Order Code RS20746
Updated July 25, 2001
CRS Report for Congress
Received through the CRS Web
Export Tax Benefits and the WTO:
Foreign Sales Corporations (FSCs) and the
Extraterritorial (ETI) Replacement Provisions
David L. Brumbaugh
Specialist in Public Finance
Government and Finance Division
Summary
The U.S. tax code’s Foreign Sales Corporation (FSC) provisions provided a tax
benefit for U.S. exporters; it permitted U.S. exporters to exempt between 15% and 30%
of income from U.S. tax. However, the countries of the European Union (EU) recently
charged that the provision was an export subsidy and thus contravened the World Trade
Organization (WTO) agreements. A WTO panel ruling essentially upheld the EU
complaint, and to avoid WTO-sanctioned retaliatory tariffs, the United States in
November 2000, enacted the FSC Repeal and Extraterritorial Income Exclusion Act.
The new extraterritorial income (ETI) provisions consist of a tax benefit for exports of
the same magnitude as FSC, but also extend tax free treatment to a certain amount of
income from exporters’ foreign operations. The EU has stated that it does not believe
the ETI provisions bring U.S. tax law into WTO-compliance, and has asked the WTO
to rule on the matter and to approve $4 billion in retaliatory tariffs on U.S. products if
the new benefit is found to be not compliant. On July 23, a WTO panel ruled that the
new provisions also contravene the WTO agreements. Some observers have suggested
that the subsequent appeals process could continue until late November. For its part,
economic analysis suggests that FSC and ETI do little to increase exports, but likely
trigger exchange rate adjustments that also result in an increase in U.S. imports; the long
run impact on the trade balance is probably extremely small. Economic theory also
suggests the export incentives likely reduce U.S. economic welfare. This report will be
updated as events in Congress and elsewhere occur.
Historical Background: DISC and the General Agreements on
Tariffs and Trade
The current FSC/ETI controversy has its roots in the legislative antecedent of both:
the U.S. tax code’s Domestic International Sales Corporation (DISC) provisions, enacted
as part of the Revenue Act of 1971 (P.L. 92-178). Like FSC and the ETI provisions,
DISC provided a tax incentive to export, although its design was different in certain
Congressional Research Service ˜ The Library of Congress
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respects. 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 produce overseas rather than in the United States;
and to offset export benefits other countries were thought to give their firms.1
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 the European Community (EC) submitted a complaint to
the GATT Council arguing that DISC was an export subsidy and therefore contravened
GATT. The United States, however, filed a counter-claim, holding that the “territorial”
income 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.
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 pricing2 must be used
in applying the territorial system to exports. Nevertheless, the controversy continued to
simmer. The United States never conceded that DISC was a subsidy, but the issue
“threatened breakdown of the dispute resolution process.”3
To defuse the issue, the U.S. Treasury proposed what became the 1984 FSC
provisions. FSC was designed to conform to GATT by providing an export tax benefit
that incorporated elements of the territorial tax system countenanced by the 1981
understanding. While the United States does not operate a territorial system (it does tax
U.S.-chartered corporations on their worldwide income), it taxes foreign-chartered
corporations only on their U.S.-source income. Firms availed themselves of the FSC
benefit by selling their exports through FSCs. FSCs are required to be chartered offshore
– either abroad or in a U.S. territory. Part of their income was classified as not being from
U.S. sources.
FSC and the World Trade Organization
The European countries were not fully satisfied of FSC’s GATT-legality. 4 Still, the
controversy remained below the surface until November 1997, when the EU requested
1 U.S. Congress, Joint Committee on Taxation, General Explanation of the Revenue Act of 1971,
(Washington: GPO, 1972), p. 86.
2 Arm’s length pricing is a method of allocating income between different parts of the same firm
that is based on the prices the different parts would charge each other if they were unrelated.
3 U.S. Congress, Joint Committee on Taxation, General Explanation of the Deficit Reduction Act
of 1984, (Washington, GPO,1984), p. 1041.
4 Bennett Caplan 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. Vol. 12, No. 1, 1986, pp. 14-15.
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consultations with the United States over FSC, thereby taking the prescribed first step in
the dispute settlement process established under the new WTO.5 The United States and
the EU held consultations without reaching a solution, and in July, 1998, the EU 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.
The panel generally supported the complaints of the EU, holding that FSC was 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 prohibit subsidies “contingent on export performance” and
provide that a subsidy exists if “government revenue that is otherwise due is forgone 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 initially
had until October 1, 2000, to bring its system into compliance with the WTO rules. The
deadline was later extended to November 1 to allow the United States time to enact its
proposed replacement for FSC.
In the United States, replacement legislation was developed to head off retaliatory
measures; its basic provisions received bipartisan support in Congress and were supported
by the Administration. The final version of legislation revamping the tax benefit passed
the Senate on November 1 and the House on November 14 as H.R. 4986, the FSC Repeal
and Extraterritorial Income Exclusion Act. The President signed the bill on November 15,
and it became P.L. 106-519.
Even before the ETI provisions were passed, the EU made known that it was
skeptical of their WTO-compatibility, and maintained that, like FSC, they provide a tax
subsidy that is contingent on exporting.7 Shortly after enactment of the new ETI
provisions, the EU asked the WTO to authorize imposition of $4 billion in tariffs on U.S.
products; the United States objected to the level of sanctions and asked for WTO
arbitration. The matter of sanctions, however, has been set aside at least temporarily.
Under a procedural agreement worked out between the United States and the EU, WTO
action on sanctions will not occur until the WTO acts on an EU request to determine
whether the ETI provisions are WTO-compliant. On July 23, a WTO panel ruled that the
new ETI provisions contravene the WTO agreements. Observers have suggested that if
an appeals process is begun, the sanctions may not be implemented until early 2002.
5 For information on the WTO’s dispute settlement process, see CRS Report RS20088, Dispute
Settlement in the World Trade Organization: An Overview, by Jeanne J. Grimmett, Feb. 26, 1999,
6 p. In 1993, the EC was subsumed into the European Union (EU). Although the complaint was
technically filed by the EC, we nonetheless use the term EU in describing events in 1993 and after.
6 World Trade Organization, United States – Tax Treatment for “Foreign Sales Corporations”:
Report of the Panel, WT/DS108/R (n.p., 8 October, 1999), p. 275.
7 BNA Daily Tax Report, Nov. 24, 2000, p. G-1.
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How FSC Worked
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 availed 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,
but the FSC provisions also provide that the parent can deduct 100% of its FSC dividends.
The size of the FSC benefit resulted from rules governing how much of the FSC’s
income was tax exempt, and on the rules governing how the combined parent-and-FSC
export income was allocated between the two. There were three alternative rules a firm
could use to divide income between the parent exporter and tax-favored FSC. Under one,
a firm can use arm’s length pricing to divide the income (see above, page 2.) The other
two rules are “administrative” methods for allocating income, under which a firm allocates
a fixed percentage of income or gross receipts to a FSC. As a result of these rules, a firm
could exempt between 15% and 30% of export income from taxes.
The FSC provisions are only one of two alternative tax benefits for exporting in 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 cases
to exempt 50% of their export 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. 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, which implies that it can be used only by
firms that have foreign operations and income.
The Extraterritorial (ETI) Income Exclusion
For exports, the new ETI provisions provide a tax benefit of the same basic
magnitude as FSC: firms can exempt between 15% and 30% of export income from tax
using the ETI provisions. The ETI provisions, however, go beyond FSC and also provide
their 15% - 30% tax exemption to a limited amount of income from foreign operations.
It is the extension of the exemption to foreign-source income that is apparently designed
to incorporate elements of territorial systems and on which the U.S. officials base their
belief in the provisions’ WTO-compatibility.
