US corporate export tax breaks held illegal again

A US law branded a corporate gravy train for granting businesses generous tax exemptions has been deemed to be in violation of multilateral trade rules by a WTO tribunal. The ruling thus allows the European Union, which had brought the case before the WTO, to impose retaliatory trade sanctions against the US in the latest in a series of recent commercial disputes between the two trading powers.

by Chakravarthi Raghavan

GENEVA: The WTO Appellate Body (AB) on 14 January handed down a ruling holding the United States to be in continued violation of WTO rules in providing prohibited export subsidies to its corporations, thus clearing the way for the European Union to impose trade sanctions against the US.

The US law in question has been held violative of the Agreement on Subsidies and Countervailing Measures (SCM), the Agreement on Agriculture (AoA), and the GATT (General Agreement on Tariffs and Trade) and GATS (General Agreement on Trade in Services) provisions for non-discrimination and national treatment between imported and domestic like products. The ruling is quite comprehensive and on the face of it does not seem to leave much leeway for the US.

The ruling was issued by the AB which heard a US appeal against the ruling of a compliance panel that the US had not complied with an earlier panel ruling and recommendations adopted by the Dispute Settlement Body asking the US to withdraw the subsidies.

The European Communities Trade Commissioner Pascal Lamy promptly announced in Brussels that the EC was seeking WTO authority to impose sanctions involving trade damage to the EC of $4 billion annually, sanctions that are automatic, subject only to arbitration on the amount.

Such a large sanction would have at least some immediate impact on trade, and will raise political and economic tensions between the two major trading entities, which have tried to cool their differences in the combined onslaught against the developing world through the new WTO round of trade negotiations.

For his part, the US Trade Representative Robert Zoellick, in a statement from Washington, expressed disappointment with the ruling and underscored its high political sensitivity in Congress.

All financial media reports out of Brussels, however, indicate that Lamy would be likely to go slow and use the ruling to secure an overall compromise over several of the major disputes between the US and the EC - involving steel, genetically modified products and beef hormone.

[Lamy indicated on 16 January that while the EC would, in order to preserve its own WTO “rights”, seek WTO authority to impose retaliatory trade sanctions against the US, it would wait to see how the US administration would comply with the WTO ruling and what roadmap the US would come up with for this purpose.]

However, France has some very strong views. Major EC corporations derive benefits through their subsidiaries operating in or from the US, while some of the EU members (Spain, Netherlands, etc.) have concerns that their own tax laws may be challenged by the US.

Zoellick and Lamy flaunt their personal friendship, and this was very much in evidence at the Doha Ministerial Conference of the WTO, but whether Zoellick’s efforts to ‘help his friend Pascal’ and Lamy’s efforts ‘to help Bob’ get over the problem and reach a settlement would be successful is not so very clear, even as a part of the new round of negotiations (and use of it to change the rules).

One thing, however, is reasonably certain: any agreed changes between the two may again short-change the developing world, which, under the Uruguay Round, found its subsidies outlawed while many of the industrial and agricultural subsidies provided by the industrialized world could be continued.

The original panel ruling on this case, and the time given to the US to comply, was itself a major concession to the US. In similar cases relating to prohibited export subsidies, Australia was asked to recover the past subsidies paid, while Brazil’s efforts (in the dispute with Canada relating to aircraft subsidies) to honour private contracts in which commitments to finance had already been made were turned down.

Under the SCM Agreement, prohibited exported subsidies are to be withdrawn “without delay”, and panels are instructed to set a shorter time limit for compliance.  In this case, the US got time no later than the new financial year beginning 1 October 2000, and this by mutual consent was further extended till November.

However, the major US corporations benefiting from these subsidies (Boeing, General Electric, Microsoft, to name only a few) lobbied the US Congress, and the changes introduced in the law appear to have effectively maintained and in fact have expanded the subsidy. The EC has estimated that the US provided $4 billion worth of subsidies annually to benefit some $250 billion worth of annual exports.

