2.8 On 2 February 1989, the Government of Japan informed the CONTRACTING PARTIES that the ad valorem tax and the grading system had been abolished, resulting in a single rate for all grades of whisky/brandies, and that the existing differences in taxation of whisky/brandies and shochu had been considerably reduced by decreasing the specific tax rate for whisky/brandies and raising that on shochu. According to Japan, these changes had been instituted "with a view to implementing the recommendations adopted by the GATT Council on 10 November 1987 on the basis of the panel report on the Japanese customs duties, taxes and labelling practices on imported wines and alcoholic beverages". ⁴ Also in 1989, an interim measure was introduced under the Special Taxation Measures Law to ease the adjustment pain for small scale manufacturers of shochu up to an annual ceiling of 1,300 kl. Under the measure which was to expire within 5 years, small producers are eligible for a 30 per cent reduction in the liquor tax they pay for the first 200 kl of the products they produce. On 1 May 1994, the Liquor Tax Law was further amended to raise tax rates on shochu and on spirits, while tax rates on whisky remained unchanged. The application of the interim measure under the Special Taxation Measures Law was also extended by 3 years at the same time.

III. CLAIMS OF THE PARTIES

The three complaining parties, namely the Community, Canada and the United States submitted the following claims against Japan:

3. 1 The Community claimed that since "spirits" (in particular vodka, gin, (white) rum, genever) are like products to the two categories of shochu, the Liquor Tax Law violates GATT Article III:2, first sentence, by applying a higher tax rate on the category of spirits than on each of the two like products, namely, the two sub-categories of shochu. In the alternative, in the event that all or some of the liquors falling within the category of spirits (mentioned above) were found by the Panel not to be like products to shochu within the meaning of the first sentence of Article III:2, the Community claimed that the Liquor Tax Law violates Article III:2, second sentence, by applying a higher tax rate on all or some of the liquors falling within the category of spirits than on each of the two directly competitive and substitutable products, the two sub-categories of shochu. The Community further claimed that since whisky/brandy and liqueurs are also "directly competitive and substitutable products" to both categories of "shochu", the Liquor Tax Law violates Article III:2, second sentence of GATT 1994, by applying a higher tax rate on the categories of whisky/brandy and liqueurs than on each of the two sub-categories of shochu.

3.2 Canada claimed that whisky is a "directly competitive and substitutable product" to both categories of "shochu", that by applying a higher tax rate on the categories of whisky/brandy than on each of the two sub-categories of shochu, the Liquor Tax Law distorts the relative prices of whisky and shochu, that in so doing the Liquor Tax Law distorts consumer choice between these categories of alcoholic beverages and thus distorts their competitive relationship. Canada claimed that consequently, the Liquor Tax Law is inconsistent with Article III:2, second sentence, of GATT 1994.

3.3 The United States claimed that the Japanese tax system applicable to distilled spirits has been devised so as to afford protection to production of shochu. For this reason and because "white spirits" and "brown spirits" have similar physical characteristics and end-uses, the United States claimed that "white spirits" and "brown spirits" are "like products" in the sense of the first sentence of Article III:2, and therefore the difference in tax treatment between shochu and vodka, rum, gin, other "white spirits", whisky/brandy and other "brown spirits" is inconsistent with Article III:2, first sentence. If the Panel were not able to make such a finding, the United States requested, in the alternative, that the Panel find that all "white spirits" are "like products" in terms of Article III:2 first sentence, and that all distilled spirits are "directly competitive and substitutable" in terms of Article III:2, second sentence for the same reasons. The United States concluded that irrespective of the legal analysis the Panel adopts, the Liquor Tax Law should be found to be inconsistent with Article III:2.

3.4 The defending party, Japan, responded to the claims from the three complaining parties. Japan claimed that the purpose of the tax classification under the Liquor Tax Law is not to afford protection and does not have the effect of protecting domestic production. Therefore, Japan argued that the Liquor Tax Law does not violate Article III:2. According to Japan, spirits, whisky/brandy and liqueurs are not "like products" to either category of shochu, within the meaning of Article III:2, first sentence, nor are they "directly competitive and substitutable products" to shochu, within the meaning of Article III:2, second sentence. Consequently, Japan claimed that the Liquor Tax Law cannot violate Article III:2.

IV. ARGUMENTS OF THE PARTIES

4.1 The United States requested the Panel to declare that the reduction in excise taxes for small-volume producers, contained in the 1989 legislation, ⁵ discriminates on its face against imported shochu, sake and wine and therefore violates Article III:2, first sentence. The operative provision of the 1989 legislation is phrased in terms of "shipment from the factory", terms which, under the Liquor Tax Law, refer exclusively to factories in Japan. These measures apply to producers of such alcoholic beverages whose taxable shipments from the factory do not exceed 1300 kilolitres in a given fiscal year; in the following fiscal year, such producers are entitled to a 30 per cent reduction in the excise tax otherwise due on their first 200 kilolitre shipped from the factory. This provision, in the US view, was provided as compensation to small domestic producers for the 1988 law reducing the other protection afforded by the tax differential between these alcoholic beverages and competing imports. In the 1994 amendment of the Liquor Tax Law, the tax relief measures for small producers of shochu A, shochu B, refined sake and wines were extended, so that the entire time period covered by the tax relief measures is 1 April 1988 through 31 March 1997.

4.2 In support of its claim, the United States referred the Panel to the Panel Report on "United States - Measures Affecting Alcoholic and Malt Beverages" ("1992 Malt Beverages"), ⁶ which examined a similar provision which provided for an excise tax on beer of $18 per barrel in general, but for a reduced tax of $7 per barrel for the first 60,000 barrels produced by US breweries with annual production of not more than 2 million barrels. In the 1992 Malt Beverages case, the panel found that the application of a lower rate of excise tax on beer, which was not available in the case of imported beer, constituted less favourable treatment of the imported product in respect of internal taxes and was therefore inconsistent with Article III:2, first sentence. The United States concluded that even if the present Panel were not to find that the tax reduction programme was inconsistent with the first sentence of Article III:2 because of the preliminary objection of Japan, this measure was a fact and must be taken into account in the Panel�s evaluation of tax/price ratios and in its evaluation of protectionist purpose and effect. This measure was a significant element of the Japanese tax policy with regard to shochu and provided important evidence of the essentially protectionist nature and effect of that policy.

4.3 Japan responded that WTO Members who request consultations in accