Order Code RS20746
Updated January 30, 2003
CRS Report for Congress
Received through the CRS Web
Export Tax Benefits and the WTO:
Foreign Sales Corporations and the
Extraterritorial 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. However, the European Union (EU) in 1997 charged that the
provision was an export subsidy and thus contravened the World Trade Organization
(WTO) agreements. A WTO ruling upheld the EU complaint, and to avoid WTO-
sanctioned retaliatory tariffs, U.S. legislation in November 2000 replaced FSC with the
“extraterritorial income” (ETI) provisions, consisting of a redesigned export tax benefit
of the same magnitude as FSC. The EU maintained that the new provisions are also not
WTO-compliant and asked the WTO to rule on the matter. In August 2001, a WTO
panel report supported the EU, and a U.S. appeal of ruling was denied. In August 2002,
a WTO arbitration panel approved the EU’s request for up to $4 billion of tariffs. In the
meantime, Chairman Thomas of the House Ways and Means Committee introduced
H.R. 5095, combining repeal of ETI with tax reductions for U.S. firms’ foreign business
operations. However, no action was taken on the bill by the end of the 107th Congress.
In late 2002, Senators Baucus and Grassley of the Finance Committee announced the
formation of a “legislative-executive, bicameral, bipartisan” working group designed to
recommend a solution to the ETI dispute; a report is expected in the Spring of 2003. 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 that export benefits likely reduce U.S. economic welfare. This report will
be updated as events in Congress and elsewhere occur.
History: 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
respects. It was thought that a tax incentive for exports was desirable to stimulate the
Congressional Research Service ˜ The Library of Congress

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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 the 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. Although 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 that were required
to be chartered offshore.
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
consultations with the United States over FSC, thereby taking the prescribed first step in
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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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 a panel to
examine the issue. The panel made its findings public on October 8, 1999.
The panel generally supported the EU, holding that FSC was indeed a prohibited
export subsidy, and that FSC violated subsidy obligations under the WTO Agreement on
Subsidies and Countervailing Measures. 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 WTO’s Appellate Body essentially upheld the initial finding on appeal by the United
States. 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 was
passed by Congress in November 2000 as H.R. 4986, the FSC Repeal and Extraterritorial
Income Exclusion Act. The President signed the bill, 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, and asked the WTO to rule on whether the ETI provisions are WTO-compliant.
On August 20, 2001, a WTO panel issued a report concluding that the ETI provisions
contravene the WTO agreements. The WTO Appellate Body denied an appeal by the
United States on January 14, 2002; an arbitration panel subsequently began consideration
of an acceptable level of tariffs. On August 30, the panel issued a report authorizing the
EU to impose up to $4 billion of tariffs on U.S. imports. However, U.S. Deputy Treasury
Secretary Kenneth Dam stated that he expects the authorization to become moot by the
United States enacting legislation bringing it into WTO-compliance.
In the meantime, on July 11, Chairman William Thomas of the House Ways and
Means Committee introduced H.R. 5095, which proposed both repeal of ETI and a range
of tax reductions for the overseas business operations of U.S. firms. However, the bill
was not considered by the full House before the 107th Congress adjourned. In the Senate,
Senators Baucus and Grassley in September announced the formation of what they termed
a “legislative-executive, bicameral, bipartisan working group” designed to produce
recommendations for solving the ETI dispute.”8 The working group was initially
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.
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, November 24, 2000, p. G-1.
8 Letter by Sens. Max Baucus and Charles E. Grassley to U.S. Trade Representative Robert B.
Zoellick and Deputy Secretary of the Treasury Kenneth W. Dam, dated Aug. 12, 2002. Reprinted
in BNA TaxCore, Aug. 13, 2002.

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expected to issue recommendations by the end of 2002, but subsequent media reports
indicate that the recommendations will not be presented until the Spring of 2003. The
group’s members appear to differ on whether to use H.R. 5095's proposals as a starting
point and what weight to give negotiations.9 Some EU officials have indicated the EU
will not apply tariffs (if approved) as long as the United States makes progress towards
WTO-compliance. Other EU officials have been more equivocal.10 On September 13,
2002, the EU published a preliminary list of U.S. products that would be subject to tariffs,
if they are imposed. The list includes a broad range of products, but would be pared back
to arrive at a final set of items. According to news reports, the final list of sanctions is
expected in February, 2003.11
How FSC Worked
In general, the United States taxes corporations chartered in the United States on
their worldwide income and ordinarily 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. 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. As a result of
these rules, a firm could exempt 15% - 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, but its use is dependent on an
exporter possessing a surfeit of foreign tax credits generated by foreign taxes on non-
export income. Thus, the sales source rule can be used only by firms that have foreign
operations and income that have borne foreign taxes.
The Extraterritorial (ETI) Income Exclusion
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
9 Alison Bennett, “Lawmakers, Officials Launch Export Tax Regime Working Group,” BNA
Daily Tax Report, Sept. 25, 2002, p. G-11; Alison Bennett, “Extraterritorial Income: Aide Says
Grassley Sees Long road Ahead in Finding Solution for Export Tax Regime,” BNA Daily Tax
Report, Dec. 17, 2002..
10 BNA Daily Tax Report, July 15, 2002, p. G-9; July 18, p. G-1..
11 The preliminary list was published in the EU’s Official Journal on Sept. 13, 2002, and is online
at [http://europa.eu.int/eur-lex/pri/en/oj/dat/2002/c_217/c_21720020913en00020015.pdf].

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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.
The mechanics of 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 rules:
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, and go on to define
extraterritorial income as income from the sale of 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 increase the aftertax return of investment in 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 result is a higher level of both imports and exports,
but no change in the 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

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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 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
two-tenths of 1% to four-tenths of 1% and increased the quantity of imports by a range
of two-tenths of 1% to three-tenths of 1%. The shift of economic welfare to foreign
consumers is equal to an estimated one-tenth of 1% of exports.12 The impact on the trade
balance was probably negligible. The Joint Committee on Taxation has estimated ETI’s
cost in foregone tax revenue at $4.8 billion for FY2003.
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. 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, under territorial tax systems, lax administration of transfer pricing
rules may result in export subsidies.)
12 CRS Report RL30684, The Foreign Sales Corporation (FSC) Tax Benefit for Exporting: WTO
Issues and an Economic Analysis, by David L. Brumbaugh.

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