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Monday, November 20, 2006

Posner Slams IRS's "Pathetic" Position in Mexican Debt-Equity Swap Case

Judge Posner has some harsh words about the Service's position in a panel opinion issued today, Kohler Co. v. United States, No. 05-4472 (7th Cir. 11/20/06):

In 1986, Kohler decided to build a plant in Mexico that it estimated would cost at least $29 million. It needed pesos in order to pay for land, building contractors, and other inputs. How to get them?

Now it happened that Mexico had defaulted on its foreign debt, and in an effort to restore its credit had adopted an ingenious “debt-equity swap” program (pioneered by Chile). The program entitled a foreign company that wanted to invest in Mexico, and therefore needed pesos, to purchase defaulted Mexican dollardenominated debt on the open market and then swap it with the Mexican government for pesos that could be spent only in Mexico rather than exchanged for dollars....

Bankers Trust, the American bank, owned Mexican debt in the face amount of $22.4 million. This debt traded at a substantial discount because of Mexico’s default, fiscal instability, and general lack of creditworthiness. As a result, Kohler was able to buy the debt from Bankers Trust for only $11.1 million, slightly less than half its par (face) value. The bank preferred the bird in the hand (11.1 million U.S. dollars) to two birds, consisting of claims against the Mexican government, very deep in the bush.

Kohler knew that under the terms of the debt-equity swap program the Mexican government would swap the $11.1 million debt that Kohler had bought from Bankers Trust for $19.5 million worth of pesos as calculated at the then current market exchange rate of 2245 pesos to the dollar....

On its federal income tax return it treated the purchase of the debt and its sale to the Mexican government as a wash, yielding no taxable income, just as if the government had paid it $11.1 million in dollars rather than paying it in pesos. The Internal Revenue Service disagreed with this treatment and instead added to Kohler’s taxable income for 1987, the year of the transaction, the difference of $8.4 million between the price that Kohler had paid Bankers Trust for the Mexican debt and $19.5 million....

The parties quarrel only over the value to Kohler of the exchange when made. The quarrel has driven them to take opposite positions, both untenable. Kohler argues that it had no gain from the sale at all, while the Internal Revenue Service argues that the entire difference between the $19.5 million in pesos that the Mexican government gave Kohler and the $11.1 million that Kohler had paid to buy the debt that it swapped for the pesos was taxable income to Kohler....

How to choose between adversaries’ valuations when both are manifestly erroneous? The conventional response would be that the party with the burden of proof (in the sense of the burden of persuasion) would lose. And that is Kohler ....

But Kohler argues that it needs no evidence, citing United States v. Davis, 370 U.S. 65 (1962), a superficially similar case won by the taxpayer....

The problem in our case is different. It is what to do when the value of the property exchanged may well be ascertainable but has not been ascertained. To permit the Internal Revenue Service to place an arbitrary value on difficult-to-value property obtained in a transaction and require the taxpayer to prove that it was worth less—and exactly how much less—would place an unreasonable burden on taxpayers....

We think the Internal Revenue Service had either to prove against all probabilities that its assessment was correct or pick a number that was prima facie plausible—a number somewhere in between $11.1 million and $19.5 million. Its effort, by means of an expert witness, to prove that the pesos were indeed worth $19.5 million fell pathetically short of the mark....

The same thing can be worth more to one person (Kohler) than to another (Bankers Trust); that is the basis of market transactions. To a holder of Mexican debt that had no use for pesos, the debt was worth only half its face amount; to someone like Kohler who needed a great many pesos, the debt was worth more. How much more? Not $8.4 million more; and we have said that before a taxpayer can be required to disprove an extravagant evaluation the Internal Revenue Service must present some evidence to support it. The Service presented no evidence that could have persuaded a rational factfinder that the pesos Kohler got from the Mexican government in exchange for the debt it surrendered were worth $19.5 million. The Service could have justified a more modest estimate yet one well above $11.1 million, but clinging stubbornly to its untenable valuation it suggested no alternative to $19.5 million. It played all or nothing, lost all, so gets nothing.

(Hat tip:  Howard Bashman.)

Update:  David Lat calls this Benchslapped: Judge Posner Gets Medieval on the IRS.

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"The Service could have justified a more modest estimate yet one well above $11.1 million, but clinging stubbornly to its untenable valuation it suggested no alternative to $19.5 million. It played all or nothing, lost all, so gets nothing."


Posted by: andy | Nov 20, 2006 4:07:05 PM

With regards to IRS performance in this case, you get what you pay for. If you want better IRS lawyers, pay for better lawyers.

Posted by: JLR | Nov 21, 2006 9:52:55 AM