The United States responds to the WTO FSC decision: Round One and counting.

• Author: Angus, Barbara M.
• Position: World Trade Organization foreign sales corporation provisions

In 1971, the United States enacted the domestic international sales corporation (DISC) provisions. In 1984, the United States repealed the DISC provisions and enacted the foreign sales corporation (FSC) provisions. Now, in 2000, the United States has repealed the FSC provisions and enacted the extraterritorial income exclusion regime.

How did we get here and why? What is the new regime? And where are we likely to go from here?

The WTO Decision and the U.S. Response

The WTO Decision

On March 24, 2000, the World Trade Organization (WTO) Dispute Settlement Body adopted the Report of the Panel, as modified by the Appellate Body, in the dispute regarding the FSC provisions of the U.S. tax law. This marked the culmination of WTO proceedings that had begun on November 17, 1997, when the European Union requested consultations with the United States with respect to the FSC matter. When the consultations failed to resolve the issues, on September 22, 1998, at the request of the European Union, the WTO Dispute Settlement Body formed a panel to make findings.

On October 8, 1999, the panel issued its report, concluding that the FSC provisions constituted a prohibited export subsidy under the WTO Agreement on Subsidies and Countervailing Measures (the "SCM Agreement") and the Agreement on Agriculture. The panel report mandated that this subsidy be withdrawn by October 1, 2000. The United States appealed the decision, and the European Union filed a cross-appeal. On February 24, 2000, the Appellate Body circulated its report upholding, with minor modifications, the findings of the panel.

WTO Panel Findings

To reach the conclusion that the FSC provisions constituted a prohibited export subsidy in violation of the SCM Agreement, the panel had to find both that the provisions constituted a subsidy and that the subsidy was contingent on export performance.(1)

Under the SCM Agreement, a subsidy exists if (i) government revenue otherwise due is forgone and (ii) a benefit is thereby conferred. The panel considered the first question under a "but for" analysis focused on three elements of the FSC provisions: the treatment of FSC income as foreign-source income not effectively connected with a U.S. trade or business, the exemption from subpart F for FSC income, and the 100-percent dividends-received deduction for distributions from a FSC. The panel concluded that these three elements taken together protected from U.S. taxation income that otherwise would be subject to tax and that the FSC provisions thus resulted in revenue forgone through which a benefit was conferred.

The SCM Agreement prohibits "subsidies contingent, in law or in fact, whether solely or as one of several other conditions, upon export performance."(2) The panel reviewed the operation of the FSC provisions and concluded that the benefit they provided was available only for income arising from transactions involving property manufactured in the United States and held for use or disposition outside the United States. Thus, the panel concluded that the subsidy provided by the FSC provisions was export-contingent because it depended on the exportation of U.S. goods.

The European Union also alleged that the administrative pricing rules of the FSC provisions constituted a separate violation of the SCM Agreement. The panel declined to rule on this issue, concluding that it was neither necessary nor appropriate to do so in light of its finding that the three elements of the FSC provisions described above gave rise to a violation. The European Union pressed for a ruling on this issue in its appeal, but the Appellate Body declined to revisit the panel's decision. Therefore, there has been no finding by the WTO on the E.U. allegation that the FSC administrative pricing rules are incompatible with the WTO Agreement.

U.S. Response

Following the Dispute Settlement Body decision that the FSC provisions constituted a prohibited export subsidy that must be withdrawn by October 1, 2000, the Clinton Administration -- led by the Treasury Department -- and the Congress -- led by the tax-writing committees -- worked together to develop a prompt U.S. response. In crafting a solution, the United States was committed to complying with the decision and satisfying its obligations under WTO agreements. At the same time, the United States was committed to developing a solution that did not adversely affect U.S. businesses competing in the global marketplace. The FSC provisions operated to help level the playing field for U.S. businesses competing against European and other foreign-based businesses, whose home countries provide more favorable tax treatment of cross-border business. The U.S. goal was a resolution that would be WTO-compatible and preserve the competitive balance for those businesses that operated under the FSC provisions.

H.R. 4986

H.R. 4986, the FSC Repeal and Extraterritorial Income Exclusion Act of 2000, was developed by the Hill, Treasury, and the business community. H.R. 4986 has two components. First, the legislation repealed the FSC provisions. Second, the legislation enacted a new regime -- the extraterritorial income exclusion regime -- that incorporates features of the territorial tax systems common in Europe.

The new regime provides an exclusion from U.S. taxation for a portion of a company's income from foreign sales and leases. The extraterritorial income exclusion applies to income from sales and leases of property for foreign use, whether the property is manufactured in the United States or outside its borders. For transactions that had been subject to the FSC provisions, the new regime effectively preserves the tax treatment that resulted under those provisions (although the new regime operates differently). The new regime, however, extends this same tax treatment to non-export transactions that were not previously covered by the FSC provisions.

H.R. 4986 passed the Senate on November 1st under a unanimous consent agreement, and the House of Representatives on November 14th by a vote of 316 to 72. The legislation was signed into law by the President on November 15, 2000.

Compliance with WTO Requirements

The new extraterritorial income exclusion regime is intended to be WTO-compliant. In structuring the new regime, the United States chose to address both the subsidy issue and the export-contingency issue, although WTO compliance requires only the absence of a subsidy or the lack of export contingency for any subsidy that is provided. The new U.S. regime is structured so that it does not provide a subsidy and the treatment it provides is not contingent on exportation.

The new regime modifies the U.S. taxing system and redefines the extent to which the United States seeks to tax extraterritorial income. With the new regime, the general rule of U.S. taxation is that extraterritorial income is excluded from gross income. There is no revenue forgone, and the regime is not a subsidy.

The new regime applies to income from all foreign sales and leases of property, without regard to where the property is manufactured. The new regime thus covers both export sales and non-export foreign sales. As a result, the tax treatment provided by the new regime is not dependent on export performance and is not export contingent.

In addition, the new regime is structured to address concerns that were raised by the European Union with respect to the FSC provisions but that were not addressed by the panel or the Appellate Body. The new regime does not require the use of a separate entity such as the FSC to which sales are made or commissions are paid. The new regime thus goes beyond the WTO decision by eliminating the E.U.-questioned administrative pricing rules as a transfer pricing mechanism.

The Operation of the New Extraterritorial Income Exclusion Regime

Overview

The new regime operates as a partial territorial tax system by providing an exclusion from U.S. taxation for certain extraterritorial income. This exclusion from gross income applies to a portion of the taxpayer's income from foreign sales and leases of property and certain related services. Detailed rules apply to determine the income to which the exclusion applies.

The new regime is intended to provide comparable tax treatment for transactions of a type that were previously subject to the FSC provisions. Accordingly, while the new regime is structured very differently, some of the concepts are familiar.

The treatment provided by the new regime is not limited to those transactions to which the FSC provisions would have applied. The new regime is not limited to income from property manufactured in the United States but applies equally to income from property manufactured outside the United States. In the case of property manufactured abroad, the manufacturer either must be subject to the taxing jurisdiction of the United States (e.g., a domestic corporation) or must elect to be subject (e.g., a foreign corporation that elects to be treated as a U.S. corporation for U.S. tax purposes). With this requirement, the income to which the new regime applies is subject to consistent U.S. tax treatment, regardless of whether the income arises from property manufactured inside or outside the United States. Specific rules are provided under which a foreign corporation may elect to be treated for U.S. tax purposes in the same manner as a U.S. corporation.

The exclusion from gross income applies as a general rule. It does not require the filing of an election or the formation of...