Caterpillar, A Whistleblower, and a $2 Billion Tax Headache

By Bryan Gruley, David Voreacos, and Joe Deaux for Bloomberg Businessweek

In the the spring of 2008, finance executives from Caterpillar Inc. gathered for a few days of meetings in the Peoria Civic Center, a few blocks from company headquarters. Early in the proceedings, Eugene Fife, chairman of the audit committee, reminded the attendees that they cradled Caterpillar’s reputation in their hands.

It would take just one or two wayward stewards to wreak havoc, Fife said, even at a company as mighty as Caterpillar, the world’s largest maker of bulldozers and other construction equipment. Anyone aware of financial malfeasance or trickery was obliged to report it immediately. Later, then-Chief Executive Officer Jim Owens pressed the point, saying he slept well because he couldn’t imagine Caterpillar experiencing the sorts of ethical lapses that had doomed Enron Corp. and other companies.

Listening with dismay was Daniel Schlicksup, an accountant who’d been with Caterpillar for 16 years. He’d been telling his bosses that the company was engaged in an overseas tax arrangement that, by his reckoning, had helped it illegally avoid more than $1 billion in taxes. Now, as Owens spoke, Schlicksup concluded that no one had passed his warnings to the CEO. “I thought to myself, ‘Jim, it’s happening here,’ ” Schlicksup later said in sworn testimony. “ ‘You just don’t know it.’ ”

He walked back to Caterpillar’s offices and at 7:35 that evening sent an email to two of Owens’s top underlings, with the subject line “Ethics issues important to you, the Board and Cat Shareholders.” In a note, he alluded to his concerns about the tax strategy and described, in emotional terms, a systematic effort to shut him down. “I am now an example to my colleagues, peers, and others that they made the correct choice when they chose to not report ethical issues and ignore Company Policy,” he wrote. Attached to the email was a 15-page memorandum describing how his superiors had retaliated against him for speaking out. The next morning he sent 137 pages of documents purporting to show how, with the help of its auditor, PricewaterhouseCoopers, Caterpillar had devised a way to shift billions in profit to Switzerland to avoid U.S. taxes.

Federal agents raid Caterpillar’s Peoria headquarters, above.

His missives began a chain reaction that’s still in motion. The IRS, aided by documents Schlicksup provided, concluded in 2013 that Caterpillar had employed an “abusive” tax strategy; the agency later demanded $2 billion in back taxes and penalties. In early 2014 a U.S. Senate investigative committee, with input from Schlicksup, grilled executives and concluded the company had avoided taxes on more than $8 billion in revenue.

Then, on the morning of March 2, 2017, agents from the IRS, Department of Commerce, and Federal Deposit Insurance Corp. showed up in Peoria with search warrants. They sequestered employees for interviews and carried off documents, computers, encryption devices, and other evidence that might be related to “false and misleading financial reports and statements,” according to the warrants. If criminal charges are brought, current or former Caterpillar executives could face jail time.

U.S. prosecutors almost never resort to splashy raids on mom-and-apple-pie companies such as Caterpillar, a huge exporter that’s kept 46,500 jobs in the U.S. “I love Caterpillar,” President Donald Trump declared in a White House meeting with CEOs one week before the March raid. The company declined to make executives available for interviews for this story. A spokeswoman says, “Caterpillar believes its tax position is right. We are in the process of responding to the government’s concerns and hope to be in a position to bring this matter to resolution within a reasonable time frame.”

Schlicksup, now 55, parted ways with Caterpillar five years ago. The company has portrayed him in court filings as a paranoid, self-righteous employee who buried his own future there. But if the IRS collects what it claims it is owed, Schlicksup might end up the best-paid whistleblower of all time, with a potential paycheck of $600 million, while Caterpillar, the 92-year-old pride of Peoria, will experience something unfamiliar: public humiliation.

In a 2011 deposition, a Caterpillar attorney asked Schlicksup if his actions threatened to hurt shareholders. “It is absolutely in the shareholders’ best interests to have the most accurate financial statements they can have,” Schlicksup replied. “I don’t think that the shareholders of Enron would think it would have been such a bad deal if somebody would have caught that before it bankrupted the company and they lost everything they had.”

