1960 U.S. Tax Ct. LEXIS 146">*146 Decision will be entered under Rule 50.
During the period October 1951 to October 1952 the petitioner, an international wool dealer, carried large quantities of sterling area and French wools in inventory. Throughout the same period rumors that the pound sterling and French franc would be devalued were widespread. Fearing that devaluation of these currencies would bring about an immediate decline in the market value of its foreign wool inventory, the petitioner sold pounds sterling and French francs short in amounts not in excess of its holdings of sterling area and French wools. Held, under these specific and unusual circumstances petitioner's currency futures are to be considered as in the nature of bona fide hedging transactions, so that the loss sustained in closing them out was an ordinary loss deductible in full against gross income.
34 T.C. 323">*323 Respondent determined a deficiency of $ 64,681.27 in petitioner's income tax for the calendar year 1952. Petitioner has paid $ 5,531.39 of this amount, so that the net deficiency involved herein is $ 59,149.88.
The deficiency arises by reason of respondent's determination that losses of $ 113,781.01, which petitioner sustained during the taxable year in closing out contracts for the future delivery of English 34 T.C. 323">*324 pounds sterling and French francs and which it reported on the return as a cost of goods sold, were capital losses allowable only to the extent of offsetting capital gains, of which petitioner had none.
FINDINGS OF FACT.
The stipulated facts, including the exhibits attached thereto, are incorporated herein by this reference.
Petitioner is a New York corporation with its principal office in Boston, Massachusetts. Petitioner's Federal income tax return for the calendar year 1952 was filed with the now district director of internal revenue, Upper Manhattan, city of New York. The return was prepared on an1960 U.S. Tax Ct. LEXIS 146">*148 accrual basis of accounting and the Lifo method of inventory valuation.
At all times material to this proceeding, petitioner operated as an international wool dealer primarily engaged in the business of buying and selling wool for its own account. Petitioner's purchases were chiefly wools of foreign origin which it bought from other dealers in the United States and paid for in United States dollars or which it bought directly in foreign markets and paid for in the appropriate foreign currency. In the latter case the amount of dollars needed to acquire the foreign currency used to pay the seller was controlled by the rate of exchange between that foreign currency and the dollar on the date of payment.
During the period October 1951 to October 1952 petitioner sold all of its wool in the United States with the exception of $ 25,000 worth which it sold in foreign markets.
Petitioner's wool purchases during the same period totaled $ 22,869,639.86. Of this amount 52.12 per cent was paid for in pounds sterling, and represented wool produced in Australia, New Zealand, South Africa, and England (hereinafter referred to as "sterling area wool"). An additional 19.37 per cent was also sterling1960 U.S. Tax Ct. LEXIS 146">*149 area wool, but was bought from dealers in the United States and paid for in dollars. The balance of petitioner's purchases consisted of French and Belgian wool (6.18 per cent) and South American and domestic wool (22.33 per cent). Like the sterling area wool, some of the French, Belgian, and South American wool was purchased abroad and some here.
With respect to sterling area wool which it paid for in pounds sterling, petitioner customarily placed its purchase orders with a buying agent in the particular commonwealth country where the wool was grown. The agent would execute the order, pay the grower in the local currency (Australian, New Zealand, or South African pounds), and then receive payment from petitioner at a later date 34 T.C. 323">*325 after the wool was shipped. In order to protect himself during this interim the agent would obtain from his local bank a guarantee that the pounds sterling he received from petitioner would be equal in value to the currency with which he had previously paid the grower. The cost of this guarantee was included in the invoice price of the wool to petitioner.
With respect to wool purchased directly in sterling area countries, petitioner occasionally1960 U.S. Tax Ct. LEXIS 146">*150 paid the buying agent in cash, but its general practice was to finance the purchase by a straight letter of credit or 120-day letter of credit, or through 120-day sterling refinancing.
Under a straight letter of credit, which petitioner would open with a foreign bank through its bank in Boston, the agent presented the necessary documents (invoices, weight specifications, and bills of lading) to the foreign bank, and received payment at that point in the foreign currency. The foreign bank in turn drew upon the Boston bank, by means of a draft to be paid immediately, the amount of foreign currency covered by the invoice presented, and the Boston bank thereupon paid the draft and charged petitioner's account with the equivalent in dollars. The rate of exchange on the date the draft was received by the Boston bank (usually 4-8 days after it was drawn) fixed the number of dollars needed to buy the foreign currency.
