The U.S. Senate’s Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs (the “Subcommittee”) issued a report on April 1, 2104 entitled Caterpillar’s Offshore Tax Strategy (the “Report”).[1] The Report is the result of an extensive inquiry by the Subcommittee’s members and staff, including a public hearing held on April 1,[2] of a business restructuring implemented by Caterpillar beginning in 1999. The Report includes responses to the Subcommittee by Caterpillar, Caterpillar’s auditor, PWC, and expert reports and testimony. The Report, which runs 95 pages, is worth reading because it catalogs in some detail the issues that U.S. multinationals face when implementing a business restructuring that increases their offshore presence while deferring income that would otherwise be subject to current U.S. tax. The final part of this article addresses the tax conundrum that successful US companies, such as Caterpillar, face in today’s tax environment and how some have addressed it.
 
Introduction
 
Faced with a U.S. statutory corporate tax rate significantly higher than the tax rate in other developed countries,[3] U.S. companies operating outside the United States, for many years, have responded by implementing new business models that grow or shift assets, risks and functions outside United States, generally to jurisdictions with a tax rate lower than the U.S. tax rate. This planning is typically done in a manner that avoids the U.S. anti-deferral rules of subpart F. Although each business restructuring project is unique, this type of planning raises a common set of issues, which are exemplified by those Caterpillar addressed. We discuss some of those issues below.
 
Formation of Caterpillar SARL
 
Caterpillar SARL (“CSARL”) was formed in 1999 when several other Swiss affiliates of Caterpillar were consolidated into CSARL. Although CSARL continued the operations of Caterpillar’s other Swiss businesses, CSARL’s main role was to replace Caterpillar Inc. as the supplier of replacement parts (referred to as “purchased finished replacement parts” or “PFRPs”) to customers in the EAME region.[4]  The replacement parts business is a key profit driver for Caterpillar because owners of Caterpillar equipment reportedly spend 2 to 3 times the equipment’s original purchase price on service and parts in many cases. As CSARL’s Swiss tax rate was 4 – 6%, this change to Caterpillar’s supply chain resulted in a substantial deferral of U.S. tax after 1999.[5]
 
The business restructuring required CSARL to enter into parts supply contracts with third party parts providers as well as Caterpillar Inc. CSARL also entered into a service contract with Caterpillar Inc. to provide CSARL many of the services necessary for CSARL to carry on its replacement parts business.  CSARL paid Caterpillar Inc. a 5% markup on its cost of providing these services. CSARL also paid a 15% royalty to Caterpillar Inc. for PFRPs, and a 7% royalty for “worked parts,” sold in the EAME region.[6]  Finally, CASRL entered into toll manufacturing arrangements with two non-U.S. Caterpillar subsidiaries to manufacture Caterpillar equipment for it.
 
Discussion of Tax Issues Identified by the Permanent Subcommittee
 
The tax issues identified by the Subcommittee are not unique. They often arise in business restructurings. However, the Report offers an extraordinarily detailed view of conversations, emails and memoranda surrounding a business restructuring that typically are not aired publicly. The Subcommittee collected and reviewed 150,000 pages of documents from Caterpillar and PWC in preparing the Report.  We discuss three key issues.
 
Whether CSARL lacked economic substance
 
According to the Report, Caterpillar employs about 118,000 persons worldwide. About 400 of those employees are located in Switzerland, and, in 2012, about 66 of CSARL’s employees were devoted to the replacement parts business. The Report also states that Caterpillar has over 8,300 employees worldwide who work in the replacement parts business. Most of these employees work in the United States because nearly 70% of PFRPs are manufactured in the United States.  The Report also states that Caterpillar’s “parts leadership and strategic functions remain centered in the United States” after the business restructuring.
 
The Report does not go into detail as to the decision-making authority of the Swiss personnel involved in the replacement parts business.  However, the worldwide parts manager in Switzerland reported to a vice president in the United States who, in turn, reported to a group president in the United States. Group presidents report to Caterpillar’s CEO.
 
The Report argues that Caterpillar’s business restructuring lacked economic substance under the case law, and states “at least two tax professionals within Caterpillar concluded the CSARL transaction lacked economic substance and had no business purpose other than tax avoidance.” The Subcommittee also presented an expert witness, a law professor, who testified that the business restructuring was subject to challenge under the economic substance doctrine. Caterpillar countered with its expert, also a law professor, who testified to the contrary.
 
There is no public evidence that the IRS challenged Caterpillar’s business restructuring based on the economic substance doctrine. Indeed, the Report does not discuss tax audits or other action taken by the IRS.[7] The economic substance doctrine has been at issue in one case involving a business restructuring, and in that case the taxpayer prevailed.[8]  The IRS has pursued the economic substance doctrine in a variety of recent cases, and has prevailed in many of them.  That body of case law will certainly continue to develop, and, perhaps, one day there will be additional guidance as to how the economic substance doctrine applies to business restructurings.
 
Whether CSARL’s transactions with its affiliates were priced appropriately
 
The Subcommittee challenged the royalty rate that CSARL paid Caterpillar Inc. stating that “it defies logic that Caterpillar would have entered into a licensing transaction with an unrelated party in which it gave away 69%, 85% or more of its business profits . . .” The Subcommittee did not engage an economist to evaluate Caterpillar’s transfer pricing, however. 
 
