Foreign Sales Corporations - Subsidies, Sanctions, and Trade Wars
Carmichael, Candace, Vanderbilt Journal of Transnational Law
The largest sanctions in the history of the World Trade Organization, the need to stabilize an ailing economy, and the need to maintain strong alliances in the face of a new global war on terrorism are all issues the United States currently faces in deciding how to resolve its dispute with the European Union regarding U.S. tax policy. In 1997, the European Union filed a complaint with the WTO claiming that the then-current U.S. tax regime violated U.S. international trade agreements. The European Union contended that the U.S. tax system gave rise to export-contingent subsidies, in violation of U.S. trade obligations.
Ultimately, the WTO found that the U.S. tax regime provided export-contingent subsidies and thus violated U.S. trade agreements. Although the United States appealed the decision, the European Union prevailed on appeal. This Note examines these WTO opinions and the bases for their findings.
After the U.S. tax framework was found to be in violation of international trade obligations, the United States drafted the Extraterritorial Income Exclusion Act of 2000, which replaced the U.S. tax laws found to be in violation of U.S. trade obligations. This Note describes the replacement law and how it differs from the past tax system.
Although Congress hoped the replacement law would resolve the tax dispute, the European Union was not satisfied that the replacement law remedied the trade violations. The European Union filed a claim with the WTO alleging that the replacement law continued to violate U.S. trade obligations. The WTO ultimately decided that the replacement law violated U.S. trade obligations. This Note examines the latest decision.
The United States filed a notification of appeal in response to the latest WTO decision. This Note concludes by addressing issues that the United States must consider in deciding how to resolve this dispute and possible solutions to the problem.
For the first time in its history, the United States has statutorily amended its domestic laws (1) in an attempt to comply with international trade obligations. In addition, the United States potentially faces sanctions for trade violations that would dwarf any sanctions previously imposed by the World Trade Organization. (2) Although the European Union (3) has complained about U.S. international tax laws for years, the European Union took official action in 1997 by filing a complaint against the United States with the WTO. The European Union claimed that the U.S. foreign sales corporation (FSC) tax structure was a breach of U.S. obligations under the Agreement on Subsidies and Countervailing Measures (SCM Agreement) (4) and the Agreement on Agriculture (AA) (5)
The European Union challenged the U.S. laws regarding FSC taxation, claiming that the laws were export-contingent subsidies that placed the United States in violation of its international trade obligations. (6) Barbados, Canada, and Japan joined the European Union in the dispute as third parties to the disagreement. (7) On October 8, 1999, the WTO dispute settlement panel (DSP) ruled that the FSC tax regime did not comply with WTO obligations. (8) Both the United States and the European Union challenged certain aspects of the DSP's findings in the WTO Appellate Body. (9) Canada and Japan joined the European Union as third parties on appeal. (10) On February 24, 2000, the WTO Appellate Body essentially affirmed the DSP ruling. (11) In an attempt to comply with the WTO rulings, President Bill Clinton signed into law the FSC Repeal and Extraterritorial Income Exclusion Act of 2000 (EIEA or replacement law) on November 15, 2000. (12)
After the enactment of the replacement law, the European Union continued to argue that the replacement law violated international trade obligations under the SCM Agreement and the AA, and challenged the replacement law. (13) The European Union again filed a petition with the WTO challenging the replacement law's compliance with U.S. trade obligations. On August 20, 2001, the DSP ruled that the replacement law failed to comply with WTO trade obligations. (14) Additionally, the DSP granted the European Union authorization to impose over four billion dollars in sanctions against the United States for past failures to comply with the DSP and Appellate Body recommendations and continuing violation of international trade obligations. (15) These potential WTO sanctions against the United States are the largest in the WTO's history. (16)
On October 15, 2001, the United States appealed the August 20 WTO decision. Clearly, the outcome of this dispute will have a significant impact on both the United States and the European Union because the industries that benefit most from the FSC tax regime are those in which U.S. and EU companies compete most fiercely. (17) Furthermore, the outcome will affect millions of U.S. jobs, in addition to revenues brought in through taxation and exportation. (18)
This Note will first explain the WTO's role in international trade disputes and the procedures that must be followed when filing a complaint with the WTO. A brief introduction to the WTO is provided in Part II. Part III depicts the long-standing dispute between the United States and the European Union regarding the U.S. tax structure. The different tax structures of the United States and European Union will also be introduced. Part IV sets forth the provisions of the original U.S. tax laws regarding FSCs that were found to be in violation of U.S. trade obligations. Part V presents the arguments made by the United States and the European Union regarding the validity of the FSC tax regime. The WTO's holdings are then discussed. The provisions of the "FSC Repeal and Extraterritorial Income Exclusion Act of 2000," which Congress enacted in an attempt to comply with the WTO ruling, are set forth in Part VI. Part VII describes EU criticisms of the replacement law, which resulted in the most recent WTO finding that the replacement law continues to violate U.S. foreign trade obligations. Finally, Part VIII discusses the latest U.S. appeal and potential responses.
