The ETI Dispute: An Opportunity to Include an Ongoing Case Study in the AICPA MTC

Author:
Wray E. Bradley, CPA, CMA, J.D., Ph.D.
Professor
The University of Tulsa
Tulsa, OK

For additional information about this column, contact Dr. Bradley at wray-bradley@utulsa.edu .

Tax educators continue to develop and refine courses specifically designed for the AICPA Model Tax Curriculum (MTC). From a teaching standpoint, capturing student interest and enabling students to be better informed about media-reported tax events may be even more important than trying to cover a variety of technical tax topics. Increasingly in MTC courses, tax educators are using case studies to do just this.

Instructors have the opportunity to develop a case study on the ongoing World Trade Organization (WTO) dispute concerning extraterritorial in-come (ETI). This dispute can add an international flavor to a tax course and provide a way to introduce basic MTC topics, such as legislative process, source of tax law, double taxation, interrelationships among taxing authorities and multi-jurisdictional taxation.

Students and practitioners alike are very interested in international tax policy discussions in the media. The WTO/ETI dispute continues to have wide media coverage. The characteristics of the dispute allow an instructor to adapt the level of coverage to a first- or second-level course, or to a graduate tax class.

Background

Prior to the 1960s, the income of U.S. multinational corporations' foreign subsidiaries was totally free from U.S. income tax, as long as the income was not repatriated. During the 1950s, many U.S. multinationals took advantage of this situation and moved operations to offshore tax havens. Typically, a U.S. manufacturer formed a foreign subsidiary (foreign-base company) in a tax-haven country with limited manufacturing resources. The subsidiary's manufacturing operations took place in the U.S. or in a foreign country with substantial manufacturing resources. The U.S. parent sold manufactured products to the subsidiary at a small markup. The subsidiary then fully marked up the products and sold them to customers. In many cases, this was merely a paper transaction; the goods were actually made in (and shipped from) U.S. plants.

Congress largely ignored these offshore foreign-base-company operations, until the U.S. began to experience declines in gross domestic product growth and deficits in the Federal budget. To raise revenue, the Kennedy Administration introduced a proposal to tax U.S. foreign-subsidiary income when earned, instead of when repatriated. Many in Congress opposed this; they thought that U.S. foreign-base companies would end up paying higher overall taxes than their foreign competitors located in the same foreign country. Eventually, in 1962, Congress passed laws governing controlled foreign corporations (CFCs).

CFC rules. CFC rules impose tax on certain types of "tainted" income generated by a U.S. controlled foreign-base company, including passive income and, generally, any business income from profit-shifting strategies. Almost immediately after enactment, several U.S. multinational manufacturers shifted all of their manufacturing operations to foreign companies that did not qualify as controlled subsidiary foreign-base companies. Because these foreign companies were not CFCs, their income was not subject to the CFC rules.

DISC rules. In 1971, in response to losing manufacturing jobs to overseas companies and to address the increasing international trade deficit, Congress enacted legislation specifically designed to promote exporting and keep U.S. manufacturing plants at home. The domestic international sales corporation (DISC) provisions, in effect, exempted certain export-related income from corporate taxation. The rules allow a U.S. corporation to create a separate U.S. corporation (a DISC) that can act as either a buyer, seller or sales agent for the original U.S. corporation's export products.

The DISC is not subject to direct U.S. corporate tax if, each year, its shareholders recognize part of the DISC income as constructive dividends. The recognition of the remaining DISC income is deferred, for Federal tax purposes, until the income is actually distributed or the DISC stock is sold. Thus, export income is partially taxed and partially deferred at the shareholder level each year. The corporation that makes and ships the export product never directly pays tax on income from qualified DISC export sales.

Almost immediately, the DISC rules created international trade controversy. In 1972, the European Economic Community (EEC) (comprised of Belgium, France and the Netherlands) lodged a formal complaint with the General Agreement on Tariffs and Trade (GATT) organization, alleging that the DISC rules violated a GATT rule prohibiting subsidies of products sold in foreign markets.

In 1973, the U.S. responded by filing counter-complaints against Belgium, France and the Netherlands. Under the territorial taxation schemes of the three countries, export income of domestic corporations' foreign branches or foreign subsidiaries was not generally taxed. The U.S. alleged that these tax systems created export subsidies.

In February 1976, a review panel examined all four complaints; in November (four years after the initial complaint), it issued final reports. Interestingly, the panel found that the tax systems of all four countries "in some cases" created export subsidies in violation of GATT rules.

