Caterpillar's tax avoidance schemes are more than a problem for cash-strapped governments. They reveal the deeper problems of globalization.
FORTUNE — Corporate America doesn’t look forward to a call from the offices of Michigan senator Carl Levin.
For years now, the Democrat and the Senate Permanent Subcommittee on Investigations he chairs have been investigating the tax strategies of some of the nation’s biggest and most well-known corporations like Apple AAPL , Microsoft MSFT , and Hewlett-Packard HPQ , and shining a light on how these corporations use elaborate and creative strategies to limit the amount of money they send to U.S. Treasury coffers.
The latest target in Senator Levin’s sights is heavy-equipment manufacturer Caterpillar CAT and its tax consultant PricewaterhouseCoopers for a scheme in which Caterpillar sold the rights to its replacements parts business to a Swiss subsidiary Levin alleges was constructed solely for the purpose of limiting the taxes Caterpillar would owe on this very profitable slice of its overall operations.
Caterpillar and PwC (along with some Republican senators like Wisconsin’s Ron Johnson) defend themselves by arguing that Caterpillar already pays a relatively high effective tax rate of 29% when compared to other multinational corporations, and that Caterpillar and PwC were merely using legal means at its disposal to reduce its tax bill.
But the testimony of its own employees seems to contradict this. According to the Senate Permanent Subcommittee Report, the changes at Caterpillar that enabled the company to pay the much-lower Swiss tax rate on its replacements-parts business were, “made on paper, but not in how the replacement-parts business actually functioned.”
In addition, accountants at PwC advising Caterpillar seemed to be aware that this change was a risky strategy that might get the company in trouble. One particularly damning email exchange took place between two PwC transfer pricing experts, Steven Williams and Thomas Quinn, when they were reviewing the Caterpillar tax strategy in 2009 in response to proposed regulatory changes from the IRS. The emails discussed whether or not Caterpillar could justify allocating so much profit to its Swiss subsidiary when much of the economic activity that generated those profits occurred in the U.S. Steven Williams concluded:
Congress made this sort of thing explicitly illegal in 2010, when it passed a law saying that if a company shifts its profits or assets overseas, there must be an economic justification for the decision beyond tax considerations. But even before 2010, tax courts had in many cases sanctioned companies for these sorts of maneuvers. The IRS apparently had no problem with the tax treatment, however. According to Wisconsin Senator Ron Johnson’s remarks at Tuesday’s hearing, the IRS has 12 full-time employees working at Caterpillar’s headquarters, and it’s highly unlikely that the agency didn’t review a decision that led to Caterpillar being able to defer or avoid paying $2.4 billion in taxes between 2000 and 2012.
After years of interviews conducted by the Permanent Subcommittee on Investigations and several hours of public questioning, the question of whether Caterpillar is a tax cheat or simply a rational actor using creative means to legally reduce its taxes appears like an inkblot test, the answer to which is defined by your attitude toward taxes in general. Republicans on the committee spent much of the hearing complaining about how the Caterpillar example is evidence of a much greater problem of an onerous tax code that is driving American businesses and jobs abroad, while Levin stressed the need for companies to follow the rules regardless of whether or not some perceive them to be onerous.
And there is evidence in the subcommittee’s report to support Levin’s claims as well as those made by Republicans. Regardless of whether or not Caterpillar set up its Swiss operation expressly for tax purposes, it’s obvious that Caterpillar is moving some of its operations abroad to take advantage of lower tax rates elsewhere.
And this dynamic, of governments competing against each other to lure businesses with lower tax rates, is something that will become increasingly prevalent as the global economy becomes more integrated. Multinational corporations will continue to play one side against the other with respect to tax rates. Without getting into the complicated debate over how the U.S. corporate tax rate compares to those in other advanced countries, it’s clear that the trend is toward lower corporate tax rates overall.
What can explain this phenomenon beyond the growing power of multinational corporations to force governments into a race to the bottom with respect to tax rates? Given that nearly every industrialized country is faced with growing government debt and looming obligations for caring for aging populations, it’s hard to place the blame anywhere else.
Essentially this one symptom of the problem of an increasingly global economy lacks a significant global authority to set the rules of that economy, or solve collective action problems of its participants. This was one factor in creating the lax financial regulatory conditions that helped cause the financial crisis, as financial centers like New York and London competed with each other to create regulatory environments most popular with powerful financial institutions, rather than most beneficial to the society at large.
As Kentucky senator Rand Paul said in Tuesday’s hearing, it’s not Caterpillar that should be on trial, but the U.S. tax code. Indeed, the U.S. tax code is a complicated mess in dire need of reform. But the one reform that everyone seems to agree on — that the corporate tax rate must be lowered — is being driven by our need to compete with other industrialized nations for the favor of multinational corporations, rather than an assessment of what the appropriate contribution corporations should be giving to governments that lay the groundwork for their success.
In other words, how do citizens of a democracy impose rules and taxes on firms that are effectively citizens of nothing at all?