A Critical Assessment and an Appeal for Fundamental Tax Reform

Paper for the World Trade Organization Panel Report (dated October 8, 1999)
Report of the Appellate Body (dated February 24, 2000)
United States Tax Treatment for "Foreign Sales Corporations"

March 11, 2000



As Deputy Assistant Secretary in the Treasury Department (1977-80), I helped negotiate provisions in the Tokyo Round Subsidies Code that both resolved the Tax Legislation Cases argued in the GATT in the late 1970s, and set out rules defining export subsidies. The export subsidy provisions of the Tokyo Round Subsidies Code were, in large part, adopted in the Uruguay Round Agreement on Subsidies and Countervailing Measures (SCM). The two WTO reports (the FSC Panel Report and the FSC Appellate Body Report) revolve around the settlement of the Tax Legislation Cases negotiated in the GATT, and the export subsidy provisions in the SCM.

Subsequent to my service in the Treasury Department, Joanna Shelton and I authored a volume that analyzed the Tokyo Round Subsidies Code and other international agreements on subsidies.1 Other papers and monographs followed. The comments in this critique of the two WTO Reports are based on my Treasury experience and subsequent scholarship.

The proposal for using the WTO decision as a springboard for fundamental tax reform, draws from my work on international tax systems.


I. Summary of the FSC Panel Report and Appellate Body Report

The FSC Panel Report is long. The arguments of the parties are stated in 277 pages; the findings of the Panel require another 64 pages; and the text is garnished with 716 footnotes. The FSC Appellate Body Report, which sustained the Panel Report on all essential points, runs 61 pages with 184 footnotes. Despite the length and detailed reasoning of these two Reports, their two core findings are fundamentally flawed. In this critique, I will only address these two core findings.

Before discussing these two critical flaws, I will summarize the logic in the FSC Panel Report, logic that the FSC Appellate Body Report endorsed. Despite the length of the Reports, their key logical elements can be succinctly stated:

  • Under Article 1 of the SCM, the FSC amounts to a subsidy because the U.S. Treasury foregoes revenue "otherwise due".

  • Under Article 3 of the SCM, the FSC amounts to a prohibited export subsidy because it is a subsidy under Article I and because its benefits are contingent upon export activity.

  • The critical 1981 GATT Council decision that adopted the Tax Legislation Reports of that era, contingent on an understanding that territorial tax systems (such as the FSC) are not per se export subsidies, was not incorporated in the GATT-1994.

  • Explicit language in the SCM that excludes territorial tax systems from the definition of prohibited export subsidies does not cover the FSC.

  • Consequently, the FSC amounts to a prohibited export subsidy.


II. Brief Tax History

The tax predecessor to the Foreign Sales Corporation was the DISC, the Domestic International Sales Corporation, enacted in 1971 by the Nixon Administration. The European Community and other GATT members instantly challenged the DISC. In turn, the United States challenged the territorial tax systems operated by France, Belgium and the Netherlands. These challenges became the subject of four GATT Panel Reports (Tax Legislation Reports), issued in 1976. The Tax Legislation Reports found fault with all four systems - but in terms that, for different reasons, were too sweeping for either the United States or the European Community to accept. The export subsidy negotiators in the Tokyo Round spent a good deal of time distilling the acceptable essence of the Tax Legislation Reports, and putting that essence into the Tokyo Round Subsidy Code. Two points of essence deserve emphasis.

  • The negotiators agreed that export subsidies are prohibited, regardless whether the exported product causes or threatens "material injury" to the importing country (the relevant effects test for countervailing duties under GATT Article VI) and regardless whether the subsidy results in "bilevel pricing" (the relevant effects test under GATT Article XVI:4). The negotiators were not able to agree on a general definition of export subsidies, but instead resorted to an Illustrative List with a catch-all phrase as the last item (item (l), which refers back to Article XVI).

  • The negotiators agreed that territorial tax systems do not per se give rise to export subsidies. Economic processes located outside the exporting country (e.g., sales and after-service activities) need not be taxed by the exporting nation. However, arm's length prices must be observed between related parties in export transactions. Otherwise, a firm in the exporting country could shift profits abroad and reduce its total tax burden by selling its export merchandise cheap to its own distribution subsidiary located in a low-tax jurisdiction, such as Switzerland. This agreement is reflected in footnote 2 of the Illustrative List.

After the Tokyo Round Agreement (including the Subsidies Code) was ratified (1979), two years of further legal wrangling preceded the adoption of the Tax Legislation Reports. Late in 1980, the U.S. Trade Representative renounced the "Hufbauer Understanding", reached in June 1979 during the last days of the Tokyo Round, regarding the disposition of the four Tax Legislation Reports.2 The Reagan Administration, however, accepted the essence of the Understanding. It became the basis for the 1981 GATT Council Decision adopting the Tax Legislation Reports, the 1982 commitment by the United States to repeal the DISC, the actual repeal of the DISC in 1984, and the creation of the FSC in the same year.


III. First Flaw: The 1981 GATT Council decision and understanding

The 1981 GATT Council adopted the Tax Legislation Reports subject to an understanding on territorial tax systems and the arm's length principle. The carefully crafted decision and understanding read:

The Council adopts these reports on the understanding that with respect to these cases, and in general, economic processes (including transactions involving exported goods) located outside the territorial limits of the exporting country need not be subject to taxation by the exporting country and should not be regarded as export activities in terms of Article XVI:4 of the General Agreement. It is further understood that Article XVI:4 requires that arm's-length pricing be observed, i.e., prices for goods in transactions between exporting enterprises and foreign buyers under their or the same control should for tax purposes be the prices which would be charged between independent enterprises acting at arm's length. Furthermore, Article XVI:4 does not prohibit the adoption of measures to avoid double taxation of foreign source income.

The first core issue addressed by the FSC Panel Report concerns the legal status, under GATT-1994, of the 1981 GATT Council's decision to adopt the Tax Legislation Reports with the accompanying understanding. Obviously, if the 1981 GATT Council decision and understanding were carried into GATT-1994, the territorial tax system applied by the FSC to U.S. exports could not be characterized as a subsidy under Article XVI:4. End of case.

GATT-1994 explicitly incorporated multiple protocols, decisions, and understandings that had previously entered into force under GATT-1947. Specifically, Annex 1A to the WTO Agreement provides, in relevant part, that GATT-1994 shall consist of:

(a) the provisions in the General Agreement on Tariffs and Trade, dated 30 October 1947… as rectified, amended or modified by the terms of legal instruments which have entered into force before the date of entry into force of the WTO Agreement;

(b) the provisions of the legal instruments set forth below that have entered into force under the GATT 1947 before the date of entry into force of the WTO Agreement:

(iv) other decisions of the CONTRACTING PARTIES to the GATT 1947;

After much straining (paragraphs VII.1572 though VII.1597), the Panel Report finds that the 1981 GATT Council decision and understanding do not pass muster as "legal instruments" within the meaning of the two provisions of Annex IA cited above. This finding is astonishing. I will not delve into the more refined aspects of Panel argumentation, which distinguishes between "should" and "shall", and quotes the reservations of the Brazilian delegation. The GATT contracting parties spent ten years, launched four Tax Legislation Reports, and held innumerable negotiating sessions before concluding their disputes. These protracted differences were concluded on the basis of the carefully crafted 1981 GATT Council decision and understanding. Robert E. Hudec tells the story at length.3 As the Panel itself recognizes (paragraph VII.1592), the 1981 Council decision and understanding were negotiated, almost word-for-word, before their adoption. If ten years of litigation and negotiation did not suffice to create a "legal instrument", what would?

To justify dismissing the 1981 GATT Council decision and understanding as a "legal instrument", the FSC Panel Report (paragraph VII.1591) relies heavily on the Chairman's statement that accompanied the decision and understanding. The Chairman's statement was pre-negotiated and carefully crafted. Stated in full, it reads:

Following the adoption of these reports the Chairman noted that the Council's decision and understanding does not mean that the parties adhering to Article XVI:4 are forbidden from taxing the profits on transactions beyond their borders, it only means that they are not required to do so. He noted further that the decision does not modify the existing GATT rules in Article XVI:4 as they relate to the taxation of exported goods. He noted also that this decision does not affect and is not affected by the Agreement on the Interpretation and Application of Articles VI, XVI and XXII [the Tokyo Round Subsidies Code]. Finally, he noted that the adoption of these reports together with the understanding does not affect the rights and obligations of contracting parties under the General Agreement.