Under the 120-day letter of credit the agent issued a 120-day sight draft to his local bank. The draft was forwarded to an English bank, and in turn to petitioner's Boston bank, which accepted it and advised the petitioner. On the due date of the draft 120 days later, the1960 U.S. Tax Ct. LEXIS 146">*151 Boston bank made payment in pounds sterling to the agent's local bank, and simultaneously charged petitioner's account with the dollar equivalent of the sterling draft at the then current rate of exchange.
The 120-day refinancing of sterling was arranged with a bank in London, England, through petitioner's Boston bank. Under this method petitioner issued a promissory note in pounds sterling to the London bank against payment for sterling area wool by the London bank on petitioner's behalf. When the note matured 120 days after date, the petitioner made payment in sterling which it bought for dollars at the then current rate of exchange.
Petitioner had a line of credit with its bank in Boston, and customarily borrowed the sums used to discharge its obligations under the straight and 120-day letters of credit and under the 120-day sterling refinancing. Exclusive of interest charges on these loans, which ranged between 2 3/4 and 3 per cent, the cost of a 120-day letter of credit ranged from 4.95 per cent to 7.18 per cent during the period October 1951 to October 1952, and the cost of 120-day sterling 34 T.C. 323">*326 refinancing ranged from 3.81 per cent to 6 per cent during the same period.
1960 U.S. Tax Ct. LEXIS 146">*152 Petitioner used 120-day letters of credit and 120-day sterling refinancing (both of which are hereinafter sometimes referred to as 120-day financing) in order to stay in the original currency of purchase as long as practicable and thereby protect itself against any fluctuations in the exchange value of that currency. These methods of payment were available only at the time of purchase, and applied only to wool purchased directly in sterling area countries. They were not available with respect to sterling area wool in existing inventory or purchases of such wool from other dealers which were paid for in dollars, nor were they available for purchases of French or Belgian wool in the markets of origin; such purchases could be financed only by cash remittance to the seller or by the use of a straight letter of credit.
In 1951 and 1952 the wool auctions in Australia were held from the end of August through the following June. As the result of substantial purchases in this market, together with a sudden decline in the demand for wool in the United States, petitioner had unusually large stocks of wool on hand during the latter part of 1951. As of September 30, 1951, its inventory amounted1960 U.S. Tax Ct. LEXIS 146">*153 to $ 14,896,754.74, a much larger inventory than petitioner had had for several years. This figure included the landed cost of the wools (cost, freight, and purchase commissions) plus the cost of 120-day financing where appropriate.
In October of 1951 petitioner, through its executive vice president and dominant shareholder, Robert G. Reiser, entered into contract negotiations with officers of Pacific Mills, Inc., a large textile manufacturer, and by the early part of November the parties had reached a general oral agreement that petitioner would supply a substantial portion of Pacific's raw wool requirements for the coming year. An important part of this agreement was the understanding that petitioner would guarantee each shipment of wool to Pacific against fluctuations in the sterling exchange rate for a period of 120 days from the bill of lading date in Australia. Specific arrangements as to pricing and the total amount and quality of wool to be supplied continued to be the subject of negotiations until February 1, 1952, when the parties signed a contract providing, in important part, as follows: During 1952 Pacific agreed to buy 8,000 bales of Australian wool of grades 60, 1960 U.S. Tax Ct. LEXIS 146">*154 60/64, 64/60, and 64, all of which are wools of superior quality and spinning characteristics. Delivery and billing, at the rate of 400 bales a week for 20 weeks, was to commence on April 1, 1952. However, pricing of the weekly shipments was to 34 T.C. 323">*327 start retroactively with the week of January 7, and be based on the then current Australian market quotation for wool of equivalent grade to that subsequently delivered under the contract. The 120-day sterling guarantee was continued, and in addition petitioner obligated itself to hedge, at Pacific's request, 200 bales a week in the New York grease wool futures market.
In anticipation of its obligations to Pacific Mills, petitioner began late in 1951 to purchase and accumulate inventory wools suitable for delivery under the contract. Some of these purchases were handled through the medium of 120-day financing; however, a substantial portion was not so that petitioner itself bore the burden of the 120-day sterling guarantee.