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The statutory mechanics of the ETI provisions also differ from FSC. No longer must
an exporter sell through a subsidiary to obtain a tax benefit. The ETI benefit results from
two general statutory mechanisms: one specifies the type of income to which its tax
exemption applies; the second dictates the size of the applied tax exemption. The
provisions set the scope of tax-favored income by first stating that “extraterritorial
income” is exempt from U.S. tax. The provisions go on to define extraterritorial income
as income from the sale of either U.S.- or foreign-made property that is sold for use
outside the United States. The provisions also stipulate that not more than 50% of the
value of qualifying property can be attributable to articles produced abroad and foreign
labor costs. Thus, the amount of foreign-source income that qualifies as “extraterritorial”
cannot exceed the amount of export income that qualifies. Or, viewed another way, the
ETI benefit applies to a firm’s exports and a matching amount of its foreign-produced
goods. The provisions set the size of the tax exemption by specifying that only part of
“extraterritorial income” is tax-exempt. The provisions set forth several percentages and
rules that have the effect of limiting the exemption to between 15% and 30% of qualified
income, depending on the circumstances of the exporter.
The Economics of FSC and the ETI Provisions
Both FSC and the ETI provisions reduce the required rate of return, before taxes, of
investment to the export sector, and thus attract investment to exporting. As a
consequence, U.S. exports are probably higher than they would be without the provisions.
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 foreigners are to the reduced prices.
Beyond this effect, however, traditional economic theory indicates that the export
benefits produce a set of effects that are perhaps surprising to non-economists. First,
because of exchange rate adjustments, the FSC/ETI-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 the provisions increase the overall level of
U.S. trade, they do not change the balance of trade or reduce the U.S. trade deficit. The
adjustments work as follows: the tax benefits increase 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 and ETI have 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. 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 a deficit on capital account. And a country’s
trade balance changes only if the balance on capital account changes. Thus, if we assume
that the export benefits do not change the balance on capital account, they cannot change
the trade balance.
The export benefits also affect U.S. economic welfare. Traditional economic analysis
indicates that they reduce overall U.S. economic welfare because at least part of the tax
benefit is passed on to foreign consumers in the form of lower prices. This price reduction
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can be viewed as a transfer of economic welfare from U.S. taxpayers in general to foreign
consumers. These effects, however, are probably not large. According to CRS estimates
based on 1996 data, FSC increased the quantity of U.S. exports by a range of 2-tenths of
1% to 4-tenths of 1% and increased the quantity of imports by a range of 2-tenths of 1%
to 3-tenths of 1%. The shift of economic welfare to foreign consumers is equal to an
estimated 1-tenth of 1% of exports.8 The impact on the trade balance was probably
negligible. 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 ETI provisions were
estimated to reduce revenue by between $300 million and $400 million per year beyond
the cost of FSC.
The ETI provisions introduce a new wrinkle to this economic analysis, but probably
not a large one: their extension to a limited amount of foreign-source income probably
provides a tax incentive for some exporters to increase their overseas investment. The size
of this new incentive, however, is probably not large, because of several factors. First, the
amount of foreign-source income that receives the benefit is limited by a firm’s exports.
Second, existing U.S. tax law provides an alternative tax benefit for investing abroad in
the form of an indefinite deferral of U.S. tax on income reinvested abroad by foreign
subsidiaries of U.S. companies. For some exporters, this deferral benefit is probably larger
than that available under the ETI provisions.
If economic analysts are generally critical of tax benefits like FSC and ETI, support
for them can be found in the business community. A reason for the divergence in views
may be perspectives: economic analysis looks at the benefits’ impact from the perspective
of the economy as a whole, attempting to account for 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 provisions were to be eliminated. For economists, there is no denying that
FSC and ETI boost employment and increase 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.
FSC and the ETI provisions have also been defended on the grounds that they
counter 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, from an economic perspective 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.9 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.)
8 CRS Report RL30684, The Foreign Sales Corporation (FSC) Tax Benefit for Exporting: WTO
Issues and an Economic Analysis, by David L. Brumbaugh, Sept. 14, 2000, 24 p.
9 Paul Krugman and Martin Feldstein, International Trade Effects of Value-Added Taxation,
Working Paper 3163 (Cambridge, MA: National Bureau of Economic Research, 1989), 26 p.