The Foreign Sales Corporation (FSC) provisions of the U.S. tax code permit U.S. firms to exempt between 15% and 30% of export income from taxation. FSC was enacted in 1984 to replace another tax benefit for exporting - the Domestic International Sales Corporation (DISC) provisions. U.S. trading partners had charged that DISC was an export subsidy, and so violated the General Agreement on Tariffs and Trade (GATT). In 1998 the European Union (EU) complained to the World Trade Organization (WTO, GATT's successor) that FSC itself is an export subsidy and violates the agreements on which the WTO is based. A WTO panel subsequently supported the EU. Under WTO procedures, the FSC provisions must be brought into compliance by October 2000, or the United States will face compensatory damages or retaliatory measures. On September 13, 2000, the House of Representatives approved a replacement for FSC that would provide an export tax benefit similar in size to FSC but that would also include--unlike FSC--a partial tax exemption for income from foreign operations. The measure is supported by the Administration and U.S. exporters, but the EU notified the United States that it considers the proposal to be not WTO-compliant. The full House approved the bill on September 13; the Senate Finance Committee approved it on September 19. While the full Senate did not act on H.R. 4986 before the October 1 deadline, the EU agreed to an extension of the deadline to November 1. The EU has indicated that it then expects to ask a WTO panel to rule on the acceptability of H.R. 4986 under the WTO rules. For its part, economic analysis suggests that FSC does increase U.S. exports, but likely triggers exchange rate adjustments that also result in an increase in U.S. imports; the long run impact on the trade balance--assuming no changes in investment flows--is probably nil. Economic theory also suggests that FSC likely reduces aggregate U.S. economic welfare. This report will be updated with events in Congress and elsewhere.

FSC's Predecessor (DISC) and the General Agreement on Tariffs and Trade

The FSC controversy has its roots in the legislative antecedent of FSC: 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, 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 establish foreign operations; and to offset export benefits other countries gave 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 article XVI of the GATT. The United States, however, filed a counter-claim, holding that the "territorial" 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 pricing ⁽²⁾ 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 the issue "threatened breakdown of the dispute resolution process." ⁽³⁾ The U.S. Treasury thus proposed what became the 1984 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. While the United States does not operate a territorial system (it does tax U.S.-chartered corporations on their worldwide income), it taxes foreign-chartered corporations only on their U.S.-source income. As described more fully below, firms avail themselves of the FSC benefit by selling their exports through FSCs. FSCs are required to be chartered abroad or in a U.S. territory; part of their income is classified as not being from U.S. sources.

FSC and the World Trade Organization

The European countries were not fully satisfied of FSC's GATT-legality. ⁽⁴⁾ 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. ⁽⁵⁾ 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 establishment of a panel to examine the issue. The panel was formed and on October 8, 1999, it made its findings public. ⁽⁶⁾

The panel generally supported the complaints of the EU, holding that FSC is indeed a prohibited export subsidy, and that FSC violated subsidy obligations under both the WTO Agreement on Subsidies and Countervailing measures and the WTO Agreement on Agriculture. In particular, Articles 3.1 and 1.1 of the Subsidies and Countervailing Measures (SCM) Agreement provide that a subsidy exists if "government revenue that is otherwise due is foregone 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. ⁽⁷⁾ The United States filed an appeal with the WTO's Appellate Body, but the Appellate Body essentially upheld the initial finding. Under the WTO's dispute procedures, the United States now has until October 1, 2000, to bring its system into compliance with the WTO rules. Failure to do so may ultimately result in the WTO sanctioning retaliatory measures by the EU against the United States. ⁽⁸⁾

On May 2, 2000, the United States presented the EU with a proposed alternative to FSC that would exempt part of all foreign-source income of branches of qualified U.S. firms from tax, not just exports. On May 29, however, the EU notified the United States that it would not accept the proposal. On September 13, the House of Representatives approved a proposed replacement for FSC (described below on page six) broadly similar to the May proposal; the Senate Finance Committee approved the bill on September 19. While the full Senate did not act on H.R. 4986 before the October 1 deadline, the EU agreed to an extension of the deadline to November 1. The EU has indicated that it subsequently expects to ask a WTO panel to rule on the acceptability of H.R. 4986 under the WTO rules. The EU has notified the United States that it does not believe the replacement to be compliant with the WTO agreements.