Beginning in the fall of 1951 and continuing until the middle of 1952, there was a widespread feeling in banking circles and among others involved in international trade that the adverse balance of payments 1960 U.S. Tax Ct. LEXIS 146">*155 of France and Great Britain and the resulting critical drain on their gold and dollar reserves would induce those countries to devalue their currencies. Certain decisions of the Bank of England, in late 1951 and early 1952, to raise the discount rate and the interest rate for borrowing sterling under letters of credit not only reinforced the general expectation that devaluation was impending but also served to increase substantially the cost of 120-day financing.
As the result of newspaper reports and discussions which its executive vice president, Reiser, had with banking officials petitioner was aware as early as October of 1951 that devaluation of the British pound and French franc was a distinct and imminent possibility. Reiser, who controlled the business policy and operation of petitioner, had been in the international wool business for many years and had recently observed and experienced the results of the devaluation of the pound which had taken place in 1949. Although a subsequent devaluation did not in fact occur, petitioner had reasonable grounds for believing that it would.
Insofar as international wool dealers were concerned, the economic result of devaluation would1960 U.S. Tax Ct. LEXIS 146">*156 have been an immediate and sharp reduction in the dollar cost of sterling area and French wool. Since the price at which foreign wool can be sold in the United States cannot as a general rule exceed its replacement cost in the market of origin plus tariff, shipping costs, and commissions, the effect of devaluation on a domestic wool dealer would be to cause a substantial decrease in the market value of any sterling area or French wool that he had already purchased and was holding in inventory.
During the period here in question petitioner reasonably anticipated the possibility that the pound and franc might be devalued and reasonably believed that devaluation would result in an immediate 34 T.C. 323">*328 sharp decline in the value of the sterling area and French wools which, throughout the period October 1951 to October 1952, comprised the major portion of its inventory. Petitioner was not in a position to sustain such a decline for the reason that it had borrowed much of the funds used to finance its wool purchases and was heavily in debt to the lending banks. Therefore, it was in danger of being compelled to liquidate its inventory at a loss in the event that devaluation occurred and1960 U.S. Tax Ct. LEXIS 146">*157 the banks chose to call their loans.
During the period in question petitioner employed two methods of protecting itself against a decline in the value of its inventory. The first method was to engage in futures transactions on the New York Wool Exchange, and the second was to sell pounds sterling and French francs short. 1
Except for a brief period in late 1951 when it maintained a long position, petitioner's wool futures transactions consisted exclusively of short sales, and were entered into as a form of insurance against the possibility of a broad downward 1960 U.S. Tax Ct. LEXIS 146">*158 movement of wool prices in the domestic market. Petitioner did not at any time offset the full value of its wool stocks with an equal amount of wool futures. It did not consider that domestic wool futures would adequately protect its large holdings of foreign wool against the kind of sharp, but not necessarily sustained, decline in price that devaluation would induce for the reason that wool futures quotations, although responsive to broad price movements in foreign and domestic wools, are influenced by a wide variety of economic factors of which devaluation would be only one.
Petitioner did not use the wool futures markets in Antwerp, Belgium, and Roubaix-Tourcoing, France. The Belgian market was restricted to small-scale operations, and consequently was not geared to handle extensive wool futures transactions. The French market dealt exclusively in French wools, and, furthermore, there was the danger that petitioner's funds would be blocked and hence unavailable to it in the United States. For these reasons petitioner determined that neither market was suitable for its requirements in the face of devaluation.
