Note: Send submissions to mbt@martintittle.com. Questions may be edited, combined, or generalized, and are posted in reverse chronological order.

Subject: The Crane-Rangel General Transition Rule

August 4, 2003

I recently read a white paper put out by Crane and Rangel [see 2003 Worldwide Tax Daily 143-21, July 25, 2003] that defends the WTO-compliance of their proposed general transition rule. I know you've said in the past that that rule probably isn't WTO-compliant, but the white paper's defense of it looks pretty good. What do you think?

K.A.

The white paper's defense is interesting and spirited. It rests on three main points, one of which is persuasive and two of which are not. Those points are:

1) the general transition rule is "fully in line with WTO rules and prior practice," as illustrated by the 5-year transition period on which the U.S. and the EU agreed in the Bananas case;

2) although the rule is based on a taxpayer's 2001 FSC/ETI benefits, it is not an extension or continuation of the FSC or ETI programs; and

3) the phrase "contingent on export performance" in Article 3.1(a) of the WTO Agreement on Subsidies and Countervailing Measures (SCM) refers only to current or future export performance, not past export performance. (For the complete text of Article 3.1(a), see The FSC/ETI Controversy, page 4, footnote 22.)

Point one is persuasive. The transition period that we agreed to give the EU in the Bananas case was based on Article 3.6 of the WTO Dispute Settlement Understanding (DSU), which allows for "[m]utually agreed solutions to matters formally raised under the consultation and dispute settlement provisions of the covered agreements." While the EU has no legal obligation to reciprocate and allow the U.S. a transition period now that the shoe is on the other foot, the white paper's authors are right that "it would be difficult to justify" nonreciprocation. However, EU Trade Commissioner Pascal Lamy has stated that the U.S. has already had almost 3 years for transition, dating back to fall 2000 when ETI was enacted. See Charles Gnaedinger et al., "U.S. Senate Taxwriters Voice Support for Crane-Rangel International Tax Plan," 2003 Worldwide Tax Daily 131-1 (July 9, 2003). As a result, the EU may feel that it needs to give us only 2 more years to "balance the scales."

Perhaps coincidentally, when John Veroneau, general counsel for the United States Trade Representative, was recently questioned by Sen. Orrin Hatch, R-Utah, on the subject of an ETI transition period, Veroneau said "a one- or two-year phase-out is a normal tax legislative aspect. Beyond that, it becomes a little more cloudy, frankly, as to what would trigger retaliation and what would not." Senate Finance Committee, "Finance Committee Praises Crane-Rangel Bill, According to Unofficial Transcript of Hearing," 2003 Worldwide Tax Daily 134-21 paras. 118-121 (July 14, 2003). Therefore, to the extent the Crane-Rangel general transition rule relies on the DSU mutual agreement procedure, it will probably succeed, but getting EU approval may require shortening the proposed five-year transition period.

Points two and three are much more problematic because together, they argue that the general transition rule is WTO-compliant "on the merits" and therefore would survive a challenge in the event the EU did not accept it under DSU Art. 3.6. Point two does little more than set the stage for point three by clarifying that the general transition rule is not an extension of FSC or ETI, but a new subsidy based on a company's eligibility for FSC/ETI benefits in 2001.

Point three argues that this new subsidy does not violate Article 3.1(a) of the SCM because it is not "contingent on export performance." "Contingent," according to the white paper, has a "standard legal meaning":

"possible, but not assured, doubtful or uncertain, conditioned upon the occurrence of some future event which is itself uncertain."

Because the new subsidy is not conditioned upon future exports, only on past export performance, it does not violate the SCM and thus is WTO-compliant.

The white paper's "standard legal meaning" of "contingent" appears, word for word, on page 321 of Black's Law Dictionary, 6th edition, and there is no doubt that the WTO sometimes adverts to Black's for definitions of terms. See, e.g., WTO, Report of the Appellate Body, United States - Section 211 Omnibus Appropriations Act of 1998, WT/DS176/AB/R (Jan . 2, 2002) para. 187 n.123.

The problem is the WTO Appellate Body has already defined "contingent" as that word is used in Article 3.1(a), saying it just means "conditional" or "dependent for its existence on something else." WTO, Report of the Appellate Body, Canada - Measures Affecting the Export of Civilian Aircraft, WT/DS70/AB/R (Aug. 2, 1999) para. 166, quoted in WTO, Report of the Appellate Body, Canada - Certain Measures Affecting the Automotive Industry, WT/DS139/AB/R (May 31, 2000) para. 98. This definition contains no reference to a future event, as the definition in Black's does, and thus would allow the WTO to apply Article 3.1(a)'s proscription to subsidies like the general transition rule that are contingent on past export performance. It's certainly possible the WTO could be persuaded to change its definition of "contingent," but the process involved in raising that issue would likely not require the EU to stay application of its approved FSC/ETI sanctions.

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Subject: The Crane-Rangel ETI Repeal Bill

July 7, 2003

If the Rangel/Crane [ETI repeal] bill gets out of Committee (which Phil Archer, now at [PricewaterhouseCoopers], said Thomas would never allow), do you think the EC will accept the phase-out provisions for ETI? Rangel says yes, but given the wording in the [ETI] Appellate Decision, I'm not so sure.

M.H.

This exact issue was raised in the Wall Street Journal over the last two weeks. Lawrence B. Lindsey, in his June 25 commentary "How to Start a Trade War," stated that large multinationals had "successfully lobbied some in Congress [later identified as Reps. Crane and Rangel] to continue to protect them by extending their current illegal trade benefits [that's ETI] for six years. This will almost certainly invite European retaliation that could begin a global trade war." On July 1, Rep. Phil Crane responded by saying that his ETI repeal bill would bring the U.S. into compliance with the WTO ruling, and by blaming any eventual trade war on Mr. Lindsey and opponents of the bill.

Both Lindsey and Crane overstated their positions on the Crane-Rangel bill's transition provisions. On Mr. Lindsey's side, the extension of ETI benefits could result in the imposition of retaliatory sanctions by the EU, but it doesn't have to. On Mr. Crane's side, a weak argument can be made that extension of ETI benefits is WTO-compliant, but that argument is unlikely to be persuasive.

The Crane-Rangel bill actually proposes two different extensions of ETI: the one alluded to by Mr. Lindsey, which is phased out between 2003 and 2008, and another, for existing, binding contracts, which lasts for the life of those contracts. See Job Protection Act of 2003, H.R. 1769, 108th Cong. secs. 2(c)(2) (binding contract), 2(e) (general transition) (2003) (visited July 7, 2003) <http://thomas.loc.gov>. The binding contract extension is not WTO-compliant because it is virtually identical to the binding contract extension of FSC benefits in ETI that was condemned by the WTO Appellate Body. See FSC Repeal and Extraterritorial Income Exclusion Act of 2000 sec. 5(c)(1)(B), 114 Stat. 2423, 2433 (binding contract transition provision); WTO, Report of the Appellate Body, United States – Tax Treatment for “Foreign Sales Corporations” Recourse to Article 21.5 of the DSU by the European Communities, WT/DS108/AB/RW (Jan. 14, 2002) paras. 223-231 (rejecting ETI's binding contract provisions).

Regarding the phased-out extension, the press release that accompanied introduction of the Crane-Rangel bill on April 11 stated that "[t]he general transition relief is not contingent upon future exports and, therefore, is WTO compliant." Philip M. Crane and Charles B. Rangel, "Summary of Crane-Rangel U.S. Job Protection Act Available," 2003 Worldwide Tax Daily 71-28 (Apr. 14, 2003). Support for this position could be based on one WTO panel's statement that "a subsidy which is contingent upon export performance can be expected to affect exporters' behaviour." WTO, Report of the Panel, Canada - Certain Measures Affecting the Automotive Industry, WT/DS139/R, WT/DS142/R (Nov. 2, 2000) para. 10.199. The argument would be that, because the Crane-Rangel phased-out extension is based on past export performance, it would not be likely to affect the current or future behavior of exporters and therefore would not be "contingent . . . upon export performance" under Article 3.1(a) of the Agreement on Subsidies and Countervailing Duties. The WTO would probably not be persuaded by this argument because it would undermine the intent of Article 3.1(a) by allowing effective enlargement of the ETI subsidy after it had been declared illegal. See, e.g., WTO, Report of the Panel, United States – Tax Treatment for “Foreign Sales Corporations” Recourse to Article 21.5 of the DSU by the European Communities, WT/DS108/RW (Aug. 20, 2001) para. 8.39 n.106 ("It is well-established that an interpreter is not free to adopt a reading that would reduce whole clauses of a treaty to redundancy or inutility. See, for example, Appellate Body Report, Brazil - Export Financing Programme for Aircraft, WT/DS46/AB/R, adopted 20 August 1999, para. 179 and note 110.").

