Flint Industries, Inc. v. Commissioner
| Decision Date | 10 October 2001 |
| Docket Number | Docket No. 10645-97. |
| Citation | 82 T.C.M. 778 |
| Parties | Flint Industries, Inc. and Subsidiaries v. Commissioner. |
| Court | U.S. Tax Court |
Mark H. Allen, Kevin L. Kenworthy, and Frances F. Hillsman, Tulsa, Okla., for the petitioner. David G. Hendricks, for the respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
Respondent determined the following deficiencies in the Federal income tax of Flint Industries, Inc., and subsidiaries:
FYE May 31 Deficiency
1989 ............................ $ 66,096
1990 ............................ 663,532
1991 ............................ 1,014,268
1992 ............................ 752,581
Flint Industries, Inc., and subsidiaries, hereinafter collectively referred to as petitioner, filed a petition to redetermine the deficiencies.1 Following concessions, the issue presented for decision is whether the following worthless stock and bad debt deductions claimed by petitioner on its consolidated Federal income tax returns for fiscal years ending (FYE) May 31, 1992 1993, and 1994, are allowable under sections 165 and 166:2
FYE May 31 Worthless stock Bad debt
1992 ......................................... $7,374,438 $6,564,124
1993 ......................................... 2,435,876 815,105
1994 ......................................... -- 6,085,248
Respondent contends that petitioner's worthless stock and bad debt deductions must be disallowed because (1) the amounts claimed as bad debts were capital in nature, and (2) petitioner has failed to prove that the alleged bad debts and worthless stock were worthless in the taxable years the disputed deductions were claimed.3 Respondent concedes, however, that all of the disallowed worthless stock and bad debt deductions constitute a long-term capital loss for FYE May 31, 1994.
Some of the facts, and pertinent German law, have been stipulated for purposes of these proceedings and are so found or stated. The stipulations are incorporated herein by this reference.
At the time the petition was filed, Flint Industries, Inc. (Flint), was a corporation with its principal place of business in Tulsa, Oklahoma. For all relevant years, Flint was the common parent of a group of affiliated corporations that filed a consolidated corporate income tax return for each of the taxable years at issue.4 For all relevant years, Flint used the accrual method of accounting and a fiscal year ended May 31.
During the years at issue, Flint was engaged primarily in the business of large-scale construction and oil and gas servicing. Flint's ability to conduct its business successfully depended heavily upon Flint's maintaining good banking and surety relationships.
In the late 1970s and early 1980s, Flint, directly or through its subsidiaries, purchased three electronics companies, one of which was W. Günther GmbH (Günther). Günther was an electronic component manufacturing firm located in Nurnberg, Germany. It was organized as a German Gesellschaft mit beshrankter Haftung (GmbH) and was classified as a corporation for U.S. tax purposes. Günther used the accrual method of accounting and a fiscal year ending on April 30.
Flint's majority-owned subsidiary, Flint Electronics Co. (Flint Electronics), purchased 100 percent of Günther's stock for $4,890,388 during FYE May 31, 1981. During FYE May 31, 1985, Flint Electronics contributed $484,050 to Günther's capital. As set forth more fully, infra, during FYE May 31, 1992, Flint Electronics contributed an additional $2 million to Günther's capital.5 As of May 31, 1992, Flint Electronics' adjusted basis in its Günther stock, before taking into account the amounts at issue in this case, was $7,374,438.
Günther's geschäftsführer, Albert Günther (Albert), and its procurist, Hans Kampfrad (Kampfrad), controlled Günther's day-to-day management and operations.6 Albert reported directly to Flint's president.
Most of Günther's products were switches, relays, and sensor devices such as those used for air bags and braking systems. The market for these products was highly cost-sensitive because Günther had several competitors that made similar products.
At some point before 1992, Günther was an industry leader in air bag sensor technology. Subsequently, however, new products superseded Günther's technology and eroded its competitive advantage. Although Günther owned patents for some of its manufacturing processes, by May 31, 1992, Günther's patents had little or no value because the underlying technology was widely available in other forms.
