The FSC Case: Background and Implications

Washington, DC

February 27, 2002


A. Quick background

  • A 1960 GATT Working Party codified the ancient distinction between permissible border adjustments for direct and indirect taxes: origin principle for direct (no adjustments at the border); destination principle for indirect (adjustments permitted at the border-i.e., impose the tax on imports, exempt the tax on exports). Hence destination principle adjustments for corporate profits taxes on export earnings (classified as a direct tax) are both an impermissible export subsidy and a violation of national treatment. But destination principle adjustments for VAT taxes on export and import sales are permitted. This distinction persists, despite the obvious economic point that a VAT amounts to a combination of a direct tax on profits, a direct tax on interest and rent paid by the corporation, and a direct tax on wages. In other words, by GATT alchemy, direct taxes can be transformed into indirect taxes and adjusted at the border. But without this magical transformation, direct taxes cannot be adjusted at the border.

  • In 1962, the United States enacted Subpart F of the Internal Revenue Code. Subpart F eliminated deferral for "foreign base company income" earned by controlled foreign corporations in tax haven countries. Base company income includes profits from handling the sales of US exports to third countries. This "anti-abuse" provision put US exporters as a tax disadvantage compared to other industrial country exporters.

  • In 1971, faced with a growing trade deficit, the United States introduced the Domestic International Sales Corporation (DISC)-tax deferral for the export earnings of a US corporation. In tax terms, the DISC softened the impact of Subpart F, which subjected foreign base company income to US tax. The United States argued that tax deferral under the DISC was not the same as tax exemption. The EC challenged the DISC in 1974. In turn, the United States challenged the European "territorial approach" to taxing export earnings. Specifically, the United States challenged tax exemption for the portion of export earnings attributed to a sales subsidiary located in a tax haven country. (None of the European countries then or now has an effective equivalent of Subpart F for current taxation of "foreign base company income".)

  • A GATT panel decided the four "tax cases" in 1976: all defendants lost. Retaliation was held in abeyance during the Tokyo Round negotiations.

  • The Tokyo Round Code on Subsidies & Countervailing Duties settled the four tax cases, based on four principles: (a) the distinction between direct and indirect taxes was preserved; (b) The United States agreed to repeal DISC (tax deferral was conceded to be an export subsidy, like tax exemption); (c) however, methods of avoiding double taxation-both the exemption method associated with territorial systems of taxation and the foreign tax credit method associated with worldwide systems of taxation-are defined not to be subsidies; (d) the arm's length pricing standard is to be observed in transactions between parent exporting companies and their foreign sales subsidiaries.

  • Following the conclusion of the Tokyo Round, in 1981 a GATT Council Decision disposed of the four tax cases, with a Chairman's note that reiterated the bargain struck in the Tokyo Round Code. In particular the Chairman's note stated: "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 and should not be regarded as export activities in terms of Article XVI:4. It is further understood that Article XVI:4 requires that arm's-length pricing be observed… Furthermore, Article XVI:4 does not prohibit the adoption of measures to avoid double taxation of foreign source income."

  • Based on this note, in 1984 the United States repealed the DISC, and enacted the Foreign Sales Corporation (FSC). The FSC allowed partial tax exemption for the income of a foreign corporate subsidiary derived from handling US export sales. The amount of income exempted was calculated by a formula designed to approximate arm's length pricing (dividing export profits between domestic and foreign sources).

B. First Round of FSC Litigation

  • In 1999, the EU challenged the FSC as a violation of the Uruguay Round Code on Subsidies & Countervailing Measures (SCM). This was a surprise to the United States, since the FSC had not been challenged during the course of the Uruguay Round negotiations. The EU motivation was to create bargaining chips to resolve other WTO disputes (e.g., bananas, beef hormones), potential disputes (e.g., Airbus and steel), and pending disputes at the expiration of the agricultural peace clause (December 2003).

