Daniel Schlicksup, an accountant, worked for Caterpillar for 16 years. He previously worked for Arthur Andersen, moved

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Daniel Schlicksup, an accountant, worked for Caterpillar for 16 years. He previously worked for Arthur Andersen, moved to Peoria to work on the Caterpillar account for PWC, until he began working on the Caterpillar tax staff in 1992. Caterpillar is the world’s largest builder of bulldozers and other construction equipment. Caterpillar’s main operations were in Peoria for many years with 85 percent of earnings allocated to the U.S. and 15 percent allocated to their Geneva, Switzerland office. Before a major reorganization, Caterpillar bought parts from third-party suppliers and then sold them to Geneva for overseas sales. They paid close to 35 percent on the .S. earnings and 4 to 6 percent on the Swiss sales. With encouragement from PWC, tax manager Robin Beran reorganized the Geneva’s CSARL so that the parts’ allocation to CSARL would be credited with 85 percent of the income from sales. PWC in a planning document said that “we are effectively more than doubling the profit on parts,” since a customer spends two or three times on parts as on the machine. After the reorganization, SARL ought parts from the suppliers, but the purchases were only on paper. Also, with approximately 400 Geneva employees, only 65 people worked on parts in Geneva and around 5,000 worked on parts in the U.S. A 2014 report on CSARL by the Senate Permanent Subcommittee on Investigations indicated that Caterpillar kept two separate sets of books. Their internal “accountable profits” account maintained operating income of the divisions which was used to calculate employee bonuses. Their public ledger account showed most of the parts profit allocated to Geneva with the lower corporate rates. Most of the parts executives and employees were in he U.S. Most of the parts were designed, built, stored, and fulfilled in the U.S. The Senate committee said Caterpillar had avoided $2.4 billion of taxes on more than $8 billion in revenues over 13 years. Whistleblower Daniel Schlicksup was adamant that the new scheme did not meet the tax laws. In an email to Robin Beran, Schlicksup said: There is a potential problem with the profit shifting strategy you along with PWC have created. The U.S. tax law requires corporate structure to have clear ‘economic structure.’ Under this doctrine an entity must show that any restructuring would have substantial impact on the entity’s assets or pre-tax profits separate from tax burden. You have changed the tax structure without significantly altering the actual flow of parts. There seems to be no reason for CSARL to exist except to lower taxes, and the IRS will catch on to this activity. Robin Beran responds as follows:

Thank you for bringing this to my concern. However, I do not find this a problem because PWC and McDermott Will & Energy LLP helped recognize the Geneva operation as CSARL. I find an accounting firm along with a law firm is more knowledgeable than a single man. However, I do thank you for keeping an eye out for this great corporation. Because of Schlicksup’s activities, he alleged that his superiors retaliated against him for complaining. He provided a 137-page document showing how the company shifted the billions in profits to Geneva to avoid $2 billion of taxes. Schlicksup was transferred to the information technology department with a seven percent raise. He filed an IRS whistleblower complaint accusing Caterpillar of tax fraud, along with a complaint with the Occupational Safety and Health Administration. In 2012, his whistleblower lawsuit was settled for an undisclosed amount. By 2013, the IRS declared the reorganization scheme to be an abusive tax strategy and gave the company a bill for $1 billion. If the IRS wins, Schlicksup could receive a whistleblower award as high as $600 million. The IRS is auditing more recent returns. On March 2, 2017, various enforcement agencies raided three Peoria-area Caterpillar facilities to collect documents and electronic evidence.

Dr. Leslie A. Robinson, an accounting professor at Dartmouth College, was commissioned by the government to prepare a report about the tax investigation into Caterpillar. In her 85-page report leaked to the New York Times, she said that “Caterpillar did not comply with either U.S. tax laws or U.S. financial reporting rules.” Robinson stated “that the company’s noncompliance with these rules was deliberate and primarily with the intention of maintaining a higher share price. These actions were fraudulent rather than negligent.”

Companies are allowed to defer taxes on profits produced offshore until they bring the income back to the U.S. When the company brings this profit back to the U.S. (e.g., called repatriation), taxes are owed, reduced by overseas taxes paid. Professor Robinson estimated that Caterpillar had brought back $7.9 billion to the U.S. as structured loans beyond the income already taxed overseas. She asserted that the company failed to report these loans for accounting and tax purposes. The IRS could bring civil or criminal charges against Caterpillar and their executives. She spent 200 hours preparing the report and she indicated that PWC was paid $55 million to develop the tax strategy. Dr. Leslie Robinson was quoted by the New York Times as saying in her report that “I was provided with all documents available to the case agents assigned to the investigation.” The Tax Cuts and Jobs Act altered the U.S. approach to taxing corporations from the worldwide system to a territorial system after 2017. This shift to the territorial system aligns the U.S. approach to taxing international transactions with the territorial system used by most other countries. Under both the territorial and worldwide systems the U.S. collects tax revenue on taxable income that has some territorial connection to the U.S. Under the worldwide system, the U.S. also will collect tax revenue on taxable income that is transferred from, in this case, CSARL, to Caterpillar’s U.S. parent company.

