The United States responds to the WTO FSC decision: Round One and counting.

In 1971, the United States enacted the domestic international sales corporation (DISC) provisions. In 1984, the United States repealed the DISC provisions and enacted the foreign sales corporation (FSC) provisions. Now, in 2000, the United States has repealed the FSC provisions and enacted the extraterritorial income exclusion regime.

How did we get here and why? What is the new regime? And where are we likely to go from here?

The WTO Decision and the U.S. Response

The WTO Decision

On March 24, 2000, the World Trade Organization (WTO) Dispute Settlement Body adopted the Report of the Panel, as modified by the Appellate Body, in the dispute regarding the FSC provisions of the U.S. tax law. This marked the culmination of WTO proceedings that had begun on November 17, 1997, when the European Union requested consultations with the United States with respect to the FSC matter. When the consultations failed to resolve the issues, on September 22, 1998, at the request of the European Union, the WTO Dispute Settlement Body formed a panel to make findings.

On October 8, 1999, the panel issued its report, concluding that the FSC provisions constituted a prohibited export subsidy under the WTO Agreement on Subsidies and Countervailing Measures (the "SCM Agreement") and the Agreement on Agriculture. The panel report mandated that this subsidy be withdrawn by October 1, 2000. The United States appealed the decision, and the European Union filed a cross-appeal. On February 24, 2000, the Appellate Body circulated its report upholding, with minor modifications, the findings of the panel.

WTO Panel Findings

To reach the conclusion that the FSC provisions constituted a prohibited export subsidy in violation of the SCM Agreement, the panel had to find both that the provisions constituted a subsidy and that the subsidy was contingent on export performance.(1)

Under the SCM Agreement, a subsidy exists if (i) government revenue otherwise due is forgone and (ii) a benefit is thereby conferred. The panel considered the first question under a "but for" analysis focused on three elements of the FSC provisions: the treatment of FSC income as foreign-source income not effectively connected with a U.S. trade or business, the exemption from subpart F for FSC income, and the 100-percent dividends-received deduction for distributions from a FSC. The panel concluded that these three elements taken together protected from U.S. taxation income that otherwise would be subject to tax and that the FSC provisions thus resulted in revenue forgone through which a benefit was conferred.

The SCM Agreement prohibits "subsidies contingent, in law or in fact, whether solely or as one of several other conditions, upon export performance."(2) The panel reviewed the operation of the FSC provisions and concluded that the benefit they provided was available only for income arising from transactions involving property manufactured in the United States and held for use or disposition outside the United States. Thus, the panel concluded that the subsidy provided by the FSC provisions was export-contingent because it depended on the exportation of U.S. goods.

The European Union also alleged that the administrative pricing rules of the FSC provisions constituted a separate violation of the SCM Agreement. The panel declined to rule on this issue, concluding that it was neither necessary nor appropriate to do so in light of its finding that the three elements of the FSC provisions described above gave rise to a violation. The European Union pressed for a ruling on this issue in its appeal, but the Appellate Body declined to revisit the panel's decision. Therefore, there has been no finding by the WTO on the E.U. allegation that the FSC administrative pricing rules are incompatible with the WTO Agreement.

U.S. Response

Following the Dispute Settlement Body decision that the FSC provisions constituted a prohibited export subsidy that must be withdrawn by October 1, 2000, the Clinton Administration -- led by the Treasury Department -- and the Congress -- led by the tax-writing committees -- worked together to develop a prompt U.S. response. In crafting a solution, the United States was committed to complying with the decision and satisfying its obligations under WTO agreements. At the same time, the United States was committed to developing a solution that did not adversely affect U.S. businesses competing in the global marketplace. The FSC provisions operated to help level the playing field for U.S. businesses competing against European and other foreign-based businesses, whose home countries provide more favorable tax treatment of cross-border business. The U.S. goal was a resolution that would be WTO-compatible and preserve the competitive balance for those businesses that operated under the FSC provisions.

H.R. 4986

H.R. 4986, the FSC Repeal and Extraterritorial Income Exclusion Act of 2000, was developed by the Hill, Treasury, and the business community. H.R. 4986 has two components. First, the legislation repealed the FSC provisions. Second, the legislation enacted a new regime -- the extraterritorial income exclusion regime -- that incorporates features of the territorial tax systems common in Europe.

