Order Code RS21742
Updated February 11, 2005
CRS Report for Congress
Received through the CRS Web
European Trade Retaliation:
The FSC-ETI Case
Raymond J. Ahearn
Specialist in International Trade and Finance
Foreign Affairs, Defense, and Trade Division
Summary
The European Union (EU) on March 1, 2004, began imposing retaliatory duties
of 5% on selected U.S. exports in the dispute over U.S. compliance with a World Trade
Organization (WTO) ruling involving the Foreign Sales Corporation (FSC) and its
successor Extraterritorial Income Exclusion (ETI) export tax regime. Despite final
passage on October 11, 2004, of legislation (H.R. 4520) that repeals the ETI-FSC tax
benefit, the EU did not act to end the sanctions until January 21, 2005. On that day EU
member states approved a new regulation to end the tariffs retroactively from January
1, 2005, but also to re-impose the sanctions on $2.4 billion of U.S. goods if the WTO
should rule later this year that the new U.S. tax law, the American Jobs Creation Act
(P.L. 108-357), also contains provisions that are violative of WTO rules. Specifically,
the EU is challenging provisions under Section 101 of the Jobs Act. This section allows
U.S. exporters to continue to benefit from FSC/ETI tax breaks through the end of 2006
for all export transactions and “grandfathers” export breaks for some existing contracts,
in particular leasing arrangements, that the EU claims will benefit companies such as
Boeing, Microsoft, and Catepillar. Both the Bush Administration and a number of
members of Congress have argued that this EU challenge is needlessly prolonging the
dispute. This report describes the EU action within the context of the WTO, evaluates
the EU retaliation list, and assesses possible consequences of EU retaliation. The report
will not be updated.
Trade Retaliation and the WTO
Retaliatory tariffs that have been implemented by the EU stem from a continuing
delay by the United States to comply with WTO rulings. The WTO found that U.S. tax
legislation (the FSC and ETI provisions) relating to export income constitute an
unacceptable export subsidy under the Agreement on Subsidies and Countervailing
Measures. When the WTO arbitrator determined on August 30, 2002, that the EU could
impose tariffs on $4 billion (an amount roughly equal to the annual value of the U.S.
export subsidy) of U.S. exports, EU officials indicated they would not apply the tariffs as
long as the United States was making progress towards WTO compliance. However,
Congressional Research Service ˜ The Library of Congress

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upon receiving final WTO authorization to retaliate on May 7, 2003, EU officials stated
they would begin imposing tariffs by January 1, 2004, if the repeal of these tax provisions
was not signed into law by then. In November 2003, EU officials again delayed the
imposition of the retaliatory tariffs until March 1, 2004, provided that Congress passed
legislation to bring the United States into compliance with its WTO obligations. While
bills (H.R. 2896 and S. 1637) that would repeal the ETI over a three-year transition period
were reported out of both the House and the Senate tax-writing committees in 2003, there
was no floor action on the bills in either chamber prior to March 1, 2004.1
Subsequently, the Senate passed its ETI repeal bill (S. 1637) by a vote of 92-5 on
May 11, 2004. The House passed its bill (H.R. 4520) by a vote of 251-178 on June 17.
The Senate voted July 15 to replace the language of the House-passed bill with the
wording of its own bill, a procedural step necessary to take the two bills to conference,
and also appointed conferees. In October 2004, conference agreement was reached and
President Bush signed the bill, which became know as the American Jobs Creation Act,
into law (P.L. 108-357).