Public interest groups in the US have characterized the law as a “gravy train” for corporations, which lavishly fund both of the country’s major political parties and key congressional figures in soft money for campaigns.

History and background of dispute

The high-profile, long-running dispute over a US subsidy programme under its Foreign Sales Corporation (FSC) law goes back to the 1970s, over a US law (enacted in 1971), the Domestic International Sales Corporation (DISC) Act, which enabled corporations to shield part of their foreign earnings from tax in the US. The US’ tax laws, unlike most other countries’ that follow the territorial principle of taxation, generally tax its residents on their world income, and non-residents on their earnings in the US.

The DISC law, providing a prohibited export subsidy and favouring domestic content, was held illegal by a GATT panel in 1976, and was allowed by the US to be adopted after some delay in 1981. The US changed its law in 1984 and enacted the FSC law, which was challenged in the WTO by the EC. A panel held in 1998 that the FSC law violated WTO rules by giving prohibited export subsidies. The US enacted changes, but these were challenged for non-compliance. The compliance panel, and now the AB, have held that the changes have still not complied with the ruling and continue to violate the rules of the SCM Agreement and the AoA.

The new US law incorporating the changes (the FSC Replacement and Extraterritorial Income Exclusion Act (the ETI Act)) repealed the provisions of the Internal Revenue Code (IRC) relating to the FSC law, prohibiting foreign corporations from electing to be treated as FSCs after 30 September 2000, and for termination of inactive FSCs. However, it created a transition period for certain transactions of existing FSCs, with the repeal of the FSC provisions not to apply to transactions of existing FSCs occurring before 1 January 2002 or those occurring after 31 December 2001, under binding contracts between the FSC and an unrelated person.

Under the amended law, new rules were introduced for exclusion from US tax of certain incomes (the ETI measure), available to US citizens and residents (including natural persons, corporations and partnerships) as also to foreign corporations that elect to be treated for tax purposes as US corporations.

AB judgment

The AB upheld the compliance panel ruling that under the new law, the US did forego revenue that would be otherwise due under its tax code, and this was thus a financial contribution under the SCM Agreement. The AB found that under the amended law too, as under the old law, there was an export contingency to benefit, namely that the subsidy was conditioned upon the requirement that the property produced in the US be used outside the US.

The AB also upheld the panel ruling that on the US claim that it was not a prohibited export subsidy but one provided to avoid double-taxation (a contingency foreseen in footnote 59 of the SCM Agreement), the US had the burden of proving this to be so, and that the US had failed to discharge this.

Under the US law, the amount of “qualifying foreign trade income” (QFTI) to be exempt is calculated at the discretion or choice of the taxpayer using one of three different formulae: one equal to 15% of the net foreign trade income of the taxpayer, the second 1.2% of the foreign trade gross receipts, and the third of income arising out of direct sale by a US corporation of property manufactured by that corporation to an unrelated foreign buyer for use outside the US.

Taking examples cited in the US Congressional House report, the AB said under the 15% rule, if a manufacturer supplies a product to an unrelated distributor in the US, making a $30 profit in an $80 sale, the manufacturer would pay US tax on the entire profit; for the distributor who sells it at a profit abroad of say $20, this would be extraterritorial income and under the 15% rule would be tax-exempt for $3. In a similar transaction, but with manufacturer and distributor as related parties, the manufacturer would be deemed to have foreign source income and $4.5 of his $30 profit would be exempt; the related distributor would still gain tax exemption for $3.  But when the manufacturer exports directly abroad, the entire $50 profit ($30 of the manufacturer and $20 of distributors) would be extraterritorial income and there would be a $7.5 tax exemption.

The difference in tax treatment, the AB says, is revealing, even though the nature and extent of foreign-based activities are identical - with the amount of exempt income from the second and third examples twice as much as in the first case.

There is thus a misallocation of income as between domestic and foreign-source and through the election by the taxpayer of the formula to be used, there is a maximum benefit to the taxpayer from the misallocation.