The new regime provides an exclusion from U.S. taxation for a portion of a company's income from foreign sales and leases. The extraterritorial income exclusion applies to income from sales and leases of property for foreign use, whether the property is manufactured in the United States or outside its borders. For transactions that had been subject to the FSC provisions, the new regime effectively preserves the tax treatment that resulted under those provisions (although the new regime operates differently). The new regime, however, extends this same tax treatment to non-export transactions that were not previously covered by the FSC provisions.

H.R. 4986 passed the Senate on November 1st under a unanimous consent agreement, and the House of Representatives on November 14th by a vote of 316 to 72. The legislation was signed into law by the President on November 15, 2000.

Compliance with WTO Requirements

The new extraterritorial income exclusion regime is intended to be WTO-compliant. In structuring the new regime, the United States chose to address both the subsidy issue and the export-contingency issue, although WTO compliance requires only the absence of a subsidy or the lack of export contingency for any subsidy that is provided. The new U.S. regime is structured so that it does not provide a subsidy and the treatment it provides is not contingent on exportation.

The new regime modifies the U.S. taxing system and redefines the extent to which the United States seeks to tax extraterritorial income. With the new regime, the general rule of U.S. taxation is that extraterritorial income is excluded from gross income. There is no revenue forgone, and the regime is not a subsidy.

The new regime applies to income from all foreign sales and leases of property, without regard to where the property is manufactured. The new regime thus covers both export sales and non-export foreign sales. As a result, the tax treatment provided by the new regime is not dependent on export performance and is not export contingent.

In addition, the new regime is structured to address concerns that were raised by the European Union with respect to the FSC provisions but that were not addressed by the panel or the Appellate Body. The new regime does not require the use of a separate entity such as the FSC to which sales are made or commissions are paid. The new regime thus goes beyond the WTO decision by eliminating the E.U.-questioned administrative pricing rules as a transfer pricing mechanism.

The Operation of the New Extraterritorial Income Exclusion Regime

Overview

The new regime operates as a partial territorial tax system by providing an exclusion from U.S. taxation for certain extraterritorial income. This exclusion from gross income applies to a portion of the taxpayer's income from foreign sales and leases of property and certain related services. Detailed rules apply to determine the income to which the exclusion applies.

The new regime is intended to provide comparable tax treatment for transactions of a type that were previously subject to the FSC provisions. Accordingly, while the new regime is structured very differently, some of the concepts are familiar.

The treatment provided by the new regime is not limited to those transactions to which the FSC provisions would have applied. The new regime is not limited to income from property manufactured in the United States but applies equally to income from property manufactured outside the United States. In the case of property manufactured abroad, the manufacturer either must be subject to the taxing jurisdiction of the United States (e.g., a domestic corporation) or must elect to be subject (e.g., a foreign corporation that elects to be treated as a U.S. corporation for U.S. tax purposes). With this requirement, the income to which the new regime applies is subject to consistent U.S. tax treatment, regardless of whether the income arises from property manufactured inside or outside the United States. Specific rules are provided under which a foreign corporation may elect to be treated for U.S. tax purposes in the same manner as a U.S. corporation.

The exclusion from gross income applies as a general rule. It does not require the filing of an election or the formation of a special entity to which sales are made or commissions are paid. This eliminates the FSC entity as a separate taxpayer, which in turn eliminates the tradeoffs with respect to the FSC election that previously had to be considered by taxpayers in an alternative minimum tax or net operating loss position.(3)

The new regime is set forth in detailed statutory provisions. Just as there were lengthy regulations under the FSC provisions, however, it is expected that additional administrative guidance with respect to the new regime will be needed. Moreover, the new regime includes concepts that are similar to concepts reflected in the FSC provisions. The legislative history makes clear that, until guidance with respect to the new regime is issued, the regulations and other administrative guidance issued under the FSC provisions may be applied in interpreting analogous rules or concepts in the new regime.

Exclusion for Qualifying Foreign Trade Income

New section 114 of the Internal Revenue Code provides a general exclusion from gross income for extraterritorial income, defined as gross income attributable to foreign trading gross receipts. Under section 114(b), the exclusion is limited to extraterritorial income that constitutes "qualifying foreign trade income." The new regime thus provides a partial exclusion from gross income for extraterritorial income. This exclusion applies to both individuals and corporations in the same manner.(4)

To the extent gross income is excluded under section 114, deductions allocated to such income are disallowed under section 114(c). For this purpose, deductions first are allocated and apportioned to the taxpayer's extraterritorial income and then are allocated on a proportionate basis to the portion of such income to which the exclusion applies (i.e., the taxpayer's extraterritorial income that constitutes qualifying foreign trade income). The exclusion from gross income coupled with the disallowance of deductions allocated to the excluded gross income yields a net reduction in the taxpayer's taxable income.