The Chairman's statement in no way detracts from the character of the 1981 GATT Council decision and understanding as a "legal instrument".

  • The Chairman properly distinguished, in his first sentence, between the decision to adopt the four Tax Legislation Reports and the accompanying understanding. These were two separate GATT Council actions, with independent importance.

  • The Chairman's second sentence points out that the decision to adopt the Reports did not modify GATT rules under Article XVI:4. This sentence preserves the "bilevel" pricing test of Article XVI:4, which was otherwise impugned by the Tax Legislation Reports.

  • The Chairman's third sentence points out that the decision does not affect the Tokyo Round Subsidies Code (and vice versa). This important statement made it clear, for future GATT panels, that they should not rely on the Tax Legislation Reports to interpret the Tokyo Round Subsidies Code. An important objective of the Tokyo Round negotiations on export subsidies was to distill the useful essence of the Tax Panel Reports from the dross. This valuable work would have been lost if future GATT panels had returned to the Tax Legislation Reports in interpreting the Code. The Chairman's statement also made it clear that the Tax Legislation Reports amounted to res judicata as to the practices litigated, and the same practices could not be re-litigated on the basis of new provisions in the Subsidies Code.

  • By its careful choice of language, the Chairman's third sentence also carries a corollary point: the 1981 GATT Council understanding emphatically would affect future interpretations of the Tokyo Round Subsidies Code. Indeed, the language of the understanding closely tracks footnote 2 of the Code's Illustrative List. Unfortunately, the FSC Panel Report did not read the Chairman's language closely, and confounded decision and understanding. The decision to adopt the four Tax Legislation Reports had no future impact on interpreting the Tokyo Round Subsidies Code, but the understanding provided a critical guide - a guide that carries right over to the Uruguay Round Agreement on Subsidies and Countervailing Measures.

  • Finally, the Chairman's fourth sentence points out that the decision and understanding do not affect the rights and obligations of contracting parties under the General Agreement. The FSC Panel Report relies heavily on this sentence to deprive the 1981 GATT Council decision and understanding of its status as a "legal instrument" under GATT-1947. The Report misreads this critical sentence to find that the 1981 GATT Council decision and understanding were merely precatory statements, without legal force. By his fourth sentence, however, the Chairman was simply observing that the contracting parties retain their rights and obligations under the General Agreement itself (not the Tokyo Round Subsidies Code). What rights and obligations were most at issue? First, the "material injury" test under GATT Article VI; and second, the "bilevel pricing" test under Article XVI:4. What the Chairman's fourth sentence means is that - for any export subsidy not specifically enumerated in the Illustrative List - a complaining party would have to show either "material injury" or "bilevel pricing" before it could have redress under Article VI or Article XVI:4. Emphatically, these same effects tests were no longer be available as defenses for export subsidies specifically enumerated in the Illustrative List of the Tokyo Round Subsidies Code.

What this history boils down to is that the 1981 GATT Council decision and understanding were indeed a "legal instrument" to be incorporated in GATT-1994. As a consequence, when a country uses a territorial system for taxing export profits (observing arm's length pricing), it does not forego government revenue "otherwise due" - the relevant definition of a subsidy under the Uruguay Round Agreement on Subsidies and Countervailing Measures. The case against the FSC accordingly collapses.


IV. Second Flaw: Uruguay Round Agreement on Subsidies

In this section, I assume, for the sake of argument, that the 1981 GATT Council decision and understanding simply did not exist. Like the FSC Panel Report, I ask how the FSC fares under the Uruguay Round Agreement on Subsidies and Countervailing Measures (SCM), without the benefit of the 1981 GATT Council's protective language.

Unlike the negotiators who hammered out the Tokyo Round Subsidies Code, the negotiators in the Uruguay Round were able to reach agreement on a general definition of subsidy, stated in Article l. The relevant language reads:

For the purpose of this Agreement, a subsidy shall be deemed to exist if:
(a)(1) there is a financial contribution by a government or any public body…where:
(ii) government revenue that is otherwise due, is foregone or not collected (e.g., fiscal incentives such as tax credits);

Under Article 3 of the SCM, export subsidies are prohibited. The relevant language reads:

3.1 Except as provided in the Agreement on Agriculture, the following subsidies, within the meaning of Article I, shall be prohibited:

  • (a) subsidies contingent, in law or in fact [4], whether solely or as one of several other conditions, upon export performance, including those illustrated in Annex I;[5] …
    4. [Footnote omitted.]
    5. Measures referred to in Annex I as not constituting export subsidies shall not be prohibited under this or any other provision of this Agreement.

