                  T.C. Memo. 1997-100



                UNITED STATES TAX COURT



  TRINOVA CORPORATION AND SUBSIDIARIES, Petitioner v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 2931-94.             Filed February 27, 1997.


     P, a corporation, filed a consolidated tax return
with its affiliated companies, including AG, a
controlled foreign corporation for purposes of sec.
957(a), I.R.C. In 1986, AG had gross income from
royalties, interest, and exchange gains. R stipulated
that the exchange gains constituted non-subpart F
income to P. In order to compute the amount of P's net
subpart F income, P and R both allocated AG's
deductions for interest expense, swap losses, and Swiss
capital tax against AG's income using the asset method
of sec. 1.861-8(e)(2)(v), Income Tax Regs. R used the
asset method by prorating AG's assets between the
subpart F and non-subpart F groupings based on the
gross income in those categories produced by the
assets. P apportioned assets according to the income
they normally produced, and apportioned all assets and
all deductions to subpart F income. R apportioned
deductions for exchange losses ratably across all gross
                                - 2 -


     income, relying on sec. 1.861-8(e)(7)(ii), Income Tax
     Regs. P apportioned those deductions in the same
     manner as the underlying expenses. Held: (1) Interest
     expense is apportioned under the asset method by
     prorating the assets between the statutory and residual
     groupings based on the income they produce; (2) swap
     losses are apportioned in the same manner as interest
     expense; (3) Swiss capital tax is apportioned in the
     same manner as interest expense; (4) sec. 1.861-
     8(e)(2)(v), Income Tax Regs., does not apply to the
     exchange losses involved in this case, and the
     deductions are apportioned in the same manner as the
     underlying expenses to which they relate.



     Frederick E. Henry, Jeffrey M. O'Donnell, and Julie C. H.

Walsh, for petitioner.

     Nancy B. Herbert and Reid M. Huey, for respondent.




                         MEMORANDUM OPINION

     TANNENWALD, Judge: Respondent determined the following

deficiencies in petitioner's Federal income taxes and additions

to tax:

                                         Additions to Tax
     Year          Deficiency              Sec. 6661(a)

     1985      $   117,988.00                 --
     1986       11,630,928.00             $1,429,687.00
     1987        4,924,255.00                 --
     1988          834,875.00                 --

After concessions by the parties, the issue for decision is how

various deductions should be allocated and apportioned between

the subpart F income and non-subpart F income of petitioner's

wholly owned subsidiary for the purposes of determining
                               - 3 -


petitioner's net subpart F income includable in petitioner's

gross income for the taxable year 1986.1



Background

     This case was submitted fully stipulated under Rule 122.2

The stipulation of facts and accompanying exhibits are

incorporated herein by this reference and found accordingly.

     Petitioner, an accrual basis taxpayer, is a corporation

having its principal offices in Maumee, Ohio, at the time it

filed the petition herein.   Petitioner changed its name to

Trinova from the Libbey-Owens-Ford Company on July 31, 1986.     It

timely filed a consolidated Federal income tax return with

certain of its subsidiaries for each of the years at issue either

with the Internal Revenue Service Center, Cincinnati, Ohio, or

the Internal Revenue Service office in Toledo, Ohio.

     Throughout 1986, petitioner owned 100 percent of Aeroquip

International, Inc. (AII), a Delaware corporation, which in

turned owned 100 percent of Aeroquip, AG (AG), a Swiss

corporation.   During 1986, AG was a "controlled foreign


1
  An additional issue, relating to investment tax credit
recapture under sec. 47, has been disposed of in a prior opinion.
Trinova Corp. and Subs. v. Commissioner, 108 T.C. ___ (1997).
2
   Unless otherwise indicated, all section references are to the
Internal Revenue Code in effect for the taxable years in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
                                - 4 -


corporation" (CFC) for purposes of section 957(a), and AII was

the "United States Shareholder" of AG for purposes of section

951(b).    Under subpart F of the Code, the net subpart F income

derived by AG during the taxable year was currently includable in

petitioner's gross income.    Sec. 951(a).