II. INTRODUCTION TO THE WORLD TRADE ORGANIZATION
The WTO was formed in 1995 to ensure that international trade flows as smoothly and freely as possible, to deal with the global rules of trade between nations, and to resolve international trade conflicts. (19) International trade disputes are resolved through the WTO's dispute resolution process, where the focus is on interpretation of agreements and commitments and determination of how to insure that each country's trade policies comply with the agreements it has signed. (2) For example, in the dispute between the United States and the European Union, the WTO will hear the arguments of both and suggest interpretations of the relevant international trade agreements. The WTO will then determine whether the U.S. tax regime is in compliance with the relevant agreements. Since the United States and European Union disagree about the validity of the U.S. FSC tax system, the WTO's role is to step in, at the request of the European Union, and interpret the related agreements to which the United States and European Union are parties.
The WTO's founding members created the organization's dispute settlement scheme to provide an established system and forum for the mutual resolution of disputes. (21) To achieve this goal, Article 4 of the Understanding on Rules and Procedures Governing the Settlement of Disputes (DSU) dictates that an application to create a DSP may only be made after consultations between the complaining party and the party allegedly in violation of its WTO obligations have failed to produce a mutually acceptable resolution. (22)
If consultations or mediations do not produce a solution, the complaining party may request that a DSP be established to "rule" on the dispute. (23) Upon receipt of a request from the complaining party, the Dispute Settlement Body (DSB) will determine the "terms of reference." (24) Three persons are then selected to serve on the DSP. (25) However, panelists cannot be from the nations acting as principal or third parties to the disagreement. (26) Interestingly, unlike the standing requirements found in U.S. courts, there is no prerequisite in the DSU requiring parties to have a legal or economic interest in the disagreement. The DSPs have also refused to read such a condition into the DSU. (27)
The DSU also permits third parties to participate in panel disputes. (28) Specifically, Article 10 of the DSU states that "any Member having a substantial interest in a matter before a panel and having notified its interest to the DSB ... shall have an opportunity to be heard by the panel[,] ... make written submissions to the panel," and receive submissions of the parties after theft first meeting with the panel. (29) Additionally, Article 4 of the DSU provides that a Member with a substantial interest (30) in an ongoing disagreement between other Members may request to be joined in consultations. (31)
Once the DSP reviews the parties' arguments and third party submissions, it will issue an interim decision that sets forth each party's arguments and presents the panel's verdict. (32) Parties are allowed to make comments on the interim report, and the panel then considers the comments. (33) Final decisions are released first to the parties and third parties and then to all WTO Members and the public. (34)
Parties may appeal the panel's decision to the Appellate Body within sixty days of its circulation to the public. (35) However, the Appellate Body review is restricted to issues of law and legal interpretation of the panel. (36) If a party is found to be in violation of its international trade obligations, then the complaining party may impose sanctions. (37)
A. History Behind the Foreign Sales Corporation Dispute Between the United States and the European Union
Due to increased global trade and the need of basically every country to export, national governments feel obligated to maintain a tax structure that, at the very least, creates a level playing field for its domestic businesses in the international trading market. (38) For years the United States has felt pressure from U.S. businesses to create and maintain such laws. Domestic businesses pressure the U.S. government, claiming they are at a disadvantage in the global trading market. (39) They also claim that the differing tax philosophies of the United States and its European trading partners are the primary reason U.S. businesses are disadvantaged. (40) In response to these complaints, the United States has repeatedly attempted to create a tax structure that provides a level playing field in the international trading market for U.S. corporations. (41) However, the European Union has long challenged the United States tax structure, claiming that the U.S. system provides export-contingent subsidies, and thereby violates international trade agreements. (42)
The debate between the United States and the European Union over export-contingent subsidies began as early as 1971 when the Domestic International Sales Corporation (DISC) (43) tax regime was enacted. (44) The European Union condemned the law, claiming it violated Article XVI of the General Agreement of Tariffs and Trade (GATT), (45) which prohibits export-related subsidies. (46)
Members of the GATT agreed to prohibit export-contingent subsides because such subsidies can affect international trade in at least two ways. (47) First, if a manufacturer can sell subsidized goods abroad for a lower price than other producers selling similar, but nonsubsidized goods, non-subsidized producers will be deterred from competing with the subsidized producers. (48) Second, if the subsidized export product sells in the foreign marketplace at below cost, its export sales will increase, often to the detriment of other exporters and domestic manufacturers. (49) The general rule is that any direct or indirect subsidy that results in the sale of an exported product at a price lower than that charged for a similar product in the domestic market violates GATT.
