United States

Swiss tax strategy garners attention at Caterpillar

U.S. officials obtain warrant to investigate CAT tax strategy

INSIGHT ARTICLE  | 

On the morning of March 2, 2017, agents from the Internal Revenue Service (IRS), Department of Commerce, and Federal Deposit Insurance Corporation entered the offices of Caterpillar Inc. (CAT or Caterpillar) bearing search warrants. The warrants indicated CAT had filed false and misleading financials, potentially breaking the law to shift corporate profits from the United States to its subsidiary in Switzerland, Caterpillar SARL (CSARL).

The allegations stem from a 2014 investigation of Caterpillar which scrutinized a tax strategy CAT implemented in 1999 at a fee of some $55 million.  Prior to the 1999 strategy, Caterpillar reported the majority of its worldwide profits from the sale of Caterpillar-branded replacement parts to non-U.S. customers on its U.S. tax return.  After adopting the new tax strategy in 1999, 15 percent of those same profits were reported on its U.S. tax return while the remaining 85 percent shifted to CSARL where the Company had negotiated an effective tax rate between four and six percent.  Allegedly, Caterpillar was able to accomplish an increase in profitability at CSARL without making any significant changes to its business operations. Reportedly, the tax strategy decreased Caterpillar’s U.S. tax liability by $2.4 billion over 13 years.  At the time, CAT’s tax advisor also served as the Company’s auditor.    

The strategy utilized a series of transactions to allocate profit to CSARL.  The Swiss entity was deemed to be the company’s global parts purchaser and Caterpillar licensed to CSARL the ability to sell Caterpillar branded, third party manufactured parts to Caterpillar’s non-U.S. dealers.  This strategy effectively eliminated Caterpillar from holding legal title to the products sold by CSARL. 

The strategy also utilized a service agreement between Caterpillar and CSARL which outlined the services the United States would continue to perform for the Swiss entity.  These services included supporting non-U.S. parts sales, forecasting parts demand, managing the company’s worldwide parts inventory, storing parts, and shipping parts from the United States. The service agreement outlined a fee equal to costs plus five percent.   

Among the items at issue, the IRS officials were questioning whether the Company’s profitability aligns with its business operations in Switzerland.  The table below highlights some of the perceived misalignment.[1]

 

United States

Switzerland

Worldwide

Employees

52,000

400

118,500

Manufacturing Facilities

54

0

125

Research & Development Costs

$1.6 Billion

Less than $200 Million

$2 Billion

Parts Business Employees

4,900

65

8,300

Parts Business Profit by Jurisdiction

15%

85%

100%

 

In addition, approximately 70 percent of Caterpillar replacement parts are manufactured by third parties in the United States and no replacement parts are sourced or manufactured in Switzerland.  Further, there are not any warehouses located in Switzerland and the United States is responsible for worldwide parts tracking, forecasting, and delivery systems with no counterparts in Switzerland. 

Members of the IRS were not the only individuals questioning the tax strategy. Daniel Schlicksup, a Caterpillar accountant in 1999, expressed concern about the strategy when it was introduced. In 2007, Schlicksup again notified Caterpillar officials saying he thought the IRS would attack CSARL for lacking economic substance. After continuing to voice his concern without response, Schlicksup went public with his allegations in June 2009.  

As a result of the tax strategy, from 2000 to 2012, Caterpillar effectively shifted taxable income related to its non-U.S. parts sales to CSARL, totaling more than $8 billion. This structure allegedly allowed Caterpillar to avoid paying approximately $2.4 billion in U.S. taxes.  As the IRS continues to investigate the case, it once again highlights the importance of taxpayers continuing to assess their tax strategies, especially with regard to transfer pricing and aggressive strategies that don’t align with economic reality.  The investigation has drawn the attention of regulators and the media and has placed a cloud over the company which may not dissipate for years.

[1] Source: Homeland Security & Governmental Affairs Permanent Subcommmittee on Investigations hearing April 1, 2014. https://www.hsgac.senate.gov/subcommittees/investigations/hearings/caterpillars-offshore-tax-strategy

 

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