Annex I of the SCM replicates, practically word-for-word, the Illustrative List agreed in the Tokyo Round Subsidies Code. In relevant part, the Illustrative List of Export Subsidies in Annex I of the SCM enumerates:

…. (e) The full or partial exemption, remission or deferral specifically related to exports, of direct taxes [58] or social welfare charges paid or payable by industrial or commercial enterprises. [59]

58. [Footnote omitted.]
59. The Members recognize that deferral need not amount to an export subsidy where, for example, appropriate interest charges are collected. The Members reaffirm the principle that prices charged for goods in transactions between exporting enterprises and foreign buyers under their or under the same control should for tax purposes be prices which would be charged between independent enterprises acting at arm's length…

The FSC Panel Report concedes, after a convoluted argument, that footnote 59 of the SCM Illustrative List recognizes that territorial tax systems need not amount to per se export subsidies. The Report, however, then goes on to invent a distinction that never existed in the Tokyo Round Subsidies Code or the SCM. It distinguishes between a territorial system that provides a "broad exemption of income deriving from foreign economic activities" and a territorial system that provides an exemption "specifically related to exports". The former is not a prohibited export subsidy, says the Report, the latter is prohibited. This sleight-of-hand creates two kinds of mischief:

  • It renders the FSC inconsistent with the SCM, while insulating the "full" territorial systems that in practice may exempt more export income from home country taxation than the FSC. Most business firms, unschooled in such refined reasoning, would find it anomalous to condemn a territorial system like the FSC that might exempt 50 percent of export profits, but exonerate a territorial system that always exempted 100 percent of export profits.

  • It ignores the basic purpose of Article 3.1 - a provision new to the SCM - namely to prevent inventive new export subsidies, not to prohibit practices that had long been accepted among GATT members. The accepted practices are enumerated in Annex I of the SCM. They include border tax adjustments that remit (or do not collect) excise taxes and value added taxes on exports, as well as territorial systems for not taxing foreign source income (including export profits). The accepted practices are explicitly "grandfathered" by footnote 5 to Article 3.1(a), quoted above.


V. Next Step: The U.S. Congress

The WTO decision, bad as it is, gives Congress a springboard to historic tax reform. European countries (and many others) routinely exempt their exports from value added tax. This saves European exporters about $100 billion a year of tax payments on export sales. European firms routinely sell these same exports through tax-haven sales subsidiaries located in exotic places like Bermuda and Hong Kong. This saves European exporters another $10 billion a year of corporate income tax.

Parallel tax savings are not available to U.S. exporters. The main reason is that the WTO - reinforced by the FSC Reports -- honors an archaic tax distinction that has no economic basis.4 WTO rules allow corporate taxes measured by value added (Europe) to be excused on exports and imposed on imports. But WTO rules forbid similar adjustments for corporate taxes measured by income (United States) - even though the distinction between the two tax bases is more form than substance. Moreover, the WTO allows European firms, and others that are taxed on a territorial basis, to export through foreign subsidiaries and pay little or no tax on the selling profits. Since the United States does not tax on a territorial basis, U.S. firms are not given the same latitude.

The Foreign Sales Corporation is stingy compared to European tax practices. Nevertheless, it saves U.S. exporters about $3.5 billion a year. Most of the 6,000 firms that use the FSC are small and medium-sized exporters with little or no production abroad. Some are big firms such as Boeing, Microsoft and General Electric, and European subsidiaries based in the United States, such as BP, Hoechst and Elf-Aquitaine.

It is unlikely that Congress will simply repeal the FSC and leave U.S. exporters at an even greater tax disadvantage. The practical question is whether Congress will redress the bad WTO decision by endorsing a small fix, or by attacking the root through tax reform. A small fix is better than nothing. The United States, for example, might lift its retaliation against EU banana and beef restrictions in exchange for EU restraint on the FSC. Or Congress might devise a targeted successor to the FSC. Rather than a small fix, Congress should use the WTO decision as a springboard for historic tax reform.

