Lessons Learned from DISC/FSC/ETI Disputes: Reshaping the Quest Towards a GATT/WTO Friendly Corporate Tax Reform in the United States

Transcription

1 O.P. Jindal Global University Research Paper No. 10/2011 Lessons Learned from DISC/FSC/ETI Disputes: Reshaping the Quest Towards a GATT/WTO Friendly Corporate Tax Reform in the United States James J. Nedumpara Jindal Global Law School Electronic copy available at:

2 Abstract The Corporate Tax Policy of the United States has long been considered to be disadvantageous to U.S manufacturers and exporters, who allege that adoption of the world-wide taxation policy has affected their competitiveness. The tax legislative measures introduced by the United States to address this criticism such as the Domestic International Sales Corporations (DISC), Foreign Sales Corporation (FSC) and the Extraterritorial Income Act (ETI), however, have failed the GATT/WTO scrutiny. Although the American Job Creation Act, 2004 has almost resolved the matter between the U.S and EU, the dispute is far from settled. The FSC/ETI disputes were considered as an opportunity to introduce fundamental tax reforms in the U.S. Among the various proposals made so far, the proposal to introduce a progressive consumption type taxation replacing the current corporate income tax has gained significant popularity. Most academic writings suggest that a progressive two-tiered consumption tax such as a destination basis X tax could be treated as a direct tax under the GATT/WTO in view of the wage tax element. But prejudging the WTO legality of destination basis X-tax would not be appropriate on the basis of a pure textual interpretation of a footnote in an Annex in the SCM Agreement, which predated the current treaty provisions. Before classifying a measure as a prohibited illegal subsidy, it needs to be examined whether such tax legislation is based on neutral or objective criteria and whether it otherwise meets the definition of subsidy. A broad based and functional interpretation of destination basis X-tax could establish that it is not a trade distorting export subsidy within the meaning of the GATT/WTO. It will be unwise to preempt discussions on this topic assuming its inconsistency with the GATT/WTO. The other proposal is to implement a territorial income tax. Although such a tax scheme is WTOcompatible, if administered under the guidelines provided by the WTO dispute panels, it will face other difficulties such as significant transition problems and interference with a number of 2 Electronic copy available at:

3 bilateral treaties. Again, it is uncertain whether such a tax system could improve the competitiveness of the U.S industry. 3 Electronic copy available at:

4 TABLE OF CONTENTS 1. INTRODUCTION 4 2. PART I a. Different Systems of Taxation of Income b. The GATT/WTO distinction of direct and indirect taxesan acorn that grew into an oak tree?... c. Concept and Treatment of Subsidies under GATT/WTO d. The United States and the Tax Legislation cases- A Four Decade Story in a Nutshell i. Genesis of DISC... ii. Genesis of FSC.. iii. Genesis of ETI... iv. Lessons of DISC/FSC/ETI disputes PART II a. Movement Towards Consumption Tax i. Will a destination basis X-tax survive the WTO ban on export subsidies? An assessment in light of the jurisprudence of DISC/FSC/ETI disputes ii. Territorial Tax proposal CONCLUSION. 35 4

5 Introduction:- The international trade rules formulated first under the General Agreements on Tariffs and Trade ( GATT ) and later under the World Trade Organization ( WTO ) were intended to promote international trade and to reduce existing barriers to trade. These treaties have broad based objectives, least of which was the desire to reform the tax policy of a Member State. But the protracted trade disputes set off with the European Union s challenge against the U.S Domestic International Sales Corporations ( DISC ) almost four decades ago and resulting in about 11 disputes 1 between the U.S. and E.U during the period have mauled the domain of trade rules and tax policy issues almost irreparably. Patchwork solutions have been found, but none of which is going to address the underlying concerns of the parties. The American Job Creation Act 2 enacted by the Bush Administration in 2004 is widely seen to have put a halt to the trade tensions between the two leading trade blocs, but it is naïve to believe that such issues are settled once and for all. At the heart of the transatlantic trade dispute was the strikingly different tax systems of the U.S and many member countries of the EU. The U.S follows the worldwide taxation system in terms of which the U.S. domestic corporations are taxed on their global income irrespective of the source, whereas a number of European countries such as France, Belgium and the Netherlands tax income on a territoriality basis, which broadly means that income arising from only an activity within the territory of a country is taxed. The GATT/WTO treaty does not recommend a member country to use one system in preference to the other. But the efforts made by the U.S to carve out a partial territorial system for U.S corporations met stiff resistance from 1 United States Tax Legislation(DISC), adopted 7-8 December, 1981, BISD 23S/98; Income Tax Practices Maintained by France, adopted 7-8 December, 1981, BISD 23S/114; Income Tax Practices Maintained by Belgium adopted 7-8 December, 1981, BISD 23S/127; Income Tax Practices Maintained by Netherlands, 7-8 December 1981, BISD 23S/137; United States- Tax Treatment for Foreign Sales Corporations, WT/DS 108/R and WT/DS 108.AB/R adopted March 20,2000; United States- Tax Treatment for Foreign Sales Corporations - Recourse to Article 21.5 by the EC, WT/DS 108/RW and WT/DS 108/RW/AB/R adopted January 29, 2002; United States- Tax Treatment for Foreign Sales Corporations - Second Recourse to Article 21.5 by the EC, WT/DS 108/RW and WT/DS 108/RW/AB/R adopted February 13, 2006, and; United States- Tax Treatment for Foreign Sales Corporations - Recourse to Arbitration by the United States under Article 22.6 of the DSU, WT/DS 108/ARB, August 30, H.R 4520, 118 Stat.1418, Public Law , October 22,

