by Chakravarthi Raghavan

Geneva, 25 Feb 2000 -- The ruling by the Appellate Body of the World Trade Organization that the US Foreign Sales Corporation (FSC) Law provides US corporations prohibited subsidies for their exports and must be changed, not only puts the United States on the spot but has the potential to damage further the credibility of the WTO and mobilise civil society against any expansion of WTO's remit.

The US administration, under the Uruguay Round implementation law, is obliged to provide an assessment to Congress by 1 March, of the benefits (and costs) to the US from the membership of the WTO. And there is an automatic trigger process, by which Congress could vote to take the US out of the WTO, and a Presidential veto could be overridden. The US is the biggest beneficiary from the WTO. Nevertheless US public opinion, some senescent industries (like steel, textiles and clothing) as also organized labour and environmental lobbies, are ranged against it.

Now the US corporate defenders will be on the spot - whether to campaign and mobilise Congress in favour of the largesse (and thus strengthen the fight against the WTO) or give up their subsidies.

The WTO Appellate Body handed down on Thursday its ruling, upholding the report and findings of a three-member panel issued last October. That panel had found that the FSC law provides prohibited subsidies to US exporters channelling exports with 50 percent US local content, through off-shore shell companies. The tax break, which amounts to taxes foregone that, but for the FSC law, would have been payable, was held to be a prohibited subsidy and thus violative of the WTO Agreement on Subsidies and Countervailing Measures (SCM) and the Agreement on Agriculture (AoA). The panel gave the US time till 1 October 2000 (the start of the US fiscal year 2001) to change its laws and bring them into compliance with WTO obligations.

In the case of 'prohibited subsidies' Article 4.7 of the SCM agreement, requires panels to ask the subsidizing member to withdraw the subsidy "without delay" and specify the time period within which the measure must be withdrawn.

But unlike in two recent cases (against Australia and Brazil), where the offending parties got less time to comply with their obligations under the SCM, and in addition were required to retroactively recover the subsidies paid in the past, the US has been dealt with more considerately. It has been given a longer time to comply, and need not recover past illegal subsidies.

The three-members of the appellate body who heard and gave the ruling were: Mr.Julio Lacarte-Muro of Uruguay, Mr.Florentino Feliciano of the Philippines and Mr. James Bachus of the United States.

In its findings and conclusions, the Appellate Body ruled:

* that the FSC measure constitutes a prohibited export subsidy under Art.3.1(a) of the SCM Agreement;

* that the US acted inconsistently with its obligations under Art.10.1 and 8 of the AoA by applying export subsidies, through the FSC measure, in a manner which results in, or threatens to lead to, circumvention of its export subsidy commitments for both scheduled and unscheduled agricultural products.

The Appellate Body reversed the panel ruling that the FSC measures involve provision of subsidies to reduce the costs of marketing exports. It however declined to examine other findings of the panel.

The EC has estimated from US budget documents that the FSC law aids some $250 billion worth of annual exports, and costs the US tax-payers three to four billion dollars.

Some US corporate giants like Microsoft, Boeing, General Motors and General Electric have been benefiting from this largesse.

And while much of the export subsidy benefits have gone to the US industrial sector, the ruling that there has also been violation by the US of its obligations on export subsidies under the Agreement on Agriculture, comes as a boost of sorts to the EC, whose common agricultural policies provide large export subsidy benefits to its farm sector and also shields its from foreign import competition.

The US corporate giants benefiting from the FSC handouts include those who hold dominant market positions (as oligopolies or virtual monopolies), and whose intellectual property rights protected by the WTO's TRIPs agreement, prevent any competition.

Given the powerful US corporations benefiting from this largesse, and their influential lobbies (through corporate election funding) in the administration and Congress, it would be difficult enough for the US to comply with the ruling and change its laws, even normally.

But it will be more difficult in a US Presidential election year.

The US could try and reach a bilateral accord with the EC, by agreeing to provide compensation (something foreseen in the WTO dispute settlement understanding) including withdrawal of its own sanctions (about $300 million on the banana issue) against the EC over the banana and beef-hormone disputes.

