Caterpillar and the US Senate Hearings – Part II : Are we any clearer on what the spirit of US tax is as a result?

In my blog of 2 April 2014 “Ways of Seeing – Senate Hearings on Caterpillar” I posed the question as to how the different ways of seeing the same issue were possible. I quoted from the Financial Times reporting on the US Senate’s hearings:

“Julie Lagacy, Caterpillar’s vice-president of finance services, and Robin Beran, the company’s chief tax officer, are among the witnesses for the hearing, along with representatives of PwC, its tax consultant and auditor.

“In her testimony, Ms Lagacy plans to say that Caterpillar pays a 29 per cent effective tax rate, which is higher than the average 26 per cent US corporate rate. For the past three years, the company paid $1.8bn in federal income taxes.

She will emphasise that the Senate focus is on the sale and purchase of replacement parts by Caterpillar’s non-US affiliates, which by law are not subject to US taxes or in other cases subject to deferred US taxes.”

“This is a standard multinational business structure entirely consistent with the letter and spirit of US tax law,” Ms Lagacy said in her written testimony, adding that the company stands by its structure. “

What I then said was:

“Now some people might see this as a strange treatment for the letter and the spirit of the US tax code to permit regardless of how many words are used to describe it. Some might think that the right area of focus would be on whether that is good law and if that was the case whether the politicians should review it and make changes. You might also wonder what the officials and politicians were doing when they were making the laws and regulations involved that permit this treatment? “

So I read with interest the report of the Senate Hearings “CATERPILLAR’S OFFSHORE

TAX STRATEGY,MAJORITY STAFF REPORT”. The conclusions make interesting reading so I will quote them in full :

 

C. Findings and Recommendations

 

Findings. Based on the Subcommittee’s investigation, the Report makes the following

findings of fact.

(1) Operating a U.S. Centric Business. Caterpillar’s third-party manufactured replacement parts business, which provides the company with its highest profit margins, is managed and led primarily from the United States.

(2) Reversing U.S.-Swiss Allocation of Parts Profits. Caterpillar negotiated a 4% to 6% effective tax rate with Switzerland and, in 1999, executed a tax strategy in which the company stopped allocating 85% or more of its non-U.S. replacement parts profits to the United States and 15% or less to Switzerland, and instead allocated 15% or less of those profits to the United States and 85% or more to Switzerland.

(3) Generating $2.4 Billion in Tax Benefits. After executing its Swiss tax strategy, over a 13-year period beginning in 2000, Caterpillar allocated more than $8 billion in non-U.S. parts profits to its Swiss affiliate, CSARL, and has so far deferred paying $2.4 billion in U.S. taxes on those profits.

(4) Using Contradictory Valuations. To justify sending 85% of its non-U.S. parts profits to its Swiss affiliate, CSARL, Caterpillar asserted that CSARL’s development and support of its offshore dealer network was highly valuable, but when it later transferred to CSARL another marketing company performing the same functions, Caterpillar treated the value of those functions as negligible.

(5) Employing a Tax-Motivated “Virtual Inventory.” To track CSARL owned parts stored in Caterpillar’s U.S. warehouses, Caterpillar devised a “virtual inventory” system that used “virtual bins” of commingled CSARL and Caterpillar parts and only retroactively, after a sale, identified the specific parts belonging to CSARL. The virtual inventory system created a second set of inventory books for tax purposes and operated in addition to Caterpillar’s global inventory system which tracked parts for business purposes.

(6) Creating a Potential Conflict of Interest. By acting as both Caterpillar’s independent auditor and tax consultant, PricewaterhouseCoopers (PWC) auditors audited and approved the very Swiss tax strategy sold by PWC tax consultants to the company, creating an apparent, if not actual, conflict of interest. PWC was paid over $55 million for developing and implementing Caterpillar’s offshore tax strategy.

 

Recommendations. Based upon the Subcommittee’s investigation, the Report makes the

following recommendations.

(1) Clarify IRS Enforcement. When reviewing multinational corporate transfer pricing transactions to evaluate their compliance with Section 482 of the tax code, the IRS should analyze, in accordance with 26 U.S.C. 7701(o), whether the transactions have economic substance apart from deferring or lowering a multinational’s U.S. taxes. The IRS should also clarify what types of transfer pricing transactions, if any, are not subject to an economic

substance analysis.

