                            In the
 United States Court of Appeals
              For the Seventh Circuit
                        ____________

No. 05-4472
KOHLER COMPANY,
                                                Plaintiff-Appellee,


                               v.


UNITED STATES OF AMERICA,
                                            Defendant-Appellant.
                        ____________
           Appeal from the United States District Court
              for the Eastern District of Wisconsin.
           No. 01-C-753—William C. Griesbach, Judge.
                        ____________
  ARGUED SEPTEMBER 27, 2006—DECIDED NOVEMBER 20, 2006
                        ____________


 Before POSNER, MANION, and WILLIAMS, Circuit Judges.
  POSNER, Circuit Judge. Kohler, the well-known manufac-
turer of plumbing products, brought suit for a refund of
federal income taxes. It won on summary judgment, 387 F.
Supp. 2d 921 (E.D. Wis. 2005), and the government
appeals.
   In 1986, Kohler decided to build a plant in Mexico that
it estimated would cost at least $29 million. It needed
2                                                 No. 05-4472

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 dollar-
denominated 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.
International Business Corporation, Debt-Equity Swaps:
How to Tap an Emerging Market 1 (1987). The program
enabled the Mexican government to retire some of its
foreign-owned debt without having to pay “hard”
money—that is, foreign currency, or, what would amount
to the same thing, pesos convertible to foreign currency.
  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. The qualification in “as calculated at the then
current market exchange rate” is critical. If for one reason
No. 05-4472                                                      3

or another that was not the right exchange rate to use for
this transaction, the pesos that Kohler received may not
really have been worth $19.5 million. That they were
worth less is shown by Mexico’s willingness to offer
$19.5 million in pesos for debt that Kohler had purchased
for only $11.1 million. Mexico had to compensate Kohler
for accepting pesos that came with restrictions that
reduced their dollar value. The pesos had to be spent in
Mexico on projects approved by the government and
could not be freely converted to dollars or other foreign
currencies until 1998. So although the market exchange
rate was, as we said, 2245 pesos to the dollar, Kohler
received a rate of 3939 pesos to the dollar, which is what
turned $11.1 million of dollar debt into $19.5 million in
pesos. Kohler did however use all the pesos to pay for real
estate and other costs that it incurred in building its plant.
  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 govern-
ment 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.
  One might have thought that the way to account for
Kohler’s purchase of Mexican debt would have been to
add $11.1 million to the basis of Kohler’s investment in the
Mexican plant, so that if it ever sold the plant the differ-
ence between on the one hand the sale price and on the
other hand the sum of $11.1 million and all the other costs
of the plant would be the taxable income attributable to
the sale. Then if the Mexican government’s purchase of
4                                                 No. 05-4472

$11.1 million in debt from Kohler for $19.5 million in pesos
was a windfall for Kohler, reducing the real cost of the
plant, Kohler would realize a greater profit from the
eventual sale of the plant than it would have realized
otherwise, and that profit would be taxable. Even if the
plant was never sold, the windfall would give Kohler
higher profits (presumably taxable) on sales of the plant’s
output because the deductions from taxable income that it
could take for depreciation of the cost of the plant would
be lessened by the $8.4 million reduction in its basis.
  An alternative way of accounting for the swap would
have been to accept Kohler’s argument that the value of
the debt that it purchased was unascertainable at the time
of purchase and treat the exchange of the debt for the peso
account as a swap yielding no taxable income. Any capital
gains that resulted in the future from Kohler’s use of the
pesos to purchase goods and services for its project would
be taxable. So if it used the entire amount to buy real estate
and construction services before any change in the ex-
change rate, it would be deemed to have realized a capital
gain of $8.4 million ($19.5 million minus $11.1 million) on
the purchase.
  Still another alternative would be to deem the difference
between the two amounts a contribution of capital to
Kohler’s enterprise by the Mexican government. Such a
contribution would not be included in Kohler’s gross
income, 26 U.S.C. § 118(a), though it would be recorded on
Kohler’s books as having a zero basis, 26 U.S.C. § 362(c),
and so could not be depreciated. Although this approach
was adopted in the nearly identical case of G.M. Trading
Corp. v. Commissioner of Internal Revenue, 121 F.3d 977 (5th
Cir. 1997), we are dubious about it. Compensation for a
“specific, quantifiable service” cannot be classified as a
No. 05-4472                                                      5

