsel. Upon their return, acting in their capacity as the
executive committee of the board of directors of WFGI, they
adopted a resolution canceling the outstanding indebtedness of
the French subsidiary reflected in the intercompany account as of
September 30, 1984, $1,061,425. The resolution was made
retroactive to the last day of FY 1984. In support of their
action, they cited the subsidiary's disappointing sales during
the year and its present insolvency; the parent's intervention to
maintain the subsidiary's line of credit at Banque de la Cite;
the defalcations of the local manager; the warnings they had
received from the subsidiary's accountants and counsel that its
capital must be increased in order to avert involuntary
liquidation under French law; and the threat that Selene's
lawsuit would lead to insolvency proceedings. They concluded:
the French Subsidiary is not now able to pay its
indebtedness to its parent corporation, * * * that
there is no basis for believing that such indebtedness
will be paid within the foreseeable future, and that
the only realistic way to deal with the potential
problems regarding other creditors and with the French
Government is for the French Subsidiary's indebtedness
to the parent corporation to be cancelled.
The subsidiary's financial statements for FY 1984 were
available by December 1984. They showed a heavy loss for the
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year before taking income from discharge of indebtedness into
account. Foreign exchange losses were again a substantial
component. The financial statements also showed that the company
was technically insolvent by $26,228 even after cancellation of
the intercompany debt. In no previous year had liabilities to
third parties exceeded assets. In March 1985 WFGI received the
results of an “accrual review” performed by its accountants to
determine an appropriate provision for taxes on the consolidated
financial statements for FY 1984. In the opinion of the
accountants, after cancellation of the intercompany debt the
subsidiary remained insolvent on a “fair market value liquidation
basis” as of September 30, 1984. In other words, if the assets
were sold at their fair market value, the amount realized would
not be sufficient to satisfy the remaining debts to third
parties. There is no indication that an independent appraisal
was performed to ascertain the fair market value of the assets.
Rather, the result turned on a determination that the book value
of the assets was not likely to understate their fair market
value by more than the “couple hundred thousand dollars” of
additional liabilities for administrative and legal costs,
severance payments, Social Security, taxes and the like, that
would be incurred in a liquidation. The conclusion of the
accrual review was that it would be reasonable for tax purposes
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to treat both the intercompany debt and the stock of the French
subsidiary as wholly worthless as of the close of FY 1984.
On their consolidated U.S. Corporation Income Tax Return for
FY 1984, filed June 20, 1985, petitioners claimed a deduction in
the amount of $1,663,237, consisting of the balance of the
intercompany account ($1,061,425) and the basis in the French
subsidiary's stock ($601,812) on September 30, 1984. The amount
written off as a bad debt had been accrued as receipts by WFGI
and included in consolidated income in prior years. The French
subsidiary reported income from discharge of indebtedness on its
French income tax return. This income was fully offset by prior
net operating losses and created no tax liability.
Notwithstanding their determination that the French
subsidiary was hopelessly insolvent, its stock worthless and the
intercompany account uncollectible, the officers of WFGI adhered
to their decision to keep the subsidiary operating after FY 1984.
For the most part, intercompany business continued as usual. The
subsidiary continued to sell paintings on consignment from WFGI,
and the intercompany account, once again, showed an increasing
balance owed to the parent. The officers of WFGI considered ways
to reduce the subsidiary's expenses and hoped that the new
intercompany debt would be repaid out of higher sales. There is
evidence that WFGI did not expect this relationship would
continue indefinitely and intended to limit its support. In
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March 1985 it declined to provide the required annual
certification to the French government that it would support the
capital of its subsidiary. As a result, under French law the
subsidiary would automatically liquidate after 2 years. When the
letter of credit furnished to Banque de la Cite expired in
July 1985, WFGI did not renew it.
There were a number of reasons why WFGI chose not to
terminate the subsidiary, even at the risk of continued losses.
During and after FY 1984 the officers of WFGI were actively
soliciting offers for the purchase of the French subsidiary,
either alone or as a part of the entire Wally Findlay Group.
They evidently continued to believe that the French subsidiary
contributed to the market value of the group, and they received
expressions of interest in the French subsidiary from some
prospective buyers. It would not have made sense to liquidate
the subsidiary so long as selling it as a going concern was a
realistic possibility. On the other hand, if the subsidiary were
to be liquidated, the amount that could be realized from
assignment of the premium lease immediately after FY 1984 would
probably be less than its potential value. In the fall of 1984
the lease was in the third trimester of its second 9-year term.
