Thomson Reuters Tax & Accounting News

Featuring content from Checkpoint

Back to Thomson Reuters Tax & Accounting News

Subscribe below to the Checkpoint Daily Newsstand Email Newsletter

U.S. manufacturer subject to multiple agency investigations over Swiss tax strategy

In a form filed with the Securities and Exchange Commission (SEC), Caterpillar Inc., which last year was the subject of a Senate hearing on multinationals shifting profits out of the U.S., revealed that numerous investigations by the Justice Department, IRS, and SEC were ongoing with respect to its tax strategies and overall business structure. According to reports, by funneling profits through a Swiss subsidiary—a move more commonly associated with multinationals in the technology sector—Caterpillar avoided approximately $2.4 billion in U.S. taxes over a 13-year period.

Background—U.S. taxation of foreign-source income. U.S. corporations are generally taxable on income from outside the U.S. (Code Sec. 862) However, a foreign corporation with U.S. owners can often earn and accumulate certain types of income overseas that is effectively insulated from U.S. tax until it is actually brought back to the U.S. (i.e., repatriated and distributed to the U.S. owners).

Background—CFCs. Under Code Sec. 957, a CFC is a foreign corporation with regard to which more than 50% of the total combined voting power of all classes of stock entitled to vote, or of the total value of the stock of the corporation, is owned (directly, indirectly, or constructively) by “U.S. shareholders.”A U.S. shareholder is defined for CFC purposes as a U.S. person who owns (directly, indirectly, or constructively) 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. (Code Sec. 951(b)) In general, the CFC rules limit the benefits of deferral by requiring U.S. shareholders to include their pro rata share of certain items of the CFC’s income (subpart F income) regardless of whether the income is actually distributed.(Code Sec. 951(a)) However, there are a number of exceptions to the subpart F rules.

Background—transfer pricing. Under Code Sec. 482, in the case of any transfer or license of intangible property between controlled entities, IRS may allocate income, deductions, credits, or allowances between the entities to prevent the evasion of taxes or to clearly reflect income.The standard to be applied is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. The Code Sec. 482 rules are sometimes called the “transfer pricing” rules.

Background—economic substance. Under Code Sec. 7701(o), codified in 2010, a transaction is treated as having economic substance only if (apart from Federal income tax effects): (1) the transaction changes in a meaningful way the taxpayer’s economic position, and (2) the taxpayer has a substantial purpose for entering into the transaction.

Caterpillar’s tax strategy. Caterpillar Inc., a U.S. manufacturer with a significant U.S. presence, adopted a tax strategy that essentially shifted a large portion of its replacement parts business to a new Swiss affiliate (CSARL).The replacement parts business was reportedly described internally as a “perpetual profit machine.”

Caterpillar implemented the “Swiss tax strategy” with the express purpose of reducing its taxes.By design, the strategy removed the U.S. parent (i.e., Caterpillar) from the chain of title for third-party-manufactured parts sold to non-U.S. customers, and replaced it with a non-U.S. entity such that the offshore income would no longer be immediately attributed to Caterpillar. Caterpillar also signed a servicing agreement with CSARL in which it agreed to keep performing the core functions supporting the non-U.S. parts sales. As a result of those licensing and servicing agreements, from 2000 to 2012, Caterpillar shifted to CSARL (and thus to Switzerland, where it had negotiated an effective tax rate between 4% and 6%) taxable income from its non-U.S. parts sales totaling more than $8 billion, and deferred or avoided paying U.S. taxes totaling about $2.4 billion.The tax strategy also involved the creation of a virtual inventory system used to track Caterpillar parts owned by CSARL in the U.S.

Senate report. According to a report by the Senate Permanent Subcommittee on Investigations, the above changes, and resulting profit shift, were accomplished making only “paper, not operational, changes” to Caterpillar’s replacement parts business. The report notes that the Swiss tax strategy raises multiple policy concerns, including whether the strategy lacked economic substance, whether the agreements between Caterpillar and CSARL violated arm’s-length principles, and whether its use of a virtual inventory system created a taxable U.S. presence for CSARL.

In addition, the report raised concerns relating to whether Caterpillar’s decision to split its high-margin parts profits off from its low-margin machine sales, and direct those parts profits to CSARL without receiving any compensation for the economic value associated with its past and future machines, is prohibited under the Assignment of Income Doctrine (i.e., as a prohibited inequitable distribution of profits).

For more details on the strategy and Senate report, see Weekly Alert ¶  46  04/03/2014.

Current investigations. On Caterpillar’s Form 10-Q (a quarterly report filed by publicly traded corporations with the SEC), filed on May 1, 2015, the company disclosed the following:

Grand jury subpoena. Caterpillar received a grand jury subpoena from the U.S. District Court for the Central District of Illinois on Jan. 8, 2015, requesting documents and information “relating to, among other things, financial information concerning U.S. and non-U.S. Caterpillar subsidiaries (including undistributed profits of non-U.S. subsidiaries and the movement of cash among U.S. and non-U.S. subsidiaries).” Caterpillar also received “an additional subpoena relating to this investigation requesting additional documents and information relating to, among other things, the purchase and resale of replacement parts by Caterpillar Inc. and non-U.S. Caterpillar subsidiaries.”

RIA observation: It is unclear at this point how Caterpillar’s tax strategies would give rise to a criminal investigation.

SEC investigation.On Sept. 12, 2014, Caterpillar was notified that the SEC was “conducting an informal investigation relating to Caterpillar SARL [CSARL] and related structures.”

IRS adjustment. Following a field examination of Caterpillar’s U.S. returns for 2007 to 2009, including the impact of a loss carryback to 2005, IRS proposed tax increases and penalties for those years of approximately $1 billion, which Caterpillar is “vigorously contesting” in Appeals.Caterpillar stated in the SEC form that IRS “proposed to tax in the United States profits earned from certain parts transactions by CSARL based on the IRS examination team’s application of “substance-over-form” or “assignment-of-income” judicial doctrines.”Caterpillar further said it “believe[s] that the relevant transactions complied with applicable tax laws and did not violate judicial doctrines,” and that the “purchase of parts by CSARL from unrelated parties and the subsequent sale of those parts to unrelated dealers outside the United States have substantial legal, commercial, and economic consequences for the parties involved” (presumably defending the strategy as having economic substance).

The May 1, 2015 filing, as well as Caterpillar’s other SEC filings, is available on its website.

References: For Code Sec. 482 allocations for transfers or use of intangible property, see FTC 2d/FIN ¶  G-4500; United States Tax Reporter ¶  4824.04. For U.S. shareholders of CFCs, see FTC 2d/FIN ¶  O-2301; United States Tax Reporter ¶  9514.01; TaxDesk ¶  393,014; TG ¶  30425.

Tagged with →