More than a decade before federal agents arrived at Caterpillar Inc. in March with search warrants, an anonymous employee claimed in a letter to its chief executive that something was wrong about how the heavy-machinery maker used a subsidiary in Switzerland to shrink its tax bill.
When customers outside the U.S., need parts for a bulldozer or mining truck, their order often is shipped from a Caterpillar warehouse in Morton, Ill. Nearly all the sales and profits flow through a company subsidiary in Geneva, where the company has paid an effective tax rate as low as 4%. Caterpillar began the practice in 1999 and has never stopped.
The employee accused Caterpillar of violating U.S. tax law and threatened to tip off the Internal Revenue Service. The company's tax director replied to the CEO and other officials that there was no doubt the strategy was legal.
"The company didn't just make this up," says someone who was a Caterpillar executive at the time.
Two CEOs and at least four investigations later, Caterpillar faces a potential tax bill of $2 billion from the IRS, which is challenging the amounts paid on profits from parts sales made through the Swiss unit, called Caterpillar SARL. The raids in March, led by the Commerce Department, were a sign of an intensifying criminal investigation into the company's taxes and exports.
No civil or criminal charges have been filed against Caterpillar or anyone at the company. A company spokeswoman says it "believes its tax position is right" and is "in the process of responding to the government's concerns."
"We're a values-based company," says Caterpillar Chief Executive Jim Umpleby, who moved into the top job at the start of 2017. "We're cooperating, and we're hopeful that that issue will be resolved in an expeditious manner."
The tax troubles clash with Caterpillar's history as an American manufacturing icon. Caterpillar machinery helped build the Hoover Dam, Golden Gate Bridge and U.S. interstate highway system. The company supplied equipment for the Allied effort in World War II and the Apollo 11 moon mission.
They also are a distraction from efforts to boost profit margins following four consecutive years of declining revenue, waves of layoffs and factory closings. Caterpillar was hurt by turmoil in construction and mining markets around the world, many of which are now rebounding.
The outcome could influence how U.S. companies structure their businesses to lower tax bills. The use of tax-avoidance strategies has been widespread since the late 1990s, including shell corporations and so-called tax inversions. American companies are keeping more than $2 trillion of profits overseas rather than at home, where they would be required to pay 21% under the new tax law signed by President Donald Trump in December.
The new law cuts the U.S. corporate tax rate from 35% and provides companies with a one-time tax cut on earnings and cash held outside the U.S. The aim is to persuade companies to bring back those profits.
Even with those changes, companies still have an incentive to book profits in lower-tax foreign countries and keep the money there, says Elise Bean, who oversaw a Senate subcommittee's investigation of the Swiss subsidiary.
"The tax bill won't cause Caterpillar to close up shop in Switzerland, just the opposite," she says.
The Caterpillar spokeswoman declined to comment, but the company has said the tax changes would help American manufacturers compete in foreign countries and gain more access to cash there.
Caterpillar's own regulatory filings indicate it shaved more than $1 billion from its taxes from 2012 to 2016, due in large part to the Swiss subsidiary. The total is roughly equal to Caterpillar's net income in the third quarter.
Under federal law, any tax shelter must have "economic substance," or a legitimate business purpose for entering into it, and can't simply be to avoid taxes. Caterpillar has never wavered from its position that the Swiss subsidiary is perfectly legal, even though some employees raised doubts internally.
A senior person in Caterpillar's management in the early 2000s recalls asking colleagues at the time how it planned to bring profits that were piling up in Switzerland back home without paying U.S. taxes on them. He says he didn't get any clear answers.
"It was pretty obviously just a tax initiative," he says. Caterpillar wouldn't comment on his recollections.
The anonymous letter arrived in May 2004. It was from someone who claimed to work in Caterpillar's tax department. "If there is no independent investigation or if there is any retribution, I will go to the Internal Revenue Service," the writer told James Owens, then Caterpillar's chief executive.
Robin Beran, Caterpillar's director of taxation at the time, responded in a memo to Mr. Owens that the allegations were "simply untrue," adding that the letter writer was "very misinformed."
"The basic operations of Caterpillar SARL are no different than any other valid and legal partnership operating anywhere in the world," Mr. Beran added. "Great care has been taken to ensure Caterpillar's operations are consistent with Switzerland's laws and any applicable U.S. and international tax laws."
The letter and memo were publicly disclosed in 2014 by the U.S. Senate's Permanent Subcommittee on Investigations, which examined the Swiss subsidiary and tax arrangements at numerous companies. Caterpillar declined to comment on the memo. Mr. Owens retired in 2010.
More than 50 years ago, Caterpillar began using its Geneva office to help expand the company's international dealer network.
After Caterpillar SARL was formed in 1999, the subsidiary took legal title over replacement parts made by outside companies, eliminating the U.S.-based parent company from the supply chain. Caterpillar has said the company was an unnecessary link in that supply chain.
In 2008, Caterpillar tax-department employee Daniel Schlicksup, who had worked in Geneva, questioned in an internal memo whether the Swiss strategy complied with federal case law or requirements of the Sarbanes-Oxley Act, enacted after accounting scandals at Enron Corp. and WorldCom Inc.
According to documents in a lawsuit Mr. Schlicksup filed against Caterpillar in 2009, he also told Mr. Beran in a memo that the Swiss tax plan lacked economic substance and was "the pink elephant issue worth a billion dollars on the balance sheet." Mr. Schlicksup said he got no response.
