The Apple and the Caterpillar

On April 1, Sen. Carl Levin held the latest in a series of hearings examining what he claims are blatant loopholes in the international tax system. 

Previous hearings had called executives from Microsoft and Apple to the carpet, forcing them to defend their tax planning strategies which result in billions of dollars being earned in off-shore subsidiaries. But this time, Levin's target was Caterpillar Inc.--not a glitzy Internet or computer company, but a Midwestern manufacturer which has been making construction equipment for nearly a century.

What Levin's hearing revealed is that, in today's economy, companies like Apple and companies like Caterpillar have more in common than you might think. They both do complex data analytics to improve their operations. They both command a certain premium through the global scope and organization of their businesses. They both use aggressive marketing techniques to enhance their public image and brand.

In short, their profits increasingly rely on "intangibles"--highly profitable assets which cannot be seen or touched. These assets can be legally defined--patents, copyrights, or other types of intellectual property--or they can be more nebulous concepts such as synergies, goodwill, or savings related to a company's location.

But while they can't be held in one's hand, they can be transferred from one country to another, often flummoxing tax collectors.

Take Caterpillar Inc., which Levin's subcommittee claims has stashed $8 billion into a subsidiary in Switzerland--where it has negotiated a low tax rate--avoiding or delaying $2.4 billion in American taxes.

Levin and his subcommittee examined a very specific part of Caterpillar's business--its distribution of replacement machine parts to its clients. For the most part, Caterpillar does not make these parts itself, but rather buys them from independent suppliers, then sells them to independent dealers, who ultimately get them to the machine users. Before a 1999 tax reorganization, Caterpillar's U.S. company was one of the buyers, but afterwards the transaction was carried through a Swiss affiliate, Caterpillar SARL (CSARL). (Read more about Levin's hearing in the April 3 issue of Transfer Pricing Report.)

So where do the intangibles come in?

Well, why exactly is CSARL so adept at buying and selling machine parts? It benefits from Caterpillar Inc.'s existing contracts and licensing agreements. It benefits from Caterpillar's internationally owned trademark. It benefits from the fact that a builder who buys a machine from Caterpillar is likely to want to buy replacement parts from Caterpillar as well--a dynamic which may, or may not, be considered in the valuation of its trademark. 

It also benefits from the fact that few companies in the world have the breadth and scope to sell products as the Caterpillar organization does. It benefits from decades of work Caterpillar--and its Swiss affiliate--have put into its global network of dealers, sellers, manufacturers and builders. It benefits from the data analysis performed by the company, predicting which city is likelier to build more high rises in 2015--New Delhi or Beijing.

Many of these intangibles were licensed or sold from Caterpillar Inc. or its subsidiaries to CSARL at the time of the restructuring. In other cases, Caterpillar claimed it discovered the true value of intangibles CSARL, and its Swiss predecessor, already owned after an analysis of the business.  

Ultimately, CSARL pays Caterpillar 15 percent for the rights to buy and sell these parts. It's justified this using transfer pricing analysis, comparing those transactions to similar transactions between unrelated parties. The IRS has closed several tax years since it came into effect. But critics claim that figure is ludicrously low, and doesn't truly reflect any real arrangement between independent parties seeking a profit. 

Another example: Starbucks Corp., which often gets lumped together with tech giants but has a traditional, 500-year-old product: coffee. In some ways, the company behaves like a tech giant. Its quick rise came during the 1990s, in the early years of the Internet boom. Like Microsoft, it's based in Seattle, and it argues a lot of its value is created there--not in the coffee bean fields, but with the creative and analytical teams that have developed the Starbucks brand into a global force.  

You can buy coffee almost anywhere, but for some reason people wait in long lines to get Starbucks coffee. That's due to the taste--and the marketing, design, brand management, ambiance of their locations and the overall Starbucks experience. Whatever those reasons are, the company felt justified charging its U.K. affiliate a 4.5 percent royalty to use its intellectual property, effectively wiping out its British profits for several years. (Under pressure from Parliament, Starbucks ultimately agreed to pay the taxes in question.) 

Much of the current debate on tax evasion and base erosion focuses on the so-called digital economy--but that phrase can be misleading if it implies these issues only affect companies in the dot-com world. The truth is, nearly everybody is working in the digital economy, and the tax laws are struggling to keep up. 

Alex Parker, Staff Writer, Transfer Pricing Report