European Trade Retaliation: The FSC-ETI Case

CRS Report for Congress
European Trade Retaliation:
The FSC-ETI Case
Raymond J. Ahearn
Specialist in International Trade and Finance
Foreign Affairs, Defense, and Trade Division
Summary
Foreign Sales Corporations (FSCs) are subsidiaries of U.S. companies that conduct
export sales on the behalf of their parents and the ETI is a successor tax regime. The
FSC law initially was found to be inconsistent with U.S. WTO obligations in early 2000.
Following the ruling, Congress passed the replacement ETI tax provision, but this law
was also found inconsistent with WTO obligations in 2002. Subsequently, the WTO
authorized the EU to retaliate in the absence of U.S. compliance, and the EU began
imposing escalating retaliatory duties (starting at 5%) on $4 billion of U.S. exports on
March 1, 2004. After reaching 14% in December 2004, these sanctions were lifted in
January 2005 subsequent to congressional repeal of the FSC-ETI provisions in the
American Jobs Creation Act (P.L. 108-357) of October 2004. But a February 12, 2006
WTO ruling determined that the act perpetuated the illegal subsidies with a two-year
phase-out of the tax breaks and a grandfather clause covering exporters that had sales
contracts dated before September 17, 2003. In announcing the EU’s decision to
reimpose sanctions, Peter Mandelson, the EU’s top trade official, said that “the EU will
not accept a system of tax benefits which give U.S. exporters, including Boeing, unfair
advantage against their European competitors.” The EU had planned to reimpose the
sanctions on May 16, 2006, but Congress passed on May 11, 2006, a tax bill which,
among other things, repealed the grandfathered FSC-ETI benefits for sales contracts and
leases. Subsequently, the EU repealed the countermeasures, thus ending one of the
longest-running and most bitter transatlantic trade dispute in recent years. This report
describes the EU action within the context of the WTO, evaluates the old EU retaliation
list, and the outcome. The report will be not be updated.
Trade Retaliation and the WTO
The initial round of retaliatory tariffs implemented by the EU stemmed from a delay
by the United States to comply with WTO rulings. The WTO found that U.S. tax
legislation relating to export income constituted 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

Congressional Research Service ˜ The Library of Congress

indicated they would not apply the tariffs as long as the United States was making
progress towards WTO compliance. However, 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. When there was no floor action on bills introduced
to bring the U.S. into compliance, the EU on March 1, 2004, began imposing retaliatory
duties (starting at 5%) on $4.0 billion of U.S. exports.¹
Subsequently, the Senate passed its ETI repeal bill (S. 1637) by a vote of 92-5 on
May 11, 2004 and the House passed its bill (H.R. 4520) by a vote of 251-178 on June 17.
In October 2004, conference agreement was reached and President Bush signed the bill,
which became known as the American Jobs Creation Act, into law (P.L. 108-357). As a
result, the EU suspended retaliation effective January 1, 2005, but moved to challenge the
legality of certain provisions (transitional arrangements for its abolition and the
“grandfathering” benefits for U.S. corporations that had already signed contracts) in the
repeal. In early 2006, the WTO’s Appellate Body agreed with an earlier compliance panel
that the U.S. repeal legislation failed to comply with its WTO obligations because of the
grandfathering and two-year transition period under which the FSC-ETI benefits would
be phased out. On January 31, 2006, the EU adopted a regulation (171/2005) providing
for the reimposition of retaliatory duties by May 16, 2006. But the countermeasures were
never imposed due to the fact that Congress as part of the May 11, 2006 “Tax Increase
Prevention and Reconciliation Act” repealed the grandfathered FSC-ETI benefits.
This trade dispute was 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

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.

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
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 — a matter of considerable continuing dispute between the two sides.
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 EU 2002 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).
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 appeared
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 tilted heavily towards a large number of
products that seemingly could be made just about anywhere in the United States. The list
also excluded 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 were also targeted less heavily. To avoid disruption to EU production, the list
was also skewed towards consumer goods rather than component parts or intermediate
goods.
As shown in Table 2, U.S. Sectors on EU 2003 FSC/ETI Retaliation List, the
precious stones and jewelry sector, was 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 included New York, Massachusetts, Rhode Island, and to a lesser
extent California, Florida, Texas, New Mexico, and New Jersey.

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.

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 EU 2003 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 2002.⁴ 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.
Outcome
If Congress had not acted on May 11, 2006, to repeal the grandfathered FSC-ETI tax
benefits, the EU planned to reimpose the sanctions by May 16, 2006. Given the value of
the tax breaks that remained at the time, the EU reportedly planned to reimpose sanctions
(a 14% additional tariff) on $2.4 billion of U.S. exports — an amount of retaliation that
would yield around an additional $330 million. This tariff rate would not be raised over
time, unlike the previous FSC retaliation revoked after Congress repealed the FSC in

2004. The EU added no new tariff items to the 2005 retaliation list, but some products

⁴ Data from the World Trade Atlas, a subscription trade statistics database, was compiled by J.
Michael Donnelly, Information Research Specialist, CRS.

codes were eliminated from the 2003 list (EU regulation 171/2005 adopted January 31,

2005, contains the revised list).