THE CORPORATE WHISTLEBLOWER is at once a celebrated and tortured figure in American culture. Think of Jeffrey Wigand, bane of the tobacco industry, and Enron scold Sherron Watkins, both portrayed in books and movies as people who told truth to power and paid a personal price.

Some get rich. Five years ago, the IRS awarded $104 million to Bradley Birkenfeld, a former banker at UBS Group AG, for telling investigators how the bank had helped thousands of Americans dodge taxes — the biggest IRS whistleblower award ever. But first, Birkenfeld had to serve prison time for his own involvement in the UBS scheme.

Schlicksup grew up near Peoria, one of eight children in a family with deep ties to the area. Bright and inquisitive, with a knack for numbers, he earned degrees in finance and law from Northern Illinois University, then a master of laws from Chicago-Kent College of Law. After several years in Chicago with the accounting company Arthur Andersen LLP, Schlicksup moved back to Peoria and worked on the Caterpillar account for PwC. He jumped to Caterpillar’s tax staff in 1992, and his new bosses urged him to travel overseas and learn international tax law. From 1996 to 2000 he worked in Brussels and Geneva and established Cat’s first overseas tax department.

Caterpillar’s Geneva operation is in an elegant marble-and-glass building facing the Parc de la Grange on Lake Geneva. It was the base for Caterpillar Overseas SA, formed in 1960 to develop a global dealer network. As that network expanded, the Geneva office oversaw distribution of replacement parts around the world — a fabulously lucrative business. Caterpillar doesn’t disclose how much replacement parts contribute to its $38.5 billion in annual revenue, but customers often spend two to three times as much on parts as on machines, according to the 2013 book The Caterpillar Way: Lessons in Leadership, Growth, and Shareholder Value. Former CEO Donald Fites saw a machine sale as “an annuity that continues to pay dividends over time” as customers keep their equipment running, the book says.

The parts are distributed from a vast warehouse in Morton, Ill., near Peoria. Morton is the hub of a global network of 25 parts warehouses, from which Caterpillar boasts of shipping 99 percent of orders within 24 hours. Along with Geneva and Peoria, Morton goes to the heart of the criminal investigation.

For years, Caterpillar accountants credited the Geneva office with 15 percent of the profits on parts sales, while the other 85 percent was allocated as earnings in the U.S. The company paid an effective tax rate of a little less than 30 percent on those U.S. profits. Around the time Schlicksup arrived in Geneva, Caterpillar embarked on a dramatic change in that accounting, led by Robin Beran, a tax manager in Peoria.

With the encouragement of PwC, where he’d once worked, and the law firm McDermott Will & Emery LLP, Beran reorganized the Geneva operation as Caterpillar Société à Responsabilité Limitée LLC, or CSARL. The move involved more than 70 transactions touching dozens of shell companies in more than a dozen countries, according to Schlicksup’s federal court filings. The objective: to cut the company’s tax bill so Cat could compete better with Komatsu Ltd. and other foreign rivals that enjoyed lower corporate tax rates. In planning documents, PwC said, “We are effectively more than doubling the profit on parts.”

For all its complexity, the basics are easy enough to understand: Caterpillar essentially flipped the parts profit allocation so the new Swiss entity would be credited with 85 percent of the income on those sales. The company then paid taxes on those earnings at rates ranging from 4 percent to 6 percent, as negotiated with the Swiss tax authorities.

A 2014 Senate hearing on Caterpillar’s offshore tax strategy, above.

In effect, Caterpillar removed its U.S. operations from the outbound supply chain of parts sold in foreign countries. Before the accounting change, Caterpillar in the U.S. bought parts from third-party suppliers and resold them to Geneva for distribution overseas. After the change, CSARL bought parts directly from the suppliers. But that was merely on paper: U.S. facilities continued to handle and manage the bulk of inventory, suppliers, and manufacturing. Of its 400 or so employees, the Geneva office had about 65 people working on parts, and Morton and other U.S. operations had about 5,000.

Why change the tax structure without significantly altering the actual flow of parts? Perhaps Caterpillar was loath to eliminate American jobs. Or maybe the reasons were internal. A hallmark of Fites’s tenure as CEO (he retired in 1999) was his creation of discrete profit centers within the corporation that rewarded managers based on the performance of their particular division. Moving the actual work to Switzerland could have deprived valuable U.S. managers of their bonuses.