This current episode of trade brinkmanship is being fought out under the auspices
of the WTO’s Dispute Settlement Understanding ( DSU). According to the DSU, a WTO
member found to have violated WTO obligations is expected to comply by withdrawing
or eliminating the offending measure. If the complaining party believes that the other
Member has not complied by the end of the compliance period, it may negotiate a
compensation agreement or it may ask the Dispute Settlement Body for authorization to
suspend concessions (usually the imposition of higher duties on items from the other
country). The purpose of “suspension of concessions,” which is referred to
interchangeably as retaliation or countermeasures, is to restore the balance of concessions
that existed before the adoption of the rule or provision that had been nullified, as well
as to serve as an incentive for compliance.2
Since the WTO went into effect in 1995, the United States has imposed retaliatory
duties on EU exports in two cases: bananas and beef. In both cases, after many years of
litigation, the WTO found in favor of U.S. petitions alleging that an EU import ban on
beef treated with hormones and a system of import quotas for bananas were
discriminatory and violated WTO rules. In 1999, EU offers of compensation for lost
exports in lieu of lifting its beef hormone ban or changing its banana regime were rejected
by the United States and 100% tariffs were imposed on $307 million ($191 million for
the banana case and $116 million for the beef case) of imports from the EU, principally
luxury products such as Danish ham, truffles, Roquefort cheese, and Italian handbags.
Exports from Britain, Spain, and France were mostly targeted in the banana case and
exports from France, Germany, Italy, and Denmark in the beef case, because these
countries were deemed most responsible and supportive of the discriminatory policy in
1 For background and summary of this dispute, see CRS Report RS20746, Export Tax Benefits
and the WTO: The Extraterritorial Income Exclusion and Foreign Sales Corporations
, by David
L. Brumbaugh.
2 For elaboration see, CRS Report RL32014, WTO Dispute Settlement: Status of U.S. Compliance
in Pending Cases
, by Jeanne J. Grimmett.

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the respective cases.3 Although the United States in 2002 lifted the 100% retaliatory
duties related to the banana case after changes in EU policy, the tariff on beef remains in
effect today.
For its part, the EU came to the brink of imposing retaliatory tariffs in reaction to
President Bush’s March 2002 decision to provide the U.S. steel industry with safeguard
tariff protection. Claiming that this action violated the WTO safeguard agreement, the
EU won its challenge before the WTO and was prepared to impose retaliatory tariffs
against $2 billion in U.S. exports. In drawing up its retaliation list, the EU targeted goods
made in states that are considered swing states in the presidential election. As shown in
Table 1, U.S. Sectors on Steel Retaliation List, categories of steel, textiles and apparel,
citrus (found in the vegetables, edible fruits, and nuts category) and fruit juice accounted
for 53% of the total trade targeted. Ohio, Pennsylvania, and West Virginia are prominent
steel producing states, the Carolinas prominent textile and apparel producing states, and
Florida a prominent citrus producing state (California also is a large citrus producer but
exports a relatively small amount to Europe).
While U.S. trade officials argued that President Bush’s December 4, 2003 decision
to lift the steel tariffs was made “independently,” (i.e., not influenced by the EU threat of
retaliation), many observers opined that the potential loss of export sales and jobs in
politically sensitive states may also have played a role. And on December 5, 2003, Pascal
Lamy, the EU trade commissioner, announced that he would use the same tactics in
pressuring the U.S. to comply in the FSC/ETI dispute. Mr. Lamy emphasized that the
EU’s key goal is compliance and that it would not change its March 1, 2004 deadline.4
FSC Retaliation List
Unlike the steel dispute, Congress, not the President, has to take action to bring U.S.
law into conformity with WTO obligations in order to settle the FSC/ETI case. Perhaps
with this important difference in mind, the EU drew up a retaliation list that appears much
more diffuse in terms of geographic impact on producers and states than in the steel case
where retaliation was concentrated in a few states arguably pivotal to next November’s
presidential election. The list tilts heavily towards a large number of products that
seemingly could be made just about anywhere in the United States. The list also excludes
politically sensitive products such as citrus fruits, orange and grapefruit juice, cigarettes,
apples and rice that were on the steel list. Steel and textile and apparel products are also
targeted less heavily. To avoid disruption to EU production, the list is also skewed
towards consumer goods rather than component parts or intermediate goods.