For the complaint against the U.S., the panel found that the DISC legislative history indicated a specific intent to increase U.S. exports. This clearly showed that the DISC rules were intended to create export subsidies, an action prohibited under the GATT. For the complaints against Belgium, France and the Netherlands, the panel found that, although the territorial tax systems were not specifically intended to encourage exports, they sometimes created export subsidies. This was due to tax-exempt revenue generated from domestic companies' foreign-source income. This could benefit exporters when income and corporation tax provisions were significantly more liberal in foreign countries.

The DISC rules remained virtually unchanged and in effect until 1984. In 1984, the U.S. forgave approximately $10 billion in deferred DISC taxes and limited future DISC income deferral to the income generated from a maximum of $10 million of export sales. This effectively removed the DISC controversy from the international scene; currently, DISCs are only useful for small exporters. The territorial tax laws of Belgium, France and the Netherlands have remained virtually unchanged to this day.

FSC rules. Because Congress still believed that the territorial tax laws of foreign countries were a disadvantage to U.S. exporters, when it changed the DISC rules, it enacted the foreign sales corporation (FSC) rules. Under the FSC rules, if a U.S. exporter meets foreign-presence, management and economic-process tests, a portion of the income earned from export sales is exempt from U.S. taxation.

Example: U.S. manufacturer A forms FSC B. B sells A's products to others. For U.S. tax purposes, B computes its income using special transfer-pricing rules. A can exclude up to 32% of B's export-related income, depending on the transfer-pricing method chosen.

Similar to the DISC rules, the FSC rules served as a basis for international trade controversy.

In 1995, the legally recognized WTO entered the international trade dispute arena. The WTO was formed out of the prolonged 1986–1994 Uruguay Round of Multilateral Trade Negotiations. Shortly after its formation, the WTO adopted the updated GATT (1994) agreements and several other trade and administrative agreements and established a formal trade dispute resolution process through its Dispute Settlement Body (DSB).

Under DSB procedures, disputing parties meet for an initial consultation, after which an expert panel reviews the dispute in multiple stages. The disputing parties can appeal the expert panel's final report to an Appellate Body (AB). Once the AB rules, the appeal process is complete. The DSB then adopts the AB's findings and (if necessary) appoints an arbitration panel to determine the allowable sanctions. The DSB then specifies the terms and time period in which the parties must settle the dispute. If the settlement terms are not completed within this time frame, the complaining party(ies) would be allowed to institute countervailing measures (such as compensatory import taxes and tariffs). Unlike GATT, the WTO dispute settlement process has full authority of law, because the legislatures of the signatory countries formally recognize the WTO and all attendant agreements.

During the Uruguay Round, the FSC rules were a topic of discussion. Unlike the DISC rules, no country brought a formal complaint under the old GATT. However, once the WTO dispute mechanism was in place, the European Community (EC) initiated WTO dispute procedures against the U.S., alleging that the FSC rules created a prohibited subsidy under the WTO Agreement on Subsidies and Countervailing Measures (SCM).

The EC further alleged that the FSC rules, in effect, granted export subsidies to certain agricultural goods in violation of the WTO Agreement on Agriculture (AA). Barbados, Canada and Japan joined the dispute as third parties, siding with the EC. In accordance with DSB procedures, the parties met several times in 1997 and 1998, but failed to resolve the matter. In September 1998, a FSC review panel was formed.

In October 1999, the panel found that the FSC rules violated SCM provisions by creating prohibited subsidies, and that they created prohibited agricultural subsidies in violation of the AA. The U.S. appealed. The AB upheld the finding of a SCM agreement violation, but partially reversed on a finding that the FSC rules specifically violated the AA. It found that the FSC scheme did not provide direct subsidies that reduced the costs of marketing agricultural exports, but that the FSC rules caused the U.S. to act inconsistently with its obligations under the AA. The AB recommended that the U.S. change the FSC scheme to comply with all WTO agreements. The DSB adopted the AB findings in March 2000 and set an October 2000 compliance deadline.

ETI rules. On Nov. 15, 2000, former President Clinton signed the FSC Repeal and Extraterritorial Income Act of 2000 (ETI Act). The ETI rules were controversial from the start; some commentators believed they resulted in bigger subsidies than the old FSC scheme. Six days after President Clinton signed the ETI bill, the EC filed a WTO complaint asking for over $4 billion in trade sanctions.

In its November 2000 complaint, the EC alleged that the ETI Act did not comply with the March 2000 FSC settlement outlined by the DSB. Instead, the ETI scheme merely "appears to replicate the violations of the Agreement found in the original dispute rather than remove them." In December 2000, the DSB referred the "new" dispute to the original FSC panel. Australia, Canada, India, Jamaica and Japan joined the dispute as third parties siding with the EC. In August 2001, the panel issued a report on the new ETI rules, finding for the EC. On Nov. 1, 2001, the U.S. appealed the ETI panel ruling to the AB. On Jan. 14, 2002, the AB ruled against the U.S., and upheld all of the panel's findings.

