FOREIGN CURRENCY GAIN NOT
ELIGIBLE FOR SECTION 108 EXCLUSION

By Bruce Meyer, JD, CPA, and Erica K. Poon, CPA, KPMG Peat Marwick

Philip Morris Inc. (Philip Morris) was denied the ability to treat foreign exchange gain associated with nonfunctional currency denominated borrowings as "income from discharge of an indebtedness" as defined under IRC Sec. 108 effective for taxable years ending before January 1, 1987. It was determined that the gain was due to a fulfillment, rather than a discharge of the indebtedness. The recent holding by the United States Court of Appeals for the Second Circuit in Philip Morris Inc. v. Commissioner of Internal Revenue (1995) demonstrates its intention to treat pre-1987 foreign currency transactions in a similar manner as post-1986 transactions.

The Court of Appeals' holding affirms the earlier Tax Court decision that Philip Morris' foreign currency-denominated debt repayment gain at issue should be treated as ordinary income. Had the Philip Morris case involved taxable years governed by IRC Sec. 988, this treatment would have been consistent with the statutory treatment. For taxable years beginning after December 31, 1986, IRC Sec. 988 generally provides that any foreign currency gain or loss attributable to a Sec. 988 transaction (which would include repayment of a loan denominated in a foreign currency) is ordinary income or loss.

Background

Between 1980 and 1984, Philip Morris entered into several borrowings, which were denominated and repaid in foreign currencies. In each of these transactions, the underlying foreign currency had depreciated in value against the U.S. dollar by the time of repayment. Thus, Philip Morris realized an economic gain on repayment of the loan caused solely by the fluctuation in foreign currency exchange rates during the period of the loan.

A summary of a Philip Morris loan transaction is provided below to illustrate the issue in the case:

On November 24, 1980, Philip Morris borrowed 100 million Swiss francs from the Union Bank of Switzerland, repayment of which were due with interest on December 1, 1987. When the obligation was incurred, one U.S. dollar was worth 1.72038 Swiss francs. Hence, the dollar value of the loan was $58,126,693 (100 million/1.72038). In 1983, the value of Swiss franc had declined with respect to the U.S. dollar; one U.S. dollar could buy relatively more Swiss francs than it could before this decline in the value of the Swiss francs. Philip Morris took advantage of the opportunity and repaid the loan principal along with accrued interest on September 1, 1983. On that date, the exchange rate was SF 2.1875 per U.S. dollar. Thus, the U.S. dollar value of the principal repayment was only $45,714,286 (100 million/2.1875).

Circumstances similar to the preceding illustration characterized the other foreign loan transactions entered into by Philip Morris. The difference between the U.S. dollar value of the foreign currency at the time of borrowing and the U.S. dollar cost of the same currency at the time of repayment represented a realized foreign currency gain for Philip Morris. Philip Morris treated the gain realized on repayment of the foreign currency loan as "income by reason of the discharge of indebtedness" under IRC Sec. 108. In accordance with that section, Philip Morris applied IRC Sec. 1017, reducing the basis of its assets by the amount of the gain on its 1983 and 1984 tax returns in lieu of current gain recognition.

The IRS, however, considered the foreign exchange gain related to the loan transactions to be ordinary income not eligible for IRC Sec. 108 treatment. The IRS determined that Philip Morris' failure to treat the gain as ordinary income resulted in deficiencies in its income tax liability for the years 1983 and 1984. Philip Morris unsuccessfully petitioned the IRS determination in the Tax Court and subsequently appealed to the Second Circuit where the lower court's ruling was affirmed on December 8, 1995.

Legal Analysis

The core of the dispute in the Philip Morris case concerned whether 1) the repayment of the loans was a "discharge" within the meaning of IRC Sec. 108; and 2) the resulting gain was by reason of "a discharge of indebtedness."

Philip Morris argued that Kentucky & Indiana Terminal Railroad. v. United States 330 F.2d 520 (6th Cir. 1964) provided authority for exclusion of the gain from gross income under IRC Sec. 108. In Kentucky & Indiana, a deferral of a gain from repayment of pound sterling-denominated bonds was allowed under IRC Secs. 22(b)(9) and 113(b)(3) of the 1939 code (predecessors of IRC Secs. 108 and 1017). In that case, the taxpayer sold bonds denominated in pound sterling. After the pound sterling had devalued relative to the U.S. dollar, the taxpayer repurchased the bonds at below face value in a combination of U.S. dollars and pounds sterling. The excess of the face value of the bonds over the purchase price consisted of two elements: 1) The discount between the face value of the bonds in U.S. dollars and the acquisition price and 2) the decline in the value of the pounds sterling. The Court of Appeals for the Sixth Circuit allowed the taxpayer to exclude from gross income not only the first but also the second element of the excess. The Sixth Circuit also allowed for a reduction of the basis in the taxpayer's assets on the ground that the exchange gain represented by the second element would not have been realized "except for the discharge of the indebtedness incurred", [330 F.2d at 523].