Thus, both the worldwide and territorial systems can encourage companies like Caterpillar to attempt to shift income from the U.S. parent company to CSARL, since the new 21% tax on corporations is still above the 6% tax rate paid by CSARL to Switzerland. However, only the worldwide system motivates the short-term financing arrangement between CSARL and the U.S. parent to avoid the U.S. tax on taxable income transferred from CSARL to Caterpillar’s U.S. parent company. For example, had the U.S. maintained a worldwide system, then taxable income transferred from CSARL to Caterpillar’s U.S. parent company would be taxed at 15% by the U.S., so that the total tax paid on taxable income is 21% (6% Swiss tax + 15% U.S. tax). The financing arrangement between CSARL and the U.S. parent allowed Caterpillar to avoid the 15% tax that would have been imposed by the U.S., but is now mostly irrelevant under the new territorial system after 2017. The new tax code has a provision where foreign profits must face at least a 10% tax rate in a foreign jurisdiction, or the taxable income will be partially taxed by the U.S. The residual tax companies face under the worldwide system is why the worldwide system has been criticized as promoting companies engaged in international tax planning to trap the cash from foreign subsidiaries in overseas operations. On March 8, 2017, Americans for Limited Government complained that the government was illegally outsourcing parts of the tax investigation to an outside source. The group argues that it is illegal for the federal government to outsource tax investigations to non-governmental personnel due to the highly confidential nature of tax records. Section 7701 (a) (11) (b) indicates that although the Secretary has broad powers to delegate authorities, any delegation is limited to an “officer, employee, or agency of the Treasury Department” unless Congress expressly grants broader authority. A valuable addition to a forensic accounting or fraud course is a mock trail near the end of the semester. The facts in the Caterpillar situation is an excellent topic for a mock trial. The dispute includes possible “cooking the books,” new tax laws, outsourcing, economic substance test, whistleblowing, civil v. criminal aspects, structured loans, fraud, negligence, IRS using expert consultants/witnesses, and much more.

Our students have engaged in mock trials on numerous occasions. We break the students into three or four-member teams. We prefer student groups to prepare for more than one trial, so they do

not cheat and fall over each other while researching. Since you need both a prosecuting team (criminal) or plaintiff (civil), and a defense, if you have 24 students there is a need for 3 disputes (24/8). Thus, for a

16-group class, there would be a need for two disputes (16/8). We prefer 3-person teams rather than 5-person teams. Four-person teams work also.

Keep in mind that one student can play more than one part (e.g., a fact witness and an expert witness). Students will wear wigs, different hats, mustaches, etc. In general, each team needs one or

two attorneys, at least one fact witness, and one expert witness. While two teams are engaged in a trial, the other students can be jurors, bailiff, investigative reporter, etc. We bring in a lawyer for the judge,

and we use the courtroom at LSU’s law school. We prefer a mock trial dealing with an accounting, auditing, or taxation subject. In a three-hour night class, we can get in at least two trials, and possibly

have the other teams give their opening and closing arguments. We randomly select the trial topic minutes before the night class. If you want only one sample trial, the first time we used the facts in J.T.

Reisch, “Brodnax Minerals Company: A Case Study for Auditors” Responsibility: Issues in Accounting Education, Vol. 14, No. 4, November 1999, pp. 601-612. We handed out a copy of the article to the class.

From the Internet and other sources, prepare answers for these questions:

1. What are the major steps in conducting a mock trial?

2. Explain the economic substance test. Did Caterpillar fail this test? Find the appropriate Internal Revenue Code sections.

3. Which alternative courts could Caterpillar select to fight the current $2 billion in income penalties the IRS is seeking? What are the differences between civil v. criminal charges?

4. How can accountants help attorneys? What are the various roles they can play in litigation services?

5. What motion is used by the opposing attorney to eliminate an expert witness? Discuss Daubert and Frye challenges against expert witnesses.

6. Can the IRS outsource part of their tax investigation? Take a position.

7. Prepare a three-to-four paragraph opening statement for the prosecution (plaintiff) in a Caterpillar mock trial.

8. Prepare a three-to-four paragraph closing statement for the defense in a Caterpillar mock trial.

9. What does Leslie Robinson mean when she indicates that Caterpillar did not comply with “U.S. financial reporting rules?”

10. Was there a transfer pricing problem after Caterpillar’s reorganization?

11. Are there any problems with the many short-term loans which Caterpillar received from the Swiss controlled entity? Be sure to look at I.R.C. Sections 951 and 956 and appropriate Regulations.