Whoever held the lease thereafter would have to renegotiate it on
or before June 30, 1987, when the term expired. WFGI had been
advised by French counsel that a third party who acquired the
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lease from the French subsidiary in its third trimester would not
be able to renew on terms as favorable as the French subsidiary
itself could expect. Consequently, if the subsidiary attempted
to assign the lease before renegotiating it, no assignee would be
willing to pay as much for the lease as the opportunity cost to
the Wally Findlay Group of surrendering it. Another reason to
delay any assignment of the lease was that the French subsidiary
was involved in a dispute over the rights to certain areas in the
Avenue Gabriel building. Another tenant was using the disputed
areas for its restaurant. The results of an investigation by a
court-appointed expert in 1983 had supported the French
subsidiary's claim and prospects for regaining possession were
good, but until the litigation was concluded or settled the
marketability of the lease was impaired.
By the end of FY 1987 the officers of WFGI had not found a
buyer for the group as a whole or for the French subsidiary
separately. The subsidiary renewed the lease for a third term
and then disposed of it. In a complex multiparty transaction,
two-thirds of the premises were assigned by the subsidiary to a
Frenchman named Mr. Leadouze, and the other one-third was
assigned to WFGI. Mr. Leadouze paid FF 1.3 million for the
portion of the leasehold that he received. WFGI acquired its
portion of the leasehold at a cost of $253,461. The French
subsidiary ceased operations during FY 1987, a liquidator was
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appointed in October 1987, and liquidation procedures were
completed by 1990. WFGI continued to use the premises for a
purchasing office until 1995. At the time of trial, it still
retained the lease.
OPINION
1. Bad Debt
A deduction is allowed for a debt that becomes worthless
during the taxable year. Sec. 166(a)(1).2 A debt is worthless
when there is no longer any reasonable expectation of recovery.
Dallmeyer v. Commissioner, 14 T.C. 1282, 1292 (1950); Tejon Ranch
Co. v. Commissioner, T.C. Memo. 1985-207; Ruane v. Commissioner,
T.C. Memo. 1958-175. Because the determination of worthlessness
calls for the exercise of business judgment, courts have tested
the taxpayer's determination for the elements of sound business
judgment: consistency, the use of all available information, and
the reasonableness of the inferences drawn from the information.
See, e.g., Riss v. Commissioner, 478 F.2d 1160, 1166 (8th Cir.
1973), affg. in part 56 T.C. 388 (1971); Minneapolis, St. Paul &
Sault Ste. Marie R.R. Co. v. United States, 164 Ct. Cl. 226
(1964); Production Steel Inc. v. Commissioner, T.C. Memo. 1979-
361. Only bona fide indebtedness can give rise to a deduction
2
The authority of the Secretary to allow a deduction for
debts that are only recoverable in part is not at issue in this
case. See sec. 166(a)(2).
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under section 166. Dixie Dairies Corp. v. Commissioner, 74 T.C.
476, 493 (1980); sec. 1.166-1(c), Income Tax Regs. Petitioners
bear the burden of proof on all issues. Rule 142(a).
In her notice of deficiency, respondent disallowed
petitioners' deduction of the intercompany account balance in
FY 1984 on the grounds that either (1) the amounts reflected in
this account were contributions to capital rather than debts, or,
alternatively, (2) if they were bona fide debts, they did not
become worthless during FY 1984. Because we sustain respondent's
determination on the alternative ground that petitioners have not
shown that any debt evidenced by such amounts became worthless
during the relevant tax year, we need not reach the question of
the true character of the amounts at issue. For purposes of this
Opinion, we shall assume that they were debts.
Petitioners defend the determination of the officers of WFGI
that the intercompany debt was worthless largely for the same
reasons that the officers cited in support of it at the time. We
are not persuaded that those reasons prove that the debt became
worthless during FY 1984. They are marred by inconsistencies,
questionable inferences, and failure to use available information
of obvious importance.
In order to establish that the intercompany debt was
worthless, petitioners must prove that no portion of it was
reasonably recoverable. The excess of other liabilities over
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assets shown on the balance sheet for FY 1984 was $26,228. To
the extent that the balance sheet may have understated the amount
that could be realized upon the sale of the subsidiary or its
assets by more than $26,228, a portion of the intercompany debt
could have been recoverable.
