Tax Break, Trade Battle?

Congress wants to replace foreign sales corporations with new foreign income rules, but the European Union is crying foul.
Ian SpringsteelNovember 1, 2000

Critics of the World Trade Organization (WTO) don’t always take to the streets, wearing turtle costumes and waving protest banners. Thanks to a long-simmering dispute over export tax breaks, some of the WTO’s biggest detractors can now be found in the executive suites of America’s largest companies.

The dispute centers on the U.S. tax code’s rules for foreign sales corporations (FSCs). Since their authorization in 1984, FSCs have enabled U.S. companies to collectively save billions of dollars on their export tax bills. But the European Union (EU) began complaining in November 1997 that the FSC regime amounted to an illegal export subsidy, and in October 1999, the WTO agreed. It set an October 1, 2000, deadline for the United States to either eliminate FSCs or change the rules according to the WTO’s terms. The ruling was upheld by a WTO appeals panel last February.

With significant input and support from business groups, the Clinton Administration and members of Congress drew up a plan that would replace the FSC regime with a completely new approach. On September 13, the U.S. House of Representatives passed a bill based on the proposal and sent it on to the Senate, where it was stalled at press time. On September 30, the United States and the EU agreed to extend the deadline for WTO compliance to November 1, giving the Senate the breathing room necessary to resolve the concerns of lawmakers on both sides of the aisle. The EU also said it would not impose sanctions without a WTO rejection of the replacement legislation, if passed.

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The one-month extension gives the issue a chance to cool off. “The agreement … reflects our common desire to handle trade disputes in a pragmatic and nonconfrontational manner,” said Pascal Lamy, European trade commissioner in Brussels, when the extension was announced. But the delay won’t stave off the inevitable challenge of the new tax regime by the EU. “The new tax regime is still a subsidy and is still focused on exports,” complains one EU delegation official in Washington, D.C., who spoke on condition of anonymity.

Once requested to take up the dispute again by the EU, the WTO would have 90 days to rule on the replacement tax regime. Simultaneously, a separate panel would be asked to determine appropriate sanctions, which the EU will argue will be “at least $4 billion, the value of the current subsidies,” predicts the EU delegation official. Appeals would certainly follow the WTO ruling, and the United States would face any consequences by mid-2001 at the earliest.

A Fine Piece of Work

The EU may be dissatisfied, but the U.S. business community has good reasons to support the new rules. For one, the rules could provide even bigger tax savings, amounting to around $5 billion per year. The Joint Committee on Taxation, Congress’s in-house tax office, estimates that the changeover to the new rules should cost the federal government just $1.5 billion in lost revenue over five years.

“Given the time constraints on the Congress, I think [the proposed new rules are] a very commendable result,” says James E. Rose Jr., senior vice president of taxes and government affairs at Tupperware Corp., in Orlando, and chairman of the tax and budget policy committee of the National Association of Manufacturers (NAM). “While the form of the tax benefit is very different, the existing benefits are largely mirrored in the new approach. Companies that benefited from FSCs will still benefit, and there’s a slight but welcome expansion for some companies manufacturing abroad.”

Companies will no longer be required to establish offshore entities to funnel sales through, or fuss with administrative transfer pricing rules for goods sold through those entities. Instead, the rules create a new category of general income called “qualifying foreign trade income,” which can be earned either through exports or through sales from an overseas manufacturing facility. All types of business entities, including sole proprietorships and S corporations, will be able to benefit from the tax break.

A portion of the qualifying foreign trade income would be exempt from U.S. taxes by an amount calculated in one of three ways: first, by 1.2 percent of a company’s gross foreign trade receipts; second, by 15 percent of the company’s foreign trade income; or third, by 30 percent of a company’s foreign sales and leasing income. Like the previous rules, this version includes the performance of many professional services–managerial services as well as engineering and architectural services–on projects outside the United States. Exceptions as to what kinds of property can generate qualifying income will be carried over from current law, including oil and gas, related-party transactions, and most intangibles.

The test for foreign manufactured goods qualifying for the exemption is twofold. First, no more than 50 percent of the value of foreign-manufactured goods can be derived from foreign inputs or foreign labor, similar to the domestic-content rules now in place for FSCs. Second, the manufacturer must be a domestic U.S. corporation, an individual subject to U.S. tax, a foreign company that elects to be subject to U.S. tax, or a partnership or pass-through entity owned by a combination of the aforementioned taxpayers. (A drawback is that income included in this category will not be allowed to qualify for foreign tax credit calculations, so taxpayers will need to be thoughtful about applying the new rules to income from various international operations, so as to minimize excess foreign tax credits.)

