Court Opinion

ID: 4332338
Source: CourtListenerOpinion
Date Created: 2018-11-14 00:39:15.511984+00
Date Added: 2024-06-11T14:20:23.449816
License: Public Domain

113 T.C. No. 1

                     UNITED STATES TAX COURT

 CMI INTERNATIONAL, INC. A MICHIGAN CORPORATION, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

    Docket No. 24752-92.                    Filed July 13, 1999.

         P's wholly owned domestic subsidiary, D,
    participated in a debt-equity-swap transaction in which
    D exchanged an interest in Mexican U.S.-dollar-
    denominated debt for stock in D's Mexican subsidiary.
    On its consolidated 1988 tax return, P reported no gain
    or loss relating to the swap transaction. In the
    notice of deficiency, respondent determined that P
    recognized an $830,000 gain relating to the
    transaction.
         Held: Pursuant to sec. 367(a), I.R.C., and sec.
    1.367(a)-1T(b)(3)(i), Temporary Income Tax Regs., 51
    Fed. Reg. 17939, P did not recognize any gain.

     James P. Fuller, Kenneth B. Clark, Jennifer L. Fuller,

William F. Colgin, James E. Beall, and Joseph A. Ahern, for

petitioner.
                                  - 2 -

     Lewis R. Mandel, and Trevor T. Wetherington, for respondent.

         FOLEY, Judge:   By notice dated October 6, 1992, respondent

determined a $291,011 deficiency in petitioner's 1988 Federal

income tax.    The primary issue for decision is whether

petitioner, pursuant to section 367(a), recognized gain relating

to the swap transaction.     We hold petitioner did not.   All

section references are to the Internal Revenue Code in effect for

the year in issue.

                            FINDINGS OF FACT

     In the 1980's, the Mexican Government created a "debt-

equity-swap" (swap) program that was designed to encourage

foreigners to invest in Mexico and reduce the outstanding balance

of the Mexican Government's foreign-currency-denominated debt.

The program's swap transactions involved a series of prearranged

steps that were accompanied by extensive documentation.      In these

transactions, a U.S. investor could purchase an interest in the

Mexican Government's U.S.-dollar-denominated debt and, in

exchange for stock, transfer such interest to its Mexican

subsidiary.1    The debt would then be canceled, and the Mexican

Government would transfer pesos to the subsidiary.

     1
        Compare G.M. Trading Corp. v. Commissioner, 121 F.3d 977,
979 (5th Cir. 1997), revg. 103 T.C. 59 (1994), supplemented by
106 T.C. 257 (1996), where the taxpayer transferred debt to the
Mexican Government in exchange for pesos.
                               - 3 -

     Petitioner is a Michigan corporation whose principal place

of business was in Southfield, Michigan, at the time the petition

was filed.   Petitioner manufactures machined-cast automotive

parts and is the parent company of a group of corporations that

in 1988 filed a consolidated corporate income tax return.

     In mid-1986, petitioner decided to build a plant in Mexico

that would supply parts to Ford Motor Company.   On June 5, 1986,

petitioner formed a wholly owned domestic subsidiary, CMI-Texas,

Inc. (CMI-Texas).   In turn, on June 13, 1986, CMI-Texas formed a

Mexican subsidiary, Industrias Fronterizas CMI, S.A. de C.V.

(Industrias), which issued 4,996 shares of class A stock to CMI-

Texas and one share of such stock to each of four individuals.

In late 1986, Industrias began construction of an industrial

plant in Nuevo Laredo, Tamaulipas, Mexico (Nuevo Laredo plant).

     On April 30 and May 11, 1987, formal requests were made on

behalf of CMI-Texas and Industrias for authorization to engage in

a swap transaction to finance additional construction of the

Nuevo Laredo plant.   On August 7, 1987, the Mexican Government

approved the transaction, authorizing CMI-Texas to acquire an

interest in U.S.-dollar-denominated debt with a face value of

US$2,300,000.   On September 4, 1987, the Mexican Government

approved a 15-percent discount rate, which would be used in

calculating the amount of pesos to be transferred to Industrias.