Petitioner concluded that the most effective way to protect its inventory1960 U.S. Tax Ct. LEXIS 146">*159 of sterling area and French wools against the specific threat of devaluation was to sell pounds sterling and French francs short. Its transactions in these currencies were as follows: 34 T.C. 323">*329
| Sterling Short Sales | ||||
| Date | Amount | Exchange | Dollar cost | Date purchased |
| sold | of pounds | rate | ||
| 10-31-51 | 20,000 | 272 5/8 | $ 54,525.00 | 4-29-52 |
| 11-19-51 | 100,000 | 277 | 277,000.00 | 5-7-52 |
| 11-21-51 | 100,000 | 279 | 279,000.00 | 1-29-52 |
| 11-23-51 | 50,000 | 278 7/8 | 139,437.50 | 1-29-52 |
| 11-30-51 | 200,000 | 277 1/4 | 554,500.00 | 4-29-52 |
| 11-30-51 | 100,000 | 278 3/4 | 278,750.00 | 2-6-52 |
| 12-12-51 | 100,000 | 276 1/8 | 276,125.00 | 5-26-52 |
| 12-14-51 | 25,000 | 275 | 68,750.00 | 1-29-52 |
| 12-14-51 | 50,000 | 272 1/2 | 136,250.00 | 4-29-52 |
| 12-14-51 | 20,000 | 273 | 54,600.00 | 3-17-52 |
| 12-14-51 | 50,000 | 272 | 136,000.00 | 1-30-52 |
| 12-14-51 | 50,000 | 272 | 136,000.00 | 1-29-52 |
| 12-14-51 | 50,000 | 273 | 136,500.00 | 3-14-52 |
| 12-14-51 | 50,000 | 276 1/2 | 138,250.00 | 12-21-51 |
| 12-14-51 | 100,000 | 273 1/4 | 273,250.00 | 3-14-52 |
| 12-14-51 | 32,000 | 272 1/2 | 87,200.00 | 3-13-52 |
| 12-14-51 | 60,000 | 273 | 163,800.00 | 1-3-52 |
| 12-14-51 | 100,000 | 273 | 273,000.00 | 3-13-52 |
| 12-14-51 | 200,000 | 272 3/4 | 409,125.00 | 3-14-52 |
| 136,375.00 | 3-13-52 | |||
| 12-19-51 | 20,000 | 275 1/2 | 55,100.00 | 5-27-52 |
| 12-19-51 | 100,000 | 276 1/2 | 276,500.00 | 4-18-52 |
| 12-21-51 | 50,000 | 275 1/8 | 137,562.50 | 3-21-52 |
| 1-3-52 | 60,000 | 276 5/8 | 165,975.00 | 4-4-52 |
| 1-30-52 | 50,000 | 275 5/8 | 137,812.50 | 5-7-52 |
| 1-29-52 | 225,000 | 274 1/4 | 137,125.00 | 5-28-52 |
| 205,687.50 | 6-26-52 | |||
| 274,250.00 | 6-24-52 | |||
| 2-6-52 | 100,000 | 275 | 137,500.00 | 7-1-52 |
| 137,500.00 | 5-29-52 | |||
| 3-14-52 | 105,000 | 279 15/16 | 293,934.88 | 3-28-52 |
| 3-14-52 | 215,000 | 279 1/2 | 600,925.00 | 4-4-52 |
| 3-21-52 | 50,000 | 279 3/4 | 139,875.00 | 4-23-52 |
| 3-28-52 | 105,000 | 279 3/4 | 293,737.50 | 4-4-52 |
| 4-8-52 | 50,000 | 277 3/4 | 138,875.00 | 10-3-52 |
| 4-17-52 | 200,000 | 278 1/8 | 556,250.00 | 10-16-52 |
| 10-16-52 | ||||
| 4-18-52 | 100,000 | 278 3/8 | 278,375.00 | 10-17-52 |
| 4-21-52 | 100,000 | 278 1/2 | 278,500.00 | 10-21-52 |
| 4-23-52 | 50,000 | 280 7/16 | 140,218.75 | 5-7-52 |
| 3,037,000 | 2.763958 | $ 8,394,141.13 |
| Sterling Short Sales | ||||
| Date | Amount | Exchange | Dollar cost | (Gain) or |
| sold | of pounds | rate | loss | |
| 10-31-51 | 20,000 | 280 31/32 | $ 56,193.75 | $ 1,668.75 |
| 11-19-51 | 100,000 | 280 1/2 | 280,500.00 | 3,500.00 |
| 11-21-51 | 100,000 | 277 7/8 | 277,875.00 | (1,125.00) |
| 11-23-51 | 50,000 | 277 7/8 | 138,937.50 | (500.00) |
| 11-30-51 | 200,000 | 281 | 56,200.00 | 7,500.00 |
| 11-30-51 | 100,000 | 277 7/8 | 277,875.00 | (875.00) |
| 12-12-51 | 100,000 | 279 1/32 | 279,031.25 | 2,906.25 |
| 12-14-51 | 25,000 | 277 7/8 | 69,468.75 | 718.75 |
| 12-14-51 | 50,000 | 280 31/32 | 140,484.38 | 4,234.38 |
| 12-14-51 | 20,000 | 280 1/2 | 56,100.00 | 1,500.00 |