Günther was the majority owner of several subsidiaries that manufactured or sold products in India, France, Switzerland, and Germany (Berlin). The French and Swiss subsidiaries were distribution outlets that sold Günther's products. The Berlin subsidiary was essentially a manufacturing subcontractor for Günther. The Indian subsidiary began as a joint venture in 1991. It operated a manufacturing facility that was supposed to produce Günther's products at a lower cost. Günther's subsidiaries were valued at historical cost (book value) on Günther's balance sheet. As of May 31, 1992, the subsidiaries' book values exceeded their fair market values.
In the 1980s, Flint also provided some working capital to Günther and guaranteed certain of Günther's bank loans. With one exception discussed below, all of these guaranties were given between 1983 and 1989. During this period, Günther did not have much equity, it had a poor relationship with German banks, and its earnings were erratic.
At some point before January 1992, without the knowledge or approval of Flint's management,7 Günther obtained a loan of roughly 2,500,000 deutsche marks (DM)8 from Bankhaus Reuschel (Reuschel).9 In February 1992, when Reuschel indicated it would demand immediate payment of the loan without Flint's guaranty, Flint guaranteed the loan. Because Günther was operating at a loss by then, Flint's management knew that guaranteeing the Reuschel loan was risky. Still, Flint extended the guaranty, as it saw no economically reasonable alternative short of advancing Günther the cash to repay the note.
Günther's long-term liabilities also included a lease for Günther's building in Nurnberg. This building was owned by Actium Leasobjekt GmbH & Co. KG (Actium), a limited partnership. Günther owned a 99-percent limited partnership interest in Actium. In the early 1980s, shortly after acquiring Günther, Flint guaranteed the lease for Günther's building in Nurnberg.
Günther's bank loans were listed on its balance sheets as notes payable. As of April 30, 1992, the principal balances of Günther's notes payable to banks totaled $10,976,220, and accrued interest thereon totaled $1,382,965. Günther also owed Actium $4,942,343 under the terms of its lease.10
In 1987, petitioner decided to focus on its core businesses and began efforts to sell Günther and its other electronics subsidiaries. Petitioner engaged investment bankers in the United States and in Germany to find potential buyers, and the bankers endeavored to do so during 1988, 1989, and 1990. As part of the sales effort, petitioner and its agents contacted hundreds of potential purchasers, and serious discussions were held with more than 10 companies.
In 1990, petitioner negotiated a letter of intent with a potential purchaser, AMETEK, to sell Günther for DM 11 million. The consideration included Flint's release from its guaranties of Günther's bank loans. In late 1990, however, AMETEK withdrew its letter of intent for undisclosed reasons while conducting its due diligence investigation. This withdrawal coincided with rising oil prices during the Gulf War and a general downturn in the European auto industry, during which the electronics and automotive industries suffered setbacks.
As of FYE May 31, 1990, the income statement of Günther and its subsidiaries showed a net profit of $387,962. During FYE May 31, 1991, petitioner began advancing cash to Günther so that Günther could service its bank loans and meet its short-term financial obligations. As of FYE May 31, 1991, the income statement of Günther and its subsidiaries showed a net loss of $414,443.
Early in FYE May 31, 1992, Günther management's interim reports to petitioner showed a fiscal-year-to-date loss of roughly DM 5 million ($3,012,500 approximately). From petitioner's perspective, this result was a disaster. Günther was unable to pay its bank loans and trade payables currently out of cashflow generated from its operations, and, consequently, petitioner had to advance the necessary funds to prevent a default by Günther on the guaranteed bank loans. Sometime later in FYE May 31, 1992, Günther's management reported that a capital contribution in the amount of $2 million was required to avert statutory bankruptcy under German law. Petitioner made the requested contribution to capital after Günther's management projected significant improvement in operating results for the latter half of Günther's FYE April 30, 1992.
Petitioner's management first became aware of the true severity of Günther's financial problems during July 1992, when it discovered a transaction that would become known as the Omega transaction.
In the Omega transaction, Günther transferred machinery to Omega-Reed GmbH (Omega), a no-asset corporation owned by one of Günther's former employees, in exchange for Omega's promise to produce switches for Günther at a reduced cost...
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