Why does Caterpillar have the Lowest Effective Tax Rate of any Public Company?

Caterpillar has boasted that it has the lowest effective tax rates of any publicly-traded company for several years now. How can a company valued at nearly $50 Billion get away with effective tax rates in the low single digits?

The answer is deceptively simple: operate at a loss in high-tax countries, and with high profits in low-tax countries.

Caterpillar’s profits depend heavily on its replacement parts business.  Most of Caterpillar’s replacement parts are actually produced by its network of thousands of third-party suppliers.  Traditionally, Caterpillar had purchased these replacement parts from the suppliers and would then sell them all over the globe.  The company would pay the high U.S. corporate tax rate of 35% on profits from these sales.

Hoping to lower its tax bill, Caterpillar paid over $55 million to an accounting firm, PricewaterhouseCoopers (“PWC”), to develop and implement a tax strategy.  The strategy PWC developed aimed to shift Caterpillar’s profits from its replacement parts business to Switzerland, where the company had negotiated an effective tax rate of about 5%.

Based on PWC’s plan, in 1999, Caterpillar formed a Swiss subsidiary.  This subsidiary purchased replacement parts directly from the third-party suppliers and then sold them to the global public, eliminating any role Caterpillar played in the sale process.  The subsidiary paid the low Swiss tax rate on its profits from these sales.  In accordance with U.S. law, the subsidiary’s profits were not taxed by the U.S. because they were not repatriated to its U.S. parent, Caterpillar.

From 2000 to 2012, Caterpillar shifted $8 billion in what would otherwise have been U.S. taxable income to Switzerland, avoiding $2.4 billion in U.S. tax. A 2010 internal report of Caterpillar boasted that it now had the lowest effective tax rate of companies in the Dow 30, based on their strategy of “losses in high-tax countries, profits in low.”

These tax savings were questioned by a U.S. Senate committee report in April 2014, which found that, in 2012, Caterpillar had about 8,300 employees involved in the purchase, storage, and sale of replacement parts; only 66 of these were located in Switzerland.  Even more remarkably, no Caterpillar replacement parts manufactured by third parties for sale outside the U.S. were actually shipped from or manufactured in Switzerland.

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