Philip Morris Inc. v. Comm'r of Internal Revenue

• Decision Date: 23 January 1995
• Docket Number: No. 28279–92.,28279–92.
• Citation: 104 T.C. No. 3,104 T.C. 61
• Parties: PHILIP MORRIS INCORPORATED, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

104 T.C. 61

104 T.C. No. 3

PHILIP MORRIS INCORPORATED, Petitioner,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 28279–92.

United States Tax Court.

Jan. 23, 1995.

Jerome B. Libin, William S. Corey, and David A. Golden, for petitioner.

Lewis R. Mandel, for respondent.

P borrowed in foreign currencies which it converted into U.S. dollars and later repaid the borrowings in the same foreign currency which it had purchased with U.S. dollars. P reported its gain, represented by the difference in U.S. dollars between the value of the foreign currencies at the time of the borrowings and the U.S. dollar cost of the currencies used for repayment, as income from the discharge of indebtedness and elected to exclude such income from gross income under sec. 108, I.R.C., and reduce the basis in its assets under sec. 1017, I.R.C. Held: P's gain does not constitute income by reason of the discharge of indebtedness eligible for exclusion from gross income under sec. 108. Kentucky & Indiana Terminal Railroad Co. v. United States, 330 F.2d 520 (6th Cir.1964), has been sapped of its vitality by United States v. Centennial Savings Bank FSB, 499 U.S. 573(1991).

OPINION

TANNENWALD, Judge:

Respondent determined deficiencies in petitioner's Federal income taxes for the 1982, 1983, and 1984 taxable years in the amounts of $4,594,256, $11,217,945, and $6,111,795, respectively. The parties have settled all but one issue involving the proper treatment of gains resulting from the use of foreign currency, the value of which changed in relation to the U.S. dollar, between the dates of borrowings and repayments in the same currency.

All the facts have been stipulated and are so found. The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.

Petitioner is a corporation organized and existing under the laws of the Commonwealth of Virginia with its principal office in New York, New York. During the taxable years in issue, petitioner was the common parent of a group of affiliated corporations. At all relevant times, petitioner used the accrual method of accounting and filed consolidated Federal income tax returns for the taxable years before us with the Internal Revenue Service, Holtsville, New York.

Petitioner engaged in the following six transactions:

(1) On November 24, 1980, petitioner borrowed 100 million Swiss francs (SF) from Union Bank of Switzerland (UBS). The loan bore interest at 6 1/2 percent per annum and was repayable on December 1, 1987. The proceeds were converted into U.S. dollars on the date of borrowing, at the rate of US$1 equals SF1.72038, for a total of $58,126,692.94. On September 1, 1983, petitioner prepaid the principal plus accrued interest, without incurring a prepayment penalty. On that date, the spot rate was US$1 equals SF2.1875 so that the U.S. dollar value of the principal payment was $45,714,286. The source of the SF100 million prepayment was: (a) SF85,229,861 acquired by petitioner on May 31, 1983, and placed on deposit with UBS until the date of prepayment, which amount was part of the proceeds of six forward contracts purchased by petitioner on May 10, 1983, at a weighted average rate of exchange of US$1 equals SF2.03045218; (b) accrued interest income of SF981,250 on said deposit, converted at an exchange rate of US$1 equals SF2.1433; and (c) SF13, 788,889 acquired by petitioner on September 1, 1983, which amount was part of the proceeds of a forward contract purchased by petitioner on August 18, 1983, at an exchange rate of US$1 equals SF2.1433.

(2) On December 22, 1980, petitioner borrowed SF125 million from UBS. The loan bore interest at 7 percent per annum and was repayable on December 31, 1985. The proceeds were converted on the date of borrowing at the rate of US $1 equals SF1.81308, for a total of $68,943,455.34. On May 31, 1983, petitioner prepaid to UBS the principal and accrued interest plus a prepayment penalty. On that date the spot rate was US$1 equals SF2.1005 so that the U.S. dollar value of the principal payment was $59,509,641. The SF125 million was acquired on May 31, 1983, as part of the proceeds of the SF280.6 million in aggregate forward contracts purchased by petitioner on May 10, 1983, at a weighted average exchange rate of US$1 equals SF2.03045218.

(3) On December 23, 1980, petitioner borrowed SF75 million from Swiss Bank Corporation (SBC). The loan bore interest at 7 percent per annum and was repayable on December 23, 1985. The proceeds were converted on the date of borrowing at the rate of US$1 equals SF1.81310, for a total of $41,365,586.86. On January 7, 1983, petitioner prepaid the SF75 million principal. On that date, the spot rate was US$1 equals SF1.9340. The source of the SF75 million was a SF100 million private placement issue by petitioner on December 22, 1982, when the spot rate was US$1 equals SF2.0150 so that the U.S. dollar value of the repayment was $37,220,844.