| 12-14-51 | 50,000 | 277 7/8 | 138,937.50 | 2,937.50 |
| 12-14-51 | 50,000 | 277 7/8 | 138,937.50 | 2,937.50 |
| 12-14-51 | 50,000 | 280 1/2 | 140,250.00 | 3,750.00 |
| 12-14-51 | 50,000 | 276 1/2 | 138,250.00 | |
| 12-14-51 | 100,000 | 280 1/2 | 280,500.00 | 7,250.00 |
| 12-14-51 | 32,000 | 279 7/16 | 89,420.00 | 2,220.00 |
| 12-14-51 | 60,000 | 278 | 166,800.00 | 3,000.00 |
| 12-14-51 | 100,000 | 279 5/8 | 279,625.00 | 6,625.00 |
| 12-14-51 | 150,000 | 280 1/2 | 420,750.00 | 11,625.00 |
| 50,000 | 280 1/4 | 140,125.00 | 3,750.00 | |
| 12-19-51 | 20,000 | 278 3/4 | 55,750.00 | 650.00 |
| 12-19-51 | 100,000 | 280 31/32 | 280,968.75 | 4,468.75 |
| 12-21-51 | 50,000 | 280 5/8 | 140,312.50 | 2,750.00 |
| 1-3-52 | 60,000 | 279 31/32 | 167,981.25 | 2,006.25 |
| 1-30-52 | 50,000 | 280 1/2 | 140,250.00 | 2,437.50 |
| 1-29-52 | 50,000 | 278 1/2 | 139,250.00 | 2,125.00 |
| 75,000 | 278 17/32 | 208,898.44 | 3,210.94 | |
| 100,000 | 278 7/16 | 278,437.50 | 4,187.50 | |
| 2-6-52 | 50,000 | 278 13/16 | 139,406.25 | 1,906.25 |
| 50,000 | 278 7/16 | 139,218.75 | 1,718.75 | |
| 3-14-52 | 105,000 | 279 15/16 | 293,934.88 | |
| 3-14-52 | 215,000 | 279 31/32 | 601,932.81 | 1,007.81 |
| 3-21-52 | 50,000 | 280 7/8 | 140,437.50 | 562.50 |
| 3-28-52 | 105,000 | 280 5/16 | 294,328.13 | 590.63 |
| 4-8-52 | 50,000 | 279 1/8 | 139,562.50 | 687.50 |
| 4-17-52 | 100,000 | 279 3/8 | 279,375.00 | 1,250.00 |
| 100,000 | 279 1/4 | 279,250.00 | 1,125.00 | |
| 4-18-52 | 100,000 | 279 3/8 | 279,375.00 | 1,000.00 |
| 4-21-52 | 100,000 | 279 25/32 | 279,781.25 | 1,281.25 |
| 4-23-52 | 50,000 | 280 1/2 | 140,250.00 | 31.25 |
| 3,037,000 | 2.795773 | $ 8,490,761.14 | $ 96,620.01 |
| French Franc Short Sales | ||||
| Date | Amount of | Exchange | Dollar cost | Date purchased |
| sold | francs | rate | ||
| 1-31-52 | 18,150,000 | 363 | $ 50,000.00 | 5-1-52 |
| 2-1-52 | 14,022,000 | 369 | 38,000.00 | 4-30-52 |
| 2-1-52 | 30,000,000 | 366.9 | 81,743.87 | 4-21-52 |
| 2-4-52 | 16,650,000 | 370 | 45,000.00 | 5-1-52 |
| 2-5-52 | 7,340,000 | 367 | 20,000.00 | 5-1-52 |
| 2-6-52 | 11,010,000 | 367 | 30,000.00 | 5-1-52 |
| 2-6-52 | 30,000,000 | 365 | 82,125.00 | 4-21-52 |
| 127,172,000 | $ 346,868.87 |
| French Franc Short Sales | ||||
| Date | Amount of | Exchange | Dollar cost | Loss |
| sold | francs | rate | ||
| 1-31-52 | 18,150,000 | 349.3 | $ 51,954.38 | $ 1,954.38 |
| 2-1-52 | 14,022,000 | 349.3 | 40,137.98 | 2,137.98 |
| 2-1-52 | 30,000,000 | 349.3 | 85,875.00 | 4,131.13 |
| 2-4-52 | 16,650,000 | 349.3 | 47,660.63 | 2,660.63 |
| 2-5-52 | 7,340,000 | 349.3 | 21,010.75 | 1,010.75 |
| 2-6-52 | 11,010,000 | 349.3 | 31,516.13 | 1,516.13 |
| 2-6-52 | 30,000,000 | 349.3 | 85,875.00 | 3,750.00 |
| 127,172,000 | $ 364,029.87 | $ 17,161.00 |
By dealing in sterling futures, petitioner obtained for its inventory of sterling area wools the same degree of protection against devaluation that 120-day financing provided with respect to new purchases of those wools. The short1960 U.S. Tax Ct. LEXIS 146">*162 sales of French francs afforded a similar protection both as to French wools in inventory and as to new purchases of those wools for which 120-day financing could not be had.