Caterpillar wound up effectively keeping two sets of books. The public one attributed the bulk of parts profits to Geneva, with its puny tax rate. An internal ledger known as “accountable profits” tracked the operating income of the divisions and calculated employee bonuses accordingly, says a 2014 report on CSARL by the Senate Permanent Subcommittee on Investigations. Under former Senator Carl Levin, a Michigan Democrat, the subcommittee scrutinized tax avoidance strategies at Cat, Apple, HP, and Microsoft.

Schlicksup wasn’t involved in CSARL’s creation, says his attorney in Peoria, Daniel O’Day. But Schlicksup expressed some concerns to the man at the center of it all, Beran, in 1999. Schlicksup worried that there seemed to be no reason for CSARL to exist other than to lower taxes. That’s a potential problem, because U.S. tax law requires a corporate structure to have clear “economic substance.” Under this doctrine, a taxpaying entity must show that any restructuring would have a substantial impact on the entity’s assets or pretax profits — separate from the tax burden. In other words, if you’re going to filter your taxes through an ice cream truck, it’s wise to sell some ice cream out of it, too.

“We’re going to hurt you a little, and if you don’t keep quiet, we’re going to hurt you a lot”

BY 2006, CSARL WAS A SUCCESS. More than $1 billion in lower-taxed earnings had accumulated in CSARL accounts. Cat’s stock price, which had been as low as $15 a share in 2000, reached $82.

Schlicksup, too, was doing well. He was back in Peoria, now in the newly created position of global tax strategy manager, reporting to Beran, who in turn reported to then-Chief Financial Officer David Burritt. Schlicksup was earning stock options, and his $200,000-plus salary made him one of Caterpillar’s 400 best-paid employees, according to his filings in federal court. He, his wife, Leah, and their two sons lived in a three-bedroom house on 17 wooded acres in Dunlap, near Peoria.

He’d gained a reputation inside Caterpillar for handling complex projects with aplomb. “He has a unique combination of leadership, financial, legal, business and communication skills,” read a supervisor’s remarks in a 2001 performance review. From 2005: “Dedicated individual who does the right thing for the company, even if very unpopular.”

At the same time, he could be difficult. He was known for sending detailed, occasionally hectoring emails about a variety of issues. He complained about a division allegedly reporting inflated earnings. He griped about an accounting issue that dated to the 1970s. He complained about supposedly unsupported payments to Caterpillar’s accounting companies. He criticized a company executive for allegedly taping meetings secretly.

Sometimes Schlicksup would send a lengthy email before a meeting and a lengthy follow-up afterward. “With all due respect,” began a note he wrote to two managers, “I would like to mention a couple of things from yesterday’s meeting that I do not think were fair and objective.” Some 800 words and two attachments followed. Burritt — who was recently named CEO of United States Steel Corp. — once wrote to Schlicksup, “Dan, we need to talk. Your behind-the-scenes emails are troublesome. Do you ever speak up in a meeting?” (Burritt declined to comment for this story.)

Late in 2006, Beran asked Schlicksup to work with a group of companies lobbying Congress about the “economic substance” requirement. After reading federal circuit court decisions, Schlicksup worried that CSARL ran afoul of the requirement. He expressed his concerns to Beran, Burritt, and other Cat executives in emails he started sending in 2007. He wrote Beran and tax counsel John Caviness on Jan. 19, 2007, that he thought the IRS would attack CSARL as lacking economic substance, according to a sworn affidavit Schlicksup filed in federal court. Caviness asked him not to debate the issue via email. His bosses, Beran and Burritt, indicated they wouldn’t do anything about it. “Dan,” Beran emailed, “I think this is really a non-issue.” (Beran did not respond to requests for comment.)

Schlicksup turned to one of Caterpillar’s in-house lawyers, who referred him to the company’s outside law firm, which pointed him to Caterpillar General Counsel James Buda, who sent him to the Office of Business Practices — which reported to Burritt, whose decisions he was questioning.

“What about the [appeals] process?” Schlicksup asked Buda in August 2007.

“There is no process,” Buda replied, according to Schlicksup’s affidavit.