With the AB procedure complete, the next stage in the dispute process calls for an arbitration panel to decide the retaliatory trade sanctions that the EC can impose. Once the sanction amounts have been determined, the DSB must decide whether to allow the EC to proceed with imposing retaliatory taxes and tariffs. The sanction amounts and the timeline for their implementation will be current news over the next several months.

Congress must significantly modify or repeal the ETI Act eventually. At some future time, the dispute will come to a close. This will take place either through negotiation (most likely) or by the EC imposing punitive tariffs on U.S. exports. Even after media coverage has subsided, the ETI dispute should remain suitable for tax-course discussion, as it is a significant landmark case in tax policy and international taxation.

Introductory-Level Tax Policy Considerations

The ETI dispute affords an excellent opportunity to develop several MTC-specific topics, whether introduced as an ongoing case study or as a historical case study. For an introductory-level course, instructors can focus only on selected findings in the Jan. 14, 2002 AB report:

1. The ETI Act created export subsidies in violation of WTO agreements.

2. The ETI Act was not a means for U.S. taxpayers to avoid double taxation of foreign-source income.

3. The ETI Act discriminated against imports.

Tax educators who teach a second-level MTC or graduate tax course can expand their ETI case-study coverage beyond these AB findings.

Sources of tax law and determining gross income. Course instructors can address how a mere trade dispute affects the internal taxation system of a sovereign nation. This can lead to a discussion of the legislative process, the legal standing of the Code, regulations, rulings, etc., and other sources of tax law.

Tax treaties: In introductory tax courses, instructors often overlook tax treaties as a source of tax law. Both beginners and advanced students often miss the point that international tax treaties have the full force of law behind them. This can be remedied by pointing out that, once Congress ratified the WTO agreements, they became law (just like the Code). This literally gives the WTO authority to intervene in sovereign internal matters that directly relate to international trade, including the U.S. tax system.

Subsidies: Another issue related to the AB export-subsidy ruling, focuses on the difference between the U.S.'s worldwide taxation system and the territorial taxation systems used by most of the major trading partners to determine gross income. The AB reasoned that, unlike most European countries, the U.S.'s taxation scheme included all worldwide income of a U.S. citizen or resident (corporation) in "gross" income. By excluding extraterritorial income from taxation, the U.S. "forgoes" tax revenue ordinarily due. This creates a subsidy under the SCM Agreement. In one sense, this reasoning would mean that all exclusions from gross income (e.g., under Secs. 101138) can be considered subsidies. However, the AB was only concerned about ETI (because it is directly related to exports).

The U.S. unsuccessfully argued that Sec. 114(a), not Sec. 61, specifically established the general rule under which ETI was not subject to taxation. It argued that because ETI is specifically excluded from gross income, forgone tax revenue never exists.

Many tax educators take the position that the general rule delineated by Sec. 61 states that everything is included in gross income unless specifically excluded. This (plus the worldwide taxation-system issue) can lead to lively class discussion about whether the AB's reasoning or the argument set forth by the U.S. representatives has the most support.

A discussion of Sec. 61 can also lead to economic, social and political issues related to specific exclusions from gross income. Instructors can also expand this topic to include a discussion of sound tax policy principals. Further, they can use the same export-subsidy topic to develop extensive multi-jurisdictional discussions and analyses in a second or Master's-level course.

Double taxation. Classroom discussion can also cover the AB ruling on double taxation. Students are often surprised to learn that the elimination of double taxation is not necessarily a guiding principle of tax policy. When instructors introduce corporate taxation, students quickly learn that double taxation and U.S. corporate taxation go hand in hand. However, Congress has tried to eliminate double taxation in many areas (e.g., the deduction allowed for state income taxes paid). In the international tax area, the motivation behind the foreign tax credit (FTC) is specifically to eliminate or minimize double taxation.

The WTO recognizes that elimination of double taxation of a member nation's residents or domestic companies is a legitimate goal. Foreign-nation double taxation is a sensitive issue directly related to tax import/export neutrality. All WTO nations have sought to maintain their sovereignty on this issue. Footnote 59 of the WTO SCM agreement specifically adopted double-taxation language. Under the footnote, an export subsidy might be legitimate if its express purpose is to avoid double taxation of foreign-source income. The U.S. argued that, even if ETI were considered to be an export subsidy under other WTO agreements, it would be allowed under footnote 59.

The ETI Act's legislative history clearly indicated that Congress specifically intended to avoid double taxation of foreign-source income. Nevertheless, in January 2002, the AB ruled that the ETI exclusion was still a prohibited subsidy. The AB reasoned that (despite the legislative history) the ETI provisions do not clearly distinguish between the ETI exclusion of foreign- or domestic-source income. Under the ETI rules, both types of income can qualify for the exclusion; the footnote 59 exclusion specifically adopted for foreign-source double taxation did not apply. Further, a U.S. taxpayer can use the ETI exclusion or pay foreign tax and use the FTC, providing alternative means for avoiding double taxation of foreign-source income.

