An analysis of foreign sales corporations and the European Communities' four billion-dollar retaliation.

• Author: Shallue, James Joseph

1. INTRODUCTION

   Located in Geneva, Switzerland, the World Trade Organization (1) is comprised of over 140 members. (2) Since its inception in 1994, (3) the WTO has provided its members a forum for trade negotiations and disputes. (4) Through the use of this dispute resolution process, the WTO's ultimate goal is to ensure free trade and fair pricing throughout the world. (5)

   Disputes in the WTO currently range from the European Communities' dispute with India over anti-dumping violations (6) to violations of Chilean alcohol taxation. (7) One dispute currently before the WTO is particularly important because it involves over four billion dollars in compensatory measures. (8)

   In a dispute entitled the "United States: Tax Treatment for Foreign Sales Corporations," (9) the European Communities allege that the Unites States is illegally subsidizing exporters through the use of the Internal Revenue Code, (10) in violation of its WTO obligations, (11) The United States counters that the Code's provisions are not subsidies, and that its tax legislation is currently meeting all WTO obligations. (12)

   This dispute is the culmination of a long and heated battle between the United States and the European Communities over the exact definition of the term subsidy. A subsidy can generally be defined as a "non-tariff measures utilized by governments either to inhibit imports (so-called 'domestic subsidies') or to enhance exports (so-called 'export subsidies'). Subsidies typically constitute direct or indirect economic benefits granted by governments to an industry or group of industries." (13) The United States and the European Communities, however, vehemently disagree over an exact definition of the term subsidy.

   This disagreement, currently in its fourth decade, began in 1971 with the advent of Domestic International Sales Corporations (DISCs). (14) At the time, American corporations were losing the export battle because double taxation and value added taxation caused their prices to be much higher than those of their foreign competition. (15) In order to be competitive abroad, DISCs were developed so that American exporters could lower their overall prices. This was accomplished by deferring part of their tax liability through the use of a tax-free commission. Because exporters had lower tax liabilities through the use of DISCs, they could lower their prices and still maintain the same profit margins. These lower prices on exports eventually translated into a more competitive environment between American and foreign corporations.

   Foreign countries affected by DISCs, however, felt that they were an illegal subsidy rather than a tax deferral. The United States argued that because DISCs mirrored territorial and value added taxation systems, they could not be considered subsidies. Eventually, under the General Agreement on Tariffs and Trade, (16) DISCs were held to be subsidies.

   In 1984, because DISCs could no longer be used as intended, the United States implemented the Foreign Sales Corporation (FSC) as a vehicle to increase competition between American and foreign corporations. (17) Unlike a DISC, a FSC was designed to be a foreign corporation that operated on a dividend-basis with its domestic parent corporation. The United States felt that FSCs complied with GATT, and were not an illegal subsidy because they mirrored territorial and value added taxation systems used by others in Europe and throughout the world.

   Many foreign countries, however, argued that FSCs, like DISCs before them, were an illegal subsidy under GATT and other international trade agreements, including the Agreement on Subsidies and Countervailing Measures (18) and the Agreement on Agriculture. (19) These foreign countries, now formally known as the European Communities, again argued that FSCs provided an illegal subsidy rather than a tax deferral. They also argued that because FSCs were export-contingent, they were also an illegal subsidy under various other WTO agreements. The newly formed WTO agreed, effectively terminating the FSC method of taxation. (20)

   Still in need of a vehicle to facilitate competition between American and foreign corporations, the United States enacted its current method of taxation called Extraterritorial Income (ETI) in 2000. (21) Unlike the previous methods of taxation, ETI allows both domestic and foreign corporations to take advantage of its tax benefits. This distinction between ETI and FSCs, the United States feels, should placate the European Communities' previous arguments regarding illegal subsidies because this system is not export-contingent.