Foreign tax credits for taxes paid or accrued with respect to income that is excluded from gross income under section 114 generally are disallowed under section 114(d). Like the foreign tax credit, the new exclusion from gross income operates as a means of alleviating potential double taxation. Because the foreign tax credit and the exclusion are alternative mechanisms to achieve the same objective, the credit does not apply to income to which the exclusion applies.

This general denial of foreign tax credits does not apply to withholding taxes that are paid or accrued with respect to excluded income. Under section 943(d), withholding taxes paid or accrued with respect to excluded income are creditable. For this purpose, a withholding tax is any tax that is imposed on a basis other than residence (e.g., a gross-basis tax described in section 871 or 881), provided that such tax otherwise is creditable. This rule preserves the creditability of withholding taxes on, for example, software royalties, which were creditable under the FSC provisions.

Determination of Qualifying Foreign Trade Income

New section 941 defines the "qualifying foreign trade income" to which the exclusion applies. Qualifying foreign trade income is the amount of gross income the exclusion of which will result in a reduction in taxable income equal to the greatest of three alternative measures: (i) 15 percent of the taxpayer's foreign trade income; (ii) 1.2 percent of the taxpayer's foreign trading gross receipts; or (iii) 30 percent of the taxpayer's foreign sale or leasing income.(5)

Qualifying foreign trade income is excluded from gross income, and there is an associated disallowance of deductions allocable to the excluded gross income. The definition of qualifying foreign trade income operates to determine a net reduction in taxable income. Therefore, the net income amount determined under one of the three alternative formulations is grossed up by the amount of associated deductions to yield the gross income amount that represents qualifying foreign trade income. The exclusion of this gross income amount and the disallowance of allocated deductions combine to result in a reduction in taxable income equal to the chosen measure.

The first alternative measure for determining qualifying foreign trade income is 15 percent of the taxpayer's foreign trade income. Foreign trade income -- a net income concept -- is defined under section 941(b) as the taxpayer's taxable income attributable to foreign trading gross receipts. Under this formulation, the exclusion from gross income and the disallowance of allocated expenses result in a net reduction in taxable income equal to 15 percent of the taxable income attributable to foreign trading gross receipts. This formulation is consistent with the tax treatment that resulted under the FSC provisions when the FSC's income was determined based on 23 percent of combined taxable income and a 15/23 exemption from U.S. tax applied to such income of the FSC.(6) For purposes of determining foreign trade income under this measure, regulations will set forth marginal costing rules for taxpayers seeking to establish or maintain a market for property. Similar rules were provided in the FSC regulations.(7)

The second alternative measure for determining qualifying foreign trade income is 1.2 percent of the taxpayer's foreign trading gross receipts. This formulation is consistent with the tax treatment that resulted under the FSC provisions when the FSC's income was determined based on 1.83 percent of foreign trading gross receipts and a 15/23 exemption from U.S. tax applied to such income of the FSC.(8)

The amount of qualifying foreign trade income that may be derived from use of the 1.2 percent of gross receipts method cannot exceed twice the amount that would result under the 15 percent of foreign trade income method. Moreover, if the taxpayer and one or more related persons engage in multiple transactions with respect to the same property (e.g., the manufacturer sells property to a related distributor that sells the property to an unrelated customer), the use of the 1.2 percent of gross receipts method in computing the excluded income from such transactions is restricted.

Under section 941(a)(3), if the taxpayer uses the 1.2 percent of gross receipts method to determine the qualifying trade income from a transaction, other transactions involving such property by the taxpayer or any related person will not generate any qualifying foreign trade income. Therefore, no portion of the income from these other transactions will be excluded. This limitation is designed to prevent the double-counting Of gross receipts to increase the aggregate exclusions provided to related taxpayers.(9) No double-counting would arise if each related person computes its exclusion based on its income from its own transaction.(10) The new regime thus does not restrict the use of the 15 percent of foreign trade income method to determine the income exclusions of related persons that enter into transactions involving the same property. Similar rules limiting the use of the foreign trading gross receipts method applied under the FSC provisions.(11)

The third alternative measure for determining qualifying foreign trade income is 30 percent of the "foreign sale and leasing income" derived by the taxpayer. This formulation is consistent with the tax treatment that resulted under the FSC provisions when the administrative pricing rules were not applied to determine the income of the FSC and a 30 percent exemption applied to such income of the FSC.(12) This formulation likely will be most relevant for taxpayers engaging in leasing transactions such as those that were conducted through the so-called ownership-FSC structure.