The discount rate reflected an estimate of the proposed venture's
                               - 4 -

impact on Mexico's economy (e.g., zero percent reflected the

greatest benefit and 25 percent reflected the least benefit).     On

September 18, 1987, Mellon Bank (Mellon), selected by CMI-Texas

as the financial intermediary, paid US$1,115,500 (i.e.,

reflecting the prevailing market discount rate of 51.5 percent)

for an assignment of debt with a face value of US$2,300,000.

     On October 1, 1987, the Mexican Government, CMI-Texas,

Industrias, and Mellon entered into a Purchase and Capitalization

Agreement (Agreement), which delineated the terms of the swap

transaction.   On October 15, 1987, Mellon informed all parties

that the transaction would close on October 28, 1987.   On October

21, 1987, CMI-Texas tendered US$1,125,000 (i.e., Mellon's cost of

the debt, US$1,115,500, plus a US$9,500 commission fee) to

Mellon.

     On October 28, 1987, the parties simultaneously consummated

the following transactions:   (1) Mellon sold to CMI-Texas, for

the previously tendered US$1,125,000, a 100-percent "undivided

interest" in U.S.-dollar-denominated debt (debt interest) with a

face value of US$2,300,000; (2) CMI-Texas transferred its debt

interest to Industrias as an equity contribution; (3) Mellon

canceled the debt interest and the underlying debt; (4) the

Mexican Government deposited Mex$3,206,085,431 in an interest-

bearing account on behalf of Industrias; and (5) Industrias
                                - 5 -

issued to CMI-Texas 3,207,177 shares (i.e., 100 percent) of newly

issued class B stock.

     On October 28, 1987, the market value of the debt interest

was US$1,125,000, and the number of pesos the Mexican Government

deposited into Industrias' account was computed based on the

following formula:    The face value of the debt (i.e.,

US$2,300,000) multiplied by the market foreign exchange rate for

pesos (i.e., Mex$1639.94/US$), discounted by the authorized rate

(i.e., 15 percent).    On that day, the U.S.-dollar equivalent of

the pesos deposited in the account was US$1,955,000.      Industrias

was required to use the pesos in the account to purchase goods

and services provided by residents of Mexico.    Prior to

disbursement of the pesos, the Mexican Government required

Industrias to make formal written requests, thus ensuring that

the pesos would finance previously approved operations.     In

addition, Industrias' class B stock was subject to restrictions

(i.e., CMI-Texas' rights to transfer, redeem, convert, and

receive guaranteed dividends relating to, the stock were

curtailed).

     On its consolidated Federal income tax return for the year

ended May 31, 1988, petitioner did not report any gain relating

to the swap transaction.    Respondent determined that petitioner

recognized a taxable gain of $830,000 (i.e., the amount realized
                                - 6 -

of US$1,955,000 minus the debt interest's basis of US$1,125,000)

relating to the transaction.

                               OPINION

     The tax consequences of the transaction depend on its proper

characterization.    Generally, taxpayers are bound to the form of

their transaction.   See, e.g., Estate of Durkin v. Commissioner,

99 T.C. 561, 571-572 (1992).   In North Am. Rayon Corp. v.

Commissioner, 12 F.3d 583, 587 (6th Cir. 1993), affg. T.C. Memo.

1992-610, the U.S. Court of Appeals for the Sixth Circuit, to

which this case is appealable, adopted a rule set forth in

Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967), revg. 44

T.C. 549 (1965).    Where the terms of a transaction are set forth

in a written contract, the Danielson rule provides that a party

to the contract may disavow the form of such transaction only

with evidence that would allow reformation of the contract (e.g.,

to prove fraud or duress).   See id. at 775.   If the contract is

ambiguous, however, the Danielson rule does not apply.    See North

Am. Rayon Corp. v. Commissioner, supra at 589.

     Respondent contends that, pursuant to the Agreement, CMI-

Texas acquired a debt interest, which it transferred to

Industrias in exchange for stock.    Respondent further contends

that the Danielson rule prevents petitioner from challenging the

terms, and petitioner is bound by the form, of the transaction.

Petitioner contends that, based on the substance of the
                               - 7 -

transaction, CMI-Texas paid US$1,125,000 for the rights to the

peso account and did not acquire a debt interest.    Petitioner

further contends that the Agreement is ambiguous and that the

proper characterization of the transaction should be determined

by considering the events occurring after the parties executed

the Agreement.