For its part, Caterpillar defended its transfer pricing stating that “Caterpillar Inc. has paid an immediate U.S. tax on approximately 35% of the total system profit from the licensed business [parts and machines]. This allocation of profit to the licensee equals or exceeds the 25-75% ‘rule of thumb’ profit split articulated by the U.S. Tax Court in Ciba-Geigy Corp. v. Comm’r, 85 T.C. 172 (1985).”
 
One of the Subcommittee’s experts appeared to concede the transfer pricing issue in testimony before the Subcommittee:
 
It should be noted that the IRS has not generally been successful in transfer pricing litigation and that the Caterpillar business restructuring follows a common model that many other U.S. and foreign multinationals have adopted. Under this model, the entrepreneurial risk is located in a low tax jurisdiction and the production and distribution functions are assigned to low profit contract manufacturers and commissionaires in high tax countries. It is not clear that the IRS can succeed in challenging such structures under current law. This suggests that current law should be changed, which is a job for Congress.[9]
 
However, the subcommittee’s other expert witness took a different approach, arguing that Caterpillar’s logistics organization and independent dealer network “created a business system that represents an intangible asset, and it is this intangible asset that explains the residual profits they can be generated from the sale of spare parts that are custom designed to fit the CAT equipment.”[10]
 
Whether Caterpillar’s virtual inventory system created U.S. tax exposure for CSARL
 
Caterpillar Inc. and CSARL shared parts stored in U.S. warehouses and used a “virtual” inventory system to track the ownership of replacement parts for U.S. tax purposes. The replacement parts were not physically separated, but were co-mingled. Citing Commissioner v. Culbertson[11] the Report states: “when a common pool of inventory is jointly managed for mutual benefit of two entities, the courts have long held that a de facto U.S. partnership may exist.”
 
One of the Subcommittee’s expert testified:
 
If the joint management of inventory has created a de facto U.S. partnership between Caterpillar, Inc. and CSARL, then the U.S. partnership is likely to have a U.S. permanent establishment. The existence of a U.S. permanent establishment on the part of the de facto U.S. partnership creates a U.S. taxable presence for each of the partners . . .”
 
Later, the expert concludes that, if indeed there were a de facto partnership, “Caterpillar actually may be subject to a higher U.S. tax result versus the tax results it would have incurred if Caterpillar had never concluded its 1999 tax restructuring. . . ”
 
Whether a de facto partnership exists is an intensely factual question that must be resolved by reference to a handful of judicial decisions. Perhaps because of the relative uncertainty in the law, neither the Subcommittee’s nor Caterpillar’s experts offered a definitive view as to whether, in fact, a de facto partnership existed.
 
Observations on the Tax Conundrum Facing U.S. Multinationals (and the U.S. Congress)
 
When successful, business restructurings result in the accumulation of earnings in non-U.S. subsidiaries and reduce the company’s global tax bill as well as its effective tax rate as reported for financial accounting purposes. Management frequently would like to return those accumulated earnings to the United States in order to fund acquisitions, dividends or share buybacks.
 
The accumulated earnings resulting from a business restructuring often are subject to a low rate of foreign income tax, however, and therefore would be subject to additional U.S. tax (after the foreign tax credit) if repatriated to the United States. This is known as the “lockout effect” and effectively keeps billions of dollars locked up in non-U.S. subsidiaries. Caterpillar faced this issue, as noted in the Report.[12] Many other U.S. companies face this issue today and have decided to borrow rather than repatriate earnings located in low tax jurisdictions.[13]
 
Today many US multinationals are frustrated by increased scrutiny and public criticism of their tax planning, the consequences of the lockout effect, and uncertainty over prospects for tax reform and a lower U.S. corporate tax rate in the future. This is their tax conundrum. Some have answered this conundrum by relocating their businesses beneath a foreign holding company so that the earnings of non-U.S. subsidiaries can be paid directly to a foreign parent company (and bypass the U.S. corporate income tax).[14] Some companies that have inverted in the past 10-15 years include Accenture, Cooper Industries, Everest Re Group, Foster Wheeler, Fruit of the Loom, Global Crossing, Ingersoll Rand, Leucadia National Group, Nabors Industries, Noble Drilling, Seagate Technologies, Trenwick Group, Triton Energy Corp. and Tyco International.
 
Beginning in 2011, in reaction to tighter U.S. tax regulations governing inversion transactions, U.S. companies have combined with smaller, established companies in order to achieve the same result. For example, Activis has acquired Warner Chilcott, Perrigo has acquired Elan Corporation, Alkermes merged with Elan Drug Technologies, and Activis acquired Forrest Laboratories.  The most recent example of this growing phenomenon is Pfizer’s proposed acquisition of AstraZeneca.
 
Traditionally tax reform is unlikely to occur in a year in which there are Congressional elections, such as 2014. It therefore is unlikely that any change in the U.S. tax laws will occur before 2015. The Obama administration’s 2015 budget included some proposals to tighten the U.S. anti-inversion rules. However, the major corporate tax reform proposals being discussed in the Congress focus on a reduction in the corporate tax rate, which could, indirectly, reduce the incentive to enter into such inversion transactions depending upon the details of the reforms actually enacted into law.  In any event, it is clear that the stakes are large for the U.S. fisc and U.S. corporations – and those stakes are growing.