So if neither of the Crane-Rangel bill's ETI extensions is WTO-complaint, why isn't Mr. Lindsey correct when he predicts that their enactment will almost certainly provoke "European retaliation that could begin a global trade war"? Because it's entirely within the power of the EU and the U.S. to decide that, WTO-noncompliance notwithstanding, they want to resolve this matter by allowing some transition period. That's exactly what happened in 2001 when the U.S. held the winning hand in the Bananas dispute with the EU: we agreed to allow the EU a transition period during which we would not impose our WTO-authorized sanctions.* See WTO, European Communities – Regime for the Importation, Sale And Distribution of Bananas, Notification of Mutually Agreed Solution, WT/DS27/58 (July 2, 2001); WTO, European Communities – Transitional Regime for the EC Autonomous Tariff Rate Quotas on Imports of Bananas, WT/MIN(01)/16 (Nov. 14, 2001). Can we depend on the EU to reciprocate now the shoe is on the other foot? Not necessarily, and certainly not with respect to the binding contract extension, but the possibility is there.

The Crane-Rangel transition rules are thus neither as good, nor necessarily as bad as the WSJ exchange between Messrs. Crane and Lindsey suggests. The wisest course, therefore, would be to proceed cautiously, allowing for the possibility that a limited transition will be acceptable to the EU, but having in place an alternate regime that will automatically fall into place if the transition we propose is rejected. The ideal alternative would be unmistakably WTO-compliant, equally beneficial to all U.S. businesses, and distasteful to the EU. Whether any single proposal could fulfill those three standards in equal measure is arguable, but searching for it would be a task that would benefit both sides.

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*July 21 addendum: At the July 8, 2003 Senate Finance Committee hearing on ETI repeal, Senator Max Baucus, D-Montana and ranking member of the Committee, noted the possibility of a transition period in his introduction, saying, "We must work together to create a new set of rules to replace the current system. Those rules should contain effective transition relief, perhaps along the lines of the transition relief the United States afforded the EU in the Bananas case." An Examination of U.S. Tax Policy and Its Effect on the Domestic and International Competitiveness of U.S.-Based Operations, Hearing Before the Senate Committee on Finance, 108th Cong. __ (2003) (statement of Max Baucus). According to an informal transcript of the hearing, Senator Orrin Hatch, R-Utah, asked John Veroneau, general counsel for the United States Trade Representative, how the EU would view a 3-4 year transition period, and Mr. Veroneau said "a one- or two-year phase-out is a normal tax legislative aspect. Beyond that, it becomes a little more cloudy, frankly, as to what would trigger retaliation and what would not." Senate Finance Committee, "Finance Committee Praises Crane-Rangel Bill, According to Unofficial Transcript of Hearing," 2003 Worldwide Tax Daily 134-21 paras. 118-121 (July 14, 2003).

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Subject: Availability of "The FSC/ETI Controversy"

July 6, 2003

Your paper detailing the FSC/ETI Controversy is excellent! Is it published?

M.H.

At present, it's available only on my Web sites. I intend to include it in a FSC/ETI law review article later this year.

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Subject: VAT Creditability

July 6, 2003

1. Does the U.S. exporter typically pay VAT on importation into the EU? My thought is the U.S. exporter is not the importer of record, hence does not incur VAT?

2. If this assumption is correct, how would the economics work so that the U.S. exporter is financially better off? Perhaps an illustration would help me better understand.

