The ETI dispute: an opportunity to include an ongoing case study in the AICPA MTC.

• Author: Bradley, Wray E.
• Position: Extraterritorial income - American Institute of Certified Public Accountants Model Tax Curriculum

Tax educators continue to develop and refine courses specifically designed for the AICPA Model Tax Curriculum (MTC). From a teaching standpoint, capturing student interest and enabling students to be better informed about media-reported tax events may be even more important than trying to cover a variety of technical tax topics. Increasingly in MTC courses, tax educators are using case studies to do just this.

Instructors have the opportunity to develop a case study on the ongoing World Trade Organization (WTO) dispute concerning extraterritorial income (ETI).This dispute can add an international flavor to a tax course and provide a way to introduce basic MTC topics, such as legislative process, source of tax law, double taxation, interrelationships among taxing authorities and multi-jurisdictional taxation.

Students and practitioners alike are very interested in international tax policy discussions in the media. The WTO/ETI dispute continues to have wide media coverage. The characteristics of the dispute allow an instructor to adapt the level of coverage to a first- or second-level course, or to a graduate tax class.

Background

Prior to the 1960s, the income of U.S. multinational corporations' foreign subsidiaries was totally free from U.S. income tax, as long as the income was not repatriated. During the 1950s, many U.S. multinationals took advantage of this situation and moved operations to offshore tax havens. Typically, a U.S. manufacturer formed a foreign subsidiary (foreign-base company) in a tax-haven country with limited manufacturing resources. The subsidiary's manufacturing operations took place in the U.S. or in a foreign country with substantial manufacturing resources. The U.S. parent sold manufactured products to the subsidiary at a small markup. The subsidiary then fully marked up the products and sold them to customers. In many cases, this was merely a paper transaction; the goods were actually made in (and shipped from) U.S. plants.

Congress largely ignored these offshore foreign-base-company operations, until the U.S. began to experience declines in gross domestic product growth and deficits in the Federal budget. To raise revenue, the Kennedy Administration introduced a proposal to tax U.S. foreign-subsidiary income when earned, instead of when repatriated. Many in Congress opposed this; they thought that U.S. foreign-base companies would end up paying higher overall taxes than their foreign competitors located in the same foreign country. Eventually, in 1962, Congress passed laws governing controlled foreign corporations (CFCs).

CFC rules. CFC rules impose tax on certain types of "tainted" income generated by a U.S. controlled foreign-base company, including passive income and, generally, any business income from profit-shifting strategies. Almost immediately after enactment, several U.S. multinational manufacturers shifted all of their manufacturing operations to foreign companies that did not qualify as controlled subsidiary foreign-base companies. Because these foreign companies were not CFCs, their income was not subject to the CFC rules.

DISC rules. In 1971, in response to losing manufacturing jobs to overseas companies and to address the increasing international trade deficit, Congress enacted legislation specifically designed to promote exporting and keep U.S. manufacturing plants at home. The domestic international salts corporation (DISC) provisions, in effect, exempted certain export-related income from corporate taxation. The rules allow a U.S. corporation to create a separate U.S. corporation (a DISC) that can act as either a buyer, seller or sales agent for the original U.S. corporation's export products.

The DISC is not subject to direct U.S. corporate tax if, each year, its shareholders recognize part of the DISC income as constructive dividends. The recognition of the remaining DISC income is deferred, for Federal tax purposes, until the income is actually distributed or the DISC stock is sold. Thus, export income is partially taxed and partially deferred at the shareholder level each year. The corporation that makes and ships the export product never directly pays tax on income from qualified DISC export sales.

Almost immediately, the DISC rules created international trade controversy. In 1972, the European Economic Community (EEC) (comprised of Belgium, France and the Netherlands) lodged a formal complaint with the General Agreement on Tariffs and Trade (GATT) organization, alleging that the DISC rules violated a GATT rule prohibiting subsidies of products sold in foreign markets.

In 1973, the U.S. responded by filing counter-complaints against Belgium, France and the Netherlands. Under the territorial taxation schemes of the three countries, export income of domestic corporations' foreign branches or foreign subsidiaries was not generally taxed. The U.S. alleged that these...