   Unfortunately, the WTO disagreed. On August 20, 2001, the WTO held that ETI was in violation of the Agreement on Subsidies and Countervailing Measures and the Agreement on Agriculture because it was, in fact, export-contingent. (22) This ruling was recently upheld by the WTO's Appellate Body. (23) In addition to these rulings, the WTO also allowed the European Communities to commence with four billion dollars in retaliation against the United States, equal to the savings afforded American exporters under FSCs. (24)

   This ruling, however, does not mean that there is a consensus on the exact definition of the term subsidy. The United States, being consistent with its argument throughout, feels that if the exact definition of a subsidy is simply a deferral of taxation, as the European Communities argue, then many other countries are also illegally subsidizing their exporters. (25) These other countries forego taxation on income by using value added taxation, a territorial taxation system, or a combination of those systems. The WTO and the European Communities argue that a subsidy is present when a country foregoes taxation on income because of the income's export nature. (26)

   To understand this lack of consensus on an exact definition of a subsidy, this article will first provide background into various aspects of the international trade community and how these aspects affect the current dispute over the term. Specifically, Part II of this article will analyze the mechanics of the WTO dispute resolution process, and how countries settle trade issues. Part III will then discuss the evolution of GATT, the WTO, and various agreements signed by the United States defining subsidies. Part IV will compare and contrast the different methods of taxation in Europe and the United States. Next, this article will examine the heart of the current disagreement over the term subsidy. Part V will look at the evolution of American taxation methods from the advent of Subpart F (27) to the FSC Repeal Act and Extraterritorial Income Exclusion Act of 2000 (ETI). (28) It will also analyze the arguments made by the European Communities and United States to the WTO on each taxation method. Part VI will discuss the different options for the United States regarding compliance with its WTO obligations. Finally, Part VII will analyze the disparity between the world's tax systems and international obligations in general. This article will conclude that it is necessary to have meetings with European Communities and WTO representatives to address future United States tax legislation specifically, and determine whether this future legislation will be WTO compliant.

2. WTO AND THE DISPUTE RESOLUTION PROCESS (29)

   As previously stated, the WTO attempts to enable free trade through the use of its dispute resolution process. (30) Governed by the Understanding on Rules and Procedures Governing the Settlement of Disputes, (31) this process is divided into five parts, culminating in a binding obligation between the WTO and its members. (32) If the country in violation of WTO agreements cannot comply, or refuses to comply, with this binding obligation, the process allows for compensatory and retaliatory measures against the non-complying country. Each of the five parts of the dispute resolution process is discussed below.

   1. Procedures for Resolving Trade Disputes

      The first step in settling a trade dispute between members of the WTO is a formal consultation. (33) The purpose of this consultation is to set the groundwork for a conclusion to the disagreement. Usually lasting two to three hours, (34) it allows for confidential discussions about the trade dispute. (35) If the countries are having difficulty reaching an agreement, they can request a WTO mediator to facilitate the discussion. (36)

      The majority of disputes that reach the consultation stage are resolved within a couple of months. (37) Some are settled for practical reasons, while others are settled on the merits of the case. (38) If the parties cannot settle the disagreement within sixty days of the consultation, the complaining party has the right to request a Panel from the Dispute Settlement Body to resolve the dispute. (39)

      The Panel is comprised of three to five experts in the field of the dispute. (40) Independent from the countries in disagreement, the Panel's members are well-qualified government and/or non-government individuals. Many of these individuals have taught or published in the field of international trade law or policy, or served as senior trade policy officials for a WTO member. (41)

      The Panel first hears the dispute between the disagreeing countries, making an objective assessment of the matter before it. (42) This includes receiving briefs from each party, and also hearing oral arguments, similar to opponents in an American court. The Panel concludes its debate, and issues a preliminary report within six months. (43)

      The Panel then files its preliminary report with findings and recommendations with the Dispute Settlement Body for approval. (44) This report is privately circulated among the body's members for review. (45) Eventually, the Panel will publicly release its report. In the interim period between private circulation and public release, the Panel does have the right to reconsider its findings and decision on the matter...