On April 1, the Senate Permanent Subcommittee on Investigations chaired by Sen. Carl Levin (D-Mich.) held hearings regarding Caterpillar Inc.'s “supply chain restructuring” that enabled it to avoid paying about $2.4 billion in U.S. taxes between 2000 and 2012. At the hearing were executives from Caterpillar Inc., representatives from its auditing firm and advisor, PriceWaterhouseCoopers ("PwC"), and tax law experts.
While many Republican senators on the Subcommittee distanced themselves from the Subcommittee Report finding considerable fault by Caterpillar, Sen. Rand Paul's (R-Ky) comments that Caterpillar deserved an award for its actions were egregious.
The plan essentially involved establishing a new Swiss affiliate in 1999, CSARL, whose function was to purchase spare parts from Caterpillar suppliers and then in turn sell these parts to Caterpillar’s non-U.S. independent dealers. Prior to the supply chain restructuring, the replacement parts business was run primarily from Morton, Illinois. This is where Caterpillar maintained its spare parts warehouse and where employees managed the business to ensure Caterpillar’s promise of replacement parts delivery anywhere in the world within 24 hours. As part of the restructuring plan, CSARL took ownership of the spare parts inventory in the Morton warehouse. The parts were legally purchased from the suppliers by CSARL and sold directly by it to the foreign dealers.
University of Michigan Law School Professor Reuven Avi-Yonah testified at the hearing. He noted that after the restructuring “physically nothing was changed. The parts were still shipped by the suppliers to Morton and shipped by Caterpillar (U.S.) from Morton to the independent dealers, without any involvement from CSARL . . . . CSARL had no warehouse or inventory management system . . . . the parts business continue(d) to be led and managed from the U.S.” CSARL earned its billions of dollars of profit from assuming the risk function, which is as Professor Avi-Yonah testified, “minimal since Caterpillar’s parts business is run so well run.”
Levin asked the right question of Caterpillar's tax advisor from PwC, Thomas Quinn. Essentially, would Caterpillar have transferred the ability to earn $8 billion of profits to CSARL if it were an unrelated third party? Quinn never answered the question. Presumably if it had done so, Caterpillar's Board of Directors would have fired its senior executive team. Section 482 of the Internal Revenue Code was designed inter alia to prevent income shifting in non-arm's length transactions. It presumably was designed to prevent taxpayers from engaging in transactions with related parties they wouldn't have ever contemplated with third-parties. If there is a loophole in section 482, allowing this type of action, it should be closed.
By legally removing Caterpillar U.S. parent company from ownership of the spare parts inventory, Caterpillar and their advisors were ensuring that a part of the Internal Revenue Code, Subpart F, would not cause CSARL’s profits to be subject to U.S. tax until if and when they were distributed back to the U.S. parent company. Subpart F is an exception to the normal rule that income not sourced or connected with the United States and earned by foreign subsidiaries will not be subject to U.S. taxation until the earnings are repatriated. The foreign base company sales income rules under Subpart F don’t apply however in a situation like this when the controlled foreign corporation’s purchases and sales are both with unrelated parties.
In addition to a possible transfer pricing challenge under section 482, the IRS has two other potential lines of attack to the Caterpillar structure under current law: lack of economic substance and assignment of income. Professor Avi-Yonah testified that he thought the IRS’s position with respect to the latter two potential arguments would be strong. Another witness, Professor Brett Wells of the University of Houston Law Center thought that Caterpillar should lose the transfer pricing issue, and both he and Professor Avi-Yonah urged that Congress make substantive changes in the law on transfer pricing to stop this type of abuse.
Paul commented that “I would like to take my time to apologize to Caterpillar for this proceeding,” adding, “Rather than having an inquisition, we should probably bring Caterpillar here to give them an award.” Assuming it’s not an April Fool’s Day joke, Paul’s comments should outrage the American public including his Tea Party supporters. The United States should not be contemplating awards for so-called "business strategies” whose raison d’etre is not to make a U.S. company commercially stronger, but to push the envelope to the edge or over in avoiding paying U.S. tax.
This is a zero sum gain. If Caterpillar can avoid paying U.S. tax by changing some contract terms it never would consider doing with an unrelated entity, it will either drive up the deficit or require ordinary American citizens and American companies to pay more tax to cover the revenue loss. If successful, it will also further encourage other companies to join in this race to the bottom.
Cohen is a tax professor at Pace University Lubin School of Business and a retired vice president-Tax and General Tax Counsel for Unilever United States, Inc. The opinion expressed here is his personal view.