Quealy, Judge:
Respondent has asserted a deficiency in the Federal corporate income tax of petitioner for the taxable year 1967 in the amount of $73,715.
Certain concessions having been made by the parties, the following-issues remain for decision:
(1) Whether petitioner's gain on a contract for the short sale of 1.1 million pounds sterling, entered into with First National City Bank and subsequently sold or transferred to Amsterdam Overseas Corp. just prior to the closing date, is taxable as ordinary income under the doctrine of Corn Products Co. v. Commissioner, 350 U.S. 46 (1955), making the gain realized on the transfer thereof taxable as ordinary income.
(2) Alternatively, whether the gain to petitioner on the above transaction should be taxable under the provisions of section 1233 on the basis that Amsterdam was, in substance, acting as a broker for petitioner in purchasing the pounds sterling used to close out the short sale.
FINDINGS-OF FACT
Some of the facts have been stipulated by the parties. Such facts and the exhibits attached thereto are incorporated herein by this reference.
International Flavors & Fragrances Inc. (hereinafter referred to as petitioner or IFF (U.S.)) is a New York corporation with its principal place of business in New York, N.Y. Petitioner filed a United States corporate income tax return (Form 1120) and an information return with respect to controlled foreign corporations (Form 2952), respectively, for the taxable year 1967 with the district director of internal revenue, Manhattan District, New York, N.Y.
IFF (U.S.) is engaged in the creation and manufacture of flavor and fragrance products used by other manufacturers to impart or improve flavor or fragrance in a variety of consumer products. Its activities are conducted on a worldwide basis through numerous foreign corporations which it, directly or indirectly, owns or controls.
IFF (U.S.) prepares consolidated financial statements which it publishes regularly to its shareholders and to the public. For the purpose of such consolidated statements, the accounts of its foreign affiliates, which are expressed in foreign currencies, are converted into United States dollars. The accounts of its foreign affiliates, however, are not consolidated for United States income tax purposes. No other financial statements are published.
Of primary concern to the present inquiry is the relationship between IFF (U.S.) and its foreign affiliate, International Flavors & Fragrances I.F.F. (Great Britain) Ltd. (hereinafter referred to as IFF (G.B.)). IFF (G.B.) is a wholly owned foreign subsidiary of International Flavors & Fragrances I.F.F. (Nederland) N.V. (hereinafter referred to as IFF (Holland)) which, in turn, is wholly owned by IFF (U.S.). IFF (G.B.) has manufacturing, research, and administrative facilities in Enfield, England. It has additional manufacturing facilities in Haverhill, England.
During the latter part of 1966, IFF (U.S.) became concerned about a possible devaluation of the British pound sterling and the adverse effect it would have in converting the operations of IFF (G.B.) into dollars for purposes of its annual consolidated statement. In a letter to the comptroller in charge of European operations for the company, II. G. Beid, Financial Vice President of IFF (U.S.), suggested that the company sell short a sufficient amount of British pounds sterling to cover,.on an after-tax basis, the exposed net current assets of IFF (G.B.), approximated to be, in terms of dollars, $1,600,000. Beid accordingly recommended the purchase, of a 1-year pounds sterling contract in the dollar equivalent of $3 million, since on an after-tax basis, the protection afforded from such contract would be only 53 percent thereof.
On December 29,1966, IFF (U.S.) entered into a written contract with First National City Bank of New York (hereinafter referred to as FNCB) pursuant to which IFF (U.S.) sold to FNCB 1.1 million British pounds sterling at $2.7691 per pound, delivery and payment to be made on January 3, 1968. The price FNCB agreed to pay per pound was approximately three-fourths of 1 percent below the then-prevailing dollar-pound exchange rate of $2.7918. The discount represented consideration for the risk to FNCB in writing a 1-year contract.
The contract provided that if, prior to the closing date, the market value of pounds sterling exceeded the exchange rate which FNCB was required to pay thereunder, FNCB could request IFF (U.S.) to deposit, as security for its own obligation under the contract, cash or its equivalent. IFF (U.S.) was additionally subject to certain penalties for noncompliance with the terms of the agreement. The contract further provided that FNCB had the power to place liens on any funds of IFF (U.S.) that were or might come into the possession or control of FNCB to enforce its rights under the contract.