Or, the US could defy the WTO, and invite the EC to retaliate. Or, it could adopt some changes in law that would still not be in compliance, and force the EC to have recourse to reconvening the original panel to assess US compliance, and then seek WTO permission to retaliate, to the extent of trade damage suffered by the US (which could prove to be much less than 3-4 billion estimated illegal subsidy)

But any of these courses would cost the US and EC dear.

While in this dispute, the EC is the only complainant (with Japan and Canada as interested parties in the proceedings) and thus could cut a deal with the US to settle this and other outstanding US-EC disputes, the FSC law (and not merely measures under it) having been ruled to be a violation of the US WTO obligations, any other member of the WTO could raise a new dispute, though a costly process.

Any bilateral accord that enables the US to keep the FSC law as it is or have one with some cosmetic changes but continuing the subsidy programme, will fuel further the rising opposition in the developing world - from their domestic enterprises, activist non-governmental organizations, and parliamentarians - who already see the WTO system as weighted against them and full of asymmetries and imbalances that prevent them, for e.g. to help their exporters overcome 'market failures' and 'disadvantages' in their export markets, while the industrial world can use a variety of permitted subsidies.

At the minimum it would put developing country governments, and their trade ministries, in more difficulties in trying to persuade their parliaments and business sectors, to agree to take on more obligations through a new round of negotiations.

US Treasury Secretary, Mr. Lawrence Summers and the US Trade Representative, Mrs.Charlene Barshefsky, have made clear that they would seek a solution (to comply with the WTO) to ensure that US workers and corporations are not at a competitive disadvantage.

The EC, which initiated the complaint in pique against losing two high profile cases to the US (the banana and beef-hormone disputes), while glad it has won the case, has been somewhat low-key and guarded in comments, saying it was for the US to make the next move on how it would comply.

The EC Commissioner Pascal Lamy in comments in Brussels said the FSC scheme has had "a major negative effect on international trade to the detriment of EC companies."

The US has a tax regime based on world-wide income of its citizens or other residents, while the EC and most other countries of the world follow the territorial principle of taxation. This last enables the EC or other countries to provide tax relief from consumption taxes applicable on the domestic market (value-added-tax or sales tax etc) from the exports. The US arguing that this places its corporations at a disadvantage has been providing tax credits from direct taxes in respect of income earned from exports. The history of this dispute goes back to two decades.

The EC raised a dispute in the old GATT over the US law, Domestic International Sales Corporations (DISC) law that provided tax-credits and benefits to US corporations on their foreign sales. In turn the US challenged the laws and practices of four EC members. The panels, consisting of the same persons, held the DISC law illegal, and also some tax provisions of the EC member states.

Both sides blocked adoption. In 1979 a subsidies code under the Tokyo Round was adopted, and in 1981, the two sides allowed the panel rulings to be adopted, and as a part of the adoption there was also an understanding.

In pursuance of all this, the US changed its DISC law and enacted the FSC laws - which are really offshore shell corporations (mostly incorporated in Virgin Islands, Guam and Barbados), which at best had a room and a fax machine to receive and send out messages. Such offshore corporations can be set up for as little as an annual fee of $2000 and are so advertised on the internet.

Under the FSC laws, these offshore corporations, wholly owned by the US corporations, get more favourable tax treatment for products exported and containing no more than 50% in value of imports. And unlike the US tax code's 'arms length' relationship requirements for such parent-subsidiary transactions, the FSC law companies can have administrative pricing. The favourable tax treatments give benefits of between 15 to 30 percent of the foreign trade income to the parent.

The FSC law divides the foreign source income of an FSC into 'foreign trade income' and all other foreign source income, which may include investment income and income from patents, licensing etc. The foreign trade income of an FSC is divided into exempt foreign trade income and non-exempt foreign trade income.

In the US the foreign source income of a foreign corporation is taxable to the extent of its being effectively connected to a trade or business conducted in the US. This is to be ascertained by a factual inquiry by the US tax authorities. In the case of an FSC, the exempt portion is set by the law, and thus not subject to any factual inquiry by the US tax authority.

Unlike in normal cases where the income earned by a foreign corporation controlled by a US corporation is taxed on repatriation, but requires the parent corporation or shareholder to include in gross income a pro-rata share of the undistributed foreign income, the parent of an FSC is not required to declare its pro-rata share.

