The case is based on the report presented in the US Senate in April 2014 - "Caterpillar Offshore Tax Strategy". 

The case has already become a study material in American universities as it shows the points on which authorities focuse during a transfer pricing investigation. And given what is at stake - beyond the huge amounts of money, it has a symbolic weight - the case is a milestone in the process of rewriting the framework of international transactions - the Base Erosion and Profit Shifting  famous project, aka BEPS.  

The case

Take this simple supply chain – for forty years, Caterpillar was the initial buyer of its third party manufactured replacement parts, and if the replacement parts were to be sold in Europe, Africa, or the Middle East (EAME region), Caterpillar typically sold the parts to its affiliated marketing company, Caterpillar Overseas S.A. (COSA), which was incorporated in Switzerland. COSA, in turn, sold the parts to Caterpillar’s independent foreign dealers in the EAME region.

But in 1999, as part of the Swiss tax strategy that is the focus of the Sucomitee Report, COSA  became CSARL  - the company’s “global purchaser” of third party manufactured replacement parts instead of Caterpillar Inc.  The US parent company continued to manage and lead the parts business from the United States, keep performing the core business functions in exchange for a service fee equal to its costs plus 5%. 

Part of this Swiss startegy, Caterpillar stopped allocating 85% or more of its non-U.S. replacement parts profits to the United States and 15% or less to Switzerland. Now is 15 % (or less) – US, 85% (or more) -  Switzerland. As a result, over the next thirteen years, from 2000 to 2012, Caterpillar shifted U.S. taxable income of more than $8 billion offshore to Switzerland and deferred or avoided paying U.S. taxes totaling about $2.4 billion – claimed the investigators. 

We have a case, a PS (profit shifter) they said, and raised some questions 

Economic substance concerns

The removal of Caterpillar from the legal title chain did not, however, otherwise change how Caterpillar’s replacement parts business functioned on the ground. Caterpillar retained the central role in managing its parts supply chain, and its replacement parts business continued to function as a U.S.-centric business that was led and managed primarily from the United States. Today, over 70% of the third party manufactured parts sold abroad are manufactured in, stored in, and shipped from the United States. Of the nearly 8,300 Caterpillar employees specializing in parts, about 4,900 work in the United States, and only 65 in Switzerland.  

Even the main warehouses are still in US. To track CSARL owned parts stored in Caterpillar’s U.S. warehouses, Caterpillar devised a “virtual inventory” system and only retroactively, after a sale, identified the specific parts belonging to CSARL.

So - the only operational changes required by the new legal title chain was ”paper change”. How does this help the business?

Arm's length transaction concerns 

Here is a classical question into a transfer pricing audit: whould the company have transacted those agreements with an unrelated party? For a transfer between related parties of valuable assets, such as licensing rights, to be valid under the tax code, the transfer must meet an arm’s-length standard, including compensating the transferring party as though the transfer were a sale to an unrelated third party.

Caterpillar’s replacement parts business was described internally as a “perpetual profit machine” analogous to an “annuity” that would continue to generate profits for as long as Caterpillar machines were in operation (a time period that averages 20 years per machine). The company not only gave up its right to 85% or more of the profits from its non- U.S. parts sales, but continued to perform the core business functions and to bear the ultimate economic risks in exchange for a service fee equal to its costs plus 5%. ”It is difficult to understand how these arrangements, when viewed in their totality, meet the arm’s-length standard”.

The report adds that Caterpillar acted to separate the “fruit,” the sale of its high-profit-margin parts, from the “tree,” the sales of its low-profit-margin machines on which the parts profits depend, and did so without seeking any compensation for producing the machines on which future parts rely to have value.

Intangible Valuation Concerns

Caterpillar told the Subcommittee that its Swiss operations had valuable marketing intangibles that had not been previously recognized and which justified allocating the lion’s share of the non-U.S. parts profits to CSARL. But the Subcomitee take a look to the past valuations made by Caterpillar itself, to prove that the company had long understood the importance of its marketing companies in supporting its dealer network ( note that the average length of a dealer relationship with CSARL’s predecessor in the EAME territory, COSA, was more than 45 years with little dealer turnover

Yet when CSARL was created, Caterpillar claimed it had found “newly recognized” marketing intangibles that were so valuable they justified dramatically increasing the portion of non-U.S. parts profits sent to Switzerland. ”Those two positions are irreconcilable”.

Fiscal protection and reaction 

In may 2014, after the hearing  in the Senate, the company reported that the Internal revenue Service is challenging its overseas transactions involving its spare-parts business. The inquiry covers the company’s tax returns for 2007, 2008 and 2009, even  the fact that the same tax position were already investigated in previous audit.

The company’s defense stays on two main pillars:

-Caterpillar's restructuring is a business decision to remove a redundant middleman between supplier and customer, fully within the text and spirit of the law and not violate the economic substance doctrine.

-As long as the relevant transactions complied with all applicable provisions of the U.S. Internal Revenue Code, the company pays the taxes it owes, not more.

Theory + Practice = Solutions 

In July 2014, Caterpillar said in a securities filing that it is "more likely than not" to persuade U.S. tax authorities that it complied with tax rules in pursuing a strategy that shifts profits to a Swiss subsidiary. 

This is already the ”feeling”,  at least technically speaking. As  New York University School of Law Professor John Steines, who was hired by Caterpillar to analyze the economic substance Issue, sais - “In my professional judgment, it is extremely unlikely that a court adjudicating with fidelity to the law presented in this report would find that the restructuring or the countless ensuing outbound PFRP (purchased finished replacement parts) transactions offend the doctrines of substance over form or economic substance.

The IRS is likely to make its determination within 12 months, Caterpillar said. If the IRS disallows Caterpillar's Swiss tax strategy, the company said, it would appeal that decision, a process that could take years.

We will follow this case closely and keep you updated with its evolution which is relevant for domestic companies too. 

For the moment let us remember some essential tips which should be follow by every affiliated company:

- Explain in detail the main activities of the company! The investigator needs to understand the business, how are the pieces of the puzzle interlinked. First of all be sure that your advisor understands the importance of the descriptive sections of the TP documentation. Only a thorough analysis can make the presentation "Too good to be destroyed." After a full inspection, the scant description form today will more than likely lead to a higher cost tomorrow (see also Transfer Pricing Audit IRS Roadmap, February 2014).

- Refer to the market! Having your prices at market value is the core of transfer pricing. A poor comparability or rather said referring to two or three shady transactions will make you lose your case. 

- Test your independence - Would I carry out this transaction with an unaffiliated party? What would the frame of reference be? 

This shows that more than ever you need a quality benchmarking study! (Click here to find Why the benchmarking study is a must)