CMI Int'l, Inc. v. Comm'r of Internal Revenue

• Decision Date: 13 July 1999
• Docket Number: No. 24752–92.,24752–92.
• Citation: 113 T.C. No. 1,113 T.C. 1
• Parties: CMI INTERNATIONAL, INC. A Michigan Corporation, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

113 T.C. 1

113 T.C. No. 1

CMI INTERNATIONAL, INC. A Michigan Corporation, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 24752–92.

United States Tax Court.

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.

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

FOLEY, J.

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.

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 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 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 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 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...