Despite the fact that it recognized the similarity between the facts in the Philip Morris case and those in Kentucky & Indiana, the Second Circuit rejected Philip Morris' reliance on the latter. Instead, the Second Circuit concurred with the Tax Court opinion, as discussed below, that the Supreme Court's later decision in Centennial Savings Bank FSB v. United States [499 U.S. 573 (1991)] effectively undermined the decision in Kentucky & Indiana.

Certificate of Deposit Penalties

In Centennial Savings Bank, the Supreme Court denied treatment of early withdrawal penalties of certificates of deposit as income by reason of the discharge of indebtedness eligible for exclusion from gross income. The Court explained that the term "discharge of indebtedness" conveyed forgiveness of an obligation to repay. As the prepayment penalty was an original term of the certificate of deposit and not the result of a release of any legal obligation, the withdrawal of deposits did not constitute a discharge of indebtedness for Centennial Savings Bank. Therefore, the prepayment penalty did not qualify as income attributable to a "discharge of indebtedness".

The Tax Court relied upon the decision in Centennial Savings Bank and determined that the foreign currency exchange gain at issue similarly did not fall within the definition of "income from discharge of indebtedness" under IRC Sec. 108. It rationalized that unless there was a forgiveness or release of an
obligation not reflected in the original terms of the indebtedness, the income would not be realized "by reason of
the discharge of indebtedness" under IRC Sec. 108.

Furthermore, in the Tax Court's view, a fulfillment of indebtedness in depreciated currency might be the occasion, but not the reason, for the realization of income. Philip Morris realized the gain simply by taking advantage of the devalued foreign currency to repay its loans. The Tax Court stated that Congress established such tax-deferral mechanism in IRC Sec. 108 to avoid burdening taxpayers, who were relieved of a debt, with an immediate tax liability. It was not the intention of Congress, however, to introduce the provisions to extend the same tax deferral benefits to taxpayers who had taken advantage of fluctuating market
conditions.

In contrast, Philip Morris argued in the Tax Court that its foreign currency-denominated borrowings should be treated as if they were U.S. dollar borrowings. By satisfying the indebtedness with the equivalent of fewer U.S. dollars than it originally borrowed, Philip Morris believed that it was relieved of a portion of the indebtedness. Thus, Philip Morris' gain represented by the difference in the U.S. dollar value for repayment and that for creation of indebtedness should
be excluded from gross income under IRC Sec. 108.

The Second Circuit affirmed the Tax Court opinion and further explained that Philip Morris' foreign exchange gain was a result of the performance of an obligation and not the forgiveness of that obligation. Thus, the gain did not result in "income from discharge of indebtedness" within the meaning of IRC Sec. 108 as interpreted by the Supreme Court's opinion in Centennial Savings Bank.

Concepts Are Affirmed

For post-1986 taxable years, foreign exchange gain or loss resulting from repayment of foreign currency-denominated loans has been denied deferral treatment under IRC Secs. 108 and 1017. On the contrary, such gain or loss is governed by IRC Sec. 988. It provides that any foreign currency gain or loss attributable to an IRC Sec. 988 transaction is treated as ordinary gain or loss to the extent of the amount realized by changes in exchange rates between the time of acquisition and repayment of the debt.

IRC Sec. 988 transactions include acquisition of nonfunctional currency-denominated debt instruments, foreign currency forward contracts, and disposition of nonfunctional currency. Had IRC Sec. 988 been effective for the taxable years at issue in the Philip Morris case, it would have been applied to the Philip Morris foreign currency transactions; the facts in the case fall squarely within the definitions in Section 988. Although the Tax Court and the Second Circuit did not refer to IRC Sec. 988 in the Philip Morris case, the courts, in effect, affirmed that its concepts of IRC Sec. 988 apply to pre-1987 transactions in this context. *

Editor:
Lawrence A. Pollack, JD, LLM, CPA
KPMG Peat Marwick LLP