Petitioner also used sterling short sales as an alternative to 120-day financing when the cost of the latter increased to such a point 34 T.C. 323">*330 that the short sales represented a more economical method of protecting its new wool purchases, some of which were destined for ultimate delivery to Pacific Mills and therefore were subject to the 120-day guarantee provided by the contract.
Throughout the period October 1951 to October 1952 the total dollar value of the currency futures and 120-day financing transactions did not exceed the dollar value of sterling area and French wools on hand.
In closing out its wool and currency short sales during the year 1952, petitioner realized a gain of $ 224,626.42 on the wool futures, but sustained losses of $ 96,620.01 on the pound sterling futures and $ 17,161 on the French franc futures. On its return for that year petitioner reported the gain as ordinary income and deducted the losses as an expense of doing business.
OPINION.
The question to be decided in this proceeding1960 U.S. Tax Ct. LEXIS 146">*163 is whether the net losses that petitioner sustained during the taxable year as the result of its dealings in pound sterling and French franc futures are ordinary losses deductible in full from gross income or, as respondent has determined, capital losses allowable only to the extent of offsetting capital gains of which petitioner had none because such futures were capital assets within the meaning of section 117 of the Internal Revenue Code of 1939. 2 The question is essentially one of fact.
1960 U.S. Tax Ct. LEXIS 146">*164 It is apparent from the contentions of the parties that the basic issue between them is whether or not petitioner's dealings in currency futures constituted transactions which may be properly characterized in this case as hedging operations carried on in connection with and as a part of its regular business. The term "hedging" does not lend itself to precise or ready definition. Kenneth S. Battelle, 47 B.T.A. 117">47 B.T.A. 117. It is more a descriptive label that the Commissioner and the courts have applied to certain futures transactions which, on 34 T.C. 323">*331 all the facts and circumstances, have been found to be a form of price insurance and thus connected so closely with the regular conduct of a trade or business as to defy classification as extraneous investments. See Corn Products Refining Co. v. Commissioner, 350 U.S. 46">350 U.S. 46; G.C.M. 17322, XV-2 C.B. 151; Commissioner v. Farmers & Ginners Cotton Oil Co., 120 F.2d 772, reversing 41 B.T.A. 1083">41 B.T.A. 1083, certiorari denied 314 U.S. 683">314 U.S. 683.
A dealer with stocks of a particular commodity1960 U.S. Tax Ct. LEXIS 146">*165 on hand runs the risk of loss should the market price of the commodity fall. To minimize that risk he will customarily enter a futures market and sell the same or a related commodity short in an amount equivalent to the amount in inventory. In this way he reaches an even or balanced position between actuals and futures, so that any loss resulting from a decline in the market price of the actuals will be offset pro tanto by the gains derived from closing out the futures at a commensurately lower cost. G.C.M. 17322, supra. However, such a balancing of gain and loss will not be possible unless the market prices of the actuals and the futures are so related that they normally rise or fall together. If they do not, then the futures will increase rather than diminish the overall risk. For this reason hedging presupposes an intimate price relationship between the two. The actuals and futures need not be in the same commodity so long as their prices move in relation to each other. Albert Kurtin, 26 T.C. 958">26 T.C. 958. Nor must the futures be in the exact amount of the actuals; the latter may be covered entirely or only to the 1960 U.S. Tax Ct. LEXIS 146">*166 extent protection is desired. Stewart Silk Corporation, 9 T.C. 174">9 T.C. 174. But a larger amount of futures than of actuals or an absence of price relationship between the two will suggest that the futures were acquired as an investment and not as a hedge.