  • The first WTO FSC Panel, in its October 1999 decision, stated that the 1981 Council Decision was not "a legal instrument" of the GATT-1947 that had been adopted by the GATT-1994, by virtue of the Annex 1A of the Uruguay Round (the grandfather or savings clause). Surprise! The Panel then went on to hold that the FSC is a prohibited export subsidy because: (a) revenue is foregone; (b) exports are taxed more favorably than production abroad. The Panel did not rule on the EC claim that FSC violates the SCM because exports are taxed more favorably than production for the home US market. However, the Panel did rule that the FSC is not a permissible application of the territorial approach-i.e., the exemption approach-to avoiding taxation of foreign source income because the FSC invokes the territorial principle for only the export segment of foreign source income. In February 2000, the WTO Appellate Body affirmed the Panel Report in all essential respects.

C. The Extraterritorial Income Exclusion (ETI) Act

  • In November 2000, the US Congress passed the ETI Act in response to the WTO Appellate Body decision. The ETI Act excluded from the US definition of gross income certain foreign source income-namely a portion of export earnings, and a portion of earnings from production abroad-with the condition that this territorial method of avoiding double tax relief could only be used if the taxpayer did not claim foreign tax credits with respect to the same earnings. The benefits of the ETI Act were also conditioned on the sale of the goods outside the United States, and the use of less than 50 percent non-US (i.e., imported) inputs. Under the ETI Act, FSC benefits are phased out.

  • In the US view, the ETI Act conformed to the Appellate Body decision because: (a) revenue was no longer foregone-ETI income was no longer part of gross income subject to corporate tax; (b) export earnings and foreign production earnings were similarly taxed under the ETI Act.

D. Second Round of FSC/ETI Litigation

  • The EU brought a second case to the WTO, claiming: (a) notwithstanding the ETI Act, revenue was still foregone; (b) the export contingency remained, even if foreign production was, in some circumstances, covered; (c) the US content requirements for export earnings under ETI violate Article III (national treatment); (d) the FSC phase-out does not respect the first Appellate Body deadline (October 2000).

    • In August 2001, the WTO FSC/ETI Panel endorsed the EU arguments in all essential respects. In reaching its decision, the Panel, like its predecessor, continued to disdain any deference to established tax practices. Instead:

    • The Panel arrogated the power to decide when a mixed system of double tax relief (territorial exemption plus foreign tax credits) amounts to a prohibited export subsidy. The ETI exclusion flunked, according to the Panel, partly because it was too broadly drawn (it could exempt income not taxed by another country) and partly because it was too narrowly drawn (only exports and selected foreign production are covered).

    • On the way to creating this power, the Panel claimed the power to say that any deduction or exclusion from gross income could amount to a departure from the "normative benchmark" of the offending nation's tax system, and thus could amount to a relief from tax "otherwise due" (SCM 1.1(ii)), and thus could amount to a subsidy.

    • The Panel did not bother to examine actual US tax practice, developed since 1913, which has long allowed deferred taxation of the income of controlled foreign corporations (CFCs). In economic terms, deferral amounts to a partial or near-total exemption. The ETI provision allows an explicit exemption where prior and current law allow for its first cousin, deferral.

    • The Panel decided that the ETI exemption was "contingent on" exports-in other words, that exporting is a necessary condition for receiving the subsidy-even though the ETI exclusion also applies to foreign production in designated circumstances. This, despite footnote 4 to the SCM which states: "The mere fact that a subsidy is granted to enterprises which export shall not for that reason alone be considered to be an export subsidy…"

    • Not surprising, the Panel found that the US content rule violated Article III.

  • The Appellate Body affirmed the Panel decision, but narrowed the rationale with two important twists. (a) The Appellate Body walked away from the Panel's "normative benchmark" concept and instead defined "revenue otherwise due" by referring to the taxation of ETI income when the taxpayer elects to claim a foreign tax credit rather than the exemption. Since the taxpayer will only elect the exemption method when his bottom line US taxes are less under the credit method, it follows that the US Treasury has foregone "revenue otherwise due". (b) The Appellate Body delved into ETI Act rules for determining the division of export income between domestic and foreign sources. Using simple-minded examples, the Appellate Body found circumstances where the rules could improperly characterize domestic source income as foreign source income.

  • In important ways, the Appellate Body returned to the main outlines of the bargain struck in the 1981 GATT Council Decision. The Appellate Body reaffirmed the arm's length principle for distinguishing between domestic source and foreign source income earned on export sales. The Appellate Body confirmed that foreign source income, properly computed, could be exempt from tax and the exemption does not automatically amount to an export subsidy prohibited by the SCM.