6 its European trading partners on the ground that such tax treatments provided economic incentives in the form of tax subsidies to domestic U.S corporations. The serial losses that the U.S suffered before GATT/WTO dispute settlement panels meant that the stand of the EU was vindicated. US exporters and policy makers cried hoarse, but GATT/WTO treaty being what it is, a politically negotiated outcome was almost impossible to reach. Eventually, the U.S. had little option but to comply with the decision to the satisfaction of the EU in the wake of trade sanctions to the tune of $4 billion as punitive tariffs. 3 There cannot be any doubt that a WTO member country has the autonomy to decide a tax policy of its choice. 4 It is often alleged that the dispute settlement panels of the GATT\WTO have wrongfully asserted their role in a field in which they have very little legitimacy and expertise to get involved. 5 More experienced hands of the trade and academic community alleged that the problem lay elsewhere as it is the mistaken distinction between direct and indirect taxes at the GATT/WTO an ill-conceived relic of GATT s adhocism--- which led to the denouncement of US tax policies. 6 At the core of the criticism is the feeling that this distinction is a pernicious fiction, created and perpetuated by trade mandarins, and has no place in either logic or fact. 7 There have been three specific legislations adopted by the U.S to level the tax playing field : the Domestic International Sales Corporation ( DISC ) enacted in 1971, the Foreign Sales Corporation ( FSC ) enacted in 1984 and the FSC Repeal and Extraterritorial Income Act, 2000 ( ETI ). All these legislation which led to international trade disputes confronted the U.S policy makers with the following dilemma: how could the U.S maintain the competitiveness of U.S exports in the international trade arena with a WTO acceptable tax policy? For example, some suggested that the U.S should adopt a form of consumption tax, thus foregoing taxation of business profits altogether, while others suggested that adopting a pure territorial tax system 3 William Chou, The $4 Billion Question: An Analysis of Congressional Responses to the FSC/ETI Dispute under the WTO Export Subsidy Standards, 25 NW.J INT L L & BUS. 415 (2005). 4 Appellate Body Report, United States- Tax Treatment for Foreign Sales Corporations ( US-FSC (I) ), WT/DS 108/AB/R, adopted on March 20, para Claude Barfield, Should WTO determine U.S Tax Policy? American Enterprises Institute, posted on July 7, 2004, available at 6 Ernest Christian and Gary Clyde Hafbauer, End This Damaging Tax and Trade Charade, FINANCIAL TIMES (March 08, 2004). 7 Id, see also Gary Clyde Hufbauer, The Foreign Sales Corporation Drama: Reaching the Last Act, International Economics Policy Briefs, Number PB02-10 (2002), Washington, D C. 6

7 along the EU model would satisfy the WTO rules; others felt that United States should put pressure on its trade partners to make necessary changes in the GATT/WTO treaty itself, as part of the ongoing round of multilateral trade negotiations. The initiative to find a lasting solution to the core issue still has not lost its vigor despite the enactment of the American Job Creation Act, One way of moving ahead of the export subsidies conundrum is by introducing a value added tax based system, reimbursing corporations throughout the manufacturing process. 9 But value added tax is generally considered to be regressive. Of the various other proposals, the proposal to introduce a progressive consumption tax in the place of income tax has gained significant popularity. 10 For instance, the Advisory Panel on Federal Income Tax Reform established by the Bush Administration, suggested replacing the corporate income with a progressive consumption tax in Growth and Investment Tax (GIT) proposal. 11 Prominent among the consumption tax proposals are the two tiered tax structures suggested by Hall-Rabushka ( Flat Tax proposal 12 ) and the tax proposal developed by Professor David Bradford, namely, the X-tax ( X-tax proposal 13 ). The Flat Tax and the X-Tax can be compared to a VAT model, except that wages are deducted by businesses and taxed at progressive rates to workers. 14 Between Flat Tax and X-tax, they differ mainly in the treatment of wage earners See a series of articles on this topic. Alex Kachaturain, Reforming the United States Export Tax Policy: An Alternative to the American Trade War with the European Union, 14 U.C DAVIS J. INT L LAW & POLICY, 185 (2008); Robert Carroll, Alan D. Viard, and Scott Ganz, The X-Tax: The Progressive Consumption Tax America Needs, American Enterprise Institute for Public Policy Research, No.4, December, James Joseph Shallue, An Analysis of the Foreign sales Corporations and European Communities Four Billion Retaliation, 31(2) DENV. J.INT L L& POL Y, NICHOLAS KALDOR, AN EXPENDITURE TAX (1959). The most recent tax debate on the approximate tax base began with Professor William Andrew s much quoted article in Harvard Law Review entitled A Consumption- Type of Cash Flow Personal Income Tax, 87 HARV. L. REV.1113 (1974). 11 President s Advisory Panel on Federal Tax Reform, Simple, Fair and Pro-Growth: Proposal s to Fix America s Tax System, (2005). Available at 12 ROBERT E.HALL & ALVIN RABUSHKA, THE FLAT TAX, (2 nd ed. 1995). 13 David F. Bradford, The X Tax in the World Economy, CEPS Working Paper No.93 (2003). 14 Joseph Bankman and Michael Schler, Tax Planning under X-tax/Flat Tax, American Tax Policy Institute, Washington DC: Available at 15 David F. Bradford, Blue Print for International Tax Reform, 26 BROOK. J. INT L.L, 1449,

