Tax Break, Trade Battle?

Congress wants to replace foreign sales corporations with new foreign income rules, but the European Union is crying foul.

Kies offers a profile of a hypothetical company that would likely benefit from the expanded tax break. It would be a company that operates a manufacturing facility in a low-tax country, such as Ireland; has a high profit margin that is immediately subject to U.S. tax; has few excess tax credits to offset; and makes a product with a high degree of content value from the United States, such as brand-name consumer goods, pharmaceuticals, or software. Examples of companies fitting this profile include Microsoft, Merck, and Guess Jeans, says Kies.

Companies should be able to adopt the rules for the 2001 tax year if they want, but current grandfathering provisions will permit FSCs to remain in place until the 2002 tax year, allowing a gradual transition to the new rules.

Current users of FSCs have been generally supportive of the new rules. “We use FSCs on a product-line-by-product- line basis, and generate some substantial tax savings as a result,” says Paula Graff, director of taxes at The Toro Co., in Bloomington, Minnesota. The lawn-care products company garners about $300 million of its $1.3 billion in annual revenues from sales abroad, and lowers its federal tax rate by about 3 percent by using the FSC rules. “We get a lot of bang for our buck from FSCs, so we’re happy as heck that the government has found a way to preserve the benefits despite the WTO ruling,” declares Graff. “And it looks like it will be easier to administer as well, which is a good thing.”

Picking a Fight

All this may be for naught, however, if the new tax regime fails to stand up to WTO scrutiny. Once the current bill in Congress has been passed into law, it’s all but certain that the European Commission, the bureaucratic body of the EU, will lodge another complaint with the WTO.

Business advocates in the United States aren’t surprised. “The Europeans are expressing outrage and disappointment, mainly because they’re surprised we’ve been able to come up with something that meets the WTO standards and still counters their VAT [value-added tax] rebate programs,” charges Kimberly Pinter, director, corporate finance and tax, at the NAM. “It’s political maneuvering, because they want to preserve the tax advantage they give to their companies, and have them eat our lunch.”

Treasury officials and trade experts are optimistic that the new law will stand up to another challenge–at least based on the points raised in the original WTO decision on FSCs. First, FSCs were found to be an export subsidy, which isn’t allowed under the General Agreement on Tariffs and Trade (GATT). Second, the exemption of taxes under FSCs was of “government revenue that is otherwise due,” making FSC benefits, whether applied to exports or not, an illegal subsidy under GATT. The new approach avoids both objections, experts say, as it applies to all income earned abroad from goods and services sold by U.S. taxpayers, and is a general exclusion on foreign income that meets certain criteria.

Still, there is a chance that the WTO will again side with the EU. The United States would likely respond with another set of rules, judging by the Clinton Administration’s support of the WTO’s dispute resolution system. Tupperware’s Rose speculates that “if the EU continues to be difficult on whether the new approach meets WTO standards, they may eventually regret it.” That’s because a likely reaction to another WTO defeat, he says, would be the adoption of a territorial system of taxation for companies, as opposed to the current worldwide taxation system. This would mean U.S. companies would pay taxes only on income in the United States. Such a system would mirror the model many European countries use, in combination with their VAT systems, and provide U.S. companies with a more level playing field, says Rose.

But EU trade officials regard that possibility as remote. “Major corporate tax reform has been on the agenda of the U.S. Congress for six years now and not much has happened,” says the EU delegation official. Moreover, EU officials believe the perception that U.S. companies operate at a tax disadvantage to European companies doesn’t hold water, another reason why the tax system hasn’t been changed. “U.S. corporations themselves have long complained that taxes in Europe are too high, and now they say they’re too low,” says the EU official. “It can’t be both.”

No matter what happens in the long run with tax reform, in the short term the possibility of trade sanctions looms large, and the likelihood that the current dispute will drag on for at least another year seems certain.

Ian Springsteel is a freelance writer based in Boston.


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