US taxation: Companies in line for capital gains windfalls
Originally published: MONDAY SEPTEMBER 29 1997;
By George Graham, Banking Editor
- The US tax authorities have suffered a court reverse that could bring millions of
dollars in tax gains to companies that carried out debt-for-equity swaps in Latin America
in the late 1980s.
- A federal appeals court earlier this month ruled that companies could not be taxed on
the premiums paid by governments in debt-for-equity swaps.
- The debt-for-equity technique was widely used by countries such as Mexico,
Brazil, Chile and Argentina to manage their debt burdens and encourage privatisations and
inward investment. Between 1985 and 1990, an estimated $54bn of debt was converted into
investment in this way.
- After the debt crisis of the early 1980s, many governments saw their debt trading at
less than half its face value. They were unable to take advantage of this discount to buy
it in, either because of covenants attached to the loans or because they lacked the
foreign currency to repay the loans, usually denominated in dollars.
- Debt-for-equity programmes allowed a company to buy debt at a steep discount from a
bank, and then trade it to the government for close to face value in local currency, on
condition that the money was used to buy a privatised company or to build a new factory.
- The IRS claimed that the gap between the price paid to the bank for the debt and the
value given by the government amounted to a capital gain which should be taxed.
- The test case for this claim involved G.M.Trading, a Texas company unrelated to General
Motors, which wanted to build a sheepskin processing plant in Mexico.
After surrendering $600,000 worth of Mexican national debt and being credited with pesos
worth $1.1m, GMT was presented with a tax bill for the $410,000 gain.
- GMT was backed in the case by many corporations with much larger sums at stake,
including Chrysler, the carmaker, and other US companies that used debt-for-equity swaps
to build assembly plants in Mexico.
- "The companies took the view that it was a subsidy, which would not be
taxable," said Jerome Libin, a tax lawyer with the law firm of Sutherland, Asbill
& Brennan.
- The IRS won twice over in the Tax Court, but has now been reversed in the fifth circuit
court of appeals. Judge Jerry Smith said the IRS position would result in the taxation of
contributions to capital, which are excluded by law.