The AB also found fault with the ETI measure doing away with the foreign economic process requirement for foreign gross trade receipts up to $5 million. A portion of the taxpayer’s income can thus be treated as foreign-source income (and thus tax-exempt) even without proof that any activities have been undertaken outside the US.

Though the US sought to justify this on the ground that the burden of proving would be too much for “small” taxpayers, the AB held that the mere fact that a buyer used the property abroad did not mean that the seller undertook activities in a foreign state, attracting the double-taxation avoidance questions dealt with in footnote 59 of the SCM Agreement.

“Such an interpretation of fn. 59 would in effect allow Members to grant a tax exemption in favour of export-related income on the ground that the export by itself renders the income ‘foreign source’. In our view, this reading would allow Members easily to evade the prohibition on export subsidies in Art. 3.1(a) of the SCM Agreement and render this prohibition meaningless.”

The US law, sought to be justified as intended to deal with double-taxation, did not change the normal double-taxation provisions of the IRC, and a party could claim whichever would be more advantageous to it.

The AB said that under the ETI measure, the taxpayer can obtain tax exemption even for income that is domestic-source income and will not have any foreign tax credits. With no tax credit to surrender, a taxpayer would most likely opt for an exemption under the ETI measure for income that includes domestic-source income. In these circumstances, the measure would operate to provide export subsidies for income earned from domestic activities.

The ETI measure, the AB said, was extremely complex, and viewed as a whole, it would not permit the AB to conclude that it exempts only “foreign-source income”.  Rather, in some situations, it exempts QFTI which is foreign-source income; in others, it exempts QFTI which is not foreign-source, and in yet others it exempts a combination of domestic- and foreign-source income.

If the ETI measure were confined to aspects granting tax exemption for foreign-source income, it would fall within fn 59 (giving Members flexibility to deal with double-taxation issues). But in several respects, the ETI measure provides exemption for domestic-source income. While avoiding double-taxation is not an exact science, and Members must have a degree of flexibility to deal with it, the flexibility under fn. 59 of the SCM Agreement “does not properly extend to allowing Members to adopt allocation rules that systematically result in a tax exemption for income that has no link with a ‘foreign’ state and that would not be regarded as foreign-source under any of the widely accepted principles of taxation we have reviewed.”

Violation of other agreements

The AB held that the ETI measure also reduces the liability of US citizens and residents to pay taxes on income earned from qualifying transactions involving agricultural products, and thus involves subsidies contingent upon export performance under Art. 1© of the AoA.

The AB also upheld the panel ruling that the ETI measure, establishing as one of the conditions for eligibility that no more than 50% of the fair market value of qualifying property be attributable to direct labour performed outside the US, violated Art. III.4 of GATT (which prohibits less favourable treatment to imported products than to products of domestic origin).

If a manufacturer in the US wished to obtain the beneficial tax exemption under the ETI measure, the fair market value rule provided a considerable impetus and, in some circumstances, a requirement for manufacturers to use domestic input products rather than imported ones. As such the rule treated imported products less favourably than domestic products, the AB ruled.

The AB also turned down the US contention that the new law requiring that the repeal of the FSC provisions not apply to transactions before 1 January 2002, or for existing FSCs to continue to use the original measure for transactions pursuant to a binding contract, was permissible.

Underscoring the requirement under the SCM Agreement for the prompt withdrawal of prohibited subsidies, and the panels being required to prescribe a time limit for achieving this, the AB said “we see no basis in Art. 4.7 of the SCM Agreement for extending the time period prescribed for withdrawal of the prohibited subsidies.”

In the Brazilian case, the AB added, it had pointed out that a Member’s obligation to withdraw prohibited subsidies “without delay” is unaffected by contractual obligations that the Member may itself have assumed under municipal law. “Likewise, a Member’s obligation to withdraw prohibited export subsidies, under Art. 4.7 of the SCM Agreement, cannot be affected by contractual obligations which private parties may have assumed inter se in reliance on laws conferring prohibited subsidies.” (SUNS5039)