Mr. Chairman, I should like to thank you for the invitation to appear before the committee this morning for this hearing regarding the implications of the WTO decision regarding the U.S. tax system for the foreign income of U.S. corporations. Because one of the other panelists, Gary Hufbauer, is an acknowledged expert on the intricate details of international trade and tax law and practice, I shall confine my testimony largely to judgments on the broader implications of this episode for U.S. sovereignty and for the increasing reach of international rules into the domestic arena.
Background
In early 2002, the judicial arm of the World Trade Organization rendered a decision that potentially could have led to punitive 100 percent taxes on $4 billion of U.S. exports to Europe--on goods and services as diverse as semiconductors, Boeing 747s, insurance policies, grains, books, and cosmetics. Specifically, the WTO Appellate Body held that a U.S. law allowing corporations that pay U.S. taxes to exempt certain “foreign” income constitutes a prohibited export subsidy under WTO rules.
To understand the background and context of the WTO ruling, one must go well back into 20th century international tax law and the problem of double taxation--that is, the potential that a corporation doing business across borders would be subject to taxation on the same income in both the home country and a foreign tax regime. As early as the 1920s, two methods of avoiding such situations were recognized in agreements among trading nations: granting a tax credit for foreign income taxes in the home country of the corporation and granting some kind of exemption from domestic taxation of foreign income. In both cases, because of the extraordinary complexity of individual national tax systems, it was acknowledged that the two systems would “shelter” some income that wasn’t taxed by any jurisdiction and, indeed, that even determining the domestic vs. foreign source of income was fiendishly difficult.
Another complicating factor that must be recognized is that two fundamental approaches exist to taxing foreign source income. Under the first (utilized in a modified form by the United States), a country generally taxes the income of persons or corporations subject to its jurisdiction, regardless of where they earn their income. This is referred to as a worldwide system of taxation. Under a second system, known as the territorial system, countries tax income all income within their borders, but do not tax income earned by their citizens or corporations abroad. This system is common among European countries.
The tension between the taxation of foreign income and trading rules first surfaced in the 1970s. In order to compensate for the tax subsidy granted automatically through the VAT rebates, the U.S. Congress in 1971 granted a limited tax deferral for U.S. exporters through the establishment of special domestic subsidiaries for exporting activities.The European Commission challenged the new law; and in turn, the United States challenged the tax exemptions provided on foreign income by several European countries. Separate panels, operating under the old General Agreement on Trade and Tariffs, came to the conclusion that both the U.S. and the European foreign tax systems violated GATT anti-subsidy rules.
The matter remained in limbo--with all parties blocking acceptance of the panel reports--until 1981, when a political solution attempted to end the impasse. At that time, the reports were adopted by the GATT General Council, subject to an “understanding” that substantially amended the rules regarding export subsidies. In relation to the GATT Subsidies Code, the Council agreed that: foreign economic processes need not be taxed by an exporting country; that failure to tax such processes did not constitute a forbidden export subsidy under the GATT; and that a nation could adopt measures to avoid double taxation.
Specifically, the 1981 Understanding stated:
“The Council adopts these reports on the understanding that with respect to these cases, and in general(italics added), economic processes (including transactions involving exported goods) located outside the territorial limits of the exporting country need not be subject to taxation by the exporting country” and should not be regarded as a prohibited export subsidy (under Article XVI:4). It is further understood that Article XVI: 4 requires that arm’s length pricing be observed…Furthermore, Article XVI: 4 does not prohibit the adoption of measures to avoid double taxation of foreign source income.”
Based upon this understanding, in 1984, the United States repealed the DISC legislation and replaced it with the Foreign Sales Corporation (FSC). The FSC provided for partial tax exemption for the income of a foreign corporate subsidiary derived from handling U.S. export sales. The amount of income exempted was calculated by a formula aimed to approximate arm’s length pricing (that is, dividing export profits between domestic and foreign sources). Though there was grousing from the EU, most considered that the issues had been settled through the political agreement. Then, in 1999, some fifteen years after FSC was created, the EU trade commissioner, in retaliation for U.S. victories in the bananas and beef hormones cases--and to attempt to create a bargaining chip to resolve these disputes--challenged FSC as a violation of the subsidies code negotiated in the Uruguay Round that ended in 1994.
