CRS Explains WTO Involvement in U.S. FSC Provisions

                       CRS REPORT FOR CONGRESS

[1] The Foreign Sales Corporation (FSC) provisions of the U.S. Internal Revenue Code provide an income tax benefit for exporting, permitting firms to exempt between 15% and 30% of export income from taxation. FSC was enacted in 1984 to replace another tax benefit for exporting -- the Domestic International Sales Corporation (DISC) provisions. U.S. trading partners had charged that DISC was an export subsidy, and so violated the General Agreement on Tariffs and Trade (GATT); the FSC provisions were an attempt to revamp the DISC benefit to make it GATT-legal. Recently the countries of the European Union (EU) lodged a complaint against FSC with the World Trade Organization (WTO, GATT's successor), arguing that FSC itself is an export subsidy and so violates the agreements on which the WTO is based. In October 1999, a WTO panel issued a report supporting the EU. Under WTO procedures, the FSC provisions are required to be brought into WTO compliance by October 2000. Absent compliance, the EU could request compensation from the United States, or request the WTO to authorize retaliation. On May 2, the United States presented the EU with a proposed alternative to FSC, but on May 29, the EU notified the United States that [sic] did not find the proposal acceptable. The Administration has indicated it will nonetheless seek to have the new plan enacted by Congress before the October deadline. For its part, economic analysis suggest that FSC does increase U.S. exports, but likely triggers exchange rate adjustments that also result in an increase in U.S. imports, the long run impact on the trade balance is probably nil. Economic theory also suggests that FSC likely reduces aggregate U.S. economic welfare. This report will be updated as events in Congress and elsewhere occur.

FSC'S PREDECESSOR (DISC) AND THE GENERAL AGREEMENT ON TARIFFS AND TRADE

[2] The current FSC controversy has its roots in the legislative antecedent of FSC: the U.S. tax code's Domestic International Sales Corporation (DISC) provisions, first enacted in 1971. Like FSC, DISC provided a tax incentive to export, although its design and mechanics were different in certain respects. DISC was enacted as part of the Revenue Act of 1971 (P.L. 92-178). At the time, it was thought that a tax incentive for exports was desirable to stimulate the U.S. economy, to offset the tax code's "deferral" benefit, which posed an incentive for U.S. firms serving foreign markets to establish foreign operations; and to offset export benefit other countries gave their firms. ¹

[3] DISC soon encountered difficulties with the General Agreement on Tariffs and Trade (GATT), a trade agreement to which the United States and most of its trading partners were signatories. Members of what was then the European Community (EC) submitted a complaint to the GATT Council arguing that DISC was an export subsidy and therefore contravened article XVI of the GATT. The United States, however, filed a counter-claim, holding that the "territorial" tax systems of France, the Netherlands, and Belgium themselves conferred export subsidies. Under a territorial tax system, a nation does not tax the income of its corporations if that income is earned by a branch located abroad.

[4] A GATT panel issued reports in 1976, finding that elements of both the territorial systems and DISC constituted export subsidies prohibited under GATT. In 1981, the GATT council adopted the panel's findings, but with an understanding aimed at settling the dispute: countries need not tax income from economic processes that occur outside their borders -- territorial tax systems, in other words, do not by themselves contravene GATT. The understanding also held, however, that arm's length pricing must be used in applying the territorial system to exports. Nevertheless, the controversy continued to simmer and the meaning of the 1981 understanding itself became an item of contention. The United States never conceded that DISC was a subsidy, but the issue was becoming more serious and "threatened breakdown of the dispute resolution process." ² The U.S. Treasury thus proposed what eventually became the 1984 FSC provisions.

[5] The provisions were designed to conform to GATT requirements by providing an export tax benefit that incorporates elements of the territorial tax system countenanced by the 1981 understanding. The understanding held that a country need not tax foreign-source income. For its part, the United States, while it does not operate a territorial system (it does tax U.S. chartered corporations on their worldwide income) taxes foreign-chartered corporations only on their U.S. source income. As described more fully below, firms avail themselves of the FSC benefit by selling their exports through FSCs. FSCs are required to be chartered abroad or in a U.S. territory; part of their income is classified as not being from U.S. sources. Thus, the mechanics of the FSC benefit were designed to emulate aspects of the territorial tax system.