The dividends received by the US corporation from foreign corporations and from an FSC corporation are also treated differently. Under the FSC law the US parent corporation is generally not taxed on dividends received that are derived from the foreign trade income of the FSC. All these benefits are dependent on exports and the exported products having no more than 50 percent of fair market value as imports.

The US in its arguments before the panel, and the appellate body, tried to inject into the WTO agreement, including the SCM agreement (which for the first time defines a subsidy) the 1981 understanding in the GATT Council at the time of the adoption of the panel rulings on the DISC law and the EC laws.

Both the panel and the Appellate Body turned down this attempt, and ruled that FSC tax exemptions involve subsidies continent upon export performance and which are prohibited under Art.3.1.(a) of the SCM agreement.

The panel had held that the tax credits or exemptions, which the corporations concerned would otherwise have had to pay under the US tax regime (but for the FSC law) also provided a marketing subsidy for marketing agricultural products, and thus subject to a reduction commitment in terms of Art.9.1(d) of the AoA, and thus violative of Art. 3.3 of the AoA (which provides for a ceiling on export subsidies and subjects them to a reduction).

Having agreed with the panel that the FSC measures involve a subsidy contingent upon exports, in terms of the SCM agreement, the appellate body also agreed that it was also a subsidy contingent upon export performance under the AoA.

The Appellate Body also held that the FSC measure creates a legal entitlement for the recipients to receive export subsidies, not listed in Art.9.1 of the AoA, with respect to agricultural products - both those scheduled in the schedule of commitments, and those not scheduled. The legal entitlement accrues to the recipient when it complies with statutory requirements of the FSC, and at that point the US government must grant the FSC a tax exemption, and there is no discretionary element vested with the government.

In respect of the unscheduled agricultural products, where members are prohibited under Art 3.3 from providing export subsidies (listed in Art.9.1), and prevented by Art 101. from using such subsides that "results in or threatens to lead, to circumvention", the appellate body held that the FSC law involved application of export subsidies, not listed in Art.9.1 in a manner that at the least it "threatens to lead to circumvention".

The Appellate Body added: "Thus we conclude that the FSC subsidies are applied in a manner that, at the very least, threatens to lead to, circumvention of the export subsidy commitments made by the US, under the first clause of Art 3.3, with respect to scheduled agricultural products."

In this light, the Appellate Body reversed the panel finding that FSC measures involved export subsidies listed in Art.9.1.(d) of the AoA. It however held that the US had acted inconsistently with its obligations under Art.10.1 of the AoA by applying export subsidies, with respect to both scheduled and unscheduled agricultural products, in a manner that at the very least threatens to circumvent its export subsidy commitments under Art.3.3 of the AoA. It also held that by providing export subsidies inconsistent with Art 10.1 of the AoA, the US had acted inconsistently with its obligations under Art.8 of the AoA.

In handing down the ruling, the appellate body stressed that its ruling related only to the FSC and not a judgement on the consistency or inconsistency with WTO obligations of any other tax measures that may be applied by a WTO member. Nor did it rule that a Member of the WTO must choose one kind of tax system over another to be consistent with WTO obligations, nor a ruling on the relative merits of 'worldwide' and 'territorial' systems of taxation.

"A member of the WTO may choose any kind of tax system it wishes - so long as, in so choosing, that Member applies the system in a way that is consistent with its WTO obligations. Whatever kind of tax system a member chooses, that Member will not be in compliance with WTO obligations if it provides, through its tax system, subsidies contingent upon export performance that are not permitted under the covered agreements.

"By entering into the WTO agreement, each member of the WTO has imposed on itself an obligation to comply with all the terms of that Agreement. This is a ruling that the FSC measure does not comply with all those terms. The FSC measure creates a 'subsidy' because it creates a 'benefit' by means of a 'financial contribution', in that government revenue is foregone that is 'otherwise due'. This 'subsidy' is a 'prohibited export subsidy' under the SCM Agreement because it is contingent upon export performance. It is also an export subsidy that is inconsistent with the Agreement on Agriculture.

"Therefore the FSC measure is not consistent with the WTO obligations of the United States. Beyond this, we do not rule." (SUNS4615)

The above article first appeared  in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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