contribution to capital, United States v. Chicago, Burlington
& Quincy R.R., 412 U.S. 401, 413 (1973)—and the Mexican
government, to the extent it “overpaid” Kohler for the
bonds, was buying a service from Kohler: retirement of a
part of Mexico’s foreign debt. See Scott A. Shane, “A U.S.
Policy Toward Debt-Equity Swaps,” 16 J. Soc., Pol. & Econ.
Stud. 287 (1991); Morris B. Goldman, “Debt/Equity
Conversion; A Strategy for Easing Third World Debt,”
Heritage Foundation Reports 1 (Jan. 21, 1987).
  The court in G.M. Trading thought the purpose of the
Mexican debt-equity swap program was to encourage
foreign investment in Mexico. That was a purpose, but it
was secondary to Mexico’s desire to retire its foreign
debt—the service for which it paid Kohler by exchanging
dollar debt for pesos. In deciding at what rate to exchange
foreign debt for pesos, moreover, Mexico ranked projects
according to their investment value, and Kohler’s type of
project was rated below several others, such as projects
designed to privatize state industries. International
Business Corporation, supra, at 56-57; Morgan Guarantee
Trust Company, “Debt Equity Swaps,” World Finance
Markets 14 (June-July 1987). The debt held by companies
that planned to use their pesos for the investments most
favored by the government was redeemed in pesos at par.
Remember that the par (face) value of the debt that Kohler
bought from Bankers Trust was $22.4 million, or 50.4
billion pesos at the market exchange rate of 2245 pesos per
dollar. Kohler was offered only 87 percent of this amount
(43.8 billion pesos). Mexico would not have gone out of its
way to encourage Kohler’s project had it not been for the
opportunity to retire some of its foreign debt. In fact it was
Kohler—whose decision to build the plant predated the
swap program—that approached the Mexican government
about initiating a swap, rather than vice versa.
6                                                 No. 05-4472

  No doubt the government’s motives were mixed, as
indicated by the fact that some companies that tendered
dollar debt for redemption in pesos were given the less
attractive exchange rate of 3399 to the dollar, compared to
Kohler’s 3939; their projects were not the kind of foreign
investment that the government especially wished
to attract. Kohler’s project was what is called a
“maquiladora,” a project whereby (in the usual case) a
plant imports raw materials into Mexico for processing
into finished products that are exported. Thus, as a further
condition of the swap, Kohler promised to export at least
20 percent of the output of its plant, which would earn
dollars for Mexico, which wanted to encourage foreign
investment that would build its dollar holdings. That
condition doubtless induced the favorable exchange rate
that Kohler received, and maybe the difference between
that rate and the bottom rate of 3399 pesos per dollar,
translated into dollars, could be considered a contribution
to capital by Mexico.
   There is no need to pursue the issue. The parties have
taken none of the paths we’ve laid out. (The second—the
wait-and-see approach—strikes us as the most practical, as
it involves no conjecture.) They treat the sale of the
Mexican debt for the peso account as just that—a taxable
sale—consistent with the rule that an exchange of “materi-
ally different” things (the Mexican dollar debt for the
pesos) is an event in which profit or loss is realized. 26
U.S.C. § 1001(c); 26 C.F.R. § 1.1001-1. Cottage Savings Ass’n
v. Commissioner of Internal Revenue, 499 U.S. 554, 556 (1991),
is illustrative: “a financial institution realizes tax-deduct-
ible losses when it exchanges its interests in one group of
residential mortgage loans for another lender’s interests in
a different group of residential mortgage loans.”
No. 05-4472                                                      7

  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 Reve-
nue 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. Kohler’s position is untenable because $11.1
million in Mexican foreign debt was worth more to it than
to Bankers Trust. It wanted pesos; Bankers Trust did not.
Kohler argues absurdly that if it gained from the purchase,
the bank must have lost, and why would it sell at a loss?
Most transactions produce a gain to both parties—that is
what induces the transaction.
  Yet the pesos were not worth the full $19.5 million at
which the Mexican government valued them for purposes
of the exchange, because they were not convertible into
dollars or any other currency. They could be used only in
Mexico and in fact only to build the intended plant. Had
Kohler decided not to build the plant, because of changed
conditions after its purchase of the debt from Bankers
Trust, it would have been battered by the severe inflation
that afflicted Mexico throughout the 1980s. That is why we
suggested earlier that the dispatch with which Kohler
spent its pesos would determine the actual value of the
exchange to it (the “wait-and-see” approach). A dollar
restricted to being used to purchase the currency of a
country in the throes of a financial crisis is worth less than
a dollar.
  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
8                                                 No. 05-4472