FSC AND THE WORLD TRADE ORGANIZATION

[6] The European countries were not fully satisfied of FSC's GATT-legality. ³ Still, the controversy remained below the surface until November, 1997, when the EC requested consultations with the United States over FSC, thereby taking the prescribed first step in the dispute settlement process established under the new WTO. ⁴ The United States and the EC held consultations without reaching a solution, and in July, 1998, the EC took the next step in the WTO- prescribed dispute-resolution process by requesting establishment of a panel to examine the issue. The panel was formed and on October 8, 1999, it made its findings public. ⁵

[7] The panel generally supported the complaints of the EC, holding that FSC is indeed a prohibited export subsidy, and that FSC violated subsidy obligations under both the WTO Agreement on Subsidies and Countervailing measures and the WTO Agreement on Agriculture. In particular, Articles 3.1 and 1.1 of the Subsidies and Countervailing Measures (SCM) Agreement provide that a subsidy exists if "government revenue that is other-wise due is foregone or not collected . . . and a benefit is thereby conferred." The panel found that the FSC provisions carved out particular exceptions to various parts of U.S. tax law that would otherwise have generally resulted in taxation of the FSC export income. ⁶ The United States filed an appeal with the WTO's Appellate Body, but the Appellate Body essentially upheld the initial finding. Under the WTO's dispute procedures, the United States now has until October 1, 2000, to bring its system into compliance with the WTO rules. Failure to do so may ultimately result in the WTO sanctioning retaliatory measures by the EC against the United States. ⁷ The United States and EU, however, would be allowed to fix an alternative, mutually agreed-on deadline.

[8] On May 2, the United States presented the EU with a proposed alternative to FSC. Although details of the plan have yet to be published, it apparently would exempt part of all foreign-source income of branches of U.S. firms from tax, not just exports. The treatment would be in lieu of the "deferral" tax benefit for U.S. firms with foreign operations, but would be elective. On May 29, however, the EU notified the United States that it would not accept the proposal. The Administration has indicated that it will nonetheless work with Congress to enact the plan by the October deadline. At the same time, the EU has indicated that it remains open to discussions on the issue, and the topic is expected to be discussed during President Clinton's trip to Europe in late May.

HOW THE FSC BENEFIT WORKS

[9] In general, the United States taxes its resident corporations -- that is, corporations chartered in the United States -- on their worldwide income. Ordinarily, then, a U.S. corporation could expect to be taxed on its export income, regardless of whether the income were adjudged to have a foreign or domestic source. In contrast, the United States taxes foreign corporations -- that is, corporations chartered abroad -- only on income from the active conduct of a U.S. trade or business. U.S. firms avail themselves of the FSC benefit by selling their exports through specially qualified subsidiary corporations (FSCs) organized abroad. (The FSC benefit can also be obtained by selling through a FSC on a commission basis.) As foreign corporations, FSCs would ordinarily be subject to U.S. tax on the part of their export income determined to be from U.S. sources. However, the FSC rules deem a specified portion of FSC income not to be from the active conduct of a U.S. trade or business, and thus exempt from U.S. tax. Ordinarily, the FSC export income could still be taxed when remitted to the U.S. parent corporation as an intra- firm dividend, The FSC provisions also provide, however, that the parent can deduct 100% of its FSC dividends.

[10] The size of the FSC benefit results from the rules that specify how much of the FSC's income is tax exempt, and on the rules governing how the combined parent-and-FSC export income is required to be allocated between the two. There are three alternative rules a firm can use to divide income between the parent exporter and tax- favored FSC. First, a firm can use "arm's length pricing" to divide the income. That is, the firm assigns a price to each transaction between the parent and subsidiary based on the price that would prevail if the parent and FSC were in fact unrelated corporations. Income is divided on the basis of the prices thus determined. Alternatively, a firm can use one of two so-called "administrative" methods for allocating income. As a result of these rules, a firm can exempt at least 15% but no more than 30% of export income from taxes.

[11] The FSC provisions are only one of two alternative tax benefits for exporting provided by the U.S. tax code. The second benefit -- known variously as the "sales source rule," the "inventory source rule," or the "export source rule" -- permits export firms in some circumstances to exempt 50% of their income from U.S. tax. The second benefit is thus generally larger than the FSC benefit. It works by permitting firms to allocate half of their export income to foreign rather than U.S. sources when they calculate their U.S. foreign tax credit limitation. For firms that have enough foreign tax credits to offset all U.S. tax on foreign-source income, the allocation rule is tantamount to a tax exemption.