How the FSC Benefit Works

In general, the United States taxes its resident corporations--that is, corporations chartered in the United States--on their worldwide income. Ordinarily, then, 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 foreign corporations--that is, corporations chartered abroad--only on income from the active conduct of a U.S. trade or business. U.S. firms avail themselves of the FSC benefit by selling their exports through specially qualified subsidiary corporations (FSCs) organized abroad. (The FSC benefit can also be obtained by selling through a FSC on a commission basis.) 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. trade or business, and thus exempt from U.S. tax. Ordinarily, the FSC export income could still be taxed when remitted to the U.S. parent corporation as an intra-firm dividend, but the FSC provisions also provide that the parent can deduct 100% of its FSC dividends.

The size of the FSC benefit results from rules governing how much of the FSC's income is tax exempt, and on the rules governing how the combined parent-and-FSC export income is allocated between the two. There are three alternative rules a firm can use to divide income between the parent exporter and tax-favored FSC. Under one, a firm can use arm's length pricing to divide the income (see above, page 2). The other two rules are "administrative" methods for allocating income, under which a firm allocates a fixed percentage of income or gross receipts to a FSC. As a result of these rules, a firm can exempt at least 15% but no more than 30% of export income from taxes.

The FSC provisions 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. The second benefit is thus generally larger than the FSC benefit. It works by permitting firms to allocate half of their export income to foreign rather than U.S. sources when they calculate their U.S. foreign tax credit limitation. For firms that have enough foreign tax credits to offset all U.S. tax on foreign-source income, the allocation rule is tantamount to a tax exemption. Note, however, that while FSC can generally be used by all exporters, the sales source rule is restricted to firms that have paid foreign taxes, which implies that it can only be used by firms that have foreign operations and income, and that have thus paid foreign taxes.

Economic Effects of FSC

The FSC exemption reduces the rate of return required, before taxes, of investment in the export sector, and thus attracts investment to exporting. As a consequence, U.S. exports are probably higher than they would be without FSC. 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 foreign purchasers are to reduced prices for U.S. exports.

Beyond this effect, however, traditional economic analysis indicates that FSC produces a set of effects that are perhaps surprising to non-economists. First, because of exchange rate adjustments, the FSC-induced increase in exports is diminished, and U.S. imports also are increased; sales of U.S. import-competing industries thus fall. Economic theory indicates that while FSC increases the overall level of U.S. trade, it does not change the balance of trade, or reduce the U.S. trade deficit. The adjustments work as follows: FSC increases foreign purchases of U.S. exports, but to buy the U.S. products, foreigners require more dollars. The increased demand for U.S. dollars drives up the price of the dollar in foreign exchange markets, making U.S. exports more expensive. This partly offsets the effect FSC has in increasing U.S. exports, but also makes imports to the United States cheaper, which causes U.S. imports to increase. The net result is a higher level of both imports and exports, but no change in the overall balance of trade. This result is perhaps 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 deficit on capital account. And a country's trade balance only changes if the balance on capital account changes. Thus, if we assume that FSC does not change the balance on capital account, it cannot change the trade balance.

FSC also affects U.S. economic welfare. Traditional economic analysis indicates that FSC reduces overall U.S. economic welfare because at least part of the tax benefit is 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, are probably not large. According to CRS estimates based on 1996 data, FSC increased the quantity of U.S. exports by a range of 2-tenths of 1% to 4-tenths of 1% and increased the quantity of imports by a range of 2-tenths of 1% to 3-tenths of 1%. The shift of economic welfare to foreign consumers is equal to an estimated 1-tenth of 1% of exports. ⁽⁹⁾ The impact on the trade balance was probably negligible. FSC's cost in terms of forgone tax revenues is estimated by the Joint Committee on Taxation at $2.7 billion for fiscal year 2000. (The sales source rule's revenue loss is estimated at $4.0 billion.)

If economic analysts are generally critical of FSC, support for the measure can be found in the business community. A reason for the divergence in views may be perspectives: economic analysis looks at the impact of FSC from the perspective of the economy as a whole, taking into account its full range of effects and adjustments in all markets. Supporters of the provision, however, are frequently businessmen whose exporting firms would likely face declining sales, profits, and employment if FSC were to be eliminated. For economists, there is no denying that FSC boosts employment and increases incomes in certain sectors of the economy. But it also results in contraction of other parts--for example, firms that compete with imports--and transfers economic welfare to foreign consumers.

