G.M. Trading Corp. v. Comm'r of Internal Revenue
| Citation | 103 T.C. No. 4,103 T.C. 59 |
| Decision Date | 25 July 1994 |
| Docket Number | No. 6983–91.,6983–91. |
| Parties | G.M. TRADING CORPORATION, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. |
| Court | United States Tax Court |
OPINION TEXT STARTS HERE
R. James Curphy, San Antonio, TX, for petitioner.
T. Richard Sealy III, Washington, DC, for respondent.
Petitioner participated in a “Mexican debt-equity-swap” transaction.
Held, Petitioner is to be treated as having realized a taxable gain on the exchange of U.S. dollar-denominated Mexican Government debt for Mexican pesos. The value of the pesos received and the amount of gain determined.
Respondent determined a deficiency in petitioner's 1988 Federal income tax and additions to tax as follows:
+-----------------------------------------------------------------------------+
¦ ¦Additions to Tax ¦
+----------+------------------------------------------------------------------¦
¦ ¦Sec. ¦Sec. ¦
+----------+--------+---------------------------------------------------------¦
¦Deficiency¦6653(a) ¦6653(a)(1)(B) ¦
¦ ¦(1)(A) ¦ ¦
+-----------------------------------------------------------------------------¦
¦ ¦
+-----------------------------------------------------------------------------¦
¦$289,141 ¦$14,457 ¦50 percent of the interest due on the portion of the ¦
¦ ¦ ¦underpayment attributable to negligence ¦
+-----------------------------------------------------------------------------+
Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
After settlement, the primary issue for decision involves the proper Federal income tax treatment of a so-called Mexican debt-equity-swap transaction.
Some of the facts have been stipulated and are so found. Petitioner is a Texas corporation engaged in the business of buying, processing, and selling sheep and lamb skins. At the time the petition was filed, petitioner's principal place of business was in San Antonio, Texas.
For many years, petitioner's sheep and lamb skin processing operations were located at petitioner's plant in San Antonio, Texas. Petitioner sells most of its processed sheep and lamb skins to customers in Europe and the Middle East.
In 1986 and early 1987, petitioner's president, Robert E. Melton, decided to move petitioner's lambskin processing operations to a new plant to be constructed in Acuna, Mexico, that would be owned and operated by a new Mexican subsidiary corporation (Mexican subsidiary). The new plant was to qualify under a Mexican Government-sponsored program that encouraged foreign corporations to establish in Mexico subsidiary corporations for the manufacture of export products. Corporations established under this program were referred to as maquiladoras.
To obtain funds for the Mexican subsidiary to use in buying land and equipment and in constructing a plant under the maquiladora program (a maquiladora plant), petitioner entered into what is referred to in the financial industry as a “Mexican debt-equity-swap transaction”. In general, the type of Mexican debt-equity-swap transaction that is at issue herein involves the transfer or surrender to the Mexican Government by a U.S. company or by its Mexican subsidiary corporation of previously issued U.S. dollar-denominated debt (which debt represents a direct liability of the Mexican Government to the U.S. company or a liability of a Mexican company to the U.S. company that is guaranteed by the Mexican Government) in exchange for the transfer by the Mexican Government of Mexican pesos into a restricted account with the Mexican Treasury in favor of the Mexican subsidiary of the U.S. company.
Mexican pesos transferred into the restricted Treasury account of the Mexican subsidiary corporation are required to be used by the Mexican subsidiary to make investments in and to expand its business operations in Mexico.
In a Mexican debt-equity-swap transaction, the U.S. dollar-Mexican peso exchange rate that is utilized to compute the number of Mexican pesos to be credited to the Mexican Treasury account of the Mexican subsidiary is extremely favorable to the U.S. corporation and to its Mexican subsidiary corporation that is participating in the debt-equity-swap transaction.
Also, as part of the debt-equity-swap transaction, the new Mexican subsidiary corporation effectively transfers 100 percent of newly issued class B restricted stock to the Mexican Government, and the Mexican Government immediately transfers this stock to the U.S. parent corporation.