8 There is a growing feeling that any tax reform should be designed to address the issues related to cross order transactions. 16 If one could assume certain unanimity to adopt a consumption tax, the key question is whether it should be an origin basis tax or a destination basis tax? At present, the U.S income tax applies on an origin basis in as much as it taxes the U.S businesses on their exports and allows a deduction for the amount they pay the foreign business for the imports. This has resulted in major transfer pricing issues and related administrative and compliance problems and is considered to be unworkable 17. Further an origin-based tax will not be politically acceptable since the tax burden will be on the exports while leaving the imports untaxed an allegation which is at the heart of the DISC/FSC/ETI controversy. A two-tier destination based consumption tax is widely considered as an alternative although it may require complex border tax adjustments and monitoring at the border. One of the advantages is that such a tax system could achieve high levels of progressivity. 18 However, there is a widely held view that such a tax would be WTO incompatible. 19 This paper will analyze in more detail whether the adoption of any of these consumption tax models, and in particular, the destination based X-tax model, would be compatible with the GATT/ WTO treaty as it currently stands. Another proposal is to change the U.S corporate income tax from the current worldwide basis to the territorial model. The territorial corporate income tax policy adopted by some of the European countries has already been challenged earlier in GATT dispute. 20 But much water has flowed under the bridge. The structure of international trade rules and its practice have changed with the advent of the WTO. This paper will also examine the compatibility of the territorial tax system with the WTO system. There are various other proposals advocated by academicians, practitioners and industry experts. This paper, however, does not examine all current proposals. 16 Lawrence Lokken, Marking up the Blueprint, 26 BROOK. J. INT L.L 1493, 1494 (2001). 17 David A. Weisbach, Does X-tax Mark the Spot?, University of Chicago Law School John M. Olin Program in Law and Economics Working Paper No. 163 (2002), available at 18 David F. Bradford, Addressing the Transfer-Pricing Problem in an Origin-Basis X Tax (2003). 19 Weisbach, Does X-tax Mark the Spot, supra note See supra note 1. 8

9 The organization of this paper as follows: Part I will provide a summary of DISC/FSC/ETI legislation with a focus on various historical developments with a view to understanding why and how such legislations violate the GATT/WTO subsidy disciplines. Part II will examine the key tax proposals outlined above, including the proposal on X-tax and territorial tax and their conformity with international trade rules under the GATT/WTO. Part III concludes. PART I A. Different Systems of Taxation of Income With regard to taxation of income, there are two generally recognized basis for imposition of a tax: jurisdiction over a party earning the income (the country of residence of the tax payer), and jurisdiction over the activity that produces the income (the country of source of the income). Under the residence principle, a country generally taxes the income of persons subject to its jurisdiction irrespective of where those persons earn the income from. This is sometimes referred to as the world wide system of taxation. Under the source principle, a country taxes income earned within its borders. This is known as the territorial system of taxation. Prior to the adoption of the FSC provisions and then the ETI Act, the U.S. tax system was generally described as operating on a world wide basis. 21 The U.S. asserted the right to tax all income earned by U.S citizens and residents (including U.S. Corporations) as well as income earned by non-residents within the U.S borders. Because the U.S. defines the residence of corporations for tax purposes on the basis of incorporation, a U.S. Corporation is defined as one that is organized under the laws of one of the 50 States within the U.S or the District of Columbia. In principle, the U.S tax system would treat income earned by U.S Corporations outside the United States as taxable, even if that income had no relationship to any transaction or economic activities occurring within the U.S. However, the United States generally does not tax income that is earned outside the United States by foreign corporations and non-resident aliens. Foreign 21 Appellate Body Report, US-FSC(I), supra note 4, at paras

10 corporations pay U.S tax at regular corporate rates only on net income that is effectively connected with a U.S trade or business. 22 The difference between the two systems of taxation can be explained below. Assume that a U.S. corporation manufactures widgets and sells them abroad, say Singapore through its branch. The widgets are sold at a price of $100 and assume that the cost of sales of the widgets is $80. There is an overall profit of $20 on this transaction and if the income tax is 20 percent, the U.S Corporation would have a tax burden of $4. Further assume that in the place of a branch the U.S Corporation sets up a subsidiary in Singapore and sells the products at a price of $85. Assuming that the cost of sales remains the same, the profit on the transaction is $5 and after paying tax at the rate of 20%, the net tax burden will be $1. If Singapore has low tax on its share of the profit, there is a significant incentive for the U.S Corporation to transfer the sales related functions to the foreign subsidiary. But in the above scenario, it is important to note that there are differences in the treatment of subsidiaries vis-à-vis the branches in the matter of taxation of U.S. Corporation s income. In the case of branches, the United States generally asserts the right to tax the worldwide income. However, when a U.S. Corporation conducts its foreign operations through a subsidiary corporation, the foreign corporation s income is exempt from U.S. taxation so long as it remains in the subsidiary s hands, for instance, reinvested in the foreign corporation. 23 The foreign subsidiary s income is generally subject to U.S tax only when it is remitted to the U.S Corporation as intra-firm dividends, interest payments, royalties or other income. 24 The possibility of deferral was an exception to the concept of worldwide taxation. A major change in the U.S. tax policy was effected in 1962 when the Kennedy Administration introduced legislation to tax foreign source income in respect of a foreign corporation. This major legislative enactment is called Subpart F which sought to curtail the possibility of deferral of 22 Section 882 of the Internal Revenue Code 23 John H Jackson, The Jurisprudence of International Trade: The DISC Case in GATT, 72 Am. J. INT L L 747 (1978) 24 Keith Engel, Tax Neutrality to the Left, International Competitiveness to the Right, Stuck in the Middle with Subpart F, 79 TEX. L. REV,