[12] The export source rule can be used by a firm in conjunction with FSC, but the FSC provisions contain rules that limit the amount of income that can be allocated to foreign sources using the sales source rule. As a result of these rules, a firm that is in a position to benefit from the sales source rule (one with sufficient foreign tax credits) generally achieves a larger tax benefit by using the source rule exclusively rather than a combination of the rule and FSC. Note, however, that while FSC can generally be used by all exporters, the sales source rule is restricted to firms that have paid foreign taxes.

ECONOMIC EFFECTS OF FSC

[13] The FSC exemption reduces the rate of return required, before taxes, of investment in the export sector, and thus attracts investment to exporting. As a consequence, U.S. exports are probably higher than they would be without FSC. How much higher depends on the extent to which export supply increases in response to the tax benefit -- that is, how much of the tax benefit U.S. suppliers pass on to foreign consumers as lower prices -- and on how responsive foreign purchasers are to reduced prices for U.S. exports.

[14] Beyond this effect, however, traditional economic analysis indicates that FSC produces a set of effects that are perhaps surprising to non-economists. First, because of exchange rate adjustments, the FSC-induced increase in exports is diminished, and U.S. imports also are increased; sales of U.S. import-competing industries thus fall. Economic theory indicates that while FSC increases the overall level of U.S. trade, it does not change the balance of trade, or reduce the U.S. trade deficit. The adjustments work as follows: FSC increases foreign purchases of U.S. exports, but to buy the U.S. products, foreigners require more dollars. The increased demand for U.S. dollars drives up the price of the dollar in foreign exchange markets, making U.S. exports more expensive. This partly offsets the effect FSC has in increasing U.S. exports, but also makes imports to the United States cheaper, which causes U.S. imports to increase. The net result is a higher level of both imports and exports, but no change in the overall balance of trade.

[15] This result is perhaps better seen by stepping back from the exchange rate mechanisms and recognizing that when a country runs a trade deficit it is using more goods and services than it produces. To do so, it must necessarily borrow from abroad by importing more foreign investment than it exports. A country's trade deficit, in other words, is mirrored by deficit on capital account. And a country's trade balance only changes if the balance on capital account changes. Thus, if we assume that FSC does not change the balance on capital account, it cannot change the trade balance.

[16] Another effect of FSC is on U.S. economic welfare; traditional economic analysis indicates that FSC reduces overall U.S. economic welfare. FSC does so because in increasing U.S. exports, at least part of the tax benefit is passed on to foreign consumers in the form of lower prices. This price reduction can be viewed as a transfer of economic welfare from U.S. taxpayers in general to foreign consumers. ⁸

[17] These effects, however, are probably not large. The most recent U.S. Treasury Department report on FSC estimated that if FSC had been eliminated for tax year 1992, U.S. exports would have fallen by 3-tenths of one percent and U.S. imports would have fallen by 2- tenths of one percent. Repealing the provision would have had a negligible effect on the trade balance, reducing net exports by $140 million. ⁹ The report did not estimate the impact of FSC on economic welfare. However, a 1994 analysis by Rousslang and Tokarick estimated that FSC and the export source rule benefit together reduced U.S. economic welfare by one one-hundredth of one percent of income, or just under $1 billion. ¹⁰ FSC's cost in terms of forgone tax revenues is estimated by the Joint Committee on Taxation at $2.7 billion for fiscal year 2000. The sales source rule's revenue loss is estimated at $4.0 billion.

[18] If economic analysts are generally critical of FSC, support for the measure can be found in the business community. A reason for the divergence in views may be perspectives: economic analysis looks at the impact of FSC from the perspective of the economy as a whole, taking into account its full range of effects and adjustments in all markets. Supporters of the provision, however, are frequently businessmen whose exporting firms would likely face declining sales, profits, and employment if FSC were to be eliminated, For economists, there is no denying that FSC boosts employment and increases incomes in certain sectors of the economy. But it also results in contraction of other parts -- for example, firms that compete with imports -- and transfers economic welfare to foreign consumers.

