FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman, Congressman Rangel, and distinguished Members of the Committee, we appreciate the opportunity to appear today at this hearing on the World Trade Organization's recent decision regarding the extraterritorial income exclusion (ETI) provisions of the U.S. tax law.

On January 29^th, the WTO Dispute Settlement Body adopted a final report finding that the ETI provisions of the U.S. tax law are inconsistent with the United States' obligations under the WTO. We all are very disappointed with this outcome. This decision is the culmination of a challenge brought by the European Union in late 1997 against the foreign sales corporation (FSC) provisions then contained in the U.S. tax law. However, the origins of this dispute go back almost 30 years, predating the WTO itself. The United States has vigorously pursued this matter and defended its laws because of the importance of the provisions and principles at stake.

At its core, this case raises fundamental questions regarding a level playing field with respect to tax policy. Few things are as central to a country's sovereignty as the right to choose its own tax system. The ETI provisions, like the FSC provisions that preceded them, represent an integral part of our larger system of international tax rules. These provisions were designed to help level the playing field for U.S.-based businesses that are subject to those international tax rules. As we contemplate our next steps, we should not lose sight of that.

The Congress has demonstrated its commitment to the U.S. businesses, both large and small, that operate in the global marketplace and to the U.S. workers that produce the output that is sold in markets around the world. The Congress took decisive action, under significant time pressure, in passing legislation in November 2000 to respond to the first WTO decision in this dispute by repealing the FSC provisions and enacting the ETI provisions. That legislation represented a good faith effort to bring the United States into compliance with its WTO obligations while protecting the level playing field for U.S. businesses.

To be facing the same issue again so soon certainly is a disappointment. Nevertheless, we must look forward and pursue all options to resolve this matter so that American workers and the businesses that employ them will not be disadvantaged.

Mr. Chairman, the Administration looks forward to working closely with the Congress, on a bipartisan basis, to find a solution that will protect America's interests and honor our obligations in the WTO.

Our testimony today will focus on the particular provisions of our tax law at issue, the history of the dispute in the WTO over these provisions, and the findings and analysis of the WTO Dispute Settlement Body with respect to these provisions.

The FSC provisions were enacted in 1984. They provided an exemption from U.S. tax for a portion of the income earned from export transactions. This partial exemption from tax was intended to provide U.S. exporters with tax treatment that was more comparable to the treatment provided to exporters under the tax systems common in other countries.

A FSC that elected to be subject to these provisions generally was a foreign subsidiary of a U.S. manufacturer. The U.S. manufacturer sold its products to the FSC for resale abroad or paid the FSC a commission in connection with its sales of products abroad. In order to qualify for these provisions, the FSC was required to be managed outside the United States and was required to conduct certain economic processes outside the United States with respect to these export transactions. These economic processes related to the solicitation, negotiation, and making of contracts with respect to such transactions.

The sales or commission income of the FSC on these transactions was determined under specified pricing rules. The exemption from tax applied to a portion of the FSC's income from sales and leases of export property and from related services. The FSC was subject to current U.S. tax on the remainder of its income from these transactions.

The FSC provisions were enacted to resolve a General Agreement on Tariffs and Trade (GATT) dispute involving a prior U.S. tax regime - the domestic international sales corporation (DISC) provisions enacted in 1971. Following a challenge to the DISC provisions brought by the European Union and a counter-challenge to several European tax regimes brought by the United States, a GATT panel in 1976 ruled against all the contested tax measures. This decision led to a stalemate that was resolved with a GATT Council Understanding adopted in 1981 (the "1981 Understanding"). Pursuant to this 1981 Understanding regarding the treatment of tax measures under the trade agreements, the United States repealed the DISC provisions and enacted the FSC provisions.

The European Union formally challenged the FSC provisions in the WTO in November 1997, thirteen years after their enactment. Consultations to resolve the matter were unsuccessful, and the EU challenge was referred to a WTO dispute resolution panel. In October 1999, the WTO panel issued a report finding that the FSC provisions constituted a violation of WTO rules. The United States appealed the panel report; the European Union also appealed the report. In February 2000, the WTO Appellate Body issued its report substantially upholding the findings of the panel.