As shown in Table 2, U.S. Sectors on FSC/ETI Retaliation List, the precious
stones and jewelry sector, is most heavily targeted. Accounting for 36% of the total trade
targeted but less than 3% of total U.S. exports to the EU, this sector consists of products
such as diamonds, gold, silver base metals and jewelry. Major jewelry producing states
3 Higher tariffs are intended to increase the cost of targeted items to consumers and, thus, lead
to declining purchases. Companies and workers hurt by declining sales, in turn, could be
expected to lobby their representatives for a change in policy.
4 Cowell, Alan, “Europeans Plan to Press For Tariffs Against U.S.,” New York Times, December
5, 2003, p. B1.

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include New York, Massachusetts, Rhode Island, and to a lesser extent California,
Florida, Texas, New Mexico, and New Jersey.
The next four sectors impacted most heavily — machinery and mechanical
appliances, wood and paper articles, leather and leather articles, and toys and sports
equipment
— account for 35% of the total targeted trade. Products listed from these
sectors also could be made in many different states and regions of the United States. For
example, in the machinery and mechanical appliances sector, products such as piston
engines, hydraulic turbines, refrigerators, household scales, cranes, fork-lift trucks, and
machine tools are included. The wood and paper products sector includes products such
as particle board, building materials, plywood, wood panels, paper and paperboard,
wallpaper, toilet paper, note books, and unused postage stamps. The leather sector
comprises products such as raw hides and skins, and articles of leather such as handbags,
briefcases, and gloves. And the toys and sports equipment sector includes such items as
doll carriages, dolls, electric trains, billiard tables, cross country and downhill skis, tennis
racquets and balls, ice skates, and fish-hooks.
As shown in Table 3, Major U.S. Sectors Excluded From FSC/ETI Retaliation
List, sectors totally left off the retaliation list account for close to 40% of U.S. exports to
the EU. In addition, exports from the two largest U.S. export sectors (machinery and
electrical machinery) were targeted minimally (less than $1 billion of the $49 billion in
exports from these sectors). As these latter two sectors account for 34% of U.S. exports
to the EU, it can be seen that close to 75% of U.S. exports to the EU were basically non-
targeted.
The non-targeted sectors are characterized by massive amounts of cross-investment
and intra-industry trade that integrates markets tightly. Trade data, for example, show that
the seven largest categories of U.S. exports to the EU (machinery, electrical machinery,
optical equipment, aircraft, vehicles, organic chemicals, and pharmaceuticals) are also
among the top nine categories of imports from the EU. These seven sectors accounted for
70% of U.S. exports to the EU and 61% of imports from the EU in 2002.5 Many of the
products in these key sectors, such as aircraft parts, auto parts, and chemicals, are
components in products that EU companies export back to the U.S. or components in
products that European subsidiaries of U.S. companies use in their production process.
Other items such as optical devices and medical equipment may not necessarily be
produced in the EU. Most of the exports from the machinery and mechanical appliances
and electrical machinery sectors were left off the list as well, due perhaps to similar
concerns about hurting or disrupting EU producer interests.
Possible Consequences
The economic consequences of the EU tariffs are likely to be relatively mild during
the first year. Political repercussions could be more significant.
Given that Brussels was permitted to impose 100% tariffs on $4 billion of U.S.
exports, the EU decision instead to impose the escalating tariff beginning at 5% and
5 Data from the World Trade Atlas, a subscription trade statistics database, was compiled by J.
Michael Donnelly, Information Research Specialist, CRS.

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culminating at 17% a year later indicates restraint. A 100% tariff on $4 billion of U.S.
exports could cause most trade in the targeted products to dry up after a short period of
time. But due to the fact that the dollar has depreciated against the euro by about 40%
over the past two years, making U.S. goods considerably cheaper, most affected U.S.
exporters can probably absorb the added cost imposed by the higher escalating tariff for
a number of months, if not a year, and still maintain market share. What happens after
a year would depend on what the EU decides to do about the tariff and the value of the
dollar versus the euro.
