A US auto-parts manufacturer, CMI International, planned to set up a manufacturing operation in Mexico. CMI bought Mexican government debt at a 51.5% discount from face value in the market. It then contributed the debt to its new Mexican subsidiary. The subsidiary cancelled the debt. The Mexican government then deposited an amount in pesos reflecting only a 15% discount from face value of the debt into the bank account of the new CMI subsidiary.

The IRS argued that CMI had income and that US income taxes were triggered under section 367(a) of the US tax code. That section requires that a “toll charge” be paid whenever a US company contributes appreciated property to an offshore company. However, the US Tax Court said there was no appreciation in the debt before it was contributed. CMI received back shares in its subsidiary that were equal to the value of the debt it contributed.

The IRS won a similar case called GM Trading in the Tax Court a few years ago (but lost on appeal).