CMI International, Inc., a Michigan Corporation v. Commissioner , 113 T.C. No. 1 ( 1999 )

113 T.C. No. 1UNITED 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.
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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.
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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
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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
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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
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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
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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
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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
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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
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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.