He alleged that he was demoted and reassigned as retribution for speaking up about Caterpillar SARL. Caterpillar denied the allegations and settled the suit in 2012 for an undisclosed amount. Through his lawyers, Mr. Schlicksup declined to comment.
In 2014, a report issued by the Senate subcommittee said Caterpillar deferred or avoided paying $2.4 billion of taxes as a result of the restructuring.
At a subcommittee hearing, Caterpillar and longtime auditor PricewaterhouseCoopers LLP, which helped put the Swiss tax plan in place, defended their work to cut Caterpillar's tax bill. But they were confronted with some embarrassing emails.
PwC tax partner Thomas Quinn wrote in 2008 that tax consultants at PwC would have to "do some dancing" to comply with looming IRS rule changes related to U.S. tax exemption.
Steven Williams, a PwC managing director, replied: " What the heck. We'll all be retired when this comes up on audit."
At the hearing, Mr. Quinn told lawmakers he had used a "poor choice of words." Mr. Williams said his reply was an "inappropriate use of words in an attempt at humor." Mr. Williams declined to comment for this article, and Mr. Quinn didn't respond to requests for comment.
The subcommittee's report concluded PwC had a potential conflict of interest as Caterpillar's auditor because PwC was essentially auditing its own tax advice. A PwC spokeswoman says it has "maintained its independence with respect to Caterpillar at all times" and has complied with all applicable auditing rules. PwC still is Caterpillar's auditor.
Senate investigators said Caterpillar had allocated more than $8 billion in profits from parts sales outside the U.S. to the Swiss subsidiary. Documents released by the subcommittee cite an IRS letter to Caterpillar in 2013 that denounced the use of Caterpillar SARL as an "abusive corporate tax shelter."
Caterpillar was as adamant about its innocence then as it is now. "We pay everything we owe," Julie Lagacy, Caterpillar's vice president for financial services, told lawmakers. She is now the company's chief information officer.
The tax strategy also has been examined by the Securities and Exchange Commission, which sought records about loans and product shipments between the Swiss unit and the parent company, according to documents obtained by The Wall Street Journal through a public-records request. The SEC also sought information about cash repatriation, the documents show.
The SEC accumulated two boxes of documents and 1.9 gigabytes of electronic records but ended its investigation in 2015 without pursuing enforcement action, according to the documents.
The Public Company Accounting Oversight Board has examined whether PwC's dual role as auditor and tax adviser was a conflict of interest. The audit regulator declined to comment on the status or outcome of its inquiry.
Caterpillar also got a subpoena from a federal grand jury in Illinois seeking financial information about its U.S. and foreign subsidiaries, according to securities filings by the company.
On March 2, agents from the Commerce Department's Office of Export Enforcement, the IRS's criminal division and the Federal Deposit Insurance Corp.'s inspector general's office raided Caterpillar's headquarters in Peoria, Ill., its parts warehouse in nearby Morton and a data center. Caterpillar has since moved its headquarters to Deerfield, Ill., a suburb of Chicago.
The searches lasted all night and into the next day. Agents were looking for information related to export data Caterpillar is required to submit to the government when it ships outside the U.S.
People familiar with the matter say investigators identified before the raid numerous instances in which they believe Caterpillar might have failed to file the required data. Search warrants reviewed by the Journal indicate the raid was focused largely on the Swiss unit.
Agents also seized documents from PwC's work site at the former headquarters in Peoria, according to a person familiar with the situation.
"I'm sorry that we had to experience this today," Mr. Umpleby, Caterpillar's chief executive, said in an internal memo to employees. He called Caterpillar an "honorable company."
As part of its investigation, the FDIC's inspector general commissioned a report by Dartmouth College professor Leslie Robinson, who concluded Caterpillar had engaged in tax and accounting fraud, according to a person familiar with the report. It hasn't been publicly released.
The report was based on publicly available financial information and nonpublic wire transfers, and it examined whether Caterpillar restructured Swiss cash into loans between its foreign subsidiaries and U.S. operations to offset a cash-flow deficit in the U.S., the person familiar with the report says.
Caterpillar wouldn't comment on the report but has privately criticized its assumptions and conclusions, according to people familiar with the matter. Caterpillar also has hired Obama administration tax official Stephen Shay and at least one other expert to defend the company's position.
The Dartmouth professor "misunderstands some amazingly basic things," says one of those people familiar with the company's opinion. A spokesman for the FDIC's inspector general's office referred questions to a spokeswoman for the U.S. attorney's office in Springfield, Ill. She declined to comment.
An analysis of securities filings by the Journal shows that manufacturing operations at Caterpillar sometimes have been boosted by loans from the company's financial unit.
Such loans increased cash flow in Caterpillar's heavy-machinery business in seven of the 14 years from 1998 to 2011. The Journal's analysis is consistent with the Dartmouth professor's findings, according to the person familiar with the report.
The federal government hasn't examined the full trove of data and documents agents seized in March because Caterpillar has argued that many of the materials are subject to attorney-client privilege, according to people familiar with the investigation.
--Richard Rubin and Aruna Viswanatha contributed to this article.
(END) Dow Jones Newswires
January 01, 2018 14:37 ET (19:37 GMT)