• International Business Alert - January 2002
  • April 30, 2003 | Author: Charles V. McPhillips
  • Law Firm: Kaufman & Canoles A Professional Corporation - Norfolk Office
  • In a major blow to U.S. exporters, the World Trade Organization issued a ruling on January 14, 2002 holding that an important income tax incentive given to U.S. exporters violated international trade law. Responding to a complaint filed by the European Union, the WTO held that the FSC Replacement and Extraterritorial Income Exclusion Act (ETI Act), enacted by Congress in 2000 as a successor to the "foreign sales corporation", constituted an illegal export subsidy benefiting U.S. companies in competition with European companies for international sales.

    The European Union has estimated that this export tax program benefits U.S. companies to the tune of U.S. $4 billion annually. Under the ETI Act, U.S. corporations may exclude a portion of their profits earned on export sales from U.S. income taxation. The European Union contends that this tax exemption unfairly subsidizes U.S. companies such as Boeing which compete with European companies such as Airbus.

    The United States argues, however, that these tax benefits for U.S. exporters merely level the playing field since U.S. law otherwise taxes U.S. companies on all of their worldwide income, whereas many other countries, including some members of the European Union, employ a "territorial" system of taxation excluding (or at least deferring) income earned abroad from national taxation. Moreover, European value added taxes are not imposed on sales outside the E.U.

    Nonetheless, the WTO sided with the European Union's argument that the U.S. tax law violated several international conventions, including the Agreement on Subsidies and Countervailing Measures, the Agreement on Agriculture and the General Agreement on Tariffs and Trade. Consequently, the European Union may now impose compensatory trade sanctions against U.S. imports unless the United States rescinds the legally-maligned FSC/ETI tax benefit once and for all. Whether Congress or the Bush administration will yield to the WTO's decision remains to be seen, and therefore the possibility of a trade row is worrisome. Negotiations between the U.S. Trade Representative and his European counterparts will certainly increase in intensity. Unless and until the ETI Act is repealed by Congress, however, U.S. exporters will still be entitled to claim the tax benefit.

    The origins of the dispute go back many years, to an FSC precursor called the Domestic International Sales Company (DISC). GATT, the international predecessor organization to the WTO, held that the DISC violated international trade rules in 1976. The U.S. responded by replacing the DISC with the FSC in 1984.

    U.S. exporters typically organized FSCs as subsidiaries under the laws of a number of off-shore tax havens, and by complying with very manageable rules for attributing some of the company's export management and marketing activities to their off-shore subsidiary, the U.S. parent could effectively exempt approximately 15% of its export profits from U.S. income tax. (The rules for calculating the exempt income allocated to the FSC were myriad, but most U.S. companies grossing $1 million or more from export sales -- provided such sales were otherwise profitable -- could easily justify the modest organizational and maintenance costs associated with a FSC by virtue of the tax savings that would fall to the company's bottom line.) Dividends remitted by the off-shore subsidiary (the FSC) to the U.S. parent company out of the income allocated to the FSC were generally eligible for a 100% dividends received deduction.

    FSC benefits were limited to income generated from the sale of products, including software, that contained more than 50% U.S. content. Some services, including engineering and architectural services on foreign in construction projects, were also eligible for FSC benefits.

    The ETI Act, passed by Congress in 2000 as a response to the E.U.'s earlier complaint against FSCs, purported to phase out FSCs, but retained the concept of excluding from U.S. taxation a portion of a U.S. company's income earned from the sale of products (and services complementing such sale) outside the U.S. as long as the "foreign economic process requirement" was fulfilled on the transaction: i.e., (1) the taxpayer or its representative must be deemed to have taken action outside the U.S. in the solicitation, negotiation or making of the export contract and (2) 50% of the direct costs of obtaining, processing, fulfilling, transporting and/or invoicing the purchase order (or accepting risk of nonpayment) must be attributable to activities outside the U.S. If this test is satisfied, some of the income derived from the transaction may be characterized as extraterritorial income and excluded from U.S. taxation. Again, the actual calculation of such excluded income ("qualifying foreign trade income") is complex, but the bottom line under the ETI Act is very similar to that under the FSC regime.

    If the U.S. exporter exploits the benefits of the ETI Act on any given transaction, then the exporter may not claim a foreign tax credit for foreign income taxes paid in connection with such transaction. However, U.S. exporters can typically escape income taxation in the country of sale by avoiding a "permanent establishment" located in that country.

    The WTO has now condemned the ETI Act (and the FSC) as a prohibited export subsidy: i.e., the United States is deliberately foregoing income taxes on qualifying foreign trade income that would otherwise be payable by the exporter on a domestic sale of the same products.

    In any event, the unfortunate result of the WTO decision is that the E.U. legal missile lobbed at the likes of Boeing, Caterpillar, General Motors and Microsoft has now inflicted collateral damage on smaller U.S. companies attempting to pry open foreign markets for their products, an often expensive and risky undertaking that merits positive reinforcement under U.S. tax law.