     In the ordinary course of AG's business, AG derived income,

incurred expenses, acquired assets, and recorded liabilities

denominated in currencies other than the U.S. dollar, which was

its functional currency for Federal income tax purposes.    For

1986, AG's assets included loans to affiliated companies

denominated in British pounds sterling (£), German Deutsche marks

(DM), and Italian lira.    Foreign currency denominated assets and

liabilities resulted in AG's realization of foreign currency

gains and losses in the ordinary course of its business, due to

fluctuations in the value of foreign currencies with respect to

the dollar, which gains and losses cannot be ascertained in

advance.

     For 1986, AG's assets consisted of the following:
                               - 5 -


                                            Value in
     Asset                                U.S. Dollars

     Cash                                 $       37,298
     Short-term investment                           687
     Royalty receivable - related                848,729
     Royalty receivable - unrelated              181,695
     Other assets                                418,675
     Loan: Vickers - Germany (DM)             31,493,116
     Loan: Aeroquip - Germany (DM)             3,612,475
     Loan: AII - US (US$)                     11,324,505
     Loan: Aeroquip - Italy (Lira)             1,145,900
     Loan: Vickers - UK (£)                      500,500
     Interest receivable                       1,031,107
     Investment in subsidiary                  4,941,966
     Patent costs                                 71,125

     Total average assets                 $55,607,778


The above asset values for all assets reflect averaging the

beginning of the year and the end of the year values stated on

the balance sheets of AG's financial statements.

     During 1986, some of AG's loan assets were repaid in part,

as follows:

                                       Average Balance
                                           Repaid
     Borrower                          in U.S. Dollars

     Vickers - Germany (DM)                   $17,378,847
     Aeroquip - Germany (DM)                    6,622,871
     Aeroquip - Italy (Lira)                       53,667
     Vickers - UK (£)                                   0
     AII - US (US$)                                     0


     For 1986, AG had the following items of gross income:
                               - 6 -


                                         Amount in
     Item                              U.S. Dollars

     Royalty income                    $ 3,865,283
     Interest income                     3,990,947
     Exchange gains                     12,371,700

     Total gross income                $20,227,930

By stipulation of the parties, $7,856,230 constituted gross

subpart F income, and the exchange gain of $12,371,700 did not

constitute gross subpart F income for purposes of section 952(a).

     The parties disagree as to the allocation and apportionment

of the following expenses incurred by AG:

                                         Amount in
     Item                              U.S. Dollars

     Interest                            $1,498,562
     Swap losses                          3,259,120
     Capital tax                            438,334
     Foreign exchange losses                720,664

     The capital tax was imposed under Swiss law and was

calculated by AG based on the amount of AG's assets less

liabilities.

     The swap losses consist of the following items:

                                         Amount in
     Item                              U.S. Dollars

     £ swaps - periodic payments         $1,652,436
     Amortization £ swap premium            (95,087)
     DM swaps - periodic payments         1,701,771

     Total swap loss                     $3,259,120

The swap losses arose out of currency and interest rate exchange

agreements entered into by AG with third parties.     Under these
                                - 7 -


agreements, AG agreed to pay interest in one currency at a

certain rate on a specific principal amount in that currency.    In

return, AG would receive interest payments in another currency

based on a certain interest rate on a specific principal amount

in that currency.

     The total currency exchange loss consisted of the following

items:

                                          Amount in
     Item                               U.S. Dollars

     Accrual   of DM swap payments          $411,151
     Accrual   of £ swap payments            (10,968)
     Accrual   of income tax                 246,033
     Accrual   of interest payments           73,528
     Other -   error                             920

     Total currency exchange loss            720,664

     Both petitioner and respondent allocated the deductions for

interest expense, Swiss capital tax, and swap losses using the

asset method set forth in section 1.861-8(e)(2)(v), Income Tax

Regs.    Petitioner allocated these three deductions solely against

subpart F income.    Petitioner treated the items constituting

exchange losses individually, allocating exchange losses

attributable to accrual of payments under the swap agreements and

to accrual of interest payments solely against subpart F income,

and allocating "accrual of income tax" and "other" items ratably

across all gross income.

     Respondent allocated and apportioned the deductions for

interest expense, swap losses, and Swiss capital tax using the
                               - 8 -


asset method to both subpart F and non-subpart F income, based on

the value of AG's assets, divided between the two categories

based on the gross income in each category produced by the loan

assets.   Respondent allocated and apportioned all exchange losses

ratably across all gross income.

