By Timothy Mclaughlin

CHICAGO (Reuters) - Federal law enforcement officials conducting a criminal probe of heavy machinery manufacturer Caterpillar Inc searched three of its facilities on Thursday, prompting a sharp sell-off in the company's stock.

A spokeswoman for the U.S. Attorney Office for the Central District of Illinois, Sharon Paul, confirmed that federal law enforcement officials conducted searches at locations in Peoria, East Peoria and Morton, Illinois, but did not say why agents raided the three facilities.

Caterpillar, in a statement issued on Thursday afternoon, said it believed the search was part of an Internal Revenue Service investigation related to profits earned by a Swiss parts subsidiary, Caterpillar SARL, or CSARL.

It said that "while the warrant is broadly drafted, we believe the execution of this search warrant is regarding, among other things, export filings that relate to the CSARL matter first disclosed in Caterpillar's Form 10-K filed on February 17, 2015, and updated in Caterpillar's most recent Form 10-K filed with the SEC on February 15, 2017."

Agencies involved in the search included the IRS' Criminal Investigation Division, the U.S. Department of Commerce's Bureau of Industry and Security's Office of Export Enforcement, and the Federal Deposit Insurance Corp.'s Office of Inspector General, Paul said.

Officials at the agencies could not be reached for comment.

Caterpillar shares fell 4.3 percent to close at $94.36 on the New York Stock Exchange after trading as low as $92.84.

IRS SEEKS $2 BLN; CATERPILLAR CONTESTS

The apparent escalation of the government's tax dispute with Caterpillar comes as the Trump administration and leaders in Congress have said they want to launch a broad overhaul of the corporate tax code, lowering rates and designing the system to encourage companies to keep jobs and profits within the United States.

Caterpillar has also had a prominent place in the Trump administration's effort to promote U.S. manufacturing. The company's outgoing chief executive, Douglas Oberhelman, met with President Donald Trump at the White House last week.

Caterpillar is fighting an Internal Revenue Service demand that the company pay $2 billion in taxes and penalties for profits assigned to its Swiss parts distribution subsidiary, according to filings with the Securities and Exchange Commission. That subsidiary was also the subject of a 2014 Senate committee report that concluded Caterpillar shifted billions in profits abroad and had $2.4 billion in taxes deferred or avoided from 2012.

"As a result of those licensing and servicing agreements,

over the next thirteen years from 2000 to 2012, Caterpillar shifted to CSARL in Switzerland taxable income from its non-U.S. parts sales totaling more than $8 billion, and deferred or

avoided paying U.S. taxes totaling about $2.4 billion," the report said.

It said the arrangement resulted in Caterpillar paying an effective tax rate of only 4 percent to 6 percent.

Caterpillar, in its 2016 annual report, said it is "vigorously contesting" the IRS demand. "We believe that the relevant transactions complied with applicable tax laws and did not violate judicial doctrines," it stated.

The Senate committee report also criticized Caterpillar's accountants, PwC, saying that the firm's roles as auditor and tax consultant represented a conflict of interest. PwC on Thursday said it had no comment.

In testimony before the Senate in 2014, PwC partner Thomas Quinn said the firm believed that its "tax advice and Caterpillar’s tax positions were correct under applicable tax laws. In sum, PwC’s provision of tax services to Caterpillar as our audit client was entirely appropriate."

Caterpillar also disclosed in its annual report that it had received grand jury subpoenas from the U.S. District Court for the Central District of Illinois seeking documents and information related to the movement of cash among U.S. and non-U.S. subsidiaries, and the purchase and resale of replacement parts by Caterpillar Inc. and non-U.S. Caterpillar subsidiaries, including Caterpillar SARL. Caterpillar said it is cooperating with the investigation and did not believe it would have a material impact on its finances.

PARTS BUSINESS; TAXES

The facility in Morton, according to the company’s website, is responsible for receiving and shipping replacement parts to parts facilities and Caterpillar dealers worldwide.

Caterpillar reported sales fell 18 percent in 2016 to $38.5 billion and since late 2015 it has shrunk its workforce by more than 16,000 employees and consolidated or closed 30 facilities. Caterpillar cut 12,300 jobs in 2016, including 7,700 in the United States.

It said it was considering closing two more major production facilities, including one in Aurora, Illinois, and also announced it was moving its corporate headquarters from Peoria to Chicago this year.

Last week in Missouri, U.S. Vice President Mike Pence toured Fabick CAT, a family-owned company that is one of the largest U.S. distributors of Caterpillar equipment. "You are the strength in the American economy, and you're going to lead an American comeback," he told workers there.

Pence said the Trump administration wants to simplify the U.S. tax code. "I'll guarantee there isn't anyone here who can make sense of America's tax code, including me. There's an old joke that says the tax code is about 10 times the size of the Bible but with none of the good news," he said.

"Our country's tax system these days penalizes success. It makes it far too hard for hardworking people and small businesses to achieve the American Dream."

(Reporting by Timothy Mclaughlin, PJ Huffstutter and Tracy Rucinski in Chicago, David Shepardson in Washington and Joe White in Detroit, writing by Daniel Grebler; editing by Diane Craft)