Legislative process: The AB's ruling on double taxation also directly examined Congress's internal legislative process. On the one hand, avoidance of double taxation is a sovereign principle agreed on by the WTO members. However, despite the written legislative history associated with ETI, Congress's method did not meet the WTO double-taxation avoidance standard. This raises the issue of who has authority to impose tax and whether there are limits.

State and local taxation systems. Instructors can easily extend a double-taxation discussion beyond the ETI Act to include state and local tax issues. Such a discussion can include ideas and policy issues on who has the authority to impose state and local tax, and how international law affects nexus. Instructors can tailor the depth of discussions and analyses to fit the course level.

Interrelationships of taxing authorities and tax systems. Under the current WTO dispute mechanism, a foreign government can challenge a state law by filing a WTO complaint. The same consultation process applies, except that a state spokesperson works with the U.S. trade negotiators. If a WTO panel ultimately rules against a state and the state refuses to change its law, the U.S. could sue the state in Federal court. Therefore, international trade agreements extend beyond state sovereignty; they can directly affect a state's taxation system. A WTO ruling has the full force of law; it is binding on the Federal government. As a result, through the supremacy clause of the Constitution, it is also binding on state governments. The effects of this were brought out in a controversy involving import discrimination.

Under the original GATT agreement and the WTO-adopted GATT agreement, member countries cannot discriminate against imports. The AB found the ETI Act in violation of this provision. The ETI Act excludes from gross income sales from certain goods or services used outside the U.S. To qualify for this exclusion, these goods or services cannot include more than 50% of foreign components or labor. The U.S. argued that this provision does not discriminate against imports, because the 50% limit applies only to labor and physical components. No limit exists on the use of intangibles (such as foreign patents, foreign capital and foreign intellectual capital).

The AB recognized the distinction between labor and tangible components and intangibles, but reasoned that the 50% rule actually served as an incentive to use domestic components and labor. A U.S. company had no incentive to use imported parts or labor, because of manufacturers' concerns about violating the 50% rule if it used more than a minimal amount of foreign labor or parts. Therefore, the 50% rule discriminates against foreign components and labor. A discussion of the ruling on import discrimination will quickly reveal that the provisions of an international trade agreement can extend well beyond Federal taxation.

Instructors can use the AB ruling on import discrimination as a bridge to a second, related case study sometimes known as "Beer II." Prior to the ETI dispute, Canada filed a GATT complaint, claiming import discrimination against the U.S. Federal government (as well as 40 different state governments), alleging that the U.S. Federal and state excise tax systems discriminated against Canadian beer, wine and cider.

Both Federal and state taxing jurisdictions impose an excise tax on alcoholic beverages. Under the excise tax system, imported beer and wine can be subject to higher taxes than domestic beer and wine. For example, in 1990, the Federal excise tax on beer was $18 per barrel for large breweries and $7 per barrel for small breweries. For wine, it was $0.90 a gallon for large wineries, with no tax on small wineries. The U.S. taxed imported beer at the $18 rate and imported wine at the $0.90 rate.

Several states provided lower excise taxes on wine and beer brewed in-state. In addition, many states had various other provisions designed to favor in-state beer and wine. For example, some states required breweries to sell imported beer and wine only through wholesalers. Other states fixed the price of imported beer and wine, while still others required that only common carriers can transport imported beer and wine. The GATT panel found for Canada, recommending that the U.S. bring all "inconsistent federal and state measures into conformity with its obligations under the General agreement."

The Canadian complaint was filed under the old GATT. This was prior to the establishment of the WTO dispute-settlement procedures when GATT did not have full force of law (because Congress had not ratified it). Because of this, the Federal government never took action against any state. Further, a large majority of the 40 states never changed the laws that discriminate against imported alcoholic beverages. However, this does not mean that "Beer II" or similar complaints have disappeared.

Conclusion

Increasingly in tax education, traditional lecture methods are being supplemented by more interactive methods. The use of case studies is one way that tax educators can create a more interactive learning environment. The problem is finding a case study suitable for a wide range of topics, students and courses. The WTO/ETI case is rare in these respects. Instructors can adapt it in simple form to a first- or second-level course, or in expanded form, to a graduate-level course.

The WTO/ETI case is easily supplemented by the "Beer II" case. The media continues to cover the ETI dispute, as final settlement is still pending. In addition, there is considerable historical media coverage beginning in 1997 with the predecessor FSC dispute. Last but not least, students may find the ETI and "Beer II" cases interesting.