11 income. 25 Subpart F only applies to foreign corporations that the U.S. tax code categorizes as Controlled Foreign Corporation ( CFC ) - foreign corporations that are more than 50% owned by U.S stakeholders, whose individual stake is over 10%. Under Subpart F, the passive income of controlled foreign corporations is deemed distributed and is therefore immediately taxable by the United States even in cases where the earnings are not repatriated as dividend payments. Subpart F provisions require that the U.S. shareholders that own stock in CFCs include in their gross income the prorata share of the foreign corporation s undistributed income, thus eliminating the benefit of deferral for such shareholders. The major objective of Subpart F was to combat the deflection of income from high tax jurisdiction to low tax jurisdictions in an economy that was primarily based on manufacturing. But it was not the objective of Subpart F to completely stop deferral. The enactment of Subpart F is considered to be self inflicted injury. 26 The types of income subject to current tax under Subpart F are generally those located in tax havens and low-tax countries that is, investment that is primarily financial in nature and does not involve the active management of a business operation and certain other types of income whose source is thought to be easily manipulated so as to locate it in countries with low tax rates. To put it differently, as a result of Subpart F, U.S. shareholders of a CFC are able to benefit only if the corporation is engaged in bonafide business activities in the foreign jurisdiction that do not result in the avoidance of the U.S. or foreign taxes. This anti-abuse provision is often alleged to have put the U.S. exporters at a disadvantage when compared to other exporters in other industrialized nations. One way to side step the consequences of anti-deferral provisions was to carve out a system of export-related tax benefits. In a way, the U.S. legislations on DISC, FSC and ETI attempted to introduce some kind of a carve-out or exemption. An analysis of how such legislations comported with GATT/WTO principles will be provided in Part I of this paper. 25 Harry G. Gourevitch, Congress Research Service (Report ), Anti-Tax Deferral Measures in the United States and Other Countries (1995). 26 Hufbauer, supra note 7. 11

12 B. The GATT/WTO distinction of direct and indirect taxes- an acorn that grew into an oak tree? The tax system of a geographically limited jurisdiction can use either the origin basis or the destination basis to address international transactions. Under the origin basis, taxes are imposed on goods and services produced within the taxing jurisdictions, while under the destination basis, they are imposed on goods and services consumed within the same jurisdiction. 27 To further explain, in an origin basis tax system, the tax base is domestic production, which equals domestic consumption plus net exports; however, in a destination basis tax system, exports are excluded from the tax base while the imports are included. One of the serious allegations against the GATT/WTO is that it recognizes a destination based indirect tax 28, but does not recognize a destination based direct tax 29. The GATT does not explicitly provide a language recommending one system over the other, but there are various provisions in GATT/WTO which distinguish a direct tax from an indirect tax. The GATT Working Party report of 1971 approving border tax adjustments is perhaps one document which explains the difference. 30 Border tax adjustments were regarded as any fiscal measures which put into effect, in whole or part, the destination principle. 31 This implicit distinction between direct and indirect tax in terms of its border adjustability was carried over to the Annex to the Tokyo Subsidies Code 32 and rather, more explicitly, in the WTO Subsidies and Countervailing Measures Agreement (for short SCM Agreement) later. Footnote 1 of SCM Agreement includes a language as follows, the exemption of an exported product from duties or taxes borne by the like product when destined for consumption or the remission of such duties or taxes in amounts not in excess of those which have accrued shall not be deemed a subsidy. A similar language was not, however, provided for direct taxes. Adoption of the destination principle meant that an 27 see generally Daniel N. Shaviro, Replacing the Income Tax with a Progressive Consumption Tax, 103 TAX NOTES 91(2004). 28 Annex 1 of SCM Agreement defines indirect taxes as sales, excise, turnover, value added, franchise, stamp, transfer, inventory and equipment taxes, border taxes, and all other taxes other than direct taxes and import charges. 29 Annex I of SCM Agreement defines direct taxes as taxes on wages, profits, interests, rents, royalties, and all other forms of income, and taxes on the ownership of real property. 30 Report of the GATT Working Party, Border Tax Adjustment, adopted on December 2, 1970, L/ Id, at para See footnote (g) of the Tokyo Subsidies Code. 12

