Long-Running Trade Dispute over U.S. Tax Break May Be Ending
Long-Running Trade Dispute over U.S. Tax Break May Be Ending


The United States has proposed revisions to its tax code—for the second time—in response to rulings from the World Trade Organization (WTO) invalidating a provision that gives U.S. companies, including major corporations such as Boeing, Microsoft, and Kodak, a tax break on exports worth $4 billion annually.

The European Union (EU) had claimed the tax break was a subsidy prohibited under the General Agreement on Tariffs and Trade (GATT), the treaty that governs world trade and the operations of the WTO. If enacted, the revisions to the U.S. tax code may finally settle the dispute, but the case raises compelling questions about the role of the WTO in domestic legislation and the functioning of the WTO dispute resolution system.

The dispute centers on a long-standing difference between the corporate tax systems of the United States and of European countries. Since the early 1960s, the United States has taxed world-wide income of U.S. corporations—that is, income on revenue of foreign subsidiaries as well as of U.S.-based operations.

European countries, however, have applied only a territorial tax—that is, a tax on revenue derived only from European-based operations. The United States, therefore, created the Domestic International Sales Corporation (DISC) provision in its tax code in the early 1970s, which deferred tax collection on U.S. corporations’ foreign operations, to lighten what it felt was an unfair burden on those corporations compared to their European competitors.

European governments considered the DISC a form of export subsidy because, they said, it encouraged companies to sell abroad through foreign subsidiaries to take advantage of the tax deferral, and so they challenged it in the GATT dispute resolution process (a precursor to the WTO). The case was resolved by a gentleman’s agreement hammered out in the early 1980s during the Tokyo Round of trade negotiations. The agreement allowed the United States to create a modified tax break, called the Foreign Sales Corporation (FSC), through which to grant tax relief to exporting companies, in exchange for dropping a challenge to the legitimacy of Europe’s value-added tax (VAT) system. This system provided that goods that are sold within a European country are subject to a tax, but not those sold to someone outside the country—effectively a tax exemption for exports and, thus, an export subsidy.

This agreement held until 1998. The EU, exasperated by the United States’ successful WTO suits against the EU’s banana import program, which benefited exporters in former European colonies in the Mediterranean at the expense of Central American nations, and against the EU’s ban on beef from cattle fed with growth hormones, challenged the FSC in the WTO.

Since the FSC did, technically, violate the WTO’s Agreement on Subsidies and Countervailing Measures (SCM) , the WTO ruled against the United States both at the first and appeals level , dismissing the gentlemen’s agreement as having no legal force. The United States, however, could not challenge the VAT system as an export subsidy because of a well-established distinction between direct taxes on revenue, such as an income tax, and indirect taxes on revenue, such as the transaction-based VAT.

To comply with the WTO ruling, the United States repealed the FSC provision but enacted a new provision called the Extraterritorial Income (ETI) provision . The ETI changed the FSC in two ways. First, while the FSC only applied to exports of U.S.-made items, ETI benefits applied to property manufactured both in and outside of the United Sates (though foreign-made property has to meet a series of standards to be eligible for the tax exemption). Second, non-U.S. corporations were also entitled to claim benefits under the ETI regime if they elected to be treated as domestic corporations for other tax purposes.

The creation of the ETI did not end the dispute, however. The EU brought a new WTO challenge because the United States had created a transition period for implementation of the ETI during which the FSC was still to remain effective, more companies would actually benefit under the ETI changes, and ETI would still function as an export subsidy because the benefit was contingent on exporting. To the disappointment of the United States, the WTO ruled again in favor of the EU in February 2002

The U.S. Treasury and Congress have now proposed 20 changes to the U.S. tax code that eliminate the export benefits of the FSC/ETI entirely, but attempt to benefit U.S. corporations by simplifying provisions of the code governing treatment of foreign income.

At the same time, the proposal would eliminate favorable tax treatment for American subsidiaries of foreign corporations so that American companies are not competitively disadvantaged by the loss of the FSC/ETI tax break.

Nevertheless, the proposed changes have angered many U.S. corporations who will lose the benefit and have created concerns that American corporations may shift production overseas. Furthermore, both American and European critics have said that ending favorable tax treatment for foreign firms may discourage foreign investment in the United States.

This case raises several compelling questions about the integration of the world’s economies and the role of international regulatory bodies in settling disputes over that integration.

First, the nature of the dispute highlights important features of the interconnectedness of transnational business relations. At the basic level, the dispute centered on the effects of countries’ tax systems on the competitive position of their corporations vis-à-vis foreign corporations. Furthermore, as reactions to the proposed changes have shown, changes in tax policy may have significant effects on trade and investment flows.

Second, the handling of the dispute by the parties demonstrates the interconnectedness, too, of trade disputes in general. As noted above, the FSC case arose again because of European resentment at aggressive U.S. prosecution of other trade cases. In fact, the FSC case has been called “Sir Leon’s Revenge,” after Sir Leon Brittan, the European trade commissioner at the time the EU brought the WTO challenge. Likewise, now that the case has come close to resolution with the proposed U.S. tax changes, both the EU and the United States have explicitly linked that resolution to yet another trade dispute—the U.S. imposition of tariffs on steel.

The United States suggested, for example, that the FSC/ETI changes could work alongside a deal for the United States to leaven the steel tariffs through generous use of exemptions of certain products if the EU delayed its retaliation for those tariffs–so long as the EU did not simultaneously retaliate for FSC/ETI.

The question, however, is whether such linkages are appropriate and what they mean for the goal of having a more rules-based world trading system, as opposed to a diplomatic, deal-making system in which interests are bargained over and the results of trade litigation are viewed less as binding decisions than as more ammunition for one side to use in a dispute. The seems to be the trend—with the bananas and beef hormones cases less important for their legal impact than for their effects on diplomatic relations.

Having said that, the case does demonstrate, however, a third important impact of globalization—the power of the international institutions to force change in domestic policy through determinations based on international treaties. The United States complied with the WTO’s rulings, providing an important example of U.S. adherence to international, multilateral decisions at a time when it is often accused of unilateralism.

But the WTO’s influence may also have a downside for several reasons. Critics of the WTO’s role in this case point to what they say was poor legal reasoning, particularly its reluctance to acknowledge the importance of the gentlemen’s agreement that had settled the dispute earlier.

In addition, critics wondered whether the WTO was risking becoming not a trade court but a “world tax court” if countries began challenging each other’s tax systems. In fact, if such challenges were to become common, then the credibility of the WTO might decline if its rulings were considered too intrusive or unfounded. In other words, the WTO risks overreaching—beyond its competence and beyond its mandate.

In the end, all these effects are deeply connected and the FSC/ETI case reveals the paradoxes of globalization. International tribunes have gained more power to change domestic policy, at a time of increasing influence of domestic policy on international business relations. The decisions of those tribunals are supposed to be made on agreed legal norms enshrined in treaties as a way to provide predictability and neutral interpretation so that governments and business can make informed policy choices, but the supposedly law-based decisions of tribunals are then subject to diplomatic horse-trading. Finally, the future effectiveness of those tribunals is subject to broader political limits on what their political masters—the countries that created them—will tolerate.

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