(2) Rationalize Profit Splitting. The IRS transfer pricing regulations should require the U.S. parent corporation to identify and value the functions of the related parties participating in a transfer pricing agreement and, in the agreement, identify, explain, and justify the profit allocation according to which parties performed the functions that contributed to those profits.

(3) Participate in OECD Multinational Corporate Tax Effort. The U.S. Treasury Department and IRS should actively participate in the ongoing OECD effort to develop better international principles for taxing multinational corporations, including by requiring multinationals to disclose their business operations and tax payments on a country-by-country basis, stop improper transfers of profits to tax havens, and stop avoiding taxation in the countries in which they have a substantial business presence.

(4) Eliminate Auditing and Tax Consulting Conflicts of Interest.

Congress and the Public Company Oversight Accounting Board (PCAOB) should prohibit public accounting firms from simultaneously providing auditing and tax consulting services to the same corporation, and prevent the conflicts of interest that arise when an accounting firm’s auditors are asked to audit the tax strategies designed and sold by the firm’s tax consultants

 

Now there is some trenchant criticism here. Let’s consider some of the issues:

 

What does the spirit of the law mean in outbound US tax planning? Well Caterpillar and PwC had both satisfied themselves that what they were doing was within the spirit of the law. The Senate committee has questioned whether using different valuation bases for different transactions passes this test? Does it?

 

How does

 

Employing a Tax-Motivated “Virtual Inventory.” To track CSARL owned parts stored in Caterpillar’s U.S. warehouses, Caterpillar devised a “virtual inventory” system that used “virtual bins” of commingled CSARL and Caterpillar parts and only retroactively, after a sale, identified the specific parts belonging to CSARL. The virtual inventory system created a second set of inventory books for tax purposes and operated in addition to Caterpillar’s global inventory system which tracked parts for business purposes.”

 

meet the spirit of the law? This would seem to imply another set of tax books in addition to the Group’s main accounting system? How does this fit with an economic substance analysis? Also why is the principal responsible for the sale only identified retroactively?

 

There is a lot of comment on substance over form and this comes to the nub of the issue. For the last twenty years, US tax advisers have argued that form is more important than substance and that contractual rights should be the primary basis of analysis for allocating taxing rights. This was the fundamental issue in the OECD project on business restructuring. The question is, is US tax policy on US outbound transactions focused on form or substance? You can’t have both, you have to choose one. The US government needs to clarify this.

 

The report goes on to state:

 

“When reviewing multinational corporate transfer pricing transactions to evaluate their compliance with Section 482 of the tax code, the IRS should analyze, in accordance with 26 U.S.C. 7701(o), whether the transactions have economic substance apart from deferring or lowering a multinational’s U.S. taxes. The IRS should also clarify what types of transfer pricing transactions, if any, are not subject to an economic substance analysis.”

 

And “The IRS transfer pricing regulations should require the U.S. parent corporation to identify and value the functions of the related parties participating in a transfer pricing agreement and, in the agreement, identify, explain, and justify the profit allocation according to which parties performed the functions that contributed to those profits.”

 

These two comments are interesting. I would suggest that they imply either the IRS is not doing its job properly as the rules are clear (that economic substance is the basis of taxation rights) or that the law isn’t clear and needs clarifying.

 

The report goes on to say :

 

“The U.S. Treasury Department and IRS should actively participate in the ongoing OECD effort to develop better international principles for taxing multinational corporations, including by requiring multinationals to disclose their business operations and tax payments on a country-by-country basis, stop improper transfers of profits to tax havens, and stop avoiding taxation in the countries in which they have a substantial business presence.” (My emphasis)

 

I have to agree with this. Government has to make clear what its tax policy principles are (because otherwise how can a taxpayer ascertain the spirit as well as the letter of the law?) but what is interesting here is the call to base those principles on “substantial business presence” ie on substance over form.

 

The confusion over what US tax policy is in this area, cannot aid the BEPS project so clarification is important. Clarification is also important for other governments and for non US based business. More on this and how it affects some proposed takeover/merger activity and the competitive balance of tax systems in due course.

 

 

 

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