To relieve tension over the legality of DISC, the Reagan Administration enacted the Deficit Reduction Act of 1984, Title VIII, that effectively replaced the DISC with the FSC. (5) In crafting the FSC, Congress sought to devise a system where it could exempt a portion of the income from foreign economic processes occurring outside the United States in order to afford U.S. exporters treatment comparable to that of Members of the European Union. (51) Contrary to underlying intentions, the 1984 legislation only intensified the debate surrounding U.S. export subsidies. (52)
When the WTO was formed in 1995, the SCM Agreement was created (53) and Article XVI of GATT was adopted by the WTO. (54) Therefore, the disagreement between the United States and European Union persisted within the newly formed framework of the WTO. Only two years after the establishment of the WTO, the European Union took advantage of the WTO dispute resolution system by initiating an official statement against the FSC tax regime, claiming that it violated the SCM Agreement and the AA. (55)
B. What is a Foreign Sales Corporation? (56)
An FSC is a foreign corporation organized outside of the fifty United States and the District of Columbia (57) that is responsible for certain sales-related activities in connection with the sale or lease of goods produced in the United States for export outside the United States. (58) An FSC must be created in an eligible U.S. possession, (59) or "under the laws of a country that either has a bilateral or multilateral exchange of information agreement with the United States or has entered into an income tax treaty with the United States that permits the exchange of information." (60) The eligible corporation must file a timely election to be taxed as an FSC during the ninety-day period immediately before the beginning of its taxable year. (61)
A corporation must fulfill several requirements to qualify as an FSC. An FSC may not have more than twenty-five shareholders at any time during the taxable year and may not issue preferred stock. (62) The FSC must also keep a set of permanent records at an office outside the United States and a duplicate set within the United States. (63)
An FSC must have a board of directors that includes at least one person who is not a resident of the United States. (64) FSC meetings between the board of directors and shareholders must take place outside the United States. (65) However, this requirement is usually not difficult to meet, as holding meetings over the telephone can easily satisfy foreign management requirements. Additionally, the corporation can use service companies in its country of incorporation to deal with paperwork. (66) That is, activities may be subcontracted, and the subcontractor is not necessarily required to have a direct contract with the FSC. Moreover, an FSC's primary bank account must be in a qualifying foreign country, and all dividends, legal and accounting fees, salaries of officers, and director's fees are required to be distributed from the foreign bank account. (67)
The FSC, or its agent, must take part in the sales process outside of the United States, including soliciting, negotiating, and contracting. (68) Also, the FSC must have a minimum percentage of direct foreign costs, (69) which include "advertising and sales promotion, processing customer orders, arranging for delivery of the export property, transportation, assembling and transmission of a final invoice or statement of accounting the receipt of payment, and assumption of credit risk." (70)
Most often, a U.S. corporation that produces goods in the United States owns an FSC. (71) The U.S. corporation may provide goods to the FSC for resale abroad or pay the FSC a commission in connection with such sales. (72) There is no statutory obligation that an FSC be associated with or controlled by a U.S. corporation; (73) however, the FSC tax regime is set up such that the benefit to both FSCs and the U.S. corporations will usually be greater if the supplier is associated with the FSC. (74) Consequently, many FSCs are controlled foreign subsidiaries of the U.S. corporations. (75) Over seventy major U.S. corporations benefit from the FSC tax system, (76) including: 3M, Cargill, Boeing, Microsoft, Duke Energy Corporation, Eli Lilly, Eastman Kodak, Exxon Mobil, Lockheed Martin, General Motors, General Electric, (77) Motorola, (78) and the Walt Disney Company. (79)
Although oversimplified, the benefit for the FSC itself amounts to an exemption of a portion of its export profits. (80) In other words, the income of an eligible FSC is partially subject to U.S. tax and partially exempt from U.S. tax. (81) For the related supplier--the exporter--generally the FSC's corporate shareholder, "a full dividends-received deduction for earnings and profits distributed out of foreign trade income (82) is available, so that the exempt portion of the FSC's foreign trade income is not taxed to the exporter and the taxable portion is not double-taxed in the hands of the exporter." (83) Thus, a U.S. corporation benefits from setting up an FSC to which it can allocate certain income and thereby reduce its overall taxation.
