                         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.
                               - 2 -


           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.
                               - 3 -


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.
                                - 4 -


     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
                                - 5 -


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,
                                   - 6 -


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
                                - 7 -


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
                               - 8 -


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.
                               - 9 -


     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
                              - 10 -


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
                              - 11 -


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
                              - 12 -


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
                              - 13 -


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
                               - 14 -


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
                                  - 15 -


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).
                              - 16 -


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
                                - 17 -


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
                              - 18 -


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. * * *
                              - 19 -


               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
                              - 20 -


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
                             - 21 -


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.
                              - 22 -


     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
                             - 23 -


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
                              - 24 -


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.
                              - 25 -


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
                             - 26 -


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.
                             - 27 -


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
                              - 28 -


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.