IFF (U.S.) had the following dollar deposits on account with FNCB as of the following dates:
Dee. 31, 1966_ $302,616.60
Dec. 20, 1967_ 688,691.19
Jan. 3, 1968_ 1,928, 354.37
On November 1851967, the British Government devalued the pounds sterling in terms of the U.S. dollar from $2.80 to $2.40.
On December 20,1967, IFF (U.S.) entered into an agreement with Amsterdam Overseas Corp. (hereinafter referred to as Amsterdam), a large international banking institution located at 70 Pine Street, New York City. Neither IFF (U.S.) nor Amsterdam held stock in the other. The agreement, which was in letter form from IFF (U.S.) to Amsterdam and accepted by Amsterdam, read in pertinent part, as follows:
Enclosed, is the original of our agreement of Decembér 29, 1966 with First National City Bank which we hereby sell to you today for $387,000. This sale is on the understanding that you will fulfill the obligation to deliver Sterling 1.1 million to First National City Bank on January 3, 1968 without recourse to us.
On the same day as the above agreement was entered into, the following events also transpired:
(1) IFF (U.S.) notified FNCB that it had sold its contract with FNCB to Amsterdam.
(2) Amsterdam notified FNCB that it had bought the contract. It agreed to assume liability thereunder if FNCB would confirm its intent to pay the sum of $3,046,010 upon the delivery of 1.1 million pounds sterling on January 3, 1968.
(3) At 4:18 p.m., Amsterdam received notification from FNCB of its approval of Amsterdam's purchase of the contract. FNCB also confirmed that on January 3, 1968, it would credit the dollar account of Amsterdam with the difference between its own obligation under the contract, $3,046,010, and the dollar cost to Amsterdam of purchasing from FNCB, at the prevailing rate of exchange, the 1.1 million pounds sterling needed to close out the contract on such date.
(4) At 4:30 p.m., Amsterdam purchased 1.1 million pounds sterling at the rate of $2.4080 from FNCB for delivery on January 3,1968.
On December 21, 1967, Amsterdam sent a check to IFF (U.S.) in the amount of $387,000 representing the price agreed upon for the purchase of the contract. On January 3, 1968, Amsterdam closed out the contract with the 1.1 million pounds sterling purchased short from FNCB on December 20, 1967. The net gain to Amsterdam on the transaction was $10,210.
In 1967, IFF (G.B.) paid the dollar equivalent of $476,000 in dividends to IFF (Holland). In the same year, IFF (U.S.) received the dollar equivalent of $1,421,136 in dividends from IFF (Holland).
With respect to IFF (G.B.), its assets and liabilities per books, stated in British pounds sterling, for the years 1966-68 were as follows:
The reconciliation of retained earnings of IFF (G.B.) per books, stated in British pounds sterling, for such years was as follows:
Retained earnings 12/31/65- $652, 393
Net income for year 1966- 329,641
Total_ 982,034
Less: Dividends declared-- 220, 000
Retained earnings 12/31/66- 762, 034
Retained earnings 12/31/66_ 762, 034
Net income for year 1967_ 407,126
Total _1,169,160
Less: Dividends declared_ 170, 000
Retained earnings 12/31/67- 999,160
Retained earnings 12/31/67_ 999,160
Net income for year 1968_ 517,442
Total_1, 516, 602
Less : Dividends declared_ 190, 789
Retained earnings 12/31/68- 1, 325, 813
During each of the years 1965, 1966, and 1967, IFF (G.B.) purchased $559,538, $626,850, and $855,113 worth of raw materials from IFF (U.S.), respectively. The billings were made in dollars and as of December 31, 1967, there was an unpaid balance of $175,632. Correspondingly, IFF (U.S.) incurred obligations in pounds sterling of 15,888-0-8, 13,348-15-1, and 11,127-19-1 on account of various raw materials purchased from and services rendered by IFF (G.B.) in each of such years.
IFF (G.B.) also owed certain dollar amounts pursuant to an agreement entered into with IFF (U.S.) on January 1,1963. In substance, the agreement provided a formula by which IFF (G.B.) was to share the cost of making certain management services of key personnel from IFF (U.S.) and its foreign affiliates, including IFF (G.B.), available to the affiliated group on an international basis. It also set forth the basis on which IFF (G.B.) would share in certain research expenses incurred by IFF (U.S.) and IFF (Holland) from which it derived some benefit. The net dollar amounts owed under such agreement were as follows:
The billings under the agreement were made quarterly. The balance due for the last quarter of 1966 was $81,467, while the balance for the last quarter of 1967, during which the pound was devalued, was $119,304.