Foreign sale and leasing income is defined to include two categories of income. The first category, set forth in section 941(c)(1)(A), is foreign trade income allocable to activities that are relevant in applying the foreign economic processes requirement (e.g., advertising, order processing, transportation for delivery, and invoicing). The second category, set forth in section 941(c)(1)(B), is foreign trade income derived by the taxpayer in connection with the lease of qualifying foreign trade property for foreign use.

Foreign sale and leasing income specifically includes foreign trade income derived from the sale of property that is or was leased, such as income from the sale of a residual interest in leased property. Where property is manufactured by the taxpayer or is acquired from a related person, the amount of foreign trade income that is treated as foreign sale and leasing income is determined under section 941(c)(2) by treating the taxpayer as having acquired the property at an arm's-length price. Thus, if a taxpayer manufactures property and then ]eases it for foreign use, the portion of its income eligible for the exclusion based on 30 percent of foreign sale and leasing income will be determined as if the taxpayer had purchased the property for an arm's-length price prior to leasing it the remainder of its income will be eligible for the exclusion based on 15 percent of foreign trade income.

In measuring foreign sale and leasing income, section 941(c)(3)(A) provides that only directly allocable expenses are taken into account. Thus, expenses that are not directly allocable do not reduce foreign sale and leasing income for purposes of the exclusion measure based on 30 percent of foreign sale and leasing income. The issue of expense allocation can be critically important. In the case of interest expense, the existing regulations provide that only interest expense incurred with respect to qualified nonrecourse indebtedness and integrated financial transactions is directly allocable.(13) Also significant is the new section 864(e) rule explicitly providing that qualifying foreign trade property leased by the taxpayer for use by the lessee outside the United States is not taken into account for purposes of allocating and apportioning any interest expense.

Under section 941(c)(3)(A), income allocable to certain intangible property is not taken into account in measuring foreign sale and leasing income. Under section 943(d)(2), the exception from the disallowance of foreign tax credits does not apply to withholding taxes paid or accrued with respect to foreign sale and leasing income. Thus, no foreign tax credits are allowed for any withholding taxes imposed on foreign sale and leasing income that is excluded from gross income.

Under each of the alternative formulations described above, qualifying foreign trade income generally is determined with respect to a particular transaction. Section 943(b)(1)(B) provides, however, that to the extent provided in regulations, the taxpayer may determine its qualifying foreign trade income on an aggregate basis for groups of transactions, based on product lines or recognized industry or trade usage, instead of on a transaction-by-transaction basis.

In this regard, the legislative history states an intent that taxpayers will be given reasonable flexibility to determine product lines or groups on the basis of recognized industry or trade usage. In addition, the legislative history specifically provides that a taxpayer's grouping that is not unreasonable will not be rejected merely because the grouped products fall within different two-digit Standard Industrial Classification codes (or within different industries as defined in the newer North American Industrial Classification System). This reference to groupings that span two-digit SIC codes is intended to clarify an issue that has arisen in interpreting similar grouping rules under the FSC provisions.(14)

As under the FSC provisions, section 941(a)(5) provides for the reduction of qualifying foreign trade income by the amount of any illegal bribe or similar payment and by the international boycott factor.(15) Unlike the FSC provisions, the amount of qualifying foreign trade income that can be derived from sales of military property is not subject to any special limitation.(16)

Determination of Foreign Trading Gross Receipts

The alternative formulations of qualifying foreign trade income eligible for the new exclusion are all measures either of the taxpayer's taxable income attributable to foreign trading gross receipts (i.e., 15 percent of taxable income attributable to foreign trading gross receipts or 30 percent of taxable income attributable to foreign trading gross receipts derived in connection with a lease of property) or of the taxpayer's foreign trading gross receipts directly (i.e., 1.2 percent of foreign trading gross receipts). Thus, the foreign trading gross receipts concept is the building block for the exclusion.