Although the United States believed that the FSC provisions were blessed by the 1981 Understanding, the WTO panel completely dismissed this argument, concluding that the 1981 Understanding had no continuing relevance in the interpretation of current WTO rules. The panel's analysis focused mainly on the application of the WTO Agreement on Subsidies and Countervailing Measures. The panel found that the FSC provisions constituted a prohibited export subsidy under the Subsidies Agreement.

Under the Subsidies Agreement, a subsidy exists if (1) government revenue otherwise due is foregone and (2) a benefit is thereby conferred. The Subsidies Agreement prohibits subsidies that are contingent, in law or in fact, on export performance. Looking first at the subsidy issue, the panel concluded that three specific aspects of the FSC provisions, taken together, resulted in an exception from taxation for income that otherwise would be subject to U.S. tax; the panel therefore concluded that the FSC provisions resulted in foregone government revenue through which a benefit was conferred. The panel then concluded that this subsidy provided by the FSC provisions was export-contingent, and therefore prohibited, because the tax treatment under the FSC provisions depended upon the exportation of U.S. goods. The panel further found that the FSC provisions constituted an export subsidy in violation of the WTO Agreement on Agriculture. The panel declined to rule on the European Union's additional arguments that the pricing rules and "domestic content" rules contained in the FSC provisions constituted separate violations of the WTO rules. The panel recommended that the subsidy provided by the FSC provisions be withdrawn with effect from October 1, 2000 (which date was later extended to November 1, 2000, under a procedural agreement between the parties).

In response to the WTO decision against the FSC provisions, the FSC Repeal and Extraterritorial Income Exclusion Act was enacted on November 15, 2000. This legislation had been voted out of this Committee with a vote of 34 to 1, and was passed by the House with a vote of 316 to 72. The legislation repealed the FSC provisions and adopted in their place the ETI provisions. The legislation was intended to bring the United States into compliance with WTO rules by addressing the analysis reflected in the WTO decision. The new regime addressed the subsidy issue by establishing a new general rule of taxation under which extraterritorial income is excluded from gross income; the new regime addressed the export-contingency issue by applying to income from all foreign sales and leases of property, without regard to where the property is manufactured. At the same time, the legislation also was intended to ensure that U.S. businesses not be foreclosed from opportunities abroad because of differences in the U.S. tax laws as compared to the laws of other countries.

The ETI provisions provide an exclusion from U.S. tax for certain extraterritorial income. This exclusion applies to a portion of the taxpayer's income from foreign sales and leases and certain related services. The ETI provisions apply to foreign sales and leases of property manufactured in the United States and also to foreign sales and leases of property manufactured outside the United States. In the case of property manufactured outside the United States, the manufacturer either must be subject to the taxing jurisdiction of the United States or must elect to subject itself to such jurisdiction. Thus, the income from transactions to which the ETI provisions apply is subject to consistent U.S. tax treatment.

Unlike the FSC provisions, the ETI provisions do not require the filing of an election or the formation of a special entity to which sales are made or commissions are paid. Also unlike the FSC provisions, the ETI provisions apply to both corporations and individuals in the same manner.

The exclusion provided under the ETI provisions generally is available only if certain economic processes are conducted outside the United States. As under the FSC provisions, these economic processes relate to the solicitation, negotiation, and making of contracts. A portion of the income from foreign transactions covered by the ETI provisions is exempt from U.S. tax. Because this exclusion is an alternative approach to addressing potential double taxation, foreign tax credits are not allowed with respect to the excluded income.

Immediately following the enactment of the ETI Act, the European Union brought a challenge in the WTO. In August 2001, a WTO panel issued a report finding that the ETI provisions also violate WTO rules. The panel report contained sweeping language and conclusory statements that had broad implications beyond the case at hand. Because of the importance of the issues involved and the troubling implications of the panel's analysis, the United States appealed the panel report.

The WTO Appellate Body generally affirmed the panel's findings. However, significantly, the Appellate Body modified and narrowed the panel's analysis. The Dispute Settlement Body adopted the report as modified by the Appellate Body on January 29, 2002.