WFGI's auditors opined that in the event that the French
subsidiary had been liquidated at the end of FY 1984, it would
have incurred additional liquidation liabilities of approximately
$200,000. Assuming this estimate to be correct, any
understatement of asset values on the balance sheet would have to
have been very large in order for sale of the subsidiary's assets
at the end of FY 1984 to have yielded enough to repay any of the
intercompany debt. Prompt liquidation, however, was only one of
the scenarios contemplated by WFGI's officers at the time, and
the least desirable. During and after FY 1984 they were actively
promoting the sale of the French subsidiary or the group as a
whole. There was sufficient expression of interest from
prospective buyers to support a reasonable expectation that
liquidation could be avoided. To have assumed that the
additional liabilities estimated by their auditors were
inevitable would not have been consistent with the expectations
driving the marketing efforts.
There are reasons to question whether the financial
statements accurately reflect the capacity of the French
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subsidiary to repay the parent's advances. Not all the assets of
the French subsidiary were stated on the balance sheet. Where a
business is sold as a going concern, there may be intangible
assets such as goodwill that enhance its value to the purchaser.
In a document apparently prepared for prospective buyers dated
January 1985, the value of the Wally Findlay Group is stated as
$41 million, of which approximately $11 million is accounted for
as “Trademark - Name Goodwill - etc.” In addition, an
unspecified amount of “goodwill” is included in the value
assigned to the New York gallery. Petitioners argue that none of
the approximately $11 million intangible value of the group is
attributable to the French subsidiary because ownership of the
tradename was held by the parent. If this logic were sound, then
presumably no goodwill would properly be attributable to the
New York gallery either. But there is reason to believe that the
French subsidiary contributed to the intangible value of the
group. Another promotional brochure entitled “Wally Findlay
Galleries International, SARL”, dated April 1986, contains
information believed to be of interest to prospective purchasers
of the “first important American gallery in Paris”. After
describing the inaugural exhibition in 1971, the brochure
summarizes achievements since that time:
This was the first of many spectacular
gala openings attended by European royalty,
the most socially prominent Parisians and
internationally known collectors. * * *
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A few of the many important names often
associated with the gallery in the press and
magazine articles are the Duke and Duchess of
Bedford, Prince Ranier and the late Princess
Grace of Monaco, the Duke and Duchess
d'Orleans, Baron and Baroness David de
Rothschild, * * *.
These openings and the enthusiastic
review of them have made Wally Findlay
Galleries, Paris, widely known in Europe. In
turn, this international recognition, added
to the longer established dominance of Wally
Findlay Galleries in America, has made Wally
Findlay Galleries a unique organization in
the art world.
Soon after the opening of the gallery at
2, Avenue Matignon, the second Wally Findlay
Galleries operation in Paris was established
at the George V Hotel. Here rotating
exhibitions have provided additional exposure
for our contemporary artists and have
resulted in developing important new partrons
[sic] from the constant flow of distinguished
visitors to this elegant hotel.
* * * * * * *
A number of years ago an art gallery was
opened in Jeddah, Saudi Arabia. From this
gallery's inception, Wally Findlay Galleries,
Paris, has been one of its principal
suppliers of paintings.
This description was composed at a time when, for purposes
of this litigation, petitioners maintain that the French
subsidiary had long since ceased to contribute any value to the
Wally Findlay Group. Even if we grant that the purpose of this
material is to excite an investor's interest, the portrait it
provides is difficult to reconcile with petitioners' contention
that none of the substantial goodwill of the group was
attributable to the French subsidiary. The fact that WFGI
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prolonged the French subsidiary's existence until 1987, then took
over its facilities and continued to use them for some of the
same functions for 8 more years, testifies to the importance that
WFGI attached to the image and customer relations that were
associated with the Paris operations.
The assets of the French subsidiary were stated on the
balance sheet at their book value. Although fair market value is
clearly the more appropriate index, there appears to have been no
attempt to appraise them. The discrepancy between book value and
fair market value was likely to be most significant in the case
of the long-term lease. The balance sheet for FY 1984 states its
value as $155,671. This represents the original cost to acquire
the lease, FF 1,445,250, translated into U.S. dollars at the
exchange rate prevailing on September 30, 1984. It does not
reflect the considerable costs incurred to improve the property.
The book value of the improvements at this time, adjusted for
depreciation over nearly 15 years, was still $360,693.
Promotional material, dated January 1985, states the value
of the French subsidiary's leasehold rights as $250,000.
Petitioners now disavow this estimate as puffery. They contend
that because the lease was in its third trimester and possession
of a portion of the premises was in dispute as of the end of
FY 1984, the market value would have been substantially impaired.