sense of the burden of persuasion) would lose. And that is
Kohler—and would be, by the way, even if it had not paid
the additional tax assessed by the IRS but instead had been
sued in the Tax Court for a deficiency. Tax Ct. R. 142(a);
Kikalos v. Commissioner of Internal Revenue, 434 F.3d 977,
982 (7th Cir. 2006); Leo P. Martinez, “Tax Collection and
Populist Rhetoric: Shifting the Burden of Proof in Tax
Cases,” 39 Hastings L.J. 239, 257-60 (1988).
  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. Pursuant to a divorce
settlement, Davis agreed to transfer stock to his wife in
exchange for her surrender of her marital property rights.
In effect he bought those rights for the value of his stock,
just as Kohler in effect bought pesos from the Mexican
government for $11.1 million, since the money it paid
Bankers Trust was the only outlay it made to get the pesos.
The Court in Davis held that the only taxable gain on the
transaction was the difference between the market value
of the stock and the taxpayer’s basis—not the difference
between the value of the wife’s marital rights, correspond-
ing to the pesos that Kohler acquired in this case, and the
taxpayer’s basis. The Court reasoned that “absent a readily
ascertainable value” of the acquired property, it should be
assumed to be equal in value to what the taxpayer had
paid for it. Id. at 72. Otherwise, as the Court explained, the
wife would not know, if she should later sell the stock,
what her basis was—that is, what she had paid in ex-
change for the stock by giving up her marital rights. Id. at
73.
  But the Court merely assumed, it did not hold, that the
wife’s marital rights could not be ascertained with suffi-
cient precision to enable a calculation of the taxpayer’s
No. 05-4472                                                      9

“real” gain (or loss). The Court of Claims had held that
because in its view the value of those rights could not
reasonably be ascertained, their exchange for the tax-
payer’s stock was not a taxable event. The Supreme Court,
assuming—but not ruling on—the soundness of the Court
of Claims’ finding on ascertainability, held that the
exchange was still a taxable event, only one in which the
only gain realized was the difference between the market
value of the stock (it was publicly traded—it was DuPont
stock) and the taxpayer’s basis in the stock. Id. at 71-73. In
other words, if property received in an exchange cannot be
valued, the taxable gain is limited to the difference be-
tween the sale price and the seller’s basis.
  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. Suppose a lawyer and a dentist
bartered legal services for dental services and the IRS
assessed the legal services as worth only $10,000 and the
dental services as worth $1 million and so assessed
$990,000 in additional taxable income to the lawyer. The
government would have to present some evidence in
defense of its extravagant assessment before the burden of
production and persuasion would shift to the taxpayer.
This conclusion is implicit in cases that hold that when the
IRS makes a “naked” assessment, which is to say one
“without any foundation whatsoever,” the taxpayer does
not have to prove what the assessment should have been.
United States v. Janis, 428 U.S. 433, 440 (1976); see also
Helvering v. Taylor, 293 U.S. 507 (1935).
10                                               No. 05-4472

   So here, the government’s assessment was undeniably
excessive because it took no account of the restrictions that
the seller of the pesos (the Mexican government) had
placed on the purchase. Among the restrictions is one that
we haven’t mentioned yet: Kohler was forbidden to trade
its pesos with Mexicans for dollars (Mexico didn’t want
dollars going out of the country), so that if it had decided
against building the Mexican plant and had no other use
for pesos it would have had to exchange them for dollars
with other foreign companies planning similar or (as
judged by Mexico) inferior projects. If, for example, a
company was contemplating a project that the Mexican
government thought so desirable that it would redeem the
company’s Mexican debt at par ($22.4 million in pesos
versus the $19.5 million in pesos that Kohler received), the
company could deal directly with the government rather
than buying Kohler’s pesos. It would buy those pesos only
if Kohler gave it a discount that would make the buyer as
well off as if he had dealt directly with the Mexican
government.
  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 patheti-
cally short of the mark. The expert had not attempted to
calculate the discount that a purchaser of restricted pesos
would have demanded. Kohler’s efforts to show that the
pesos it received from the Mexican government were
worth the same as the debt it had exchanged were equally
pathetic. Kohler was committed, though apparently not
irrevocably, to a project that would cost more in pesos
than the pesos it was obtaining from the Mexican govern-
No. 05-4472                                                11

ment. Although the pesos obtained in the swap wouldn’t
be spent all at once, the government had guaranteed that
until they were spent they would earn interest at a high
rate and be guaranteed against any devaluation of the
peso (though not against inflation). Given Mexico’s
parlous financial situation, the transaction was not riskless
to Kohler. But Kohler would not have paid $11.1 million to
obtain pesos from the Mexican government had it not
thought that the government’s offer to give it 75 percent
more pesos than it could have bought on the open market
for $11.1 million ($19.5 - $11.1 = $8.4 ÷ $11.1 = .75) would
yield it a profit.
   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.
                                                AFFIRMED.
12                                            No. 05-4472

A true Copy:
       Teste:

                       _____________________________
                        Clerk of the United States Court of
                          Appeals for the Seventh Circuit




                USCA-02-C-0072—11-20-06