13 exported product could be relieved of some or all of the tax charged in the exporting country in respect of similar domestic products sold to consumers on the domestic market while an imported product sold to consumers could be imposed with some or all of the tax imposed in the importing country in respect of similar products. In other words, border adjustment of taxes permits similar products to be taxed equally at the place of destination, regardless of their origin. 33 Therefore, while GATT/WTO permits a country to rebate or adjust indirect taxes such as VAT, excise duties or other cascade taxes on exports, it does not permit a remission of income tax, wage tax or other social security taxes. Remission or exemptions from such direct taxes in regard to exports are generally considered as illegal subsidies. Even during GATT Council meeting in 1971, the question was raised by some Members as to why only direct taxes should be eligible for adjustment since the economic basis for such a clear distinction between direct and indirect taxes for adjustment purposes was not clearly demonstrated. 34 There is a view that border tax adjustments were not product of any economic theory, but a codification of practices followed by various Contracting Parties. It is rather surprising that even the United States did not consider this a serious issue at that time. The discussions within the GATT Working party indicate that most of the Contracting Parties felt that indirect taxes would be passed on into higher product prices whereas direct taxes would be borne by entrepreneurs profits and personal income and essentially would not have any price effect. 35 Economists generally agree that destination taxes are neutral rather than favoring exports. 36 However this is not the view necessarily shared by policy makers and legislators for whom the absence of border adjustability of direct taxes creates a significant trade disadvantage. For instance, this popular perception is well conveyed during a hearing before the House Ways and Means Committee: 33 Thomas W. Anniger, DISC and GATT: International Trade Aspects of Bringing Deferral Home, 13 HARV. INTL. LAW JOURNAL 391(1972). 34 Report of the Working Party, Border Tax Adjustment, adopted on December 2, 1970, L/3464; see also A.B Atkinson, The Distribution of Tax Burden, In MODERN PUBLIC FINANCE,(Joseph J. Cordes eds, 2004). 35 Report of the GATT Working Party, Border Tax Adjustment, supra note 30, para Charles McLure, The Value Added Tax: Key to Deficit Reduction, 1987; see also Gene M.Grossman, Border Tax Adjustments: Do They Distort Trade?, 10 JOURNAL OF INT L. ECON 117 (1980). 13

14 Mr. Jim McCrery: But the practical effect of allowing indirect taxes to be rebated at the border, and not direct taxes as they are defined by the WTO, is that a product coming from, say, France, which has a price attached to it, part of which is the value-added tax, the indirect tax, when you subtract that part of the price, what happens to the price that we pay in the United States for that product? It is reduced, isn t it? Whereas the same product emanating from the United States, going to France, and the tax component is an income tax, that can t be rebated at the border so you don t get that reduction of that price, right? 37 Part of the anger stems from the fact that the United States does not impose a VAT similar to the European VAT and has a world-wide income system as compared to the territorial system prevalent in the EU. In this context, the views expressed above captures the sentiments for providing a level playing field for U.S manufacturers and exporters through tax legislations providing export benefits. The following sections will examine the concept and treatment of subsidies at least in the legal, though not in the economic meaning under the GATT/WTO. C. Concept and Treatment of Export Subsidies under GATT/WTO The foregoing paragraphs provided a brief overview of the treatment of export subsidies in the context of the distinction between direct tax and indirect tax. It will be instructive to refer to at least three different sets of provisions under the GATT rubric. (a) Article XVI (4) of GATT (b) GATT Working Party Reports, and (c) Illustrative List of Annex I to the SCM Agreement 37 See Statement of Congressman Jim McCrery before the United States House Ways and Means Committee, February 27, 2007, available online at http//waysandmeans.house.gov. 38 When WTO treaty was signed in 1994, the erstwhile GATT, 1947 was reincorporated as GATT In other words, GATT 1994 which is an essential component of the new WTO Treaty is merely a rechristening of GATT, Report adopted 19 November, 1960, GATT doc. L/1381, reprinted in GATT, 9 th Supp. BISD, February, Report adopted 2 December 1970, GATT doc.l/

15 The primary GATT provision which directly deals with subsidies is Article XVI (4). Article XVI (4) can be broken down into four elements: the WTO Members shall cease to grant any form of subsidy (i) either directly or indirectly; (ii) on the export (iii) of any product other than a primary product (iv) which results in the sale of such product for export at a price lower than the comparable price charged for the like product to buyers in the domestic market. The 1960 GATT Working Party Report is one of the most useful documents for the interpretation of the provisions of GATT Article XVI (4). The Working Party set forth a list of eight specific practices considered to be subsidies in the sense of Article XVI based on a range of practices by the GATT community. Item (c) and (d) from the list of eight specific practices, which deal with remission and exemption, appear to be the key provisions. 41 These two terms were in fact the focus of attention in the various GATT/WTO panel reports. The Tokyo Subsidies Code ( Tokyo Code ) restated GATT s rule prohibiting the subsidizing of exports. More importantly, a clear illustration of the concept of export subsidy was provided for the first time in the Tokyo Code. The Tokyo Code added an illustrative list of practices which the Contracting Parties considered to constitute subsidizing activities. Within the Illustrative list, paragraph (e) of the Annex stated that full or partial exemption, remission, or deferral specifically related to exports of direct taxes, or social welfare charges paid or payable by industrial or commercial enterprises is considered an export subsidy. Annex I of the WTO Agreement on Subsidies and Countervailing Measures ( SCM Agreement ) follows almost verbatim the language of paragraph (e) of the Annex of the Tokyo Code and accordingly retains an Illustrative List. Notable among Item (e) of Annex I are paragraphs 2 and 41 Relevant part of the Working Party Report interpreting various practices as constituting subsidies under Article XVI(4) of GATT (c ) The remission, calculated in relation to exports, of direct taxes or social welfare charges on industrial or commercial enterprises; (d) The exemption, in respect of exported goods, of charges or taxes, other than charges in connection with importation or indirect taxes levied at one or several stages on the same goods if sold for internal consumption; or the payment, in respect of exported goods, of amounts exceeding those effectively levied at one or several stages on these goods in the form of indirect taxes or of charges in connection with importation or in both forms; 15