We find this argument unconvincing. Inasmuch as the officers of
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WFGI intended to retain the lease until these obstacles to
marketability were removed, the potential value of the lease
under the more favorable conditions that were expected seems to
be the more appropriate measure for purposes of this case than
the amount that could be realized by assigning it at the end of
FY 1984.
The $250,000 estimate may well have been closer to the
potential market value of the lease than its book value. The
total amount that WFGI and a French individual paid for the lease
3 years later, translated into U.S. dollars at the exchange rate
prevailing at the end of FY 1984, was $307,653.3
3
The lease for one-third of the premises was acquired by
WFGI at a cost of $253,461, or FF 1,556,251 at the current
exchange rate on Sept. 30, 1987. The lease for the other two-
thirds was assigned to a French individual for FF 1.3 million.
The total premium paid for the lease of the premises by both
parties was FF 2,856,251, which at the exchange rate prevailing
on Sept. 30, 1984 would equal $307,653. WFGI acquired its lease
in two parts, one part from the French subsidiary and one part
from a company referred to in the stipulations as “Elysee
Matignon (the real estate management company).” This appears to
be the same company that the French subsidiary had sued to
recover possession of space that had been appropriated for the
use of a restaurant. If the space that WFGI paid this company to
acquire in the complicated multiparty transaction corresponded to
the portion of the original leasehold that was in dispute, or
other space exchanged for that portion in a settlement of the
dispute, then $307,653 may be an overstatement of the amount that
the French subsidiary could have expected to receive upon the
assignment of its lease at the end of FY 1984. If the amount
that WFGI paid to Elysee Matignon is not taken into account,
however, the total lease premium would still amount to $243,026
at the Sept. 30, 1984 exchange rate.
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Another serious weakness in petitioners' defense of the
deduction lies in the failure to take account of the important
effects of the exchange rate, both in the diagnosis of the French
subsidiary's financial difficulties during the years at issue and
in the forecast of its capacity to repay the debt thereafter. On
the balance sheets of the French subsidiary asset values were
converted into U.S. dollars at the current exchange rates as of
the fiscal yearend. Although most of the subsidiary's
liabilities were denominated in francs, the cost of sales
reflected in the intercompany account, which constituted by far
the largest liability, was fixed in U.S. dollars at the time of
sale. As a result, the value of assets, and shareholder's
equity, exhibited a high degree of sensitivity to changes in the
value of the franc vis-a-vis the U.S. dollar. Between 1981 and
1985 the U.S. dollar rose dramatically against the franc, as well
as against most other major currencies. This depressed the U.S.
dollar value of the French subsidiary's assets and its equity.
The effect on the book value of the premium lease is particularly
noteworthy. The balance sheet for FY 1984 reports the book value
of the lease as $155,671, using an exchange rate of 9.284
FF per U.S. dollar. The rates used in preparation of the
subsidiary's balance sheets during the 5-year period FY 1977-81,
before the tremendous appreciation of the U.S. dollar, were in
the range of 4.0 to 5.5. At a rate of 5.0, the book value of the
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lease would have been $289,050. If at the end of FY 1984 WFGI's
officers had believed the lease to be worth about $250,000 at
current exchange rates and they had correctly predicted the level
of exchange rates as of September 30, 1987, when the lease was
ultimately assigned, they would have expected the disposition of
the lease to yield $378,000; if they had anticipated that the
exchange rate would return to its historic levels, they would
have expected approximately $100,000 more ($464,200 at 5.0 FF per
U.S. dollar).
Exchange rates also affected the French subsidiary's ability
to repay the intercompany debts out of current cash flows.
According to the consolidated financial statements for the Wally
Findlay Group, the French subsidiary's cumulative loss on
currency exchange transactions between FY 1981 and FY 1984 was
$562,000, a loss of repayment capacity corresponding to more than
half of the intercompany account balance by the end of FY 1984.
At the rate of exchange prevailing at that time, to pay off this
balance required FF 9,854,270. If the franc returned to a level
of 5.0, only FF 5,307,125 would have been needed. These
numerical exercises are intended only to suggest how important
exchange rate expectations would have been for a reasonable
determination of the collectibility of the intercompany debt.