Unlike the United States, most other countries have adopted territorial systems of taxation: they do not tax overseas investment. For example, if a French company makes and sells products in the United States (pharmaceuticals, banking, or telecommunications, it doesn't matter), France doesn't tax the income.

The United States, by contrast, has an impractical general rule: it taxes worldwide income. If a U.S. company makes and sells products in France, the U.S. taxes the income. The worldwide tax approach is justified by emotion not logic: "Every U.S. corporation should pay U.S. tax, whether it operates in Indiana or India, New Mexico or old Mexico." Carried to its extreme, the general rule would render U.S. firms totally non-competitive in a global economy, both as exporters and producers.

Successive Congresses, in their wisdom, have modified the general rule with practical exceptions, ranging from the foreign tax credit, to deferral, to the DISC and the FSC. But the tensions stretching back to 1918 between the impractical general rule and the practical exceptions have generated an extraordinarily complex U.S. tax code. The administrative burden is a nightmare for the IRS and U.S. firms.5

Meanwhile, old and new problems fester in the world of international taxation. One old problem is the "runaway plant", re-christened by Ross Perot as "the great sucking sound". Will U.S. firms pull up stakes and move to developing countries, and then sell back into the United States - free of U.S. corporate tax?

A new problem is E-commerce. Will U.S. firms be taxed on their internet sales to customers abroad? Can foreign firms sell into the U.S. market free of tax?

Congress could, in a single historical stroke, level the field of export taxation, end anxiety about runaway plants, resolve the looming debate over E-commerce, and discard the hideously complex corporate income tax. It could achieve all these goals by replacing the corporate income tax. In its place, the Congress should adopt the model USA tax, jointly sponsored by former Senator Sam Nunn (D-Ga) and Senator Pete Domenici (R-NM) and Congressman Phil English (R-Pa).6

At a business tax rate of about 15%, the Nunn-Domenici-English USA tax would finance astounding reform of the individual income taxation. Personal tax rates would be drastically reduced. Everyone would be allowed a tax-free savings account. Tax returns would be simplified to a few pages.

Under the USA business tax, taxable income would be determined by subtracting permitted deductions from taxable receipts. Taxable receipts cover revenue from sales in the United States, but not exports or production abroad. Permitted deductions cover all costs of business purchases from taxpaying U.S. firms. Payments for imports are not a permitted deduction. By excluding exports from taxable receipts, and by excluding imports from deductible expenses, the USA business tax provides a "border tax adjustment" - just as in Europe, but without adopting a sales tax.

The USA business tax would level the field of export taxation, eliminate the tax motive for runaway plants, resolve the looming E-commerce debate, and radically simplify the U.S. income tax code. As a grand bonus, it would finance real reform of the individual tax. How so?

  • The steep tilt in export tax practices is leveled because U.S. companies, like their European counterparts, would pay no tax on exports.

  • The runaway plant motive would disappear because any firm that produces abroad and sells in the U.S. market effectively pays the same tax as a competitor located in the United States.

  • The looming debate over E-commerce is resolved because sales to foreign buyers are not taxable receipts and purchases from foreign sellers are not deductible expenses.

  • American taxpayers win a grand bonus of low tax rates, simplified tax returns and enhanced savings for retirement.

Congress can neither slice bread nor build the internet. But it can use a bad WTO decision as a springboard to historic tax reform.



1. Gary Clyde Hufbauer and Joanna Shelton Erb, Subsidies in International Trade, Institute for International Economics, 1984.

2. The text of the "Hufbauer Understanding" appears in Appendix C ofSubsidies in International Trade.

3. Robert E. Hudec, "Reforming GATT Adjudication Procedures: The Lessons of the DISC Case", Minnesota Law Review, v. 72, no. 6, June 1988.

4. Gary Clyde Hufbauer assisted by Carol Gabyzon, Fundamental Tax Reform and Border Tax Adjustments, Institute for International Economics, January 1996.

5. Gary Clyde Hufbauer assisted by Joanna M. van Rooij, U.S. Taxation of International Income: Blueprint for Reform, Institute for International Economics, 1992.

6. Hufbauer and Gabyzon, Fundamental Tax Reform.