     There is no dispute as to whether any of the expenses at

issue may be deducted, but rather merely as to how they should be

allocated and apportioned.



Statutory and Regulatory Framework

     The statutory authority governing deductions from subpart F

income is section 954(b)(5), which provides that gross subpart F

income "shall be reduced, under regulations prescribed by the

Secretary, so as to take into account deductions (including

taxes) properly allocable to such income."   The regulations under

section 954 offer little guidance, other than the admonition that

"no expense, tax, or other deduction shall be allocated to an

item or category of income to which it clearly does not apply."

Sec. 1.954-1(c), Income Tax Regs.

     The "regulations prescribed by the Secretary" in force for

the taxable year at issue are found in section 1.861-8, Income

Tax Regs., governing the allocation of deductions between income

from sources within and without the United States.   Section

1.861-8(f)(1)(v), Income Tax Regs., specifies that "This section
                               - 9 -


provides rules for identifying which deductions are properly

allocable to foreign base company income" under the authority of

section 954(b)(5).

     A taxpayer first allocates deductions to the appropriate

class of gross income and then apportions those deductions within

the class of gross income (defined as "the gross income to which

a specific deduction is definitely related") between the

statutory grouping (in this case, subpart F income) and the

residual grouping (in this case, non-subpart F income).     Sec.

1.861-8(a)(2), (3), and (4), Income Tax Regs.   If a deduction is

not related to a specific class of gross income, it will be

treated as relating to all gross income and will be allocated

ratably by gross income.   Sec. 1.861-8(b)(1), (5), Income Tax

Regs.   Once a particular deduction has been allocated to a class

of gross income, it must be apportioned within that class between

the "statutory" and "residual" groupings of income.   The

regulations stress that allocation and apportionment reflect the

"factual relationship" between the deductions and the gross

income.   Sec. 1.861-8(a)(2),(b)(1), and (c)(1), Income Tax Regs.

     In addition, there are special rules for interest

deductions.   Because money is fungible, and a taxpayer has a

great deal of flexibility in the use of borrowed funds, interest

expense is normally allocated "to all the gross income which the

income producing activities and properties of the taxpayer
                              - 10 -


generate, have generated, or could reasonably have been expected

to generate."   Sec. 1.861-8(e)(2)(ii), Income Tax Regs.3

Interest deductions are apportioned on the basis of values of

assets which produce income in such groupings, according to the

"asset method" set out in section 1.861-8(e)(2)(v), Income Tax

Regs.

     The use of the asset method requires the taxpayer to place

its assets in either the statutory or residual grouping,

according to the type of income the assets produce.    The asset

values are determined by an average of the asset values at the

beginning and the end of the year.     Sec. 1.861-8(e)(2)(v), Income

Tax Regs.   On the basis of the ratio of asset values, the

taxpayer apportions the deductions to those two groupings.     Id.;

see sec. 1.861-8(g), Examples (1) and (2), Income Tax Regs.4

3
   There are certain exceptions to this broad rule that do not
apply here. Sec. 1.861-8(e)(2)(iii) and (iv), Income Tax Regs.
In addition, a taxpayer may elect to apportion interest expense
according to gross income. Sec. 1.861-8(e)(2)(vi), Income Tax
Regs. Because petitioner did not so elect and neither party
contends that the gross income method should be used, we do not
discuss the rules for its application.
4
     Sec. 1.861-8(g), Income Tax Regs., provides:

     Example (1)--Interest--(i) * * * [X has $150,000 of
     interest expense.]
     Tentative apportionment on the basis of assets * * *
     Assets * * * that generate
     U.S.-source income * * * ..................$3,200,000
     Assets * * * that generate
     foreign-source income * * * ...............   800,000
     Total...................................... 4,000,000
                                                   (continued...)
                             - 11 -


Thus, the regulations effectively combine the allocation and

apportionment steps for interest expense.