Schlicksup grew increasingly nervous about his future with Caterpillar. Beran and Burritt had started making remarks about him not getting along with colleagues. Negative comments showed up on his 2007 performance review. At one point in 2007, Schlicksup told Nancy Snowden, director of the business practices office, that he was worried about getting fired. She told him, he said in a court filing, that wasn’t likely because, “If they fired you, then a whole lot of bad things would come out; the gig would be over.” Snowden didn’t respond to interview requests.

AS 2008 DAWNED, a pain-in-the-ass accountant was among the least of Caterpillar’s concerns. The company was about to crash into the U.S. fiscal crisis and recession, ending years of healthy revenue and profit growth. The share price fell from $85 in early 2008 to the mid-$40 range by the end of the year.

Schlicksup and Beran spent the first few months of the year debating Schlicksup’s performance review. He wanted a 1 rating, highest on a 1-to-5 scale, whereas Beran said he deserved no higher than a 2. Schlicksup kept bringing up CSARL and other issues he’d complained about. In March, Beran told Schlicksup that questions about CSARL had been addressed in four memos prepared by PwC and the law firm McDermott Will. Schlicksup, who hadn’t heard of the memos, asked to see them. Beran demurred, citing attorney-client privilege, and said he didn’t want Schlicksup calling the advisers either.

Not long after that, Schlicksup attended the finance meeting where he heard CEO Owens’s remarks about sleeping well. He sent his May 1, 2008, email to two group presidents, one of whom, Douglas Oberhelman, would become CEO in 2010. “I do not believe you or the Board can manage risks if you are not aware” of them, Schlicksup wrote.

The memo changed nothing except, perhaps, Schlicksup’s career. Four months later, he was summoned to a meeting with Chief Information Officer John Heller and Alice Barbour, a human resources manager. Heller and Barbour told Schlicksup that Caterpillar was eliminating his position and transferring him to the information technology division. He resisted because he wasn’t well-versed in IT and thought the shift would make him less valuable to the company, with fewer opportunities for advancement. Barbour said taking this job was Schlicksup’s only option. Schlicksup became upset.

Heller asked Barbour to leave the room. He then tried to reassure Schlicksup that the transfer actually wasn’t mandatory and emphasized that nobody wanted him to take the “nuclear option,” which Schlicksup understood to mean going to the media or the government. “The message to me was clear,” he later testified. “We’re going to hurt you a little, and if you don’t keep quiet, we’re going to hurt you a lot.”

Daniel Schlicksup, above.

He took the new job, and then, late that year, took the nuclear option, filing an IRS whistleblower complaint accusing Caterpillar of tax fraud and a complaint with the Occupational Safety and Health Administration contending that his employer had retaliated against him for raising concerns about “improper and illegal conduct.” He went public with his allegations in June 2009 in a retaliation lawsuit filed in federal court in Peoria against the company and a number of executives.

An odd game of chicken followed. Schlicksup remained at Caterpillar, assigned the gargantuan task of consolidating its 200-plus data centers around the world while he pursued his retaliation case, taking unpaid leave to sit for depositions with company lawyers. His professional life grew more and more miserable. He and his new boss, Ronald Jensen, had been working together for barely a year when Jensen told Schlicksup, “I cannot have a conversation with you without worrying about it showing up in black and white in print somewhere,” Schlicksup’s affidavit says. Jensen declined to comment for this story.

Eventually, according to Schlicksup’s affidavit, Jensen prohibited him from bringing his laptop to meetings and required that he get written approval to eat lunch outside the building. Schlicksup was seeing three doctors and a physical therapist for stress. “My career has been taken from me,” he told a Cat lawyer in a deposition. “I want my job back in tax.”

Caterpillar twice asked a federal judge to dismiss Schlicksup’s retaliation lawsuit — the company pointed out that he’d received a 7 percent raise when he was transferred to IT. The judge agreed that Schlicksup hadn’t suffered financially but let the case proceed. Caterpillar’s second dismissal petition was pending when, on Valentine’s Day 2012, Schlicksup and the company settled. Terms were not disclosed.

It’s possible Cat thought dispensing with Schlicksup would end the dispute about CSARL — a reasonable view given that, by then, the IRS had signed off on at least seven annual audits that included the Swiss structure. But neither the IRS nor Schlicksup was done. In the summer of 2013, he was interviewed for two days by staffers for the Senate investigative panel. That December, the IRS, armed with scads of emails and other documents Schlicksup supplied, sent Caterpillar a formal notice that the company had understated its U.S. income by more than $3 billion for 2005 and 2007 through 2009.