16 5 of footnote 59 which constituted the major plank of United States defense in the US-FSC and US-ETI disputes. These two provisions, in principle, enable a Member to exempt foreign source income and to design territorial or exemption based tax systems. The relevant paragraphs are worth noting. Sentence 2 of footnote 59 of Item (e) Annex I The Members reaffirm the principle that prices for goods in transactions between exporting enterprises and foreign buyers under their or under the same control should for taxes be the prices which could be charged between independent enterprises acting at arm s length Sentence 5 of footnote 59 of Item (e) to Annex I Paragraph (e) is not intended to limit a Member from taking measures to avoid the double taxation of foreign source income earned by its enterprise or enterprises of another Member The other contribution of the SCM Agreement was to incorporate a definition of subsidy. Part II (A) of this paper deals in detail with regard to some of the interpretive issues of the definition of subsidy. C.2. United States and the Tax Legislation cases- A Four Decade Story in a Nutshell United States was an extremely dominant manufacturer of industrial goods during the postwar period and had enjoyed persistent trade surplus. Therefore the U.S tax policies, viz., the adoption of a worldwide taxation system or the non-adoption of a consumption tax along the lines of the European VAT were not perceived to be serious disadvantages during the decades of the fifties and sixties. But the situation changed substantially during the decade of the seventies. 16

17 The following discussion provides a thumbnail sketch of the long and arduous path undertaken by the U.S since the early 1970 s to address the complaint that the U.S tax policy was tilted against the export interests of its businesses. A slew of legislative measures have been taken since then, but each one of them was either repealed or modified to a significant degree pursuant to the outcome in various international trade disputes. a. Genesis of DISC In 1971, the U.S Congress enacted the Domestic International Sales Corporations ( DISCs ) statute 42 to enhance the competitiveness of American exporters and, more importantly, to alleviate the deteriorating U.S. balance of payment situation. The DISC legislation attempted to carve out a partially territorial approach to taxation and was comparable to the EU approach. In other words, the U.S. Congress intended to reproduce the tax incentives for export sales under the territorial system, without formally introducing such a system. A DISC is a domestic corporation, a substantial portion of whose gross receipts arise from, and whose assets relate to, exporting activities. 43 To qualify as a DISC, a corporation must be incorporated within the United States and it must ensure that (1) 95% or more of its gross receipts are Qualified Export Receipts ; (2) 95% of its assets are Qualified Export Assets ; and (3) the corporation has only one class of stock and a minimum of $2500 in capital. One of the objectives of implementing the DISC legislation was to allow for the deferral of taxes on income from exports; a DISC was able to defer tax for up to one-half of its foreign profits 44 ; moreover the profits of the DISC are not taxed to the DISC, but instead are taxed to the shareholders of DISC when the profits are distributed or deemed to be distributed to them. Furthermore, the special inter-company pricing rules enabled the DISC to earn more profits than it would have been possible under the arm s length pricing requirement of I.R.C Section Pub. L. No , 85 Stat.497 (1971); The DISC statute came into force on January 1, 1972 and was incorporated in the United States Internal Revenue Code as Sections 991 to See Internal Revenue Code Sections Internal Revenue Code S. 995(b) (1) 17

18 The EC alleged that DISC was illegal because it allowed indefinite deferral of direct taxes on income from exporters earned through business activity conducted in the United States. The United States on the contrary alleged that the structure of the EU territorial systems provided export subsidies under certain circumstances, for example, by not rigorously applying arm s length pricing, thereby resulting in a large fraction of the export income being concentrated in exempt offshore branches. The United States was of the view that the DISC was not offensive of GATT Article XVI:4 or the 1960 Working Party Report since it was a deferral and not a remission or exemption, cancellation, release or forgiveness of direct taxes calculated in respect of exports. In 1973, the GATT Council established four panels which are commonly referred to as the Tax Legislation cases 45. The first among the Tax Legislation cases involved a complaint by the EU against the DISC whereas the remaining three panels, dealt with complaints by the United States that certain income tax practices of Belgium, Netherlands and France were inconsistent with Article XVI:4 of the GATT. 46 As far as the U.S. complaint against EU tax systems is concerned, the panel concluded that the territorial systems provided a subsidy for export sales through low tax countries and that lenient intra-firm pricing and cost allocation rules amplified the benefits.. The United States did not concede that the DISC regime violated the GATT 47. The GATT report (including the other three cases) and findings, after many years of deadlock, were formally adopted through a Memorandum of Understanding in 1981 ( 1981 Understanding 48 ) which 45 Tax Legislation, L/5271, 7-8 December, 1981, BISD 28S/ Supra, note 1 47 Joint Committee on Taxation: Background and History of the Trade Dispute Relating to the Prior-Law Foreign Sales Corporation Provisions and the Present-Law Exclusion for Extraterritorial Income and Description of These Rule, (JCX-10-02), February 25, Tax Legislation, BISD 28S/114, 7-8 December, The relevant part of the 1981 Understanding provides as follows: [T]he Council adopts these reports on the understanding that with respect to these cases, and in general, economic processes (including transactions involving exported goods) located outside the territorial limits of the exporting country need not be subject to taxation by the exporting country and should not be regarded as export activities in terms of Article XIV:4 of the General Agreement. It is further required that Article XVI:4 requires that arm s length pricing be observed, i.e., prices for goods in transactions between exporting enterprises and foreign buyers under their or the same control should for tax purposes be the prices which would be charged between independent enterprises acting at arm s length. Furthermore, Article XIV:4 does not prohibit the adoption of measures to avoid double taxation of foreign source income. 18