     Finally, there are special rules for losses incurred in the

sale, exchange, or disposition of property.   Normally, the

deduction for such a loss is allocated "to the class of gross

income to which such asset or property ordinarily gives rise in

4
 (...continued)
     As a result of the above computations, X would apportion its
     interest deduction as follows:

     To gross income from sources within the United States
     (residual grouping):
                 $3,200,000
     $150,000 x             .........................120,000
                 $4,000,000
     To gross income from sources outside the United States
     (statutory grouping):
                   $800,000
     $150,000 x             ........................ 30,000
                 $4,000,000
     Total.........................................150,000
                  *    *     *    *    *    *     *
           Example (2)--Interest--(i) * * * [X has $200,000
     interest expense, $3,200,000 of assets related to its
     domestic source income; $800,000 of assets related to its
     foreign source income from Y; and $1,000,000 of assets
     related to its foreign source income from Z.]
                  *    *     *    *    *    *     *
          Tentative apportionment on the basis of assets
     Interest expense apportioned to sources outside the United
     States (statutory grouping):
                    ($800,000 + $1,000,000)
     $200,000 x                               ........$72,000
                ($800,000 + $1,000,000 + $3,200,000)
     Interest expense apportioned to sources within the United
     States (residual grouping):
                     $3,200,000
     $200,000 x                               ........128,000
                ($800,000 + $1,000,000 + $3,200,000)
     Total apportioned interest expense............200,000
                                - 12 -


the hands of the taxpayer."     Sec. 1.861-8(e)(7)(i), Income Tax

Regs.     In "the unusual circumstances" where apportionment is

necessary, it is done "in the same proportion that the amount of

gross income within such statutory grouping * * * and such

residual grouping bear, respectively, to the total amount of

gross income within the class of gross income."     Sec. 1.861-

8(e)(7)(ii), Income Tax Regs.

     To summarize, deductions are first allocated then

apportioned based on a factual relationship between the income

and the deduction.     If the deduction is one for interest, it is

allocated and apportioned among the groupings of income according

to asset values of the income producing activities and

properties.     If the deduction is one for loss on the disposition

of property, it is allocated based on the income ordinarily

produced by that property, and further apportioned, if necessary,

according to gross income.     Finally, if the deduction relates to

no specific item of gross income, it is allocated ratably across

all income.



Discussion

        Interest Expense

        Following the instruction of section 1.861-8(e)(2)(ii),

Income Tax Regs., the parties applied the asset method to

apportion the deduction between the statutory and residual
                              - 13 -


groupings according to asset values.5    Petitioner apportioned all

of AG's assets to the statutory grouping, because they all

normally produce subpart F income.     It apportioned none of AG's

loan assets to the residual grouping, because, although they

sometimes produce non-subpart F income (in this case, foreign

exchange gain), it is impossible to predict whether there will be

gain or loss, based on the nature of foreign exchange rates.

According to petitioner, the loan assets do not normally produce

such gain.   Petitioner thus allocated the entire interest

deduction, in the amount of $1,498,562, to gross subpart F

income.

     Respondent disagrees with petitioner's application of the

asset method.   While she agrees that the non-loan assets should

all be apportioned to the subpart F grouping, she reasons that

the loan assets should be apportioned in some manner between the

statutory and residual groupings, because they actually produced

both subpart F and non-subpart F income.    Respondent applies the

asset method by: (1) apportioning the non-loan assets all to the


5
   The asset values are determined by an average of the asset
values at the beginning and the end of the year, unless this
method produces a "substantial distortion" of the asset values.
Sec. 1.861-8(e)(2)(v), Income Tax Regs. Petitioner has computed
an average value for AG's assets based on monthly averages, which
differs by 0.6 percent from respondent's computation that follows
the exact wording of the regulations. We find that 0.6 percent
is not a substantial distortion, and thus find respondent's
computation of AG's average asset values, which we set forth
above, to be correct.
                              - 14 -


subpart F grouping; (2) then adding together (a) all the assets

and the portions of loan assets that produced subpart F income

according to the income they produced, and (b) all the assets and

portions of loan assets that produced non-subpart F income

according to the income they produced; (3) using these subtotals

to calculate a percentage of the total asset values in each

grouping; (4) and then apportioning the interest deduction

between the two groupings, based on these percentages.