Caterpillar presented its first detailed public defense of CSARL the following April Fools’ Day at a hearing of the Senate panel. Beran, two other executives, and two PwC accountants and an economist argued that the restructuring became necessary and wise as parts sales grew globally and the company invested in warehouses and other facilities around the world. CSARL was running the foreign business from Geneva regardless of where parts were being made or stored, they said — and that constituted the “economic substance” required by law. “The tax department has to continually adapt to the way the business is run … and that is what we were doing,” Beran told the senators. Caterpillar’s vice president for finance services, Julie Lagacy, said, “We do not invent artificial tax structures.”

The Senate panel didn’t buy it. Its 95-page staff report, which mentions Schlicksup dozens of times, concluded that Caterpillar had avoided or deferred paying $2.4 billion in taxes. Months later the committee singled out a moment in the hearing when Beran was asked whether the IRS had actually blessed CSARL. “That is the way I have taken it,” Beran said. The panel called that testimony “false,” asserting that Beran “knew or should have known” that three months before the hearing, the IRS had proposed that Cat pay tax adjustments and penalties.

CATERPILLAR’S FORTRESS-LIKE HEADQUARTERS looms over an entire city block in downtown Peoria. On a chilly Thursday in March, federal agents in dark jackets rushed into the building from vehicles parked haphazardly in a no-parking zone along Northeast Adams Street. Simultaneously, they entered the Morton parts facility and a data center in East Peoria, armed with search warrants a federal judge had signed the day after Trump declared his affection for the company.

It’s unclear precisely what the agents were seeking. In addition to tax issues, the warrants suggest the feds may be exploring whether Caterpillar sold goods to countries such as Sudan, Syria, and Iran in violation of U.S. export bans. The company has no operations in any of those countries and has said any such sales in them were made by independent, unaffiliated dealers.

Former federal prosecutors say the most likely reason for the raid is that investigators felt Cat hadn’t been forthcoming with information — or they were worried that someone would destroy evidence, as Arthur Andersen did with Enron documents. Jim Umpleby, who became the CEO of Caterpillar in January, told reporters the raid came as a surprise, because the company believed it was cooperating fully. It has since hired former Attorney General William Barr of the law firm Kirkland & Ellis LLP to “take a fresh look at Caterpillar’s disputes with the government,” Umpleby said.

It’s hard to say whether the Trump Justice Department would pursue criminal prosecution of such an iconic American manufacturer. Even if the government chooses to forgo a criminal case, though, Caterpillar still has to deal with the IRS’s claim that it owes $2 billion — about $100 million more than the company’s 2016 adjusted net earnings. That bill might be growing, because the IRS has yet to finish auditing more recent years. To date, Wall Street doesn’t seem concerned; after a drop following the March raid, Caterpillar’s stock is trading near its 52-week high.

The IRS has a standard formula for whistleblower awards: It pays 15 percent to 30 percent of what it collects. If Cat pays the full $2 billion, Schlicksup stands to get $300 million to $600 million. But nothing is guaranteed. The IRS determines how much a whistleblower contributed to a case and, in turn, how much he or she is paid.

In court filings, Caterpillar says it took Schlicksup seriously, but he was just wrong. “Caterpillar has investigated every one of Mr. Schlicksup’s complaints and has been satisfied with the investigative process and the conclusions drawn,” the company told OSHA. “Mr. Schlicksup, however, was, and continues to be, unwilling to accept that investigations are initiated, closed, and owned by Caterpillar and that he is not entitled to know the outcomes of investigations.”

Unlike Jeffrey Wigand, Schlicksup hasn’t appeared on 60 Minutes or received death threats. He gets together now and then with former Cat colleagues for a beer. His attorney, O’Day, wouldn’t say whether his client is testifying before the grand jury investigating Caterpillar. Schlicksup recently was divorced from his wife and no longer lives on the 17 acres in Dunlap. But he’s still in the area, with his trove of emails and documents, as sure of his case as ever.

— With Mario Parker and Andy Hoffman

Originally published at www.bloomberg.com on June 1, 2017.