The US Senate issues occasionally reports which demonstrate how some U.S. multinational corporations have employed complex transactions and licensing agreements with offshore affiliates to exploit tax loopholes, shift taxable income away from the United States to tax heaven jurisdictions, and indefinitely defer paying their U.S. taxes. A relevant report, issued in April 2014, focuses on the Caterpillar’s aggressive tax strategy regarding BEPS. Based on the estimation of the investigators, this strategy resulted in a reduction of the US taxable income by USD 8 million. The corresponding tax was about USD 2.4 million.
Caterpillar in the US
Caterpillar is the world’s leading manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives. From a legal and tax perspective, Caterpillar is a multinational corporation with headquarters in the US. In addition, the majority of the company’s Research and Development (R&D) activity and information technology planning and development occur in the United States.
To sell its machines and support the operation of those machines over time, Caterpillar has an extensive network of independent dealers in the United States and around the world. Such dealers also offer repair services, providing Caterpillar replacement parts. Replacement parts also represent a critical aspect of Caterpillar’s profitability since machines are often sold at low profit margins.
Note that the main activities related to replacement parts take place in the US (Storing Parts, Managing Parts Inventories, Manufacturing Parts and ordering systems, Transporting Parts etc). Therefore, thousands of Parts Personnel and Key Parts Personnel reside in the US.
The substance in Switzerland
Caterpillar Overseas, S.A. (COSA) acted as lead marketing company of the group for the Europe, Africa and Middle East. COSA’s responsibilities included purchasing machines and parts from Caterpillar for resale to dealers, developing, maintaining and supporting the corresponding dealer network. Aside from COSA’s marketing work, Caterpillar had a very limited presence in Switzerland. In more detail, neither manufacturing plants nor distribution centers were located there. As for the profit allocation, the marketing companies’ share was set at about 13% of those non-U.S. parts profits for the period 1992-1999.
In 1999, COSA and several other Swiss affiliates’ assets and business activities were consolidated into a new Swiss entity, named Caterpillar SARL (CSARL). Further to marketing activities, CSARL was designated as Caterpillar’s “global purchaser” of purchased finished replacement parts (PFRPs), the replacement parts manufactured by third-party suppliers.
The TP case
The U.S. parent company designated CSARL as the nominal PFRP purchaser for more and more of its geographical regions. In this context, it executed a series of licensing agreements with the Swiss affiliate. The licensing agreements generally directed that between 4% and 6% of the sales of licensed products by CSARL be paid to Caterpillar as a royalty.
In addition, CSARL entered into a servicing agreement with Caterpillar Inc. to pay Caterpillar’s costs plus a 5% markup. This consideration was for the U.S. parent to continue to perform a number of core parts functions, including managing the worldwide parts inventory, supervising suppliers, forecasting parts demand, supervising parts logistics, and storing CSARL-owned parts in the United States. It is obvious that CSARL was unable to perform those parts functions itself, lacking the necessary personnel, infrastructure, and expertise. Note that the Swiss entity used to employ less than 0.5% of CAT’s 118,500 employees. Therefore, the capacity for managing PFRPs along with marketing activities and supporting of dealers network was quite limited.
Profit shifting and tax matters
The Swiss tax strategy was designed by PWC and implemented by Caterpillar Inc. By 2008, approximately 45% of Caterpillar’s consolidated revenues and 43% of its profits had been shifted to CSARL. In absolute values, U.S. taxable income of more than $8 billion was shifted offshore to Switzerland within the period 2000 to 2012. As a result, Caterpillar deferred or avoided paying U.S. taxes totaling about $2.4 billion.
The application of this aggressive tax strategy resulted in a significant tax advantage at a group level. In more detail, in Switzerland, Caterpillar had negotiated an effective tax rate of 4% to 6%. This tax rate was significantly lower even than the Swiss federal statutory rate of 8.5%.
This case study reveals that Transfer Pricing (TP) methodology shall not only incorporate profit margins to review the arm’s length principle. A full TP documentation includes:
- A thorough description of the functions performed by each affiliated company. The interlinkages between activities carried out by various related companies shall be also taken into account.
- An investigation if the associated party has the necessary capacity to undertake the operations designated by group’s headquarters.
- A strong comparability analysis and direct reference to real market circumstances. This step requires an accurate procedure to determine the comparable uncontrolled transactions.
Last but not least, a responsible TP consultant and the competent CFOs of multinational groups should ask themselves: Would I enter into a specific agreement or carry out such a transaction with an independent party? Most of the times, subsidiaries shall follow and apply the group directives. However, the management must be aware of potential tax risks related to BEPS due to controlled transactions.