     The divergent approaches of the parties to the asset method

are explained by the fact that section 1.861-8(e)(2)(v), Income

Tax Regs., assumes that any given asset will produce income

belonging to only one grouping--statutory or residual.6   This

assumption is reflected in the examples found in section 1.861-

8(g), Income Tax Regs.   Because the regulations simply do not

contemplate a situation where a single asset produces income in

more than one grouping, we are left with the task of determining

the apportionment of the loan assets "in a manner which reflects

to a reasonably close extent the factual relationship between the


6
   We note that respondent has substantially revised these
regulations, and addressed this ambiguity by providing specific
rules for the case where an asset produces income in more than
one grouping. Sec. 1.861-9T(g)(3), Temporary Income Tax Regs.,
53 Fed. Reg. 35477-35484 (Sept. 14, 1988), effective for tax
years beginning after Dec. 31, 1986. Respondent's solution in
this case to the silence in the "old" regulations is identical to
her approach in the "new" temporary regulations. However, the
"new" regulations were not in force for the tax year at issue,
and we do not consider it in reaching our own conclusions.
                              - 15 -


deduction and the grouping of gross income."   Sec. 1.861-8(c)(1),

Income Tax Regs.

     In making our determination, we note that in Occidental

Petroleum Corp. v. Commissioner, 55 T.C. 115, 124 (1970), the

regulations at issue there, section 1.613-4(a), Income Tax Regs.,

provided that expenses not directly attributable to specific

property were to be "fairly apportioned", and we held for the

party whose approach produced a "fairer apportionment".    We see

little difference between an approach that is "fairer" and one

that more closely reflects the "factual relationship" between the

income and the expenses.   For the reasons hereinafter set forth,

we find that respondent's approach to the asset method better

reflects the factual relationship involved in this case.

     Preliminarily, we reject petitioner's argument that the

predictability of income is the critical element in the

allocation of deductions against it.   Even though petitioner

cannot always predict AG's foreign exchange income from year to

year, AG nonetheless had exchange income in 1986.   This is no

different from the case of many businesses that do not know,

based on the vagaries of the market, whether they will have

losses or gains in a given year.   In the case of those

businesses, they allocate deductions against their income, and if

they have no income, they carry over the deductions.
                              - 16 -


     Interest expense is allocated under the regulations to all

gross income that the property or activity "could reasonably have

been expected to generate."   Sec. 1.861-8(e)(2)(ii), Income Tax

Regs.   Even if not predictable with precision, exchange gains

were certainly a reasonable possibility.   Furthermore, the

regulations specifically contemplate a situation where there will

be a deduction even with no corresponding income.7

     Next, although exchange gain has traditionally been treated

separately from the underlying income from the transaction,

Philip Morris Inc. v. Commissioner, 104 T.C. 61, 66 (1995), affd.

71 F.3d 1040 (2d Cir. 1995), we do not see how such separate

treatment undermines the validity of respondent's approach.    In

prorating the assets across two groupings of income, respondent

is not challenging the separateness of the income, but is merely

attempting a reasonable allocation of interest expense to that

income.

     Furthermore, while the regulations are silent on this

particular point, they do provide a foundation for respondent's

approach.   When a single item of deduction is attributable to two

different sources, it must be prorated between them.   See supra

note 4.   When a piece of property produces income attributable to

two different sources, the loss on the sale of that property can

7
   "Each deduction * * * shall be allocated * * * even though,
for the taxable year, no gross income in such class is received
or accrued". Sec. 1.861-8(d)(1), Income Tax Regs.
                                - 17 -


be prorated between them.    See sec. 1.861-8(e)(7)(ii), Income Tax

Regs., supra pp. 11-12.

       Finally, this is not a case where respondent's determination

conflicts with the regulations, see, e.g., Woods Investment Co.

v. Commissioner, 85 T.C. 274 (1985), nor is it a case where the

regulations are found to conflict with the statute, see, e.g.,

Jackson Family Foundation v. Commissioner, 97 T.C. 534 (1991),

affd. 15 F.3d 917 (9th Cir. 1994).       This is a case where the

Secretary's regulations do not adequately deal with a problem.