Except as described above, no other obligations were incurred between the parties during the period of 1965-68.
In addition to the transaction in question, the petitioner made short sales of British pounds sterling in 1967 and 1968 with respect to which losses were sustained. In the determination of its tax liabilities for those years, such losses were deducted as ordinary losses.
On it corporate return for the taxable year 1967, IFF (U.S.) reported the $387,000 gain realized from the purported sale of its contract with FNCB as long-term capital gain. The respondent asserted deficiencies for such year on the basis that IFF (U.S.)'s sale of the contract to Amsterdam was a sham and the gain therefrom should have been reported as short term. In the alternative, he asserted the short sale was a hedging transaction and the gain should have been taxable as ordinary income.
OPINION
The petitioner both directly and indirectly through its foreign affiliates was engaged worldwide in the preparation and distribution of flavoring extracts. During the latter part of 1966, the petitioner became concerned that a devaluation of the English jiound sterling would adversely affect, at least on paper, petitioner's investment in its second-tier subsidiary, IFF (G.B.), which was organized and operated in the United Kingdom. In an effort to protect against that risk, petitioner entered into a short sale contract with FNCB on December 29, 1966, whereby it sold 1.1 million British pounds sterling at the rate of $2.7691 per pound for delivery on January 3, 1968.
On November 18, 1967, of the succeeding year, the pound was devalued in terms of the U.S. dollar from $2.80 to $2.40.
On December 20,1967, only a few days prior to the closing date of the contract, petitioner purported to sell its contract to Amsterdam for $387,000, treating such amount as long-term capital gain from the sale of a capital asset held for more than 6 months. That same day Amsterdam made an offsetting purchase of the 1.1 million pounds sterling from FNCB at the current exchange rate of $2.4080, delivery set for January 3,1968.
On January 3,1968, both contracts were closed out with Amsterdam realizing a net gain of $10,210 on the transaction.
At the outset, the Court is faced with the question whether, on the basis of the facts in this case, either the contract entitling the petitioner to sell to FNCB 1.1 million pounds sterling on January 3,1968, or the subject of that contract, i.e., pounds sterling, constituted a "capital asset" in the hands of the petitioner within the meaning of section 1221. Foreign currency is recognized as "property" as that term is used in the internal revenue laws. Such property meets the literal definition of a capital asset as set forth in section 1221. However, the respondent contends that petitioner's transactions in foreign currency come within the exception to a literal reading of the statute which was carved out under the decision in Corn Products Co. v. Commissioner, supra, and the innumerable cases which followed. See Chemplast, Inc., 60 T.C. 623 (1973).
In response to this argument, petitioner points to the ostensible basis upon which it decided to enter into the short sale contract, namely, as suggested in an internal memorandum, to offset a possible write-down of the net current assets of IFF (G.B.) in preparing the annual consolidated statements of the petitioner and its affiliated corporations in the event of the devaluation of the pound sterling. The amount of pounds sterling to be sold short was supposed to have been calculated with that in mind.
In determining the effect of the short sale with respect to petitioner's business, this Court is not prepared to accept that memorandum as controlling. Rather, we must look to the facts. Any diminution in value of the assets of IFF (G.B.) as measured in pounds sterling would be offset by a corresponding reduction in its liabilities, which likewise were payable in pounds sterling. The only loss that the petitioner could sustain was the loss on the conversion into U.S. dollars of the earnings and profits of its British affiliate and, secondly, the loss in U.S. dollars on account of its investment, if any, in the capital stock of such corporation. So long as IFF (G.B.) stayed in business, the latter would never be realized. All the petitioner really accomplished by the short sale of the pounds sterling was to recoup an amount equivalent to the ultimate losses in earnings which might be sustained when and if the pounds sterling earned by its British affiliate were remitted to the petitioner and converted into U.S. dollars.