During the year before us, the Mexican Government participated in debt-equity-swap transactions in order to reduce the total balance of outstanding U.S. dollar-denominated debt obligations that were guaranteed by the Mexican Government (Mexican foreign debt) (the interest on which was causing high inflation and rapid devaluation of Mexico's currency vis-a-vis other currencies) and to encourage foreign businesses to invest in plants and equipment in Mexico.
In general, U.S. companies participated in debt-equity-swap transactions in order to expand their business operations in Mexico on terms that were financially favorable. Through debt-equity-swap transactions, U.S. companies could receive significantly more Mexican pesos with which to fund their business expansion in Mexico than they could receive, for the same price, by directly buying Mexican pesos with U.S. dollars on the open foreign exchange markets.
During the period at issue, because of general uncertainty regarding the Mexican Government's ability to repay its debt obligations, U.S. dollar-denominated debt obligations of or guaranteed by the Mexican Government were sold at a steep discount at a price equal to approximately 50 percent of the principal amount of the debt.
By participating in debt-equity-swap transactions, U.S. companies and their Mexican subsidiaries could purchase from other U.S. companies at the prevailing steep discount rate U.S. dollar-denominated debt that was owed or guaranteed by the Mexican Government and then sell or exchange such debt with the Mexican Government for Mexican pesos at a significantly reduced discount of 0 to 25 percent of the principal amount of the debt. The reduced discount rates associated with debt-equity-swap transactions were established on a case-by-case basis by the Mexican Ministry of Finance and Public Credit and representatives of the U.S. companies and were generally dependent upon the perceived benefit of each proposed investment to the Mexican economy. Anticipated improvements in Mexico's export business, level of employment, and level of technology were factors typically affecting the size of the discount associated with specific debt-equity-swap transactions.
On February 1, 1987, petitioner's directors unanimously resolved to form in Mexico a subsidiary corporation by the name of Procesos G.M. de Mexico, S.A. de C.V. (Procesos) to participate in a debt-equity-swap transaction and to contribute capital to Procesos for the purpose of having Procesos construct and operate a lambskin processing plant in Acuna, Mexico.
On May 19, 1987, Procesos was organized under the laws of Mexico for the above-stated purpose. On incorporation of Procesos, 1,000 shares of class A stock were issued. Petitioner was issued 996 shares, and four Mexican citizens were issued 1 share each. Each share was issued in exchange for 10,000 Mexican pesos (Mex$). As the initial capitalization of Procesos, petitioner contributed Mex$9,960,000 or approximately US$7,800.
In the bylaws of Procesos, provision was made for issuing shares of a second class of stock (class B stock) that would also have a nominal value of Mex$10,000 per share and that would be subject to certain limitations described below.
On August 18, 1987, petitioner paid a fee of US$3,000 to the Mexican Government and was registered as a foreign investor in Mexico in order to participate in a debt-equity-swap transaction.
On August 26 and 28, 1987, formal requests were submitted on behalf of petitioner and Procesos to the Mexican Ministry of Finance and Public Credit and to the Mexican National Commission on Foreign Investments for permission for petitioner to fund through a debt-equity-swap transaction the construction of a maquiladora plant to be owned and operated by Procesos.
On August 31, 1987, petitioner agreed to purchase from NMB Nederlandsche Middenstandsbank N.V. (NMB), an unrelated party, U.S. dollar-denominated debt of, or guaranteed by, the Mexican Government in the principal stated amount of US$1,200,000. Petitioner agreed to pay US$600,000 for this debt—reflecting the prevailing market discount rate of 50 percent of the principal face amount of U.S. dollar-denominated debt of the Mexican Government.
On September 28, 1987, the Mexican National Commission on Foreign Investments informed petitioner and Procesos that it had approved the request that petitioner be permitted to fund the construction of a maquiladora plant by participating in a debt-equity-swap transaction.
On October 6, 1987, the Mexican Ministry of Finance and Public Credit and representatives of petitioner and Procesos agreed that, through the proposed debt-equity-swap transaction, the Mexican foreign debt that petitioner had agreed to purchase in the principal stated amount of US$1,200,000 would be converted into Mex$1,736,694,000 reflecting a discount rate of only 13 percent of the principal stated amount of the debt. At the time of this transaction, Mex$1,736,694,000, in general, had a fair market value in U.S. dollars at the prevailing open...
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