(4) On January 13, 1982, petitioner financed, in pounds sterling, 80 percent of the contract value of certain rotary tobacco-cutting machines purchased by petitioner, with the financed amount (including a 2.6 percent finance charge equivalent) to be repaid in 10 equal semiannual installments with interest at 8.5 percent per annum on the unpaid balance. The pound sterling/dollar exchange rate of the 80 percent of the contract value plus the finance charge equivalent was US$1,282,959 and of two semiannual installments was US$256,592. In 1983, two semiannual installments were paid in pounds sterling having U.S. dollar value of 215,633 based on the exchange rate on the dates of payment. In 1984, two semiannual installments were paid in pounds sterling the U.S. dollar value of such repayment being US$188,410.

(5) On September 28, 1982, petitioner financed, in pounds sterling, 80 percent of the contract value of certain cigarette manufacturing machinery to be purchased by petitioner, with the financed amount (including a 2.6 percent finance charge equivalent) to be repaid in 10 equal semiannual installments and interest at 11 percent per annum on the unpaid balance. The contemporaneous pound sterling/dollar exchange rate of the 80 percent of the contract value plus the finance charge equivalent was US$10,633,669, and one semiannual installment was equivalent to US$1,063,367, and of two semiannual installments was equivalent to US$2,126,734. In 1983, petitioner made one semiannual installment payment in pounds sterling having a U.S. dollar value of $981,144, based on the exchange rate on the date of payment. In 1984, petitioner made two semiannual installment payments in pounds sterling having a total U.S. dollar value of $1,759,735 based on the exchange rate on the dates of payment.

(6) On February 10, 1982, a wholly owned subsidiary of petitioner sold to a German bank, for ultimate sale to the public, 150 million German marks (DM) of 9 1/2 percent, 7–year bearer bonds, which were guaranteed by petitioner. The net proceeds of the bearer bond issue amounted to DM147, 888,333.33 after underwriting and other expenses. The net proceeds were transferred from the subsidiary to petitioner on a discount basis at a 10 1/2–percent interest rate on February 16, 1982. Petitioner received DM147, 888,333.33 and was obligated to repay DM150 million. The net proceeds of DM147,888,333.33 were converted by petitioner into US$62,581,611.08 on February 16, 1982, at an exchange rate of US$1 equals DM2.36313. From March 12, 1984, through May 3, 1984, the subsidiary purchased in the market bearer bonds with an aggregate par value of DM10 million, at an aggregate purchase price of DM10, 924,824.92 plus accrued interest. A portion of the funds for the repurchase of bonds was supplied by petitioner through a series of prepayments by it aggregating DM10 million of its intercompany indebtedness to the subsidiary, plus accrued interest. At the exchange rates on the dates of prepayments, the cost of DM10 million was US$3,769,505.

In each transaction, the value of the foreign currency had decreased in value relative to the U.S. dollar between the date the borrowings were incurred and the date of repayment, so that fewer dollars were necessary to acquire the foreign currency for repayment than the U.S. dollar value of the borrowings at the time they were created.

In its consolidated returns for 1983 and 1984, petitioner treated its gain from the aforesaid use of foreign currency (hereinafter referred to as “exchange gain”), representing the difference between the U.S. dollar value of the foreign currency on the date of borrowing and the dollar cost of the currency used for repayment, as income from the discharge of indebtedness under section 108 ¹ and reduced its basis under section 1017 by the same amount.

In the notice of deficiency, respondent disallowed petitioner's elections under section 108 and treated the amounts of gain reported by petitioner as section 61 ordinary income and not income from discharge of indebtedness eligible for such election.

Section 108 provides in pertinent part:

(a) Exclusion From Gross Income.—

(1) In General.—Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—

* * *

(C) the indebtedness discharged is qualified business indebtedness.

“[I]ndebtedness of the taxpayer” means any indebtedness for which the taxpayer is liable or subject to which the taxpayer holds property. Sec. 108(d)(1). Indebtedness is treated as “qualified business indebtedness” where it is incurred or assumed by a corporation, which elects to treat it as such indebtedness. Sec. 108(d)(4).² The amount excluded as qualified business indebtedness “shall be applied to reduce the basis of the depreciable property of the taxpayer”, as provided by section 1017. Sec. 108(c)(1). Thus, section 108 does not exempt income from taxation, but defers the...