The bottom line: a reduction in companies’ federal tax rate from 35 percent to 29.2 percent on such qualifying income. Just how broadly the benefit will be adopted, however, is difficult to predict, along with the effect on federal tax revenues. “Budget estimates are just that, estimates, and this could be low or high,” says Ken Kies, co­managing partner in the Washington, D.C., national tax-services practice of PricewaterhouseCoopers. “It’s especially hard to predict, due to the interaction with the tax laws of other countries and our own treatment of other international income. So, we won’t know how applicable this will be for several years, until after companies have had a chance to use the new rules.”

Kies offers a profile of a hypothetical company that would likely benefit from the expanded tax break. It would be a company that operates a manufacturing facility in a low-tax country, such as Ireland; has a high profit margin that is immediately subject to U.S. tax; has few excess tax credits to offset; and makes a product with a high degree of content value from the United States, such as brand-name consumer goods, pharmaceuticals, or software. Examples of companies fitting this profile include Microsoft, Merck, and Guess Jeans, says Kies.

Companies should be able to adopt the rules for the 2001 tax year if they want, but current grandfathering provisions will permit FSCs to remain in place until the 2002 tax year, allowing a gradual transition to the new rules.

Current users of FSCs have been generally supportive of the new rules. “We use FSCs on a product-line-by-product- line basis, and generate some substantial tax savings as a result,” says Paula Graff, director of taxes at The Toro Co., in Bloomington, Minnesota. The lawn-care products company garners about $300 million of its $1.3 billion in annual revenues from sales abroad, and lowers its federal tax rate by about 3 percent by using the FSC rules. “We get a lot of bang for our buck from FSCs, so we’re happy as heck that the government has found a way to preserve the benefits despite the WTO ruling,” declares Graff. “And it looks like it will be easier to administer as well, which is a good thing.”

Picking a Fight

All this may be for naught, however, if the new tax regime fails to stand up to WTO scrutiny. Once the current bill in Congress has been passed into law, it’s all but certain that the European Commission, the bureaucratic body of the EU, will lodge another complaint with the WTO.

Business advocates in the United States aren’t surprised. “The Europeans are expressing outrage and disappointment, mainly because they’re surprised we’ve been able to come up with something that meets the WTO standards and still counters their VAT [value-added tax] rebate programs,” charges Kimberly Pinter, director, corporate finance and tax, at the NAM. “It’s political maneuvering, because they want to preserve the tax advantage they give to their companies, and have them eat our lunch.”

Treasury officials and trade experts are optimistic that the new law will stand up to another challenge–at least based on the points raised in the original WTO decision on FSCs. First, FSCs were found to be an export subsidy, which isn’t allowed under the General Agreement on Tariffs and Trade (GATT). Second, the exemption of taxes under FSCs was of “government revenue that is otherwise due,” making FSC benefits, whether applied to exports or not, an illegal subsidy under GATT. The new approach avoids both objections, experts say, as it applies to all income earned abroad from goods and services sold by U.S. taxpayers, and is a general exclusion on foreign income that meets certain criteria.

Still, there is a chance that the WTO will again side with the EU. The United States would likely respond with another set of rules, judging by the Clinton Administration’s support of the WTO’s dispute resolution system. Tupperware’s Rose speculates that “if the EU continues to be difficult on whether the new approach meets WTO standards, they may eventually regret it.” That’s because a likely reaction to another WTO defeat, he says, would be the adoption of a territorial system of taxation for companies, as opposed to the current worldwide taxation system. This would mean U.S. companies would pay taxes only on income in the United States. Such a system would mirror the model many European countries use, in combination with their VAT systems, and provide U.S. companies with a more level playing field, says Rose.

But EU trade officials regard that possibility as remote. “Major corporate tax reform has been on the agenda of the U.S. Congress for six years now and not much has happened,” says the EU delegation official. Moreover, EU officials believe the perception that U.S. companies operate at a tax disadvantage to European companies doesn’t hold water, another reason why the tax system hasn’t been changed. “U.S. corporations themselves have long complained that taxes in Europe are too high, and now they say they’re too low,” says the EU official. “It can’t be both.”

No matter what happens in the long run with tax reform, in the short term the possibility of trade sanctions looms large, and the likelihood that the current dispute will drag on for at least another year seems certain.

Ian Springsteel is a freelance writer based in Boston.