19 accepted the principles codified in footnote 2 of the Annex of Tokyo Subsidies Code. 49 It may be noted that the Tax Legislation cases were adjudicated well before the conclusion of the Tokyo Round, but were adopted with the incorporation of principles which were negotiated later in the Tokyo Round. In short, the report mentioned that the GATT Contracting Parties were not required to tax export income attributable to economic processes located outside their territorial limits, so long as arm s length pricing principles are observed in cross border transactions involving affiliates. In addition, the panel s 1981 decision held that GATT does not prohibit the adoption of measures in order to avoid double taxation of foreign source income, even if it otherwise resulted in export subsidies. b. Genesis of FSC Following the repeal of DISC, the Foreign Sales Corporations were enacted as part of Deficit Reduction Act of The FSCs sought to provide to a limited extent an exemption for the foreign source income from U.S taxation. Under the FSC rules, if U.S. exporters met the tests of foreign presence, management and economic processes, a fraction of income earned on exports sales were exempt from U.S taxation. 51 FSC was designed to conform to GATT by incorporating elements of the territorial tax system countenanced by the 1981 Understanding. FSCs are corporations generally incorporated in certain foreign countries mainly in off shore locations such as Guam, Barbados and British Virgin Island to obtain a U.S. tax exemption on a portion of their earnings generated by the sale or lease of the export property, which is a property 49 The panels in these disputes, each of which had the same composition, circulated their reports to the GATT Contracting Parties in November, These panel reports were highly controversial and resulted in an impasse which prevented the adoption of any of the reports. Eventually in 1981, the parties adopted the report long time after the conclusion of the Tokyo Round. 50 Tax Reform Act of 1984, Pub.L.No , 98 Stat.(1984). 51 The FSC treats 32 percent of the foreign trade income of the FSC as exempt income. The foreign trade income of the FSC is determined under generally applicable transfer pricing principles. But the FSC provisions also permitted the foreign trade income to be determined under administrative pricing rules. One of the methods included apportioning 23% of total taxable income derived from the sale of the export property while the other allocated 1.83% of the gross receipts of the FSC. The exempt income was then calculated as 16/23 of the foreign trade income so determined. See IRC 923 (a) (3). 19

20 manufactured or produced within the U.S. As a general principle under the U.S tax law, the foreign source income of a foreign corporation engaged in trade or business in the U.S. is taxable only to the extent that it is effectively connected with the conduct of a trade or business within the U.S. 52 This rule applies whether or not a foreign corporation is controlled by a U.S corporation. The key benefits of the FSC were three fold: first, the exempt foreign trade income of the FSC was legislatively determined not to be effectively connected with the conduct of a trade or business within the United States and thus was exempted from U.S tax which would be otherwise due and; second, the foreign trade income 53 of the FSC was excluded from the controlled foreign corporations (CFC) provisions of the Internal Revenue Code 54, which would otherwise require such income to be taxed in the U.S as part of the parent, and; third, under the FSC measure, U.S corporate shareholders of an FSC were allowed to deduct 100 percent of dividends received from distributions made out of the foreign trade income of an FSC. The WTO panel and later the Appellate Body held that the application of special rules for FSC serves to protect a certain portion of the foreign trade income of an FSC from direct taxation, whether or not that income would be taxable under the source rules provided for in Section 864 of the Internal Revenue Code. It was also held that exemption from the anti-deferral rules of Subpart F of the U.S. Internal Revenue Code ensured that the undistributed foreign trade income of the FSC was not immediately taxable to the U.S. parent of the FSC, even though such income might otherwise be subject to the anti-deferral rules. Finally, it was held that the 100 percent dividend-received deduction exempted the U.S. parent from taxes on that income even in cases where the FSC distributed earnings attributable to foreign trade income of the U.S. parent. In the opinion of the WTO panel and Appellate Body, the carve out of foreign source income 52 Section 882 (a) of Internal Revenue Code 53 The foreign source income of an FSC may be broadly divided into foreign trade income and other foreign source income. Foreign trade income is essentially the foreign source income attributable to an FSC from qualifying transactions involving the export of goods from the U.S. The foreign trade income is again divided into exempt foreign trade income and non-exempt foreign trade income. 54 The application of special rules for the FSC serves to protect certain proportion of the foreign trade income of a FSC from direct taxation. Whether or not that income would be taxable under the source rules is provided for in Section 864 of the US Internal Revenue Code. The exemption from the anti-deferral rules of Subpart F of the US Internal Revenue Code ensure that the undistributed foreign trade income of a FSC is not immediately taxable to the U.S parent of a FSC, even though such income might otherwise be subject to anti-deferral rules. 20