In this case, the business of IFF (G.B.) was the business of the petitioner. The loss which the petitioner sought to offset by the short sale of pounds sterling was a loss to which its British affiliate was exposed in its everyday business. Purchases and sales of foreign currency, which in terms of the Internal Revenue Code must be considered as property other than money, for the purpose of offsetting losses which' might result from fluctuations in the exchange rates, are part and parcel of a multinational business. If the petitioner had conducted its foreign business in the United Kingdom through a branch of the parent corporation rather than a British subsidiary, applicability of the Com Products doctrine to such transaction in foreign exchange could hardly be questioned. The fact that a U.S. corporation conducts its foreign business through foreign subsidiaries rather than branches, does not necessarily warrant applicability of a different rule. See, e.g., Schlumberger Technology Corp. v. United States, 443 F. 2d 1115 (C.A. 5, 1971).
The short sale of pounds sterling by the petitioner must be regarded as an ordinary income-related transaction and not an "investment." It constituted a loose "hedge" against the risk of future losses of income. See Wool Distributing Corporation, 34 T.C. 323 (1960). If petitioner in this case had closed out its short sale of British pounds in accordance with its contract with FNCB by purchasing pounds at the lower rate resulting from the devaluation, the resulting gain would have been taxable as ordinary income. Wool Distributing Corporation, supra; America-Southeast Asia Co., 26 T.C. 198 (1956). See also Corn Products Co. v. Commissioner, supra; Commissioner v. Farmers & G C. Oil Co., 120 F. 2d 772 (C.A. 5, 1941), reversing 41 B.T.A. 1083 (1940), certiorari denied 314 U.S. 683 (1941). The fact that petitioner chose to sell the contract instead does not change the character of the transaction.
In view of our decision with respect to the applicability of the Corn Products doctrine, it is not necessary to decide the alternative question whether the petitioner has met its 'burden of proving that the transaction between the petitioner, Amsterdam, and FNCB was not in substance a purchase by the petitioner of pounds sterling to meet its obligation under the short sale, thereby making the gain taxable under the provisions of section 1233. In view of the sequence of events, however, it is clear that Amsterdam did not intend to assume any risk. In the absence of any testimony from the representatives of Amsterdam, suffice it to say that its role appears to be more nearly that of the broker than a purchaser. Cf. Frank C. LaGrange, 26 T.C. 191 (1956).
Beviewed by the Court.
Decision will be entered umder Rule 155.
All statutory references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated.
SEC. 1221. CAPITAL ASSET DEEINED.
Eor purposes of this subtitle, the term "capital asset" means property held by the taxpayer (whether or not connected with his trade or business), but does not Include—
(1) stock In trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer If on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;
(2) property, used In his trade or business, of a character which Is subject to the allowance for depredation provided in section 167, or real property used in his trade or business;
(3) a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by—
(A) a taxpayer whose, personal efforts created such property,
(B) in the case of a letter, memorandum, or similar property, a taxpayer for whom such property was prepared or produced, or
(C) a taxpayer in whose hands the basis of such property is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such property in the hands of a taxpayer described in subparagraph (A) or (B) ;
(4) accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1) ; or
(5) an obligation of the united States or any of its possessions, or of a State or Territory, or any political subdivision thereof, or of the District of Columbia, Issued on or after March 1, 1941, on a discount basis and payable without interest at a fixed maturity date not exceeding one year from the date of Issue.
It should be noted that for accounting purposes the transaction whereby the petitioner realized a gain on the short sale of pounds sterling would have no effect on the consolidated balance sheet except as reflected in the computation of earnings and profits. The petitioner merely realized a nonrecurring gain.
For tax purposes, any adjustment on account of the devaluation of the pound sterling would be limited to the pounds sterling which might ultimately be remitted to the petitioner. See G.C.M. 4954, VII—2 C.B. 293; cf. Methods of adjustment with respect to branches, O.D. 489, 2 C.B. 60, and O.D. 550, 2 C.B. 61.
The decision with respect to the applicability of the Corn Products doctrine in the Schlumberger case may appear to be in conflict with a prior decision of the Court of Claims in KVP Sutherland Paper Co. v. United States, 344 F. 2d 377 (Ct. Cl. 1965), in that the Court of Claims there found that the loan in Canadian currency by the taxpayer to its subsidiary and the subsequent repayment thereof in kind was a "capital transaction." However, since that court proceeded to tax the gain realized at each step of the transaction either as ordinary income or as a short-term capital gain, the net result was the same.