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February 18, 1983


The opinion of the court was delivered by: Getzendanner, District Judge:


This tax refund litigation concerns the deductibility of corporate payments to a nearly wholly-owned foreign subsidiary under the terms of an indemnification pledge. By agreement of the parties, trial has been held on stipulated facts and exhibits.*fn1 The memorandum which follows constitutes the court's findings of fact and conclusions of law.

I. Facts

Taxpayer Nalco Chemical Company ("Nalco") is a Delaware corporation whose principal place of business is in Oak Brook, Illinois. Nalco manufactures and sells specialty chemicals and related products throughout the world. (Stip.*fn2 ¶ 2) Prior to 1967, Nalco owned the entire stock of a British subsidiary, Nalco Limited. (Palmer Dep.*fn3 at 7) Nalco Limited furnished specialty chemical services for customers in the petroleum, metal, paper, textile and mining industries. (Ex. 3, p. 5) The subsidiary acted as "a sales organization selling and servicing Nalco Chemical — or delivering Nalco Chemical type business in the U.K." (Palmer Dep. at 8)

In 1967, Nalco agreed to combine Nalco Limited with ICI Alfloc, a wholly-owned British subsidiary of Imperial Chemical Industries, Limited ("ICI"), a British chemical firm. (Ex. 3). ICI Alfloc had engaged principally in "the business of supplying a service for the resolution of [water treatment] problems." (Ex. 3, p. 5) Out of the resulting combination a new joint venture entity, Nalfloc Limited ("Nalfloc"), was created. Nalfloc succeeded to the assets, liabilities and businesses of both Nalco Limited and ICI Alfloc. It was contemplated that Nalfloc would counsel clients experiencing particular types of chemical problems, and would procure the chemicals and equipment needed to effectuate its advice. (Ex. 3, p. 7)

Under the terms of the joint venture agreement, Nalco obtained a 49% equity interest in Nalfloc, and ICI acquired the remaining 51%. As a further condition of the agreement, Nalco agreed to lend Nalfloc 1,300,000 British pounds at a 7% annual rate. (Ex. 4)

At this time, the British Exchange Control Act of 1947 barred foreign corporations from engaging in certain transactions without the prior approval of the British Government. (For. Stip.*fn4 ¶ 2) Nalco sought permission from the Bank of England*fn5 to borrow "by way of a sterling loan raised in the U.K." the 1,300,000 pounds it needed to loan to Nalfloc. (Ex. 1) Permission was denied as the Bank ruled that the loan monies had to be raised from "external" (i.e., non-British) sources. (Ex. 2) Nalco consequently fulfilled its joint venture obligation by loaning Nalfloc pounds which Nalco purchased in the United States with American dollars. (Palmer Dep. at 11)

Because it was a creditor of a loan payable in a foreign currency (i.e., pounds), Nalco was exposed to the risk of a currency exchange loss in the event the pound lost value relative to the dollar during the pendency of the loan.*fn6 To protect itself, Nalco purchased contracts committing it to a future delivery of pounds. (Palmer Dep. at 35; Ex. 2 to Jackson Dep.*fn7)

Eight months later, on January 3, 1968, President Lyndon B. Johnson issued Executive Order 11387. This Order restricted the permissible amount of capital that could be exported from the United States. Most significantly, under the Foreign Direct Investment Controls ("FDIC") regulations, a foreign subsidiary's annual earnings were deemed a capital outflow chargeable to the subsidiary's domestic parent. This interpretation created a need for Nalco to "repatriate" its outstanding loan to Nalfloc. Nalfloc's repayment would be a capital inflow offsetting the outflows attributed to the earnings of Nalco's existing foreign subsidiaries. (Palmer Dep. at 18-20; Ex. 11)*fn8 To achieve this result, Nalco's officers decided to establish a foreign financing subsidiary. Their plan was to have the new subsidiary borrow funds offshore and lend them to Nalfloc. Nalfloc would then use the latter proceeds to repay Nalco.*fn9

For various reasons, Nalco selected Switzerland as the situs for its new subsidiary, and on December 19, 1968, Nalco Capital Corporation A.G. ("Capital") was formed. (Palmer Dep. at 19-20) Thirty thousand shares of Capital's stock were issued, with Nalco owning all but five.*fn10 The subscribed capital was three million Swiss francs; one million Swiss francs were paid in. The board of directors (called in Switzerland the "board of administrators") consisted of five individuals, three of whom were prominent Swiss businessmen having no formal connection with Nalco. (Ex. 23) Swiss law required that a majority of Capital's directors be Swiss nationals. (Mueller Dep.*fn11 at 9-10).*fn12

Prior to the actual incorporation of Capital, Nalco negotiated the terms of a loan under which Dow Banking Corporation of Zurich ("Dow") agreed to loan Nalco's prospective Swiss subsidiary 14,000,000 Swiss francs. The interest rate was 6 1/4% per annum. (Ex. 24) Dow demanded and received from Nalco an unconditional guarantee for the repayment of this loan. (Ex. 25)

As discussed before, the plan was to have Capital use the proceeds of its Dow loan to make a second loan, at 7% and in British pounds, to Nalfloc. For reasons to be detailed later, Capital's three Swiss directors demanded that Nalco indemnify Capital for any losses it might incur on its loan to Nalfloc. (Ex. 19) The Swiss directors made it quite clear that they would not assume their positions without the requested indemnification. (Bruderer Dep. at 15; Bruppacher Dep. at 16-17*fn13) Their demand was received at Nalco headquarters on December 17, 1968, and on that same day, Nalco responded with a telegram agreeing to the proposed terms. A followup letter (also dated December 17, 1968) memorialized the arrangement:

