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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
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