E. Questions Raised

  • First question: how big is the bargaining chip that the WTO has created for the WTO? Under the SCM, the Arbitral Panel decides the permitted level of retaliation-i.e. "appropriate countermeasures" (Article 4.11 of the SCM)-in the event that the subsidizing member does not "withdraw the subsidy without delay". The Arbitral Panel has said it will reach a decision at the end of April 2002. Once decided, the Arbitral Panel's ruling cannot be appealed. There is little case guidance on "appropriate countermeasures"-only the Brazil-Aircraft arbitration. In that case, the Arbitral Panel decided that "appropriate countermeasures" means the "the full amount of the subsidy to be withdrawn"-not the level of trade impairment to Canada (as Brazil had argued). Following this precedent, the United States argues that the bargaining chip is $956 million, calculated with reference to the tax benefits on FSC/ETI exports to the EU directly, and to third country markets where US and EU exports compete. The EU says the bargaining chip is $4,043 million, based on total FSC tax benefits on exports to the world. Both submissions avoid an explicit calculation of the trade impact of the FSC/ETI benefit. However, their implicit calculations assume that the size of trade impact equals the size of tax benefit (i.e., an export demand elasticity of -1.0). The Arbitral Panel's decision will set an important precedent for calculating "appropriate countermeasures".

  • Second question: what is in the EU shopping bag? The EU claims that it only wants the United States to amend or repeal the ETI law in a WTO-consistent manner. This oft-repeated EU statement is only a ploy to force the United States into opening negotiations, offering "compensation" in the form of concessions on other trade issues. Plausible candidates for the EU shopping bag: (a) beef hormones and potential biotechnology claims; (b) Section 201 restrictions on steel imports (but there the EU can retaliate directly); (c) agricultural subsidies. The logic from Pascal Lamy's standpoint is to hold the bargaining chip in his pocket, and threaten but not invoke retaliation. Possible outcome: a standstill on all retaliation that lasts until the end of the Doha Work Program in 2005.

  • Third question: will other WTO members use the decision to create their own bargaining chips for negotiations and dispute resolution with the United States? They would have to mount new cases against the FSC/ETI to get permission to retaliate, but the precedent seems straightforward. If this scenario unfolds, how will future Arbitral Panels go about allocating the rights to "appropriate countermeasures" among WTO complainants?

  • Fourth question: will the United States (and possibly other members) use the logic of the WTO's decision to launch their own tax cases against their trading partners? Export processing zones, widely used by developing countries, are vulnerable. So is the US export source rule. The EU countries may have arbitrary formulas for calculating exempt foreign source income tucked away in their tax laws and regulations. The Appellate Body decision is an invitation to tax litigation-member A can respond to a non-tax WTO case brought against it by launching its own tax case against member B. This danger underscores the standstill option mentioned earlier.

  • Fifth question: will WTO members renegotiate the SCM in the Doha Work Program? Two possible objectives: (a) Stop the DSM from turning itself into a World Tax Court. For example, the SCM could instruct the DSM to defer to jurisprudence established in bilateral tax treaties and the OECD for defining foreign source income. (b) Eliminate the artificial distinction between border adjustment rules for direct and indirect business taxes. For example, the SCM rules could allow members to exempt 50 percent of export earnings from corporate profits tax. (c) As a matter of transparency, require WTO members to publish their schedules of border tax adjustments applied on a product basis, following the Harmonized Tariff System.

  • Sixth question: when and how will the US Congress change the tax law? Congressional action is clearly necessary, both to take away bargaining chips from the EU and to avert "piling on" by other WTO members. My guess as to timing: not until 2003, because of soapbox and piggyback problems in 2002. As to how, there are three broad options: (a) The "minimal" fix-repeal the ETI Act, and exclude export income from "foreign base company" income under Subpart F. (b) Abandon export tax relief-repeal the ETI and use the revenue for other business tax reform, for example phasing out the AMT. (c) Use the WTO decision as a springboard for fundamental reform, through a territorial system of taxing corporate profits. This is clearly the best answer. Politically, it may be the most difficult.