A Foreign Debt-Swap Plan

A Foreign Debt-Swap Plan

October 01, 2005

A foreign debt-swap plan was a headache for a US company, but the company eventually won in court.

Mexico tried, starting in 1985, to reduce its heavy debt burden through an ingenious plan where it encouraged foreign companies with subsidiaries in Mexico to buy government bonds being held at the time by foreign lenders. The bonds were trading at a steep discount because of market fears about Mexico’s ability to repay its debt. Mexico lacked the foreign exchange reserves to keep paying its debts. Under the program, a foreign company would buy the bonds at a discount in the market and then trade them to the Mexican government for a larger sum in Mexican pesos than the company paid to acquire the debt. The company had to spend the pesos in Mexico with local vendors.

Kohler, a US manufacturer of plumbing fixtures, bought $22.4 million in Mexican government debt from Bankers Trust in 1987 for $11.1 million, or a 50% discount off the face amount of the debt. It then traded the bonds to the Mexican government for what was nominally the equivalent of $19.5 million in pesos. The Internal Revenue Service charged that the company had an $8.4 million gain.

Kohler asked a US court to rule in 2003 on “summary judgment” — that is, solely on the basis of legal briefs filed by the parties — that it had no gain. The court refused, saying that it was not persuaded by Kohler’s arguments. However, the company went back again with new arguments, and this time the court agreed that Kohler had no gain. It said the best evidence of what the pesos Kohler received were worth was the amount it paid Bankers Trust for the “property” it traded a short time later for them. The court said the two amounts might not always be equivalent, but the US tax authorities failed to offer compelling evidence that the pesos were worth more.

The case is Kohler Co. v. United States. A US district court in Wisconsin released its decision in September.