C. Tax Systems
The United States and countries within the European Union have fundamentally different tax frameworks. (84) These different systems help fuel the long-standing debate over subsidies and the taxation of exports. Both the United States and the European Union argue that the other side misunderstands the other's tax structure, which gives rise to many issues within the tax dispute. (85)
Essentially, there are two basic types of income tax systems: (1) a residence-based--or worldwide system, which has been adopted by the United States, and (2) a territorial system, which has been implemented by countries in the European Union. (86) In practice, however, neither the United States nor the Member States of the European Union employ a "pure" system; (87) most countries employ some combination of the two concepts. (88) Both systems are intended to avoid double taxation of income. (89)
Each country is permitted to develop its own unique tax structure because there are no rules of international law requiring nations to conform to a single tax system. (90) Each country is encouraged to implement the tax system of its choice, so long as the provisions of the tax regime do not breach any international trade agreements. (91) WTO Members agree that it has never been the WTO's intent to establish international tax "norms." (92) The freedom each country has to establish a distinctive tax structure is beneficial because it allows each country to create tax laws that promote that country's objectives. It complicates the drafting of tax laws, however, because each country wants its corporations to be on a "level playing field" in the international market, while simultaneously maximizing its own tax revenue.
1. World-Wide System Currently in Place in the United States
The U.S. tax regime, although not a pure system, is regarded as a worldwide system of taxation. (93) Under a worldwide system, all of the income earned by a resident (94) is subject to tax, regardless of where that income is earned. (95) Thus, U.S. residents begin with the premise that all their worldwide income is subject to tax. U.S. residents must then look for specific provisions within the Internal Revenue Code (I.R.C.) for exceptions to this general rule. (96)
A worldwide system generally avoids double taxation by granting foreign tax credits. (97) When income is earned abroad and taxed by a foreign government, a tax credit is provided to U.S. corporations to avoid double taxation. (98)
In addition to residents, the United States also taxes any income earned by foreign corporations within the United States. (99) Under U.S. tax law, all corporations that are not incorporated in one of the fifty states or the District of Columbia are considered foreign corporations. (100) The United States generally does not tax income that is earned by foreign corporations outside the United States. However, foreign-source (101) income of a foreign corporation generally will be subject to U.S. taxation when such income is "effectively connected with the conduct of a trade or business within the United States." (102) U.S. tax laws and regulations provide for the tax authorities to conduct a factual inquiry to determine whether a foreign corporation's income is "effectively connected income." (103)
Alone among the large economies, the United States relies largely on the income tax for its national revenue base. (104) Arguably, the U.S. tax system collects more money than any other tax system in the world and at the lowest cost of any system. (105) The United States favors the worldwide system because it is perceived to be fairer for income taxes to be based on the taxpayer's ability to pay rather than on the source of income. (106)
2. Territorial System Currently in Place Within the European Union
Most countries within the European Union operate under a hybrid tax system; however, the tax system in those countries is closer to a territorial system than a worldwide system. (107) Under a territorial system, only income earned within the borders of the taxing jurisdiction is subject to tax. (108) Thus, a resident of a country within the European Union can earn income from sources outside his home country and will not be taxed on that income, regardless of whether the entity earning the income is a resident of the country or not. To avoid double taxation, the territorial system grants a general exemption--income earned abroad is simply not subject to tax. (109) This leads to problems for U.S. businesses because a European business could set up an operation in a low tax jurisdiction and reduce its overall taxes, while a U.S. business doing the same could not reduce its overall taxes. (110)
IV. THE FORMER U.S. FOREIGN SALES CORPORATION TAX REGIME
To understand where the tax dispute currently stands and the options the United States faces, it is first necessary to understand the FSC tax regime that the European Union challenged in 1997. The general assumption under the U.S. worldwide tax system is that the United States has the right to tax all income earned worldwide by its citizens and residents, including all foreign source income. (111) Thus, a U.S. corporation benefits from setting up an FSC to which it can allocate certain income and thereby reduce its overall tax burden.
Under the former FSC tax regime, although an FSC is a foreign corporation, (112) and therefore not a U.S. resident, the United States asserted its taxing jurisdiction over the foreign corporation through the corporation's election to become an FSC. (113) Therefore, the …
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Publication information: Article title: Foreign Sales Corporations - Subsidies, Sanctions, and Trade Wars. Contributors: Carmichael, Candace - Author. Journal title: Vanderbilt Journal of Transnational Law. Volume: 35. Issue: 1 Publication date: January 2002. Page number: 151+. © 1999 Vanderbilt University, School of Law. COPYRIGHT 2002 Gale Group.
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