New section 942 defines "foreign trading gross receipts" as gross receipts from the following activities: (i) the sale, exchange, or other disposition of qualifying foreign trade property; (ii) the lease or rental of qualifying foreign trade property for use outside the United States; (iii) services related and subsidiary to any such sale or lease; (iv) engineering or architectural services for construction projects located outside the United States; or (v) the performance of managerial services for an unrelated person in furtherance of the activities in the first three categories. Gross receipts from these activities generally constitute foreign trading gross receipts only if certain economic processes occur outside the United States.

Under section 943(a)(3), a taxpayer may elect to exclude from its foreign trading gross receipts the amount of gross receipts from any transaction or transactions. Foreign tax credits would be allowed in connection with any gross receipts so excluded. The taxpayer may redetermine which gross receipts it takes into account as foreign trading gross receipts, as long as the statute of limitations for refund claims is still open.

Receipts from certain transactions involving property used in or by the United States are excluded from the definition of foreign trading gross receipts. Also excluded are receipts from qualifying foreign trade property or services for ultimate use in the United States or for use by the United States where such use is required by law or regulation and receipts from transactions accomplished by a subsidy granted by the government of the country or possession where the property is manufactured. Similar exclusions applied under the FSC provisions.(17)

Definition of Qualifying Foreign Trade Property

Foreign trading gross receipts arise from transactions of the type described above that involve "qualifying foreign trade property." Under section 943, property must meet three requirements to qualify. First, the property must be manufactured within or outside the United States.(18) Thus, the new regime eliminates the U.S.-manufacturing requirement of the FSC provisions and applies to both U.S.- and foreign-manufactured property. Second, the property must be held primarily for sale or lease in the ordinary course of business for direct use, consumption, or disposition outside the United States. Third, not more than 50 percent of the fair market value of the property may be attributable to the sum of the fair market value of articles manufactured outside the United States and the direct costs for labor performed outside the United States. For this purpose, the fair market value of an article that is imported into the United States is its appraised value for customs purposes. Direct costs of labor are determined under the principles of section 263A and do not include direct labor costs attributable to articles that are taken into account under the first prong of this limitation.

Property manufactured outside the United States constitutes qualifying foreign trade property under section 943(a)(2) only if it is manufactured by a person that is subject to the U.S. taxing jurisdiction. Thus, the manufacturer must be a domestic corporation, a U.S. citizen or resident, a foreign corporation that has elected to be subject to U.S. tax, or a partnership (or other pass-through entity) all of the partners of which are themselves subject to the U.S. taxing jurisdiction.

Sections 943(a)(3) and (4) exclude several categories of property from the definition of qualifying foreign trade property: property leased for use by a related person, certain intangible property (other than films, recordings, or computer software), oil and gas (and primary products), unprocessed softwood timber, products subject to certain mandated transfer prohibitions or curtailments, and property designated by the President to be in short supply. For this purpose, property that is leased or licensed to a related person who in turn subleases or sublicenses the same property to an unrelated person for use outside the United States is not excluded from the definition of qualifying foreign trade property.

Foreign Economic Processes Requirement

Under section 943(b), a transaction gives rise to foreign trading gross receipts only if certain economic processes with respect to the transaction take place outside the United States. This foreign economic processes requirement is deemed met under section 943(c) if the taxpayer's foreign trading gross receipts for the taxable year do not exceed $5 million (aggregating for this purpose the foreign trading gross receipts of all related persons).

The foreign economic processes requirement consists of two elements. First, the taxpayer or its agent must participate outside the United States in the solicitation (other than advertising), the negotiation, or the contracting with respect to the transaction. Second, the foreign direct costs incurred by the taxpayer with respect to the transaction must equal or exceed 50 percent of the total direct costs with respect to the transaction. Alternatively, the direct cost element of the requirement is satisfied if, for at least two of the specified categories of activities with respect to the transaction, the foreign direct costs incurred by the taxpayer equal or exceed 85 percent of the total direct costs. A taxpayer is treated as having satisfied the requirement with respect to a sale of property if any related person has satisfied the requirement in connection with such sale or any other sale transaction involving the same property.

Total direct costs with respect to a transaction are the total direct costs incurred by the taxpayer attributable to specified activities that are performed by the taxpayer or an agent. Foreign direct costs are the portion of the total direct costs that are attributable to activities performed outside the United States. The specified categories of activities taken into account in measuring total and foreign direct are (i) advertising and sales promotion; (ii) processing of customer orders and arranging for delivery; (iii) transportation outside the United States in connection with delivery to the customer; (iv) determination and transmittal of a final invoice or statement of account or receipt of payment;(19) and (v) assumption of credit risk.