In such a situation, it is our task to construct the best

solution we can.    Cf. First Chicago Corp. v. Commissioner, 88

T.C. 663, 676 (1987), affd. 842 F.2d 180 (7th Cir. 1988).

       In sum, respondent takes into account the fact that the loan

assets produced income in both groupings, whereas petitioner does

not.    Such being the case, we approve of respondent's method of

allocating and apportioning interest expenses because it better

fits the facts and constitutes the more reasonable interpretation

of the statute and the regulations.       Cf. Occidental Petroleum

Corp. v. Commissioner, supra.    At least, petitioner, who has the

burden of proof, Rule 142(a),8 has not convinced us that its

allocation method is more reasonable than that of respondent.



8
   That burden is not lessened in a fully stipulated case.
Borchers v. Commissioner, 95 T.C. 82, 91 (1990), affd. 943 F.2d
22 (8th Cir. 1991).
                              - 18 -


     We are of the opinion, however, that respondent's approach

must be modified in one respect.   That approach is based on the

notion that assets which produce income in two groupings must be

prorated between the two groupings.    If an asset produces income

in only one grouping, it may only be apportioned to that

grouping.   Thus, the U.S. dollar loan asset, which could not have

produced any exchange gain, can only be apportioned to subpart F

income, as respondent concedes on brief.   In addition, some of

the foreign currency loans were not repaid to any extent in 1986,

could thus yield no exchange gain, and may therefore only be

counted toward subpart F income since they only produced interest

income.   Other loans were repaid only in part, and only the

amount of repayment yielded exchange gain.   These loan assets

should only be apportioned between the two groupings to the

extent of their repayment.   The portion of the loan not repaid

should only be apportioned to the subpart F grouping.   We agree

with petitioner that the proper formula to accomplish this is to

prorate the average outstanding principal balance of the foreign

currency denominated loans repaid during 1986 between the

statutory and residual groupings, and to apportion the average

outstanding principal balance of the foreign currency denominated

loans not repaid during 1986, as well as the average outstanding
                                 - 19 -


principal balance of the U.S. dollar denominated loans during

1986, solely to the subpart F grouping.9



      Swap Losses

      Both parties have allocated and apportioned the deductions

for swap losses using the asset method.     Given the fact that the

regulations provide for the use of the asset method only in

respect of interest expense, section 1.861-8(e)(2)(v), Income Tax

Regs., we interpret the use of the asset method by both parties

as an agreement to treat swap losses in the same manner as

interest expense.     In this connection, we note that, based on the

record herein, the swap losses involved streams of interest

payments, so that the treatment of the losses as interest expense

is appropriate.     We therefore hold that the deduction for swap

losses will be allocated and apportioned using respondent's

approach to the asset method, discussed and upheld above.



      Swiss Capital Tax

      Similarly, both petitioner and respondent have allocated and

apportioned the deduction for the Swiss capital tax using the

asset method.10     Again, we interpret this use of the asset method

9
   These adjustments can be made in the Rule 155 computation that
will be necessary in this case.
10
     We note that respondent contends at one point on brief that
                                                     (continued...)
                               - 20 -


as an agreement to treat this deduction in the same fashion as

interest expense.    We have some doubt whether the Swiss capital

tax would generally qualify as interest for purposes of section

1.861-8(e)(2), Income Tax Regs.   However, the factual foundation

for determination may be a critical element in resolving such

issue.   Such being the case, we accept the agreement of the

parties for purposes of the case.   Accordingly, this item should

be allocated in the same manner as we have concluded is proper

for interest expense.




     Exchange Loss

     The parties treat the deductions for exchange loss

differently.   Respondent would put the deductions in a catch-all

category, and would apportion these losses all at once, ratably

across all income.   Petitioner would deal with each item

individually, based on the nature of the underlying expense.    We

think petitioner has the better approach.   The most accurate way

to treat the deductions in question, in keeping with the mandate

that allocations be made "on the basis of the factual


10
 (...continued)
the Swiss capital tax does not relate to any one class of income,
and thus should be allocated ratably to all AG's gross income.
However, respondent thereafter on brief continues to argue that
the asset method should be used to apportion the expense in
accordance with the stipulation of the parties.
                                - 21 -


relationship of deductions to gross income", is to deal with each

item individually.   Sec. 1.861-8(a)(2), Income Tax Regs.      Because

petitioner agrees with respondent that the "accrual of income

tax" and "other" items are properly allocated against all income,

we need only discuss the proper treatment of the "accrual of

interest payments" and "accrual of swap payments" items.

