Export Tax Benefits and the WTO: The Extraterritorial Income Exclusion and Foreign Sales Corporations
Export Tax Benefits and the WTO:
The Extraterritorial Income Exclusion and
Foreign Sales Corporations
David L. Brumbaugh
Specialist in Public Finance
Government and Finance Division
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 was also not
WTO-compliant, and WTO decisions again supported the EU while approving the EU’s
request for tariffs. The EU began to phase in tariffs on U.S. goods in March 2004.
In October 2004 Congress approved legislation (P.L. 108-357) that repealed ETI
while implementing a mix of business tax benefits not explicitly related to exports.
While the EU lifted its tariffs, it also lodged a complaint with the WTO, objecting to the
repeal legislation’s phase-out provisions, and in 2005 a WTO panel supported the EU’s
complaint. EU officials stated their intention to reimpose tariffs, but in May 2006, the
Tax Increase Prevention and Reconciliation Act (TIPRA; P.L. 109-222) included a
provision repealing a part of the ETI transition rules, and the EU did not reimpose its
tariffs. Thus, the dispute over the U.S. export tax-subsidies appears to have ended.
Economic analysis suggests that provisions like 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.
History: DISC and the General Agreements on Tariffs and Trade
The FSC/ETI controversy had 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
was concerned that the issue threatened breakdown of the dispute resolution process. 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 incorporating elements of the
territorial tax system countenanced by the 1981 understanding. Although the United
States does not operate a territorial system (it taxes U.S.-chartered corporations on their
worldwide income), it taxes foreign 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, ETI, and the World Trade Organization
The European countries were not fully satisfied of FSC’s GATT-legality. 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.3 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.
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 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.
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.4
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.5 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 a U.S. appeal. On August 30, a WTO arbitration panel authorized the EU
to impose up to $4 billion of tariffs on U.S. imports.
In the 107th Congress, Chairman 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, but the bill was not taken up by the full
House. In the 108th Congress, Representatives Crane and Rangel and Senator Hollings
introduced a bill (H.R. 1769/S. 970) that would replace ETI with a tax benefit linked to
domestic U.S. production income rather than to foreign investment. Chairman Thomas
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 investment along with
the bill’s benefits for foreign investment. In October 2003, the Senate Finance Committee
approved S. 1637, containing its own mix of benefits, and the House Ways and Means
Committee approved H.R. 2896.6 Congress did not act on the bills in 2003, but in May
2004, the Senate approved an amended version of S. 1637. In the House, Representative
Thomas introduced a modified ETI bill as H.R. 4520, and the full House approved the
measure in June. A conference committee version of the bill was approved in October.
For its part, the EU indicated it would not apply tariffs as long as the United States
made progress towards WTO-compliance. However, in November 2003, it set a deadline
of March 2004, and on March 1 began a phased-in application of tariffs on U.S. products.
4 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.
5 BNA Daily Tax Report, November 24, 2000, p. G-1.
6 For a description and analysis of the bills, see CRS Report RL32066, Taxes, Exports, and
International Investment: Proposals in the 108th Congress, by David L. Brumbaugh.
The tariffs began at an initial rate of 5% but were scheduled to increase by 1% each month
for a year, reaching a ceiling of 17% in March 2005.7 Following enactment of U.S.
legislation phasing out ETI, the EU suspended its tariffs but also lodged a new complaint
with the WTO, objecting to the legislation’s transition rules providing for a two-year
phase out rather than immediate repeal of ETI and to provisions allowing ETI to apply to
exports made under existing contracts. On August 12, 2005, a WTO panel ruled against
the United States. The United States appealed the ruling, but on February 13, 2006, the
WTO Appellate Body upheld the panel’s ruling. EU officials stated that tariffs would be
reimposed beginning May 16. However, on May 9, a conference agreement on the Tax
Increase Prevention and Reconciliation Act (TIPRA; P.L. 109-222) included a provision
repealing a part of the ETI transition rules. The EU did not reimpose its tariffs, and the
long dispute apparently came to an end.
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 provided 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.
The ETI provisions, however, went beyond FSC and also provided their 15% — 30% tax
exemption to a limited amount of income from foreign operations. It was the extension
of the exemption to foreign-source income that was 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 differed from
7 For further information on the application of tariffs, see CRS Report RS21742, European Trade
Retaliation: The FSC-ETI Case, by Raymond J. Ahearn.
FSC. No longer was an exporter required to sell through a subsidiary to obtain a tax
benefit. The ETI benefit resulted from two rules: one specifies the type of income to
which its tax exemption applied; the second dictated the size of the applied tax
exemption. The provisions set the scope of tax-favored income by first stating that
“extraterritorial income” was exempt from U.S. tax, and went on to define extraterritorial
income as income from the sale of property that is sold for use outside the United States.
The provisions also stipulated that not more than 50% of the value of qualifying property
could be attributable to articles produced abroad and foreign labor costs. Thus, the
amount of foreign-source income that qualified as “extraterritorial” could exceed the
amount of export income that qualified. Or, viewed another way, the ETI benefit applied
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 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 increased the after tax return of investment in the
export sector, and thus attracted investment to exporting. As a consequence, U.S. exports
were probably higher than they would have been 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 produced effects that are perhaps surprising to non-economists. First, because
of exchange rate adjustments, the FSC/ETI-induced increase in exports was diminished,
and U.S. imports also were increased; sales of U.S. import-competing industries thus fell.
Economic theory indicates that while the provisions increased the overall level of U.S.
trade, they did not change the balance of trade or reduce the U.S. trade deficit. The
adjustments worked as follows: the tax benefits increased foreign purchases of U.S.
exports, but to buy the U.S. products, foreigners require more dollars. The increased
demand for U.S. dollars drove up the price of the dollar in foreign exchange markets,
making U.S. exports more expensive. This partly offset the effect FSC and ETI had in
increasing U.S. exports, but also made imports to the United States cheaper, which
caused U.S. imports to increase. The result was a higher level of both imports and exports,
but no change in the balance of trade. This result is 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 that
the export benefits do not change the balance on capital account, they cannot change the
The export benefits also affected U.S. economic welfare. Traditional economic
analysis indicates that they reduced overall U.S. economic welfare because at least part of
the tax benefit was 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, were 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.8 The impact on the trade
balance was probably negligible. The Joint Committee on Taxation estimated ETI’s cost
in foregone tax revenue at $4.8 billion for FY2003.
The ETI provisions introduced a new wrinkle to this economic analysis, but
probably not a large one: their extension to a limited amount of foreign-source income
probably provided a tax incentive for some exporters to increase their overseas
investment. The size of this new incentive, however, was probably not large, because of
several factors. First, the amount of foreign-source income that received the benefit is
limited by a firm’s exports. Second, existing U.S. tax law provided 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 was 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 likely faced declining sales, profits, and employment upon elimination
of the provisions. For economists, there is no denying that FSC and ETI boosted
employment and increased incomes in certain sectors of the economy. But they also
resulted in contraction of other parts (for example, firms that compete with imports) and
transfered economic welfare to foreign consumers.
FSC and the ETI provisions were also defended as a counter to 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.)
8 CRS Report RL30684, The Foreign Sales Corporation (FSC) Tax Benefit for Exporting: WTO
Issues and an Economic Analysis, by David L. Brumbaugh.