A Debt-Equity Swap

A Debt-Equity Swap

January 01, 2007

A debt-equity swap between a US company and the Mexican government produced income for the US company, but because the IRS guessed wildly at the amount, a US appeals court let the company off.

Kohler Co., a US maker of plumbing fixtures, planned in 1986 to build a plant to manufacture such fixtures in Mexico. Mexico was buckling under the weight of foreign debt.Mexican sovereign debt was trading at a steep discount to face value. The government put an enterprising program in place to reduce its debts without having to use scarce foreign currency reserves. If a foreign company planning to invest in Mexico would purchase existing Mexican debt, then the government would exchange the notes at a favorable rate for pesos; the pesos had to be invested in Mexico. Kohler bought Mexican sovereign debt with a face amount of $22.4 million from Bankers Trust Co. for $11.1 million. It then traded the notes with the government for pesos worth $19.5 million at the exchange rate in effect at the time.

The IRS said Kohler had to report the $8.4 million difference as taxable income.

A US appeals court said Kohler had some amount of income, but the IRS claim that Kohler had $8.4 million in income failed to take into account the restrictions on how the pesos could be used.

The court called the effort by the IRS to prove the pesos were worth the full $19.5 million “pathetically short of the mark.”It called the claim by Kohler that it received no more value than the $11.1 million it paid for the notes from Bankers Trust “equally pathetic.”It said the burden would normally be on Kohler to prove that it did not have the income the government said it did, but the government had to pick a number that was at least plausible on its face in order for the burden to shift. In this case, the court said, the government insisted on “all or nothing, lost all, so gets nothing.”

The case is Kohler Co. v United States.

The appeals court released its decision in late November. Kohler and the IRS agreed that the swap was a taxable exchange, but they disagreed about the amount of income it produced. The court was not sure the swap was a taxable exchange. Another US appeals court said that a US company had no income in a 1997 case called G.M.Trading involving the same Mexican swap program. It said the value the US company received in the swap fell into the category of some government grants that are not taxable to the recipient because they serve a government purpose and leave the taxpayer no better off economically. An example is where a government reimburses a railroad for the cost of elevating its tracks above a highway. Such grants are called nonshareholder “contributions to capital.”

The court in the Kohler case did not buy that analysis. It thought the better way to report the transaction would have been for Kohler to take a tax basis in its Mexican plant of only $11.1 million. That way, any additional value would be taxed as gain when Kohler makes a future sale of the plant.

Keith Martin