Election to be Treated as a U.S. Corporation

The new regime applies to income from foreign sales and leases of property, without regard to where the property is manufactured. Property manufactured outside the United States is subject to the new regime if the manufacturer is subject to U.S. tax. Where the manufacturing is done through a foreign corporation, the taxpayer may elect to have the foreign corporation treated in the same manner as a U.S. corporation.

Section 943(e) provides an election for a foreign corporation to be treated as a domestic corporation for U.S. tax purposes. In order to be eligible to make the election, the corporation must waive any benefits provided by the United States under any treaty. The waiver of treaty benefits -- which extends only to benefits provided by the United States to the corporation itself -- is intended to avoid issues regarding the interaction of the election and any permanent establishment provisions. The foreign corporation also must satisfy any requirements prescribed by the IRS to ensure that its taxes will be paid. In addition, regulations may designate certain classes of corporations that may not elect the treatment.

The election may be made by any foreign corporation that manufactures property in the ordinary course of business. The election may also be made by a foreign corporation substantially all the gross receipts of which are foreign trading gross receipts. This latter category is likely to include former FSCs, other foreign distribution companies, and foreign corporations engaged in the leasing of property (e.g., so-called ownership FSCs).

The election applies for the taxable year for which made and all subsequent years, unless revoked by the taxpayer or terminated because the corporation ceases to satisfy the two alternative criteria for qualification to make the election. A revocation or termination will take effect for the taxable year after which it occurs. A new election may not be made for five years after the year in which a revocation or termination occurs.

A foreign corporation electing to be treated as a U.S. corporation is treated as transferring all its assets in a transaction subject to section 367(b), which generally triggers an income inclusion of the corporation's earnings and profits. Conversely, a corporation that revokes its election (or has its election terminated) is treated as a domestic corporation transferring its assets to a foreign corporation in a transaction to which section 367(a) applies, which may require the recognition of gain.

An electing foreign corporation is treated as a U.S. corporation for all U.S. tax purposes. Obviously, its income will be subject to current U.S. tax and any losses will also have current U.S. tax implications. If the stock of the electing corporation is owned by members of a U.S. consolidated group, the electing corporation will be included in the consolidated group. Therefore, its attributes -- including foreign-source income and assets, foreign taxes paid, and any losses -- will be taken into account by the group.

Other Rules

Section 943(c) provides a limitation on the sourcing of the non-excluded portion of income that arises from a sale of property manufactured in the United States. This limitation parallels the "section 927(e) haircut" under the FSC provisions. Under the new regime, however, the limitation explicitly applies only to income from sales transactions (and does not apply, for example, to software royalty income).

Under the new regime, detailed rules are provided with respect to the treatment of agricultural and horticultural cooperatives.(20) The new regime also includes rules allowing shared partnerships to allocate excluded qualifying foreign trade income among the partners based on separate accounts.(21)

Effective Dates

The extraterritorial income exclusion regime generally applies to transactions entered into after September 30, 2000. Moreover, no corporation may elect FSC status after that date. Finally, any existing FSC that is dormant for a five-year period (i.e., that generates no foreign trade income) will cease to be treated as a FSC.

The FSC provisions are continued for a limited transition period and apply to transactions in the ordinary course of business involving a FSC that occur before January 1, 2002, or that occur after that date pursuant to a binding contract with an unrelated person in effect on September 30, 2000, and thereafter. Taxpayers may choose, however, not to apply this transition rule to any transaction or transactions.

A transition rule allows existing FSCs and certain foreign distribution companies to elect to be treated as a U.S. corporation under the new regime without triggering an immediate inclusion in income of the electing corporation's accumulated earnings and profits. This rule is comparable to the treatment of foreign insurance companies that elect U.S. status under section 953(d).

Rules also are provided that coordinate the application of the FSC provisions with the new regime in the case of (i) leasing transactions in which the lease income is subject to the FSC provisions while the income from the sale of the residual interest in the leased property is subject to the new regime and (ii) transactions in which the income of a FSC was determined using the gross receipts method.