The Appellate Body report makes four main findings with respect to the ETI provisions: (1) the ETI provisions constitute a prohibited export subsidy under the WTO Subsidies Agreement; (2) the ETI provisions constitute a prohibited export subsidy under the WTO Agriculture Agreement; (3) the limitation on foreign content contained in the ETI provisions violate the national treatment provisions of Article III:4 of GATT; and (4) the transition rules contained in the ETI Act violate the WTO's prior recommendation that the FSC subsidy be withdrawn with effect from November 1, 2000.

The analysis of the prohibited export subsidy under the Subsidies Agreement involved three separate issues.

First, the Appellate Body found that the ETI provisions constitute a subsidy under Article 1.1(a)(ii) of the Subsidies Agreement. The Appellate Body compared the ETI exclusion to the tax rules that otherwise would have applied to income from this type of transaction. Based on that analysis, the Appellate Body found that the ETI exclusion constitutes the "foregoing of revenue which is 'otherwise due'," that it confers a benefit, and that it is therefore a subsidy.

Second, the Appellate Body found that the ETI provisions are export contingent because of the provisions' application only to income from transactions involving property that is sold, leased, or rented for direct use, consumption, or disposition outside the United States. As did the lower panel, the Appellate Body bifurcated the ETI provisions, separating the application to transactions involving property produced within the United States from the application to transactions involving property produced abroad. For property produced within the United States, the foreign use requirement could be met only by exporting the property. Based on this bifurcation, the Appellate Body found that the ETI provisions are export contingent with respect to domestically produced products. This conclusion was not affected by the fact that the ETI provisions apply in circumstances that are plainly not export contingent (i.e., with respect to property produced outside the United States and sold for use outside the United States).

Third, the Appellate Body rejected the U.S. argument that the ETI provisions constitute a permitted measure for avoidance of double taxation. The United States believed that the ETI provisions fell within the fifth sentence of footnote 59 of the Subsidies Agreement which effectively permits a country to "tak[e] measures to avoid the double taxation of foreign-source income," even if the measures constitute export subsidies. The Appellate Body found that footnote 59 applies only to "foreign-source income" and that, to be considered "foreign-source income," the income must have sufficient links to another country that the income could be taxed by that other country. The Appellate Body further viewed the ETI provisions as potentially applying to income that would not fall within the reach of this rule as so interpreted. Therefore, the Appellate Body found that the ETI provisions do not constitute a measure to avoid double taxation under footnote 59.

Because the Appellate Body held that the ETI provisions constitute a prohibited export subsidy under the Subsidies Agreement, it followed that the ETI provisions also violate the export subsidy provisions of the WTO Agriculture Agreement.

The Appellate Body affirmed the panel's finding that the 50 percent limitation on foreign articles and direct labor costs contained in the ETI provisions violates GATT Article III:4.

The Appellate Body dismissed the U.S. factual point that taxpayers may meet this requirement without using any U.S. content whatsoever. The Appellate Body found that this limitation in the ETI provisions represents an encouragement of domestic manufacturers to use domestic over imported components, thereby providing less favorable treatment to imported products than to like domestic products.

The Appellate Body also rejected the transition rules included in the ETI Act, finding no basis for permitting the continuance of the application of the FSC provisions beyond the November 1, 2000 date specified for withdrawal of the subsidy found to have been provided by the FSC provisions. The Appellate Body rejected the U.S. position that efficient and fair administration of the tax laws frequently requires tax legislation to include transition rules and binding contract relief for taxpayers that acted in reliance on the prior law provisions.

When it challenged the ETI Act in November 2000, the European Union simultaneously requested authority from the WTO to impose trade sanctions on $4.043 billion worth of U.S. exports. The United States responded by initiating a WTO arbitration proceeding on the grounds that the amount of trade sanctions requested by the European Union was excessive under WTO standards. This arbitration was suspended pending the outcome of the European Union's challenge to the WTO-consistency of the ETI Act, and resumed on January 29^th with the Dispute Settlement Body's adoption of its final report. The parties are filing written submissions and will meet with the arbitration panel, which will issue its report on the appropriate level of trade sanctions on April 29^th. Following adoption of that report, the European Union will be authorized to begin imposing trade sanctions on U.S. exports up to the level set by the arbitrators.