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Caterpillar to Face Tax Hearing Today

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Shares of Caterpillar Inc. (CAT - Free Report) dipped 0.02% in anticipation as the company prepares to testify in a hearing before the U.S. Senate Homeland Security and Governmental Affairs Permanent Subcommittee on Investigations (PSI) today for possible overseas tax evasions. It is alleged that the company evaded around $2.4 billion of U.S. taxes by shifting profits to a wholly owned Swiss subsidiary.

With this, Caterpillar adds to the list of bigwigs like Apple Inc. (AAPL - Free Report) , Microsoft Corporation (MSFT - Free Report) and Hewlett-Packard Co. (HPQ - Free Report) that have been investigated by the committee.

Per the report, Caterpillar lessened its tax burden by transferring profits from its parts business to a wholly controlled Swiss affiliate, CSARL, even though no employees or business activities were moved to Switzerland. In exchange, CSARL paid a small royalty and the income was taxed at a special rate of 4–6% per Caterpillar’s negotiation with the Swiss government.

The report further states that prior to this arrangement, in 1999, 85% of the profits from the parts business were taxed in the U.S. Subsequently, only 15% of the profits were taxed in the U.S., while the balance was taxed at a much lower rate rate in Switzerland. Caterpillar has 4,900 U.S. employees working in its parts distribution, while CSARL has only 65 parts workers in Switzerland.

In her prepared written testimony, Caterpillar’s Vice President responsible for the Finance Services Division, Julie Lagacy discussed Caterpillar's lawful business planning that is also followed by other U.S. multinational corporations. Lagacy, in Caterpillar’s defense, put forward that the company’s effective income tax rate averages about 29%, which is one of the highest for a U.S. multinational manufacturing company and that it strictly abides by the tax laws enacted by Congress, by the states and by all of the jurisdictions in which it conducts its business.

In this regard, the company will have to prove that its parts business is operated in Switzerland instead of the U.S. This will justify shifting 85% or more of the parts profits to Switzerland and subsequently, the lower tax rate.

The investigation began in 2009 when a Caterpillar employee working on the company’s tax strategy alleged that the mining equipment maker resorted to a “Swiss structure” to siphon profits to offshore companies. He further alleged that Caterpillar used a “Bermuda structure,” which allows shell companies to return profits to the U.S. without paying obligatory taxes.

All this comes at a time when things were starting to look up for the mining and equipment behemoth. After a dismal run in 2013, it has been so far a good year for Caterpillar, with its share prices holding up steadily above $90 since the fourth-quarter earnings release on Jan 27.

In fact, Caterpillar touched $100 during intraday trading yesterday. This was mainly driven by dovish comments from Federal Reserve Chair, Janet Yellen and increase in China’s Purchasing Managers' Index which indicates expansion and expectations that the country will adopt a stimulus plan to meet its growth target. However, in the near term, Caterpillar shares could see some volatility given the negative market sentiment following reports of tax evasion and the Russia-Ukraine geopolitical tensions.

Caterpillar currently carries a Zacks Rank #2 (Buy).

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