Next Steps in the WTO

The United States and the European Union have had continuing discussions concerning the FSC, covering substantive issues regarding the WTO-compatibility of the legislation enacted by the United States and administrative issues concerning the procedures to be followed in the WTO as this matter moves forward. In contrast to the procedures in the General Agreement on Tariffs and Trade (GATT), under which the challenge to the DISC provisions was brought 25 years ago, the dispute settlement procedures in the WTO are more specific and more efficient.

U.S. officials travelled to Brussels on May 2, 2000, to present the European Union with a proposal for the resolution of the FSC matter. That proposal outlined the legislative changes the United States was prepared to make to come into compliance with the WTO decision. The principles underlying the proposal are reflected in the new extraterritorial income exclusion regime that ultimately was enacted. With further refinements crafted based on thorough consideration of the WTO agreements and the analysis underlying the WTO decision, the proposal outlined to the European Union in May evolved into H.R. 4986, which was introduced in late July.

The European Union has considered the legislative action taken by the United States and expressed its views in detail, both through formal letters and diplomatic channels and through press releases and public comments. The European Union has been consistent in its criticism of the new regime. The position taken by the European Union is that the United States has not complied with its WTO obligations in enacting the new extraterritorial income exclusion regime. EU Trade Commissioner Pascal Lamy was quite direct in his May 26, 2000 letter to Deputy Treasury Secretary Stuart Eizenstat regarding the U.S. approach, concluding that "your proposal does not in our view fulfill the conditions for WTO compatability."

The views that have been expressed by the European Union demonstrate a fundamental difference of opinion regarding what it means for a tax regime to be contingent on exports under WTO agreements. The European Union has argued that the new extraterritorial income exclusion regime is contingent on exports because it applies only to foreign sales; in other words, the only way that income from U.S.-manufactured property will be subject to the regime is if the property is exported. The European Union chose a rather unusual example to illustrate its position in a May 29 press release:

   If hunting elephants is prohibited by an international treaty, a national
   law which allows elephants to be hunted will not be brought in line with
   the treaty if a new law is passed saying that also giraffes can be hunted.
   The violation of the treaty continues and will not be remedied by adding
   giraffes to the law as elephants can continue to be hunted in breach of the
   treaty.

Although the United States has not attempted any animal analogies, the U.S. position on this point is clear. The new regime, unlike the FSC provisions, does not apply only to income from property manufactured in the United States. The new regime applies equally to property manufactured abroad and therefore applies to income from both export and non-export foreign sales. As a result, the application of the new regime does not depend on exportation. The new extraterritorial income exclusion regime is predicated on the belief that a regime that applies the same tax treatment of all foreign sales, without regard to whether the sale is an export of property manufactured at home or is a sale of property manufactured abroad, is not "contingent, in law or in fact, whether solely or as one of several other conditions, upon export performance" within the meaning of the SCM Agreement.

The fundamental disagreement between the United States and the European Union regarding the new extraterritorial income exclusion regime will have to be resolved by the WTO. The European Union has expressed its intention to request that the WTO review the actions taken by the United States to determine whether the new regime complies with the WTO decision. Under the WTO procedural rules, the panel that will be established by the WTO pursuant to the E.U. request is expected to issue its report within 90 days. Either party may appeal the panel report; in the event of an appeal, the Appellate Body is expected to issue its report within 60 days.

If this timetable fully plays out, the final decision regarding the compliance of the United States will not be issued by the WTO before Spring 2001, if not later. In the meantime, a new Administration will take office in the United States, which may change the dynamics in the U.S. relationship with the European Union. Moreover, this particular dispute is only one matter pending between the two parties. Developments with respect to the WTO decisions supporting the U.S. challenges to the E.U. regimes regarding importation of bananas and hormone-treated beef could affect the ultimate resolution of the FSC matter. Certainly, it is in the interests of all for the two sides to work to prevent the escalation of their differences into a full-scale trade war.

Membership Rules Streamlined

TEI's Board of Directors has streamlined the membership approval process. Under the new rules, there is no longer a requirement that applications be reviewed and approved both at the chapter and the Institute level. Instead, there will be only one level of review ... by the Institute's Membership Committee. According to Institute Membership Chair Vincent Alicandri, the change will free the chapters from the obligation to review and approve each application. Now they will be able to devote their energies and resources to membership recruitment and retention.

Mr. Alicandri predicted that the change, which was made in anticipation of the Institute's taking its membership application process on-line in 2001, will materially reduce the amount of time it takes to review applications. Mr. Alicandri also reported that the Board of Directors had eliminated the requirement that returning members pay another $200 initiation fee. In other words, the initiation fee is a one-time-only charge.