FSC has sometimes also been defended on the grounds it counters 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, economists have long held that 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. ⁽¹⁰⁾ 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, in the case of countries with territorial tax systems, lax administration of transfer pricing rules may result in export subsidies.)

H.R. 4986: A Proposed Replacement for FSC

On July 27, 2000, the House Ways and Means Committee overwhelmingly approved H.R. 4986, the FSC Repeal and Extraterritorial Income Exclusion Act. The bill was approved by the full House on September 13. A slightly modified version of the bill was approved by the Senate Finance Committee on September 19. For exports, the size of the tax benefit under the proposal would be essentially the same as under FSC. Unlike FSC, part of the tax benefit could also apply to income from foreign operations. The Joint Tax Committee has estimated that the proposal's revenue cost will be $1.5 billion over 5 years in addition to the revenue that would be lost under FSC.

The bill begins by exempting "extraterritorial income" from U.S. tax, and continues by defining "extraterritorial income" and other concepts in a way that results in a partial tax exemption for U.S. exports and a partial exemption for a limited amount of income from foreign operations. First, the extraterritorial exemption only applies to "qualifying foreign trade income," as defined by the bill. This definition includes specified percentages that effectively determine the size of the tax benefit. Next, foreign trade income can, in effect, only be generated by what the bill defines as "foreign trading gross receipts." Foreign trading gross receipts, in turn, are contingent on the sale of "qualifying foreign trade property," as defined by the bill. Qualifying foreign trade property--a critical concept, since it is the first link in the chain of definitions--is property produced in either the United States or abroad. Qualifying property must be used abroad, and not more than 50% of its value can be attributable to value added outside the United States.

The percentages embedded in the bill's definitions are such that the size of the tax exemption for exports is likely to be the same as that of FSC--somewhere between 15% and 30% of export income. And due to the provision that 50% of the value of qualifying property can be added outside the United States, the bill would apparently enable firms to exempt somewhere between 15% and 30% of part of their foreign-source income from U.S. tax. However, since 50% of the value of property must be added in the United States, the volume of foreign income eligible for the partial exemption would necessarily depend on how much a firm exports. Unlike FSC, corporations would be able to use the new benefit directly rather than having to create specially defined subsidiaries (i.e., FSCs) and also contrasts with the proposal made to the EU in May 2000.

Footnotes

1. ^(back)U.S. Congress, Joint Committee on Taxation, General Explanation of the Revenue Act of 1971, (Washington: GPO, 1972), p. 86.

2. ^(back)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. ^(back)U.S. Congress, Joint Committee on Taxation, General Explanation of the Deficit Reduction Act of 1984, (Washington, GPO,1984), p. 1041.

4. ^(back)Bennett Caplan and Matthew Chametzky. "Domestic International Sales Corporations (DISCs) and Foreign Sales Corporations (FSCs): Providers of Economic Incentives for Wholly-Owned Domestic Exporters," Brooklyn Journal of International Law. Vol. 12, No. 1, 1986. pp. 14-15.

5. ^(back)For information on the WTO's dispute settlement process, see: U.S. Library of Congress. Congressional Research Service. Dispute Settlement in the World Trade Organization: An Overview, by Jeanne J. Grimmett, CRS Report RS20088 , (Washington: Feb. 26, 1999), 6 p. In 1993, the EC was subsumed into the European Union (EU). While the complaint was technically filed by the EC, we nonetheless use the term EU in describing events in 1993 and after.

6. ^(back)For a chronology of the FSC-WTO controversy see: United States - World Trade Organization. Tax Treatment for Foreign Sales Corporations. Report of the Panel. P. 1.

7. ^(back)World Trade Organization, United States - Tax Treatment for "Foreign Sales Corporations": Report of the Panel. WT/DS108/R. 8 October, 1999. p. 275.

8. ^(back)Dispute Settlement in the World Trade Organization: An Overview, p. 5.

9. ^(back)U.S. Library of Congress. Congressional Research Service. The Foreign Sales Corporation (FSC) Tax Benefit for Exporting: WTO Issues and an Economic Analysis. Report No. RL30684, by David L. Brumbaugh. Sept. 14, 2000. 24 p.

10. ^(back)Paul Krugman and Martin Feldstein, International Trade Effects of Value-Added Taxation, Working Paper 3163. (Cambridge, MA: National Bureau of Economic Research, 1989), 26 p.