21 attributable to exports from the worldwide income tax system allowed by the FSCs constituted a prohibited subsidy. The United States was obviously under the belief that partial exemption schemes such as the FSCs were blessed by the 1981 Understanding and was also protected by Footnote 59. Interestingly, the panel ruled that the 1981 Understanding was not a governing law since it was not specifically incorporated in the new SCM Agreement. As regards Footnote 59, both the panel and the Appellate Body found that the FSC regime went considerably beyond protecting only foreign source income from U.S taxation. c. Genesis of ETI FSC Repeal and Extraterritorial Income Exclusion Act, was the legislative step taken by the United States to comply with the ruling of the WTO in the FSC dispute. This Act amended the IRC, inter alia, by inserting Section 114 entitled extraterritorial income. 56. In comparison with the FSCs, the principal change was that the ETI was an exclusion taxation method rather than a deferral taxation method and that a foreign entity vehicle was not necessary to obtain tax benefits. The ETI regime addressed the subsidy issue by establishing a general rule of taxation under which extraterritorial income was excluded from gross income. In order to qualify for treatment as an ETI measure, the income should be attributable to gross receipts, i.e. the income should derive from: (i) specific types of transactions such as sale, lease or rental transactions; (ii) involving qualifying foreign trade income ( QFTI ) 57 ; and (iii) the foreign process requirement is fulfilled with respect to each transaction. Section 942 (a) IRC designates as foreign trading gross receipts ( FTGR ) the receipts generated in transactions satisfying all three of the above conditions. 55 United States Public Law Stat.2423 (2000). Section 2 of the ETI Act repealed Sections IRC. 56 Section 3 of the ETI Act also introduced Sections 941, 942 and 943 into the IRC. 57 Section 943 (a) (1) IRC defines QFTI as including, inter alia, property manufactured, grown or extracted within or outside the United States, or held for sale, lease or rental for direct use, disposition or consumption outside the U.S and that not more than 50 percent of the fair market value of which is attributable to direct material and labor costs outside the United States. 21

22 The ETI Act clarified that gross income does not include extraterritorial income to the extent it is QFTI. QFTI is the amount of gross income that, if excluded, would result in a reduction 58 of taxable income by the greatest of (1) 1.2 percent of the FTGR derived by the taxpayer from the transaction, (2) 15 percent of the foreign trade income derived by the taxpayer from the transaction, or (3) 30 percent of the foreign sale and leasing income derived by the taxpayer from the transaction. In order to qualify for excluded extraterritorial income, the income must satisfy requirements relating to use outside the United States and foreign articles/labor limitations. In order to examine whether the ETI constituted a subsidy, the panel as well as the Appellate Body bifurcated the ETI provisions, separating the application to transactions involving property produced within the U.S. and abroad. 59 For property produced within the U.S., it was found that the foreign use requirement could be met only by exporting the property, which rendered the ETI Act export contingent. For instance, the definitions of FTGR, QFTP, and QFTI could be met only if the goods were exported from the U.S. The Appellate Body further stated that where a taxpayer elects to apply the ETI rules, the amount of tax paid by the taxpayer will very likely be less than the tax which the taxpayer would have otherwise paid on that income. The Appellate Body concluded that the right of election given to the tax payers to choose the most favorable rules of taxation in identifying the QFTI meant that United States had foregone revenue on income which was otherwise due. 60 The panel as well as the Appellate Body found that although the ETI was designed to avoid double taxation of income under Footnote 59, in effect, it provided tax exemption for even domestic source income. It was held that the ETI was both over and under inclusive to be considered a double taxation elimination measure. It was overly broad in that it included income that was unlikely to be taxed in another jurisdiction. For instance, a corporation that makes a sale 58 An example can be provided as follows: If a U.S. corporation and its overseas subsidiary sell an exported item for $100 and earn $40 of which 20% is attributable to the overseas subsidiary, the reduction in taxable income would be: Under 482 Transfer Pricing Method: 40*20%= $8*20%=$1.6; Under Combined Taxable Income: $40*15=$6, and; Gross receipts:- $100*1.83%=$ Report of the Panel, United States-Tax Treatment for Foreign Sales Corporations - Recourse to Article 21.5 of the DSU by the EC ( US- FSC (II) ), WT/DS 108/RW, adopted on January 22, Id, at para

23 abroad without having a permanent establishment in that jurisdiction was unlikely to be taxed there and, consequently, may not be subject to double taxation. d. The Lessons of DISC/FSC/ETI cases All the above legislations, in one form or another, attempted to provide carve outs of the foreign source income from world wide taxation, a long accepted benchmark of the U.S tax policy. In FSC as well as in ETI, the U.S. relied on the exemptions under Footnote 59, which enabled a Member to take steps for the avoidance of double taxation. The second prong of the U.S strategy was to rely on the 1981 Understanding which, in the opinion of panel and Appellate Body, did not have significance beyond resolving the Tax Legislation cases of the 1970 s. However, one could generally comment that the above legislations failed the WTO scrutiny because they were not tailored to fit in with the exceptions provided under the SCM Agreement. PART II A. Movement towards consumption tax The losses in the FSC/ETI disputes, amongst other reasons, revived the need to have a fresh look at the long running debate on income tax versus consumption tax in the U.S. There is a general criticism that income tax penalizes saving, whereas consumption tax does not. A consumption tax would not distort saving and investment decisions, and would treat all investment projects the same way. Many feel that consumption tax could be a viable alternative to the detailed and complex rules of income tax system and could bring in fairness, simplicity and economic efficiency. 61 It is widely believed that by eliminating disincentives to saving, a consumption tax could encourage capital formation, leading to higher growth rates, more capital per worker and higher before-tax-wages. 62 Even the U.S manufacturing and services industry demanded the adoption of a consumption tax with the flexibility of border tax adjustments, which many believed could restore the competitiveness of the U.S industry. However, this paper is not about 61 Daniel N. Shaviro, Beyond the Pro-Consumption Tax Consensus, 60 STAN. LAW REVIEW 745 (2007). 62 US Department of Treasury, Blueprint for Basic Tax Reforms (1977). 23