TEI has revised its Membership Application to reflect the changed procedures, and a copy may be downloaded from the Institute's public website (www.tei.org/app112000.pdf).

(1) The SCM Agreement prohibits export-contingent subsidies delivered through a direct tax system -- such as the U.S. income tax -- but does not prohibit export-contingent subsidies delivered through an indirect tax system, such as the VATs common in Europe.

(2) WTO Agreement on Subsidies and Countervailing Measures, Article 3.1(a).

(3) The FSC filed a separate U.S. tax return, and its tax liability with respect to the income allocated to it could not be offset by AMT credits or NOLs of the U.S. parent's consolidated group. The new regime does not require the creation of a separate entity and therefore does not isolate income and tax liability on a separate tax return.

(4) The application of the same regime to individuals and corporations is in contrast to the FSC provisions, which had significant differences in their application to individuals and corporations.

(5) The taxpayer may elect to determine its qualifying foreign trade income instead under one of the alternative measures that does not result in the greatest reduction in its taxable income. See I.R.C. [sections] 941(a)(2).

(6) A 16/23 exemption applied under the FSC provisions if the shareholders of the FSC were individuals.

(7) See former I.R.C. [sections] 925(b) and Treas. Reg. [sections] 1.925(b)-1T.

(8) Applying the 15/23 exemption to the FSC's taxable income of 1.83 percent of foreign trading gross receipts yielded an exemption for 1.1935 percent of foreign trading gross receipts. As noted above, a 16/23 exemption applied under the FSC provisions if the shareholders of the FSC were individuals.

(9) Consider, for example, a situation in which a manufacturer sells property to a related distributor for $80, and the distributor sells the property to a foreign customer for $100. If both the manufacturer and the distributor were to compute their exclusions based on 1.2 percent of their gross receipts, the total gross receipts taken into account for purposes of measuring the exclusions would be $180, even though the actual gross receipts with respect to the transactions total only $100 (because the distributor's gross receipts of $100 include the related manufacturer's gross receipts of $80).

(10) If, for example, the manufacturer has costs of $50 for the property it sells to the distributor for $80, its profits would be $30. The distributor, which sells the property to an unrelated customer for $100, would have profits of $20. If the manufacturer and the distributor each calculate the exclusion based on 15 percent of its own income, the aggregate income taken into account ($30 plus $20) will not exceed the related group's total income ($100 sales proceeds minus $50 costs).

(11) See former I.R.C. [subsections] 924(D and 925(d) and Treas. Reg. [sections] 1.925(a)-1T(c)(2).

(12) A 32-percent exemption applied under the FSC provisions if the shareholders of the FSC were individuals.

(13) See Treas. Reg. [sections] 1.861-10T.

(14) See former I.R.C. [sections] 927(d)(2)(B) and Treas. Reg. [sections] 1.952(a)-lT.

(15) See former I.R.C. [sections] 927(e)(2).

(16) See former I.R.C. [sections] 923(a)(5), which provided a "50-percent haircut" for sales of military property.

(17) See former I.R.C. [sections] 924(f).

(18) The term "manufactured" used in this context includes "produced, grown, or extracted."

(19) While the specified categories generally parallel the categories of activities that were relevant in applying the foreign economic processes requirement under the FSC provisions, this fourth category has been modified in a way that makes the requirement easier to satisfy. Under the FSC provisions, the relevant category included determination and transmittal of invoices or statements and receipt of payment. Under the new regime, the relevant category includes determination and transmittal of invoices or statements or receipt of payment. Thus, ensuring that 85 percent of the costs incurred with respect to the receipt of payment are incurred outside the United States will be sufficient to satisfy the 85-percent test for this category of activities, without regard to where statements or invoices are determined and transmitted.

(20) See I.R.C. [subsections] 941(b)(2) and 943(g).

(21) See I.R.C. [sections] 943(f).

BARBARA M. ANGUS is a partner in the Federal Tax Policy Group of the PricewaterhouseCoopers's Washington National Tax Services office, where she consults with clients on international tax planning and tax legislative matters. KENNETH J. KIES is a co-managing partner of the firm's Washington National Tax Services office. He chairs the Federal Tax Policy Group which provides strategic and technical tax advice on tax policy matters before the Congress, the U.S. Treasury Department, and the Internal Revenue Service.