  Nalco Chemical Company has agreed to indemnify
  Dow Banking Corporation for any losses incurred
  in connection with loans it has agreed to make to
  Nalco Capital Corporation A.G. Nalco Chemical
  Company hereby agrees that it will not seek
  reimbursement from Nalco Capital Corporation A.G.
  for any amounts which Nalco Chemical Company may
  be required to pay to Dow Banking Corporation in
  connection with the guaranty which has been
  Nalco Chemical Company further agrees to
  indemnify and hold harmless Nalco Capital
  Corporation A.G. from any loss which may be
  incurred in connection with its loan agreement
  with Nalfloc Limited, a United Kingdom company,
  as a result of devaluation of the pound sterling,
  the currency in which the loan from Nalco Capital
  Corporation A.G. to Nalfloc Limited is

(Ex. 21) Two days later, on December 19, 1968, the transactions were closed: Capital was incorporated, and the loans from Dow to Capital and from Capital to Nalfloc were executed.*fn14

The latter loan matured 15 months later and was then renewed, but for a different term (one year) and at a different interest rate (9%). (Ex. 35) At the same time, Capital took out a new 11,000,000 Swiss franc loan from Dow payable in one year. The interest rate charged by Dow was 9 1/8%. (Ex. 31) In connection with this loan, Nalco executed a second guarantee in Dow's favor. (Ex. 34) Also, a second letter of indemnification, identical in all material respects to the initial one, was given to Capital to cover its exposure on its renewed loan to Nalfloc. (Ex. 37)

Both loans were renewed for one year on two additional occasions. (Exs. 45, 50, 60, 65) Capital charged Nalfloc 7 3/8% interest each time. (Exs. 50, 65) Moreover, Nalco renewed its guarantee and its indemnification pledge at each instance. (Exs. 46, 49, 61, 62)

Between December 1968 (when the initial Capital loan to Nalfloc was made) and March 1973 (when Nalfloc repaid Capital), the British pound lost value relative to the Swiss franc. In the process, Capital suffered a substantial exchange loss — 3,008,200 Swiss francs — on its loan to Nalfloc. (The exact dollar amount of this figure is disputed, but it appears to be somewhere in the vicinity of one million dollars.) Capital lacked sufficient funds to repay Dow.

It is undisputed that Nalco was at this point legally obligated under its indemnification agreements to hold Capital harmless from the exchange loss it had incurred. It is further agreed that Nalco was obligated to pay Dow whatever amount Capital could not. In order to satisfy these obligations, Nalco immediately transferred 1,200,000 Swiss francs to Capital (Ex. 74). This payment allowed Capital to repay Dow in full.

The remaining 1,800,000 Swiss francs owing under the indemnification agreements were accrued on Nalco's books as an account payable. Final payment of this amount occurred in May 1974.*fn15

In computing its 1973 income tax return, Nalco deducted the dollar equivalent of the payments it had made to Capital under the indemnification agreements. The Internal Revenue Service disallowed the deduction and this suit followed.*fn16

II. Section 162(a)

Nalco first argues that its indemnification payments are "ordinary and necessary" business expenses deductible under section 162(a) of the Internal Revenue Code of 1954.*fn17 The Government concedes that the "necessary" prong of this test is satisfied, but otherwise disputes the taxpayer's position.

Resolution of this controversy turns primarily on whether the subject payments served to benefit Nalco's business in a "direct" or "proximate" manner.*fn18 The Government contends that by entering into its indemnification pledges, Nalco merely enhanced the value of its ownership interest in Nalfloc, thereby rendering the resulting payments nondeductible contributions to the capital of the latter entity.*fn19 This argument derives from the observation that whenever a loan is extended in a nondomestic currency, one or both of the parties to the transaction must bear the risk of loss caused by the possibility of a change in the applicable currency exchange rate. To protect itself, a rational creditor will thus do one of two things: shift the risk to the borrower (i.e., demand repayment in the creditor's domestic currency), or charge an interest rate which is higher than that demanded in domestic currency transactions, in order to compensate for the added risk. The Capital-Nalfloc loans, so the Government argues, deviated from this norm. The creditor (Capital) was to be repaid in a foreign currency (pounds) at rates insufficient to reflect the true risk at stake. Thus, only because Nalco had placed*fn20 Capital in such a disadvantageous position was the "independent" Swiss demand for indemnification ever made. Furthermore, by agreeing to this demand, Nalco essentially paid the premium that Nalfloc itself would have incurred had it attempted to procure a pound loan from a nonaffiliated Swiss source. The agreement to indemnify must thus be viewed, according to the Government, as an attempt by Nalco to relieve Nalfloc of an expense and thus as a contribution to the subsidiary's capital.

The Government alternatively points out that Nalco agreed in its initial discussions with ICI to bear the risk of currency loss on Nalco's initial loan to Nalfloc. ICI "was not agreeable to Nalfloc having a foreign currency exposure in the form of foreign currency other than pounds sterling running from Nalfloc to Nalco or any affiliate company." (Palmer Dep. at 26) When the loan was transferred to Capital, this principle remained intact; the loan continued to be denominated in pounds sterling, and the risk of loss fell once again — via the indemnification agreement — upon Nalco. Thus, "[s]ince the payments under the indemnification have, as their origin, taxpayer's agreement with ICI to bear the ...

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