Reasoning from the principles of these cases, we think that under the peculiar facts of this case the petitioner has successfully met the burden of qualifying the instant currency futures as being essentially hedging transactions. During the period October 1951 to October 1952 the petitioner carried an extraordinarily large wool inventory which for the most part was of sterling area and French origin. Throughout the same period rumors that the pound sterling and French franc would be devalued were widespread. Petitioner reasonably anticipated such an event as a possibility. Had it occurred, the devaluation of these currencies would have effected an immediate reduction in the price of sterling area and French wools in terms of dollars. Since the price those wools bring in the domestic market characteristically follows their replacement cost in the markets of origin, the petitioner could reasonably anticipate1960 U.S. Tax Ct. LEXIS 146">*167 that devaluation 34 T.C. 323">*332 would bring about a substantial decline in the value of its inventory -- a decline it was in no position to sustain because that inventory had by and large been paid for with borrowed funds. An additional factor was the 120-day sterling guarantee to Pacific Mills which made devaluation a particular threat with respect to wools accumulated for delivery under the contract.
Accordingly, and in specific response to what it believed to be an imminent possibility of devaluation, the petitioner sold pounds sterling and French francs short in amounts which it estimated to approximate its holding of sterling area and French wools. At no time did its holdings of currency futures exceed its inventory of those wools.
Under normal business circumstances the price of pound sterling or French franc futures and the price of sterling area or French wools have little connection with each other. But devaluation is not a normal business circumstance, and it was the prospect of devaluation in 1951 and 1952 that established a bridge between the two insofar as American dealers in foreign wools were concerned. In the light of this unusual economic situation we are satisfied1960 U.S. Tax Ct. LEXIS 146">*168 that the dealings in currency futures involved herein were transactions entered into by petitioner with the bona fide intent of providing a particular temporary form of price insurance protecting its large inventory from the particular temporary threat posed by the reasonably anticipated possibility of currency devaluation, and thus were sufficiently in the nature of hedging operations as to remove the currency futures dealt in from the category of capital assets.
Respondent points out, however, that petitioner realized a profit of $ 224,626.42 from its transactions in the domestic wool futures market, and draws the conclusion that more extensive recourse to that market would have provided all the price insurance that petitioner required. According to the expert and uncontradicted testimony herein this was not so. Concededly, domestic wool futures are sensitive to broad movements in domestic wool prices which in turn tend to follow the prices of foreign wools of equivalent grade. But wool prices either here or abroad are influenced by a number of independent economic and physical factors, of which devaluation would be only one. For this reason it cannot be said with any degree1960 U.S. Tax Ct. LEXIS 146">*169 of certainty that domestic wool futures quotations would have adjusted immediately, or even ultimately, to the kind of sharp, but not necessarily sustained, decline in foreign wool prices that devaluation would induce. But even if we assume arguendo that domestic wool futures would have afforded equally effective insurance against the peculiar peril of devaluation, it does not follow that petitioner's 34 T.C. 323">*333 foreign currency futures were not substantially in the nature of bona fide hedging transactions for the petitioner was entitled to examine different methods of shielding itself from the potentially ruinous effects of devaluation and choose the one that seemed best suited to its needs. In our opinion, the integral relationship of these futures to petitioner's regular business operations is clear. See 350 U.S. 46">Corn Products Refining Co. v. Commissioner, supra;America-Southeast Asia Co., 26 T.C. 198">26 T.C. 198.
Upon the issue presented to us herein, we decide in favor of petitioner.
Decision will be entered under Rule 50.
Footnotes
1. A short sale of foreign currency obligates the seller to deliver a fixed amount of the foreign currency, at a specified date in the future, at a specified rate of exchange. On the date of delivery, or before, the seller may "cover" by buying the fixed amount of currency at the then↩ current rate of exchange. The gain or loss to the seller is determined by comparing the rate at which he agreed to sell with the rate of exchange on the date of "cover."
2. SEC. 117. CAPITAL GAINS AND LOSSES.
(a) Definitions. -- As used in this chapter --
(1) Capital assets. -- The term "capital assets" means property held by the taxpayer (whether or not connected with his trade or business), but does not include --
(A) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;
(B) property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 23(l), or real property used in his trade or business;
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(d) Limitation on Capital Losses. --
(1) Corporations. -- In the case of a corporation, losses from sales or exchanges of capital assets shall be allowed only to the extent of gains from such sales or exchanges.↩