A number of U.S. companies and workers affected by the retaliatory tariffs have
complained bitterly to their representatives. These complaints, in turn, have provided
impetus to passage of the repeal legislation, contained in H.R. 4520, the American Jobs
Creation Act of 2004.
Table 1. U.S. Sectors on EU Steel Retaliation List
Estimated
Percent of
Sector
Value
Total U.S.
Percent of
(Harmonized
Targeted
Exports to EU-
Total Targeted
System 2-Digit Level)
(millions of
15, 2002
dollars)
Steel (HS, 72, 73)
0.8
572
25.7
Cotton, Textiles, Carpets, and
0.3
488
21.9
Footwear (HS 61, 62,63,64)
Paper Products (HS 48)
0.7
359
16.1
Vegetables, Edible Fruits & Nuts
0.8
252
11.3
(HS 7,8,10)
Yachts and Pleasure Boats (HS 89)
03
192
8.6
Processed Food-Primarily Orange
0.2
116
5.2
and Grape Fruit Juice (HS 20)
Furniture and Bedding (HS 94)
0.5
87
3.9
Optical Equipment (HS 90)
9.8
63
2.9
Tobacco (HS 24)
0.5
41
1.8
Machines and Mechanical
22.5
28
12
Appliances (HS 84)
Misc. Manufactures and Sports
0.7
26
12
Equipment (HS 95,96)
Sources: European Commission and World Trade Atlas.

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Table 2. U.S. Sectors on EU FSC/ETI Retaliation List
Percent of
Estimated
Total U.S.
Value
Percent of
Sector
Exports to
Targeted
Total
(Harmonized System, 2-digit level)
EU-15,
(euros in
(Targeted)
2002
millions)
Precious Stones and Jewelry (HS 71)
2.1
1,431
36.0
Machinery and Mechanical Appliances (HS
22.5
627
15.6
84)
Wood and Paper Articles (HS 44, 48, 49)
2.1
300
7.5
Leather Articles Thereof (HS 41, 42, 43)
0.1
289
7.2
Toys, Games, Sports Equipment (HS 95)
0.6
181
4.5
Copper and Aluminum Articles (HS 74, 76)
0.4
181
4.5
Electrical Machines (HS 85)
11.8
146
3.6
Cotton, Textiles, and Footwear
0.4
139
3.4
(HS 61, 62,63, 64)
Vegetables, Fruits, Grains, and Oils
2.2
138
3.4
(HS 7, 8, 10, 11, 12, 15)
Iron and Steel (HS 72, 73)
0.8
131
3.2
Certain Prepared Foods and Food Residues
1.3
123
3.0
(HS 19, 20, 21, 23)
Ceramic Glass Products (HS 69, 70)
0.5
113
2.8
Meat and Dairy (HS 1, 2, 4, 5)
0.2
72
1.8
Prepared Foods and Sugar (HS 16, 17)
0.1
71
1.7
Tools, Implements (HS 82, 83)
0.6
88
2.2
Sources: European Commission and World Trade Atlas.
Table 3. Major U.S. Sectors Excluded from EU FSC/ETI Retaliation
List
U.S. Exports to EU-15 in
Percent share of
Sector
2002
U.S. Exports to
(Harmonized system 2-digit Level)
(Dollars in millions)
EU-15
Optical and Medical Equipment (HS 90)
14,104
9.82
Aircraft/Spacecraft (HS 88)
13,055
9.09
Vehicles/Not Railway (HS 87)
8,032
5.59
Organic Chemicals (HS 29)
7,282
5.07
Pharmaceuticals (HS 30)
6,985
4.86
Plastics (HS 39)
4,211
2.93
Art and Antiques (HS 97)
1,595
1.11
Totals
$55,264
38.47
Sources: European Commission and World Trade Atlas.