Avoiding a nuclear trade war: strategies for retaining tax incentives for U.S. corporations in a post-FSC world.

• Author: Von Hoff, Carrie Anne
• Position: Foreign Sales Corporation Act

ABSTRACT

On January 14, 2002, the World Trade Organization (WTO) Appellate Body affirmed that the FSC Repeal and Extraterritorial Income (ETI) Exclusion Act, a replacement for the Foreign Sales Corporation (FSC) Act, was an unlawful export subsidy under WTO agreements. Though the European Union has indicated a willingness to wait before imposing the largest trade sanctions in the history of the WTO, it insists that the United States comply with the ruling. This Note explores the history of the conflict and consider possibilities for the future of international trade taxation.

This Note first examines the background to the conflict, beginning with the General Agreement on Tariffs and Trade conflict over domestic international sales corporations (DISCs). After years of haggling, the United States replaced DISCs with FSCs in 1986. Following many years without dispute over the issue of how the United States would tax its imports, the European Union challenged the FSC system in 1997 and prevailed before the WTO Panel.

This Note then examines the two most recent decisions regarding the FSC-ETI laws. The WTO Panel and Appellate Body have both concluded that the laws are impermissible because they constitute a foregoing of revenue otherwise due to the government that was based on export performance. Both bodies also rejected the defense that the laws are permissible because they help companies avoid double taxation.

The length of the dispute and the high financial stakes have made this battle particularly bitter. Further, the impact on trade and the U.S. economy would be enormous, which has furthered the tensions between the parties. The European Union has said it may forego the sanctions altogether if the United States complies with the WTO ruling. The United States should not test the European Union by refusing to comply. Still, the United States justifiably has serious concerns about bending to the will of the WTO and changing its preference on taxation systems based on a Geneva edict. In light of these concerns, this Note concludes by exploring potential solutions for the problem and recommending one course for changing U.S. law. This option will maintain competitiveness and national sovereignty, and still meet international obligations. This Note advocates adopting an excise tax system on exported products to maintain the tax system that the United States has chosen while complying with the WTO mandate.

1. INTRODUCTION

   On August 20, 2001, the World Trade Organization (WTO) decided a two-year battle between the European Union and the United States by declaring that the FSC Repeal and Extraterritorial Income Exclusion Act of 2000 (hereinafter EIEA or Replacement Law), a U.S. law allowing U.S. companies to receive a tax break through foreign sales corporations (FSCs), was an impermissible subsidy on exports. (1) Consequently, the WTO has authorized the European Union to impose four billion dollars in trade sanctions on the United States in response. (2) The United States claimed that the sanctions, if imposed, should be worth about $956 million (3) but no more than $1.1 billion. The United States contended that the figure endorsed by the European Union was "somewhat high." (4) The European Union countered that the amount it requested was "rather conservative." (5) On August 30, 2002, the WTO accepted the EU's proposed amount and authorized four billion dollars in sanctions. (6) These sanctions would not be exercised to force corporations that received the benefit to make payments to the European Union; rather, the sanctions would serve as reprisals against any U.S. industries that the European Union may choose. (7) The European Union plans to delay sanctions as of now but has reserved the right to impose them at a later date, choosing to exact the punishment on industries such as agriculture and machinery. (8) The United States decided to appeal the decision, hoping that the WTO Ruling Panel would reverse the Appellate Body's decision and save the tax scheme used by many U.S. corporations. (9) The Panel affirmed the decision that the tax plan was illegal on January 14, 2002, and compliance is now the key issue in the long battle. (10)

   There is still hope for corporations to receive tax benefits for their export operations. While the United States may not wish to go through another round of revisions, (11) the elimination of the FSC Replacement Law provides an opportunity for the United States to undertake full-scale reform of portions of the tax code that affect trade. (12) The Replacement Law contained flaws that made it more objectionable to international trade organizations than the original law. (13) The key objective is to "prevent the development of an international double standard that will disadvantage the United States and, in the end, cripple the WTO." (14) With careful revisions, the U.S. Congress can retain the tax incentives for domestic corporations operating abroad while appeasing the European Union and the WTO.

