U.S. export rules in question; dispute over international trade agreements continues.

U.S. taxation of profits companies make from exporting goods has gone through several stages over the years. For a long time, U.S. multinational corporations were able to set up and use foreign subsidiaries whose income was free from U.S. income tax (as long as it was not repatriated and brought back into this country). Corporations set up offshore operations, through which the U.S. parent channeled manufactured products.

CFCs. In the 1960s Congress decided to tax some of this income when it was earned (rather than when it was brought back into the United States), by taxing certain controlled foreign corporations (CFCs). The CFC rules imposed tax on certain types of income.

DISCs. In 1971 Congress decided it wanted to promote exporting and keep U.S. manufacturing in this country. It created the domestic international sales corporation (DISC), which, in effect, exempted certain export-related income from corporate taxation.

International controversy. With all these changes in U.S. tax laws came disputes. What was then the European Economic Community (EEC) claimed DISC rules violated trade agreements between the United States and European countries. These claims led to a settlement, with this country's limiting the amounts of DISC income it would allow to be deferred.

FSCs. In the 1980s Congress again changed the laws governing foreign income. Believing that foreign tax laws disadvantaged U.S. exporters, Congress set up the foreign sales corporation (FSC) rules. If a foreign corporation (established in a qualifying jurisdiction that met a number of requirements) elected FSC treatment, a portion of the income earned from export sales was exempt from U.S. taxation.

More problems. In 1995 the World Trade Organization (WTO), of which this country is a member, was formed. It set up a formal process to resolve trade disputes.

Once this dispute mechanism was in place, the EEC brought a complaint against the United States for its FSC rules. The WTO ultimately round this country to be in violation of the trade rules and recommended it change its FSC laws to comply with all WTO agreements. In April 2000 the United States indicated it would comply with the ruling. Soon after, Congress repealed the FSC rules and enacted a new set of rules governing certain foreign income.

ETI. In November 2000 the President signed the new legislation, repealing the FSC rules and replacing them with provisions that allowed U.S. taxpayers to exclude a portion of their extraterritorial income (ETI) from their gross income.

Further questions. Despite Treasury's attempts to make the ETI provisions WTO-compliant, the European Union challenged these rules, and in August 2001 the WTO again ruled against the United States. This country appealed the decision in November 2001, but its efforts were denied in January 2002.

Based on this decision, the European Union will be allowed to increase the tariffs on U.S. imports or request that this country provide compensation by reducing its tariffs on European Union imports to the U.S.

In addition, it is now up to the United States to change its laws again and bring them into conformity with the trade agreements the WTO felt were violated. Politically and economically, such actions will not be accomplished easily.

For detailed discussions on the dispute and the new ETI legislation, see "New Rules for Taxing Extraterritorial Income," by David Benson and John Kennedy, and the Tax Education column, by Wray Bradley, in the May 2002 issue of The Tax Adviser.