     The terms of the transaction unambiguously provide that CMI-

Texas acquired a debt interest, which it transferred to

Industrias in exchange for stock.   CMI-Texas agreed to these

terms, and petitioner did not produce any evidence that would

allow reformation of their agreement.   Accordingly, pursuant to

the Danielson rule, petitioner may not disavow the form of the

transaction and must accept the tax consequences resulting

therefrom.   See generally Golsen v. Commissioner, 54 T.C. 742,

756-757 (1970), affd. 445 F.2d 985 (10th Cir. 1971) (indicating

that the Tax Court will generally follow the law as stated by the

Court of Appeals in the circuit to which the case is appealable).

     Section 1001(c) provides that taxpayers generally recognize

gain realized on the sale or exchange of property.    Though

section 351(a) allows the tax-free exchange of property from a

shareholder to its wholly owned subsidiary, section 367(a) may

deny such treatment if the transfer is from a domestic to a

foreign corporation.   CMI-Texas' transfer of its debt interest in
                               - 8 -

exchange for Industrias' stock falls within the scope of section

367(a).

     Respondent contends that petitioner received stock with a

value of US$1,955,000 (i.e., equal to the U.S.-dollar equivalent

of the pesos) and transferred a debt interest with a basis of

US$1,125,000.   Respondent further contends that the gain

realized, $830,000 (i.e., US$1,955,000 minus US$1,125,000), must

be recognized pursuant to sections 1001(c) and 367(a).

Petitioner contends that CMI-Texas did not realize gain on the

transfer because the fair market value of the stock received

equaled the basis of the debt interest transferred.    Petitioner

alternatively contends that, if CMI-Texas did realize gain, the

amount of gain recognized is, pursuant to section 1.367(a)-

1T(b)(3)(i), Temporary Income Tax Regs., 51 Fed. Reg. 17939 (May

16, 1986), limited to zero because the debt interest was not

appreciated property.

     Assuming arguendo that CMI-Texas realized gain on the

transaction, we agree with petitioner that the amount of

recognized gain is limited to zero.    Section 1.367(a)-

1T(b)(3)(i), Temporary Income Tax Regs., provides that the gain

recognized under section 367(a) "shall in no event exceed the

gain that would have been recognized on a taxable sale of those

items of property if sold individually".    The regulation includes

the gain limitation to "[ensure] that the gain recognized under
                                 - 9 -

section 367(a) upon a transfer of appreciated property is not

greater than the gain that would be recognized on a normal

taxable exchange."   Id. 51 Fed. Reg. 17937 (May 16, 1986).        We

also note that the legislative history accompanying amendments to

section 367 provides that section 367(a)'s "aim is to prevent the

removal of appreciated assets or inventory from U.S. tax

jurisdiction prior to their sale".       H. Rept. 94-658, at 242

(1975), 1976-3 C.B. (Vol. 2) 695, 934; S. Rept. 94-938, at 264

(1976), 1976-3 C.B. (Vol. 3) 49, 302; see also H. Rept. 98-432

(Part 2), at 59 (1984) (referring to section 367 as "rules

governing transfers of appreciated property abroad"); S. Rept.

665, 72d Cong., 1st Sess. 26 (1932), 1939-1 C.B. (Part 2) 496,

515 (stating that the section's purpose was to close the "serious

loophole" available to domestic taxpayers transferring abroad

property with "large unrealized profits").

     CMI-Texas did not transfer appreciated property.       On the

date of the transfer, the basis of the debt interest was

US$1,125,000 (i.e., the amount CMI-Texas paid to Mellon), and, as

respondent acknowledges, "Had * * * [CMI-Texas] just exchanged

the MPD [debt interest] on the open market, * * * [CMI-Texas] and

thus Industrias would have only received US$1,125,000 worth of

MXP [pesos]."   Thus, a taxable sale of the debt interest would

not have resulted in any gain.    Accordingly, pursuant to section

367(a) and section 1.367(a)-1T(b)(3)(i), Temporary Income Tax
                             - 10 -

Regs., petitioner did not recognize any gain relating to the swap

transaction.

     All other contentions that have not been addressed are

irrelevant, moot, or meritless.

     To reflect the foregoing,

                                        Decision will be entered

                                   for petitioner.