   The United States, in dealing with the FSC problem, cannot afford to suffer the potential consequences of non-compliance, nor can it depend on amicable negotiations. Rather, it is crucial that the United States devise a tax plan that will safeguard the interests of U.S. corporations while mollifying the European Union. These interests must be balanced with sovereignty concerns, requirements of the WTO agreements, and worries about future challenges to laws affecting international trade--both those to be brought by the United States and those to be brought against the United States. Given President Bush's decision this year to impose tariffs on steel, (15) causing a major stir in the European Union, (16) the United States must make every effort to allay the fears of EU leaders and come into compliance with the WTO decision. The implications of this conflict cannot be taken lightly, especially in a time of war and economic uncertainty. If mishandled or ignored, the squabble over FSCs could erupt into an entirely different kind of battle. (17)

   This Note examines the background of the tax scheme, from the inception of the domestic international sales corporation (DISC) to the ultimate legislation embodied in the 2000 Replacement Law that allowed for the tax exemption on extraterritorial income. It then considers the impact of the WTO decision on foreign trade and on competition abroad. It also evaluates the implications of potential reprisal by the European Union. Finally, this Note analyzes several proposals for retaining the tax benefits in the post-FSC world to ensure competitiveness of U.S. exports, compliance with the WTO decision specifically and international obligations generally, and preservation of national sovereignty with respect to U.S. choices regarding taxation of its citizens.

2. BACKGROUND OF CONFLICT--THE FSC-ETI CHALLENGES

   While the U.S. government taxes the foreign income of its taxpayers, the European Union does not. (18) To offset this disadvantage and maintain the competitiveness of its products in the global market, the U.S. government developed the foreign sales corporation (FSC) to provide tax benefits for corporations operating abroad. (19) The stated purpose of the FSC was to "promote exports" of the goods of the parent company. (20) Small exporters and large corporations alike used FSCs for tax purposes. (21) Popular locations for these companies were Caribbean countries, such as Bermuda. (22) The parent corporation sold the product to be exported to the FSC, who sold the product to the purchaser. (23) The FSC, however, contracted the shipping of the product out to the parent corporation. (24) U.S. corporations benefited from the FSC scheme. (25) In 2000, for example, Boeing saved $291 million in taxes through its offshore company. (26) General Electric saved $746 million; Motorola saved $378 million from 1991 to 1998. (27) The rebates were also important to many chemical companies. (28)

   The European Union challenged the legislation before the WTO in 1998. (29) It characterized the competitive disadvantage suffered by the United States as "an internal problem." (30) There is much speculation, though, that the European Union was merely avenging its losses in other WTO rulings. (31) In March 2000, the WTO Ruling Panel ordered that the United States withdraw the FSC subsidies by October 1, 2000. (32) The deadline was extended to November 1, 2000. (33) On November 15, Congress passed the EIEA. (34) Lawmakers in the United States described it as "a ringing endorsement in favor of promoting free trade." (35)

   The European Union, however, was not as pleased with the results. In early December 2000, the European Union requested review of the new legislation, citing a "disagreement as to the existence or consistency with a covered agreement of measures taken to comply with the recommendations and rulings" of the WTO Ruling Panel. (36) The Panel found that the tax scheme was a financial contribution that conferred a benefit that is based on export performance as prohibited by Article 3.1(a) of the Agreement on Subsidies and Countervailing Measures (SCM). (37) Before the WTO decision on FSCs is analyzed, an overview of the origin and development of FSCs is necessary.

3. CHANGES IN TRADE TAX LAW--DISCS, FSCS, AND ETI

   The taxation scheme on FSCs differs substantially from the normal U.S. tax system. Usually, U.S. taxpayers are taxed on all income, regardless of the source. (38) The United States gives taxing rights to foreign countries from which foreign income is obtained. (39) From this, a double taxation potentially arises because of different tax laws in different countries. (40) The FSC provision was designed to alleviate this problem. (41) The FSCs were designed to "promote the export of their parent U.S. company's products and services," but are actually more like paper companies that "book profits from overseas sales." (42)

   The original law at issue set forth a...