The EU’s plan to reimpose sanctions aroused a strong U.S. reaction. The Office of
the U.S. Trade Representative issued a statement urging the EU not to reimpose sanctions
and argued that “new sanctions will reinforce the perception that the EU is primarily
acting in response to the U.S. filing of a WTO complaint against Airbus subsidies.”
Senate Finance Committee Chairman Charles Grassley stated that the “Europeans seemed
to have appreciated and accepted our compliance efforts until we raised the issue of
Airbus subsidies in the WTO. The blatant linkage of WTO disputes is a dangerous
precedent . ”
But after President Bush signed on May 17, 2006, the repeal of the grandfathered tax
provisions into law, the EU countermeasures were definitively repealed as announced in
a Commission Notice published in the Official Journal (2006/C 126/07) on May 30, 2006.
Thus ended one of the longest running and most bitter transatlantic trade disputes in
recent years.
Table 1. U.S. Sectors on EU 2002 Steel Retaliation List
Percent ofEstimated
Sectortotal U.S.value targeted
(Harmonized exports to EU-(millions ofPercent of
System 2-digit level)15, 2002dollars)total targeted
Steel (HS, 72, 73)0.857225.7
Cotton, Textiles, Carpets, and0.348821.9
Footwear (HS 61, 62,63,64)
Paper Products (HS 48)0.735916.1
Vegetables, Edible Fruits & Nuts0.825211.3
(HS 7,8,10)
Yachts and Pleasure Boats (HS 89)031928.6
Processed Food-Primarily Orange0.21165.2
and Grape Fruit Juice (HS 20)
Furniture and Bedding (HS 94)0.5873.9
Optical Equipment (HS 90)9.8632.9
Tobacco (HS 24)0.5411.8
Machines and Mechanical22.52812
Appliances (HS 84)
Misc. Manufactures and Sports0.72612
Equipment (HS 95,96)
^Sources^:^Eu^ropean^C^o^m^mⁱ^s^sⁱ^on^an^{d W}^o^{rld T}^r^{ade A}^tlas^.

Table 2. U.S. Sectors on EU 2003 FSC/ETI Retaliation List
Percent ofEstimated
total U.S.value
exports totargetedPercent of
SectorEU-15,(euros intotal
(Harmonized system, 2-digit level)2002millions)(targeted)
Precious Stones and Jewelry (HS 71)2.11,43136.0
Machinery and Mechanical Appliances (HS22.562715.6

84)

Wood and Paper Articles (HS 44, 48, 49)2.13007.5
Leather Articles Thereof (HS 41, 42, 43)0.12897.2
Toys, Games, Sports Equipment (HS 95)0.61814.5
Copper and Aluminum Articles (HS 74, 76)0.41814.5
Electrical Machines (HS 85)11.81463.6
Cotton, Textiles, and Footwear0.41393.4
(HS 61, 62,63, 64)
Vegetables, Fruits, Grains, and Oils2.21383.4
(HS 7, 8, 10, 11, 12, 15)
Iron and Steel (HS 72, 73)0.81313.2
Certain Prepared Foods and Food Residues1.31233.0
(HS 19, 20, 21, 23)
Ceramic Glass Products (HS 69, 70)0.51132.8
Meat and Dairy (HS 1, 2, 4, 5)0.2721.8
Prepared Foods and Sugar (HS 16, 17)0.1711.7
Tools, Implements (HS 82, 83)0.6882.2
^Sources^:^Eu^ropean^C^o^m^mⁱ^s^sⁱ^on^an^{d W}^o^{rld T}^r^{ade A}^tlas^.
Table 3. Major U.S. Sectors Excluded from EU 2003 FSC/ETI
Retaliation List
U.S. exports to EU-15 inPercent share of
Sector2002U.S. exports to
(Harmonized system 2-digit level)(Dollars in millions)EU-15
Optical and Medical Equipment (HS 90)14,1049.82
Aircraft/Spacecraft (HS 88)13,0559.09
Vehicles/Not Railway (HS 87)8,0325.59
Organic Chemicals (HS 29)7,2825.07
Pharmaceuticals (HS 30)6,9854.86
Plastics (HS 39)4,2112.93
Art and Antiques (HS 97)1,5951.11
Totals $55,264 38.47
^Sources^:^Eu^ropean^C^o^m^mⁱ^s^sⁱ^on^an^{d W}^o^{rld T}^r^{ade A}^tlas^.