M.H.

If by "U.S. exporter," you mean U.S.-based businesses with no foreign branch or subsidiary, I don't know whether U.S. exporters typically pay VAT when they export to destinations in the EU. U.S. exporters delivering software or other digital e-products to EU consumers over the Internet certainly do, now that the July 1 inception date for the E-VAT Directive has passed. With other transactions, however, it depends on how the transaction is structured. I address this issue on page 818 of the TNI version of my VAT creditability article, in the paragraph that begins "U.S. e-tailers will meet those three requirements . . ." Here's the relevant text, sans footnotes:

"U.S.-based businesses with no foreign presence will meet [the] requirements [for crediting VAT] when they sell goods to EU businesses and the transactions require that they be the importing parties. As a general rule, import VAT is due on goods imported into the European Union at the same rate as if the goods had been supplied from within the country. The importer usually is designated as the party to pay that VAT, and if the U.S. business imports the goods itself, then it will owe, and have to pay the import VAT. Setting up this kind of transaction can require appointment of a VAT representative in the country to which the goods will be shipped, but in many cases, the EU business-buyer will be qualified to fill that post."

For example, a U.S.-based exporter might need to double as EU importer if (1) the exporter's cutting-edge U.S. product were dependent on components that could not be manufactured without some defects, (2) the exact defects in the particular product the EU customer would receive would be crucial to the product's performance and integration with the customer's other devices, and (3) the customer could not specify the type or arrangement of defects that would be acceptable because, due to the product's cutting-edge character, the customer had no previous experience with it or with similar devices.

An example of a component that could not be manufactured without defects - although not, to my knowledge, of a component involved in this kind of transaction - is the active matrix screen used by Apple Computer in its early-1990's Powerbook 170 portable computer. Every pixel on this screen was controlled by its own separate transistor, and it was not possible for Apple to get screens in sufficient quantity in which every pixel performed correctly. In some cases, a few pixels would be permanently "on," or lighted, and in others, a few would be permanently "off," or dark.

If the hypothetical transaction in this example had involved these Powerbooks, then it would have been the placement of the malperforming pixels that would have been crucial to the functionality of the Powerbook when it was used with the customer's other equipment, software, etc. If it were not possible for Apple to supply a Powerbook with acceptable defects, the customer would not have wanted any Powerbook at all. In this kind of situation, the customer doesn't want to pay import duties and VAT on something that, regardless of how many times it's replaced, may never be satisfactory. Only a successful on-site test will make the sale.

The manufacturer, confident that its product will be satisfactory, imports the product into the customer's country itself, paying the import VAT, and, if necessary, securing the services of a VAT representative to do so. (This does not require creation of a foreign subsidiary or branch.) In this situation, if the customer were to agree to serve as the manufacturer's VAT representative, not only would it get to test the product without obligation, it would also get consideration for its services as VAT rep.

Depending on the level of confidence or skepticism on both sides, other permutations of this basic transaction are possible, such as the customer-cum-VAT-representative loaning the U.S. supplier the money to pay the import VAT, thereby putting itself in the position of having to pursue the supplier for those funds if the sale falls through and the supplier does not reimburse it. The supplier, in this permutation, gets an additional assurance of good faith from the customer's assumption of this risk.

The problem with this transaction in a world without VAT creditability is that, if the deal falls through, the U.S. supplier is left on the hook for the entire VAT payment. It gets to deduct that VAT as an expense, but, at a 35% U.S. corporate tax rate, that still leaves it out-of-pocket for other 65%, which could easily be more than the profit margin on the deal. If, however, it could get credit for the VAT, dollar for dollar, subject to a limitation on the maximum reduction of any single year's U.S. tax liability, then the downside of a worst-case outcome would be less punitive, and that much closer to the "go" side of the "go, no-go" equation.

It's my guess that U.S.-based exporters avoid these kinds of transactions now, both for the reasons just discussed and to save the administrative costs involved in VAT compliance. Therefore, even if we knew how many of them currently pay VAT, that wouldn't necessarily be an indication of how many would benefit if VAT were creditable, and thus less of a negative factor in deal making.

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