     Respondent argues for the application of section 1.861-

8(e)(7), Income Tax Regs., which provides that loss from the

sale, exchange, or disposition of property be allocated to "the

class of gross income to which such asset or property ordinarily

gives rise in the hands of the taxpayer."    Respondent further

argues that the facts of this case represent "unusual

circumstances" and that apportionment by gross income is

necessary.   Sec. 1.861-8(e)(7)(ii), Income Tax Regs.   Respondent

contends that foreign currency is "property" for purposes of the

Code, and that the losses at issue resulted from the exchange of

this property.

     We are not convinced.   The cases cited by respondent do not

support the application of section 1.861-8(e)(7), Income Tax

Regs., to the facts of this case.    It is true that this Court has

held that foreign currency is property.     Federal National

Mortgage Association v. Commissioner, 100 T.C. 541, 582 (1993);

National-Standard Co. v. Commissioner, 80 T.C. 551 (1983), affd.

749 F.2d 369 (6th Cir. 1984).    Nevertheless, this Court has also
                              - 22 -


held that a foreign exchange transaction does not involve an

exchange of property.   National-Standard Co. v. Commissioner,

supra.   Furthermore, the many cases interpreting foreign currency

as property have, for the most part, involved the issue

characterization of gain as ordinary or capital, and consequently

are of little help in the present case.

     Respondent relies heavily on Black & Decker Corp. v.

Commissioner, 986 F.2d 60 (4th Cir. 1993), affg. T.C. Memo. 1991-

557, which we find distinguishable on its facts.   In Black &

Decker Corp., the taxpayer liquidated the stock of a Japanese

subsidiary at a loss, and argued that the loss should be

apportioned under section 1.861-8(e)(7), Income Tax Regs., to its

worldwide income, because the taxpayer's purpose in setting up

the subsidiary was to augment its worldwide economic position.

The Tax Court and the Court of Appeals for the Fourth Circuit

both rejected the taxpayer's argument, and held that the loss had

to be apportioned to foreign source income, because the stock of

a wholly owned subsidiary, viewed objectively, "ordinarily gives

rise" to dividend income, which in that case would have been

foreign source.

     In the instant case, the foreign currency, while qualifying

as property, would not ordinarily produce a type of income

itself, independent of the assets that were denominated in that

currency.   We are not prepared to say that foreign currency,
                                - 23 -


which produced the losses involved here, "ordinarily gives rise"

to a gain from the sale, exchange or disposition of property, for

purposes of section 1.861-8(e)(7), Income Tax Regs., within the

meaning of National-Standard Co. v. Commissioner, supra, and

Black & Decker Corp. v. Commissioner, supra.

     We move then to the proper treatment of the items in

question under the general rules for allocation and

apportionment.   First, exchange losses attributable to the

accrual of interest payments should be treated in the same

fashion as the underlying interest expense.    Interest income

cannot properly be measured without taking into account interest

expense.   Interest expense, in turn, cannot properly be measured

without the costs related to measuring it.     In this case, the

related accrual of exchange losses was a cost related to

measuring the underlying expense.    That item should be

apportioned in accordance with our disposition of interest

expense.   See supra pp. 12-18.

     For the same reasons, exchange losses attributable to the

accrual of swap payments must be treated in the same fashion as

the underlying swap payments.     The gain or loss relating to the

currency swap agreements cannot accurately be measured if one

does not take into account the cost attributable to the payments.

Exchange losses were an intrinsic cost of these transactions, and

must be taken into account.   We have already held that the swap
                              - 24 -


losses are to be treated as interest expense under section 1.861-

8(e)(2), Income Tax Regs.   Consequently, the exchange losses

related to swap losses should also be apportioned as interest

expense in accordance with our treatment of that item.   See supra

pp. 12-18.

     To take into account the concessions of the parties and our

disposition of the investment tax credit issue, see supra note 1,



                                    Decision will be entered

                               under Rule 155.