There is no evidence that the officers of WFGI incorporated
any explicit exchange rate forecast into their assessment of the
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French subsidiary's prospects. This had the same effect as an
assumption that the franc would not recover significantly against
the dollar in the foreseeable future. The record does not
disclose the reasons why they may have discounted this
possibility nor that they considered it at all. Petitioners have
made no attempt to defend this assumption. In retrospect, of
course, we know it to be incorrect. It may be that the peaking
and steep decline of the U.S. dollar, beginning in 1985, could
not reasonably have been anticipated on the basis of information
available to the officers of WFGI at the time they decided to
write off the intercompany debt. The point is not that they
lacked perfect foresight, but that they seem to have neglected to
make a reasoned forecast.
They were not unaware of the powerful effect of exchange
rate instability on the subsidiary's finances. During the years
at issue, the losses that the French subsidiary sustained on
currency exchange transactions were duly noted by the
subsidiary's auditors and reported in the consolidated financial
statements. Promotional material prepared for investors blamed
the subsidiary's financial difficulties on “the french economic
situation and of [sic] losses on rates of exchange”. Yet, the
officers' analysis of the subsidiary's situation for tax purposes
made no mention of the influence of exchange rates, a factor
deserving attention in the exercise of sound business judgment.
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This omission detracts from the officers' conclusion that the
intercompany debt was worthless.
The succession of untoward events during FY 1984 that the
officers of WFGI identified to justify their decision is not
compelling. The actions of Banque de la Cite confirm that the
French subsidiary's position had seriously deteriorated. But the
bank would have acted to protect itself as soon as doubt arose
that its loans would be repaid in full. It does not follow that
the French subsidiary was unable to repay any portion of its
debts. The misappropriated funds uncovered in July 1984 do not
appear to have had a substantial impact on the company's
finances. The Selene lawsuit and the advice that WFGI's officers
received from the auditors of the subsidiary concerning the
consequences of noncompliance with French capital requirements
seem to have played a significant role in the decision to cancel
the debt. But WFGI's willingness to cancel the debt in order to
avert the damage to its reputation that would result from
involuntary insolvency proceedings does not prove that the debt
was totally worthless.
The circumstances that confronted WFGI in FY 1984 might have
provided sufficient cause to cancel the intercompany debt even if
WFGI could reasonably have expected to recover some of it. At
that time elimination or capitalization of the intercompany debt
may well have seemed imminent in any case, as a necessary part of
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a sale of the group or of the French subsidiary alone.4 In the
circumstances, we do not give dispositive effect to the officers'
conclusion that the debt should be written off as worthless.
Petitioners have failed to make the showing required in order to
qualify for the deduction under section 166.
2. Worthless Stock
Section 165(g) provides for a deduction of the loss that
results when stock becomes worthless during the taxable year.
To establish worthlessness, the taxpayer must show not only
current balance sheet insolvency, but also the absence of any
reasonable expectation that the assets of the corporation will
exceed its liabilities in the future. Both liquidating value and
potential value are relevant in this context. Steadman v.
Commissioner, 50 T.C. 369, 376-377 (1968), affd. 424 F.2d 1 (6th
Cir. 1970); Morton v. Commissioner, 38 B.T.A. 1270, 1278-1279
(1938), affd. 112 F.2d 320 (7th Cir. 1940).
Respondent disallowed the deduction under section 165(g) on
the ground that petitioners had not shown that the stock of the
French subsidiary became worthless in FY 1984. We agree. So
long as intercompany indebtedness of more than $1 million
remained on the subsidiary's balance sheet, the extent of balance
4
When WFGI sold the stock of its Beverly Hills and New York
galleries in 1980, it capitalized the subsidiaries' intercompany
account debts.
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sheet insolvency was so great that there may well have been no
reasonable expectation that a continuation of the business would
provide the parent with a return of its investment. Cf.
Morton v. Commissioner, supra at 1279. Yet once the intercompany
debt was forgiven, the balance sheet for FY 1984 showed a deficit
in shareholder's equity of only $26,228, and the same
considerations that would have supported a reasonable expectation
of recovering part of the intercompany debt preclude a
determination that the stock was worthless.
As internal corporate documents of WFGI reflect, the primary
purpose of canceling the intercompany debt was “to get the
capital structure back into compliance with French law” and avert
the threat of involuntary insolvency proceedings. WFGI's
officers would not have forgiven the subsidiary's debt if they
did not believe that this would provide meaningful support to its
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capital. The evidence suggests that in this belief they were
justified. We find that petitioners have not proven that the
stock of the French subsidiary became worthless during FY 1984.
To reflect the foregoing,
Decision will be entered
for respondent.