Order Code RS20746
Updated September 25, 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 contravened the World Trade Organization (WTO)
agreements. A WTO ruling upheld the EU complaint, and to avoid retaliatory tariffs,
U.S. legislation in 2000 replaced FSC with a redesigned export benefit, the
“extraterritorial income” (ETI) provisions. The EU maintained that ETI is also not
WTO-compliant, and WTO panel reports again supported the EU, and approved the
EU’s request for up to $4 billion of tariffs. The EU, however, has indicated it will not
impose tariffs as long as the United States makes progress on achieving WTO
compliance. In the 107th Congress, Representative Thomas introduced H.R. 5095,
combining repeal of ETI with tax reductions for U.S. firms’ foreign business operations,
but no action was taken on the bill.
In the 108th Congress, Representatives Crane and Rangel and Senator Hollings
proposed H.R. 1769 and S. 970, which would replace ETI with a tax benefit linked to
domestic U.S. production income. Representative Thomas introduced H.R. 2896,
containing provisions similar to those in H.R. 5095, but with the addition of several tax
benefits for domestic investment. Senator Hatch introduced S. 1475, a similar, but not
identical proposal. On September 18, Senators Grassley and Baucus proposed S. 1637,
with a different mix of benefits for domestic and overseas investment. 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 warrant.
Congressional Research Service ˜ The Library of Congress

---

CRS-2
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
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.
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.

---

CRS-3
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
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 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.
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.
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.

---

CRS-4
In the meantime, 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 108th Congress,
Representatives Crane and Rangel have introduced a bill (H.R. 1769) that would replace
ETI with a tax benefit linked to domestic U.S. production income rather than to foreign
investment; Senator Hollings has introduced S. 970, an identical bill. Representative
Thomas has introduced H.R. 2896, which contains provisions similar to H.R. 5095 in the
107th Congress, but with the addition of several tax benefits for domestic rather than
foreign investment. Senator Hatch has proposed S. 1475, containing a similar mix of tax
benefits for domestic and foreign investment. Senators Grassley and Baucus introduced
S. 1637, containing its own mix of benefits.8
The EU has indicated it will not apply tariffs as long as the United States makes
progress towards WTO-compliance. On May 7, however, EU officials stated that the EU
will review the situation in the fall and, if necessary, begin procedures that would impose
tariffs by January 1, 2004.
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 corporations chartered abroad only
on income from the conduct of a U.S. business. U.S. firms used the FSC benefit by
selling their exports through specially qualified subsidiary corporations (FSCs) organized
abroad. 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. business,
and thus to be 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 and its successor 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 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.
8 For a description and analysis of the bills, see CRS Report RL32066, Taxes and International
Investment: Proposals in the 108th Congress, by David L. Brumbaugh.

---

CRS-5
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 based 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

---

CRS-6
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.9 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.)
9 CRS Report RL30684, The Foreign Sales Corporation (FSC) Tax Benefit for Exporting: WTO
Issues and an Economic Analysis, by David L. Brumbaugh.

---