[19] FSC has also occasionally been defended on the grounds it counters subsidies provided to foreign producers by their own governments. A purported subsidy that is sometimes cited is the practice among European (and other) countries of rebating the Value Added Taxes (VATs) that would otherwise apply to export sales. However, economists have long held that such "border adjustments" do not distort trade and are in fact necessary if exported goods are to be part of the same relative price structure as other goods in the importing country. ¹¹ In addition, U.S. sales and excise taxes do not apply to exports, while European countries do not have a formal system for forgiving corporate income tax on exports. (However, in the case of countries with territorial tax systems, lax administration of transfer pricing rules may result in export subsidies.)

[20] In recent decades, some economists have applied models of market imperfections to international trade and have concluded that in some cases, government intervention in trade might improve a country's economic welfare. For example, in markets where only a few firms compete for profits, a "strategic trade policy" such as an export subsidy might shift profits from a foreign firm to a domestic one. Or, external economies such as knowledge spillovers might recommend a subsidy for the industry in which the economies occur. These policy prescriptions, however, have been met with considerable skepticism among trade economists for a variety of reasons. First, the theory that supports strategic trade is not robust -- for it to work requires a variety of special assumptions. Second, a more appropriate way to address external economies that occur in the domestic economy may be to apply a subsidy in the domestic economy rather than the international one. Third, as an empirical matter, cases where export subsidies can improve economic performance may well be quite limited. And finally, groups that can benefit from a subsidy may coopt a subsidy that is initially well-targeted so that its aim ultimately fails. ¹² Perhaps more importantly for FSC, even if developments in trade theory were to support export subsidies in certain circumstances, they likely do not support a broadly available benefit such as FSC as a structural and permanent part of the tax code.

² U.S. Congress. Joint Committee on Taxation. General Explanation of the Deficit Reduction Act of 1984. Washington, U.S. Govt. Print. Off. 1984. p. 1041.

³ Caplan, Bennett, and Matthew Chametzky. Domestic International Sales Corporations (DISCs) and Foreign Sales Corporations (FSCs): Providers of Economic Incentives for Wholly- Owned Domestic Exporters. Brooklyn Journal of International Law. V. 12. No. 1, 1986. p. 14-15.

⁴ For information on the WTO's dispute settlement process, see: U.S. Library of Congress. Congressional Research Service. Dispute Settlement in the World Trade Organization: An Overview. Report RS20088, by Jeanne S. Grimmett. Washington, 1999. 6 p.

⁵ For a chronology of the WTO dispute process relating to FSC, see: United States -- World Trade Organization. Tax Treatment for Foreign Sales Corporations. Report of the Panel. P. 1.

⁶ World Trade Organization. United States -- Tax Treatment for "Foreign Sales Corporations": Report of the Panel. WT/DS108/R. 8 October, 1999. P. 275.

⁷ Dispute Settlement in the World Trade Organization: An Overview. P. 5.

⁸ As noted above, FSC increases both imports and exports -- the overall level of trade. If FSC were to operate in isolation, this increase in trade would reduce economic welfare in a second way by causing the U.S. economy to inefficiently specialize in the items it exports and under-produce goods that compete with items the country imports. But in view of other trade distortions that work in the opposite direction, it may be premature to conclude that FSC causes an efficiency loss.

⁹ U.S. Department of the Treasury. The Operation and Effect of the Foreign sales Corporation Legislation: July 1, 1992 to June 30, 1993. Washington, 1997. P. 15.

¹⁰ Rousslang, Donald J. and Stephen P. Tokarick. The Trade and Welfare Consequences of U.S. Export-Enhancing Tax Provisions. IMF Staff Papers. V. 41. Dec., 1994. P. 680. Their original estimate was $660 million 1987 dollars; inflating it to current dollars results in $968 million.

¹¹ Krugman, Paul, and Martin Feldstein. International Trade Effects of Value-Added Taxation. Working Paper 3163. Cambridge, MA, 1989. National Bureau of Economic Research. 26 p.

¹² See: Baldwin, Robert E. Are Economists' Traditional Trade Policy Views Still Valid? Journal of Economic Literature. V. 30. June, 1992. Pp. 804-29; Bhagwati, Jagdish. Free Trade: Old and New Challenges. The Economic Journal. V. 104. March, 1994. Pp. 231-46; and Krugman, Paul. Does the New Trade Theory Require a New Trade Policy? World Economy. V. 15. July, 1992. Pp. 423-41.