In 1999 and 2000, successively, a WTO panel and the Appellate Body ruled against the United States. This produced an attempt to reconcile U.S. law with the WTO rules by passage of the Extraterritorial Exclusion Act (ETI) of 2000, which changed the definition of gross income by excluding a portion of export earnings and a portion of earnings from production abroad--with the stipulation also that such exclusion could only be utilized by corporations that did not claim foreign tax credits. In 2001 and early 2002, once again a panel and the AB ruled that the new U.S. law still did not conform to WTO rules. To complete the story, an arbitrator’s panel (actually composed of members of the original WTO panel) then ruled that the EU was entitled to punitive damages equal to the entire worldwide impact of the U.S. law--l00 percent tariffs on $4 billion worth of goods and services.
Flawed Law and Flawed Process and the Danger for National Sovereignty
I should like to highlight four large issues that the series of panel and Appellate Body decisions raise.
1. National Sovereignty and the Reach of WTO Rules into Domestic Policy.
The FSC/ETI decisions raise troubling questions about the reach of multilateral trading rules versus the right of national government to determine fundamental tax policy. Because these decisions cannot be overturned short of a unanimous agreement by WTO member states, they also highlight a major constitutional flaw in the WTO that already is operating in this and other cases to undermine its legitimacy: that is, the imbalance between the highly efficient (and virtually unchecked) dispute settlement system and the inefficient and practically unworkable consensus rulemaking procedures. In the final appeals before the WTO Appellate Body, the Bush administration clearly recognized the gravity of the issue raised by the earlier decisions and starkly warned the AB of the consequences of an adverse ruling. In an unprecedented move, the administration sent Kenneth Dam, the Deputy Secretary of the Treasury--and not some career USTR lawyer--to make the U.S. case.
Dam stated: “Few things are as central to a country’s sovereignty as how it raises revenue…The necessary implications of the Panel’s analysis is that the WTO may second-guess the reasonableness of a Member’s decisions regarding the most basic elements of its tax system. However, it is not the role of the WTO to substitute its judgment for the judgment of a Member’s own lawmakers in this regard.”
In almost every respect, the final judgment of the AB (and earlier panel reports), despite pious protestations to the contrary, ignored Dam’s warning.
After the final decision of the AB in 2002, in my judgment, the Bush administration erred in not vigorously and bluntly warning that at a minimum the decision would cause the United States to rethink its commitment to the WTO. In retrospect, given a series of other decisions that clearly go beyond the negotiated rules--in antidumping, safeguards, environmental protection--not laying down the gauntlet represents a missed opportunity.
2. WTO as (an incompetent) World Tax Court
Delving deeper into the details of the decisions one can see that the WTO panels and the AB demonstrated an appalling ignorance of international tax law and practice. As evidence that the WTO was over its head in this area, it should be noted that the four judicial reports (two each for the FSC and ETI cases by a panel and the AB) each offered widely differing, and even conflicting, interpretations of WTO rules and of international tax rules and law. In this testimony, I will only point to elements of the final panel and AB decisions.
In the ETI ruling, the AB posited the necessity for clean, bright lines between domestic and foreign source income, ignoring the impossibility of finely tuning such divisions when attributing income from transactions related to R&D, manufacturing, marketing, advertising, and transportation. In the complex and shadowy world of international taxation, systems aimed at avoiding double taxation inevitably allow some income to escape all taxation--and in most countries these fine lines are the subject of endless haggling between the government and its corporations. No knowledgeable international tax expert would have advanced such a naïve, simplistic interpretation.
In the earlier panel ruling, the panel arrogated to itself (i.e., the WTO) the determination of which exceptions a nation might introduce to the regular “normative benchmarks” of its tax system. And it did so in a way that inevitably discriminates against one prevailing form of international taxation--the universal system (U.S) by which a nation asserts the right to tax all income earned on a worldwide basis by its citizens and corporations. While the AB retreated from this sweeping language, in effect it also arrogated this power to the WTO.
3. WTO as Avenger: “Outrageous” Arbitrators Penalty Determination
At the time the arbitrators handed down their decision granting the EU the power to levy $4 billion in tariff retaliation for the ETI legislation, one leading international legal expert called the decision “outrageous.” His point was well taken.
The WTO rules are reciprocity based, and thus it has been standing practice and doctrine since the early days of the GATT that retaliation for a breach of obligations should be limited to the trade effects of that breach. There is also in the WTO subsidy rules the obligation that retaliation be proportionate to the effects of the subsidy. In this case, the United States argued (correctly in my judgment) that the trade damage to the EU was about $1 billion. The EU, however, argued not only that the amount of the subsidy be used as the basis for the calculation of damages but also that it be allowed to assess damages as a surrogate for the entire WTO membership--that is, for the full $4 billion of the subsidy to U.S. companies. Astonishing, the arbitrators bought this interpretation. They did on the basis of what they called the “gravity of the breach and the nature of the upset in the balance of rights and obligations”--wholly ignoring the mandate of proportionality. To reach this conclusion, the arbitrators invoked international law normally used for political and human rights violations, arguing that the U.S. breach represented an erga omnes offense--that is, against all WTO members and not just against the EU. As the trade scholar mentioned above wrote at the time:
“This sort of theory, created in a different context and for different purposes, was meant to apply in situations such as human rights violations where there is no quantifiable damage to the state seeking to impose sanctions and the “crime” truly does offend all. It has no place in trade disputes covered by the specific treaty language of the WTO Agreements. But the arbitrators and their staff went out of their way to misapply (this language) in an apparent attempt to embarrass the United States. The real embarrassment, however, is to those who wrote the decision.”
4. Need to Reform and Retrenchment
Stepping back from the arcane details of these individual cases, I would argue that what is needed is a major change in the mindset and intellectual isolation of the WTO dispute settlement system. In the FSC/ETI cases, both the panels and the AB demonstrated a stunning technocratic determination to barrel forward with their own pet legal theories and ignore the political history and context of the issues at hand. Legally, there was a strong case to uphold the 1981 Understanding that ended the 1970s standoff between the U.S. and the EU.
In other forums, I have argued for two potential reforms to the current system. In both cases, they would represent quite different instructions to the panels and AB.
A. Non Liquet
This legal term literally means “it is not clear.” Given the widespread agreement that WTO texts are replete with lacunae and contradictory provisions, and given that questions concerning the legitimacy of judicial decisions are magnified at the international level, the panels and the AB should be instructed to utilize this doctrine much more frequently--and throw the decision back to the WTO General Council or to trade round negotiations. Critics of non liquet have argued that it is prohibited because international law is necessarily “complete,” or that it is the duty of judges to step in and fill gaps, particularly in contentious areas.WTO rules, by common consent, are certainly not “complete” and arguments for “gap-filling” by judges reflect a dangerous--even anti-democratic--myopia.
B. Political Question Doctrine
Alternatively, the WTO could adopt a variation of the so-called “political issue doctrine,” developed by the US Supreme Court. The doctrine is meant to provide a means for the judiciary to avoid decisions that have deeply divisive political ramifications and thus, in the opinion of the court, should be settled through more traditional democratic processes, involving both the legislature and the executive. Once again, if such a doctrine is deemed important for preserving checks and balance at the national level, an even more cogent argument can be advanced for its introduction in WTO law--where the sources of legitimacy of judicial bodies are much weaker than within democratically constructed nation states.
In summary, the proposition advanced here is that heading off corrosive conflicts between the US and the EU in the future will necessitate reform of the international trading rules that have enmeshed--and entrapped--both trading superpowers.
Claude E. Barfield is a resident scholar at the American Enterprise Institute.
