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WTO Ruling Makes Tax Change Imminent
by William New
A World Trade Organization decision last week erased U.S. hopes of keeping intact a law allowing U.S. companies to exempt overseas earnings from domestic taxes. But as they study the Jan. 14 ruling, some U.S. lawyers believe they may find a way to make a partial change in the law and still comply with WTO rules, thus sidestepping some $4 billion in annual retaliation against U.S. exports by the European Union, as well as a potential trade war.
'Thank God We Appealed'
The latest decision is more balanced and narrower than any previous ruling in the case, according to Homer Moyer, a partner at the Miller, Chevalier law firm who counsels an industry coalition on the issue headed by the National Foreign Trade Council (NFTC). "It also accepts and adopts a number of key arguments the United States has made throughout this proceeding," he said.
Specifically, the ruling more definitively interprets an exception to the prohibition on export subsidies in the WTO Agreement on Subsidies and Countervailing Measures (SCM), lawyers said. That exception, footnote 59 of the SCM, says that certain subsidies may exist in order to avoid double taxation if foreign-source income is susceptible to foreign taxation.
The appellate body decided that allowable subsidies need not be "perfectly tailored to the actual double tax burden," the lawyers argued. Therefore, the United States could adopt a provision that excludes foreign-source income from its tax as generously as it wants to, they said. "Thank God we appealed" the WTO ruling in the case, one U.S. lawyer said.
An official with the Office of the U.S. Trade Representative (USTR) told industry representatives in a telephone briefing last week that it appears the United States has some "latitude" for compliance, one industry source said. But no further specifics have emerged from USTR, and it is unclear how the new interpretation will help U.S. firms comply.
The industry coalition has offered to share its views with USTR, according to Judith Scarabello, vice president for tax policy at NFTC.
From FSCs To ETIs
High-tech companies are heavy users of the illegal tax break. In addition, large software and hardware companies such as Microsoft have followed the WTO case closely because they might be targets for retaliation from the European Union.
The U.S. tax system considers foreign earnings of U.S. companies to be taxable, but companies have been able to escape that tax by establishing offshore foreign sales corporations (FSCs). In 2000, FSCs were deemed illegal by a WTO dispute-settlement panel, in a case brought by the European Union. The panel said FSCs were an illegal export subsidy, as defined under the SCM.
After the United States lost its appeal of that first panel decision, Congress acted on Nov. 15, 2000, to replace the FSC regime with the Extraterritorial Income Exclusion Act (ETI). A WTO review called for by the European Union found that the ETI did not comply with the original panel ruling on the U.S. tax system. The United States lost its appeal of that finding last week and must change its tax system immediately.
One of European Union's complaints about ETI was that it created a transition period for existing, active FSCs until Jan. 1, 2002, and therefore, the United States did not fully withdraw the offending FSC subsidies in the time required. In the European Union's eyes, the United States was required to comply with the original panel ruling against the FSC on Oct. 1, 2000. That its attempt to comply by establishing the ETI was unsuccessful does not change the original compliance date, Europe says.
Under WTO rules, the penalty for a prohibited subsidy is derived from a quantification of the subsidy, not the amount of damages to the complainant. Using U.S. figures, the European Union calculated that the U.S. government forewent more than $4 billion in tax revenue annually, effectively giving a subsidy in that amount to companies with FSCs.
The Case Against Retaliation
The next step is for the WTO to formally adopt the appellate body's report, which is expected to happen late this month, and then for arbitrators to agree on the amount owed by the United States within 60 days, which is expected by early April. Retaliation would allow European countries to impose tariffs, typically 100 percent in these cases, on any U.S. imports in order to recapture the annual amount of the subsidy.
An EU official said last week that a list of potential targets for retaliation has not changed since Europe issued it in November 2000. That broad list included a wide range of technology products.
According to the electronics association AeA, U.S. high-tech exports in 2000 were at least $223 billion, which was 29 percent of the total $780 billion. Technology is the biggest U.S. export sector. U.S. industry sources have maintained, however, that Europe knows it also would be harmed by retaliation against U.S. tech companies.
One EU official quipped to a U.S. industry source that $4 billion is "10 Boeing 747s," which may have been a reference to an acrimonious trans-Atlantic dispute over aircraft involving the U.S.-based Boeing and Airbus, a France-based aircraft manufacturer.
Europe also must consider that several U.S. subsidiaries of European companies benefited from the FSC program, further muddying the political waters. Meanwhile, four major U.S. trading partners -- Australia, Canada, India and Japan -- weighed in as third parties in the case in support of the panel's decision against the ETI.
Another available option is for the United States to compensate the European Union, but that is uncommon and unlikely, sources said.
Back To The Bargaining Table?
Time will be tight for a U.S. legislative fix to the problem, but it is much more likely if the entire tax system does not need to be overhauled. Still, experts said it would be difficult to change the law in a way that does not create "winners and losers." House Ways and Means Committee Chairman Bill Thomas, R-Calif., has said he wants to overhaul the entire tax system.
The Senate Finance Committee's version of a trade-negotiating bill contains language ordering the Bush administration to seek re-negotiation of WTO tax treatment. Re-negotiation is U.S. industry's preferred path because it considers WTO rules to favor Europe's system of taxing only income earned by a company within a country's territory. Industry groups are pressing for Europe to give the United States more time to comply. Re-negotiation is probably years off, however.
While the European Union will follow procedures in order to maintain its rights in the case, it has no desire to retaliate, an EU official said. Rather, the 15-nation union is waiting to hear that the United States plans to comply, and how and when it proposes to do so, he said. The official noted that Europe does not have to retaliate immediately after the arbitrators' decision on the amount of retaliation. However, it does not plan to suspend the arbitration process again, he said.
The trans-Atlantic tax fight has a 30-year history, and in essence the FSC program was created in the early 1980s, after the United States lost a trade case brought by Europe against the FSC predecessor, the Domestic International Sales Corporations (DISCs).
Questions remain over who has the authority to decide whether any further U.S. action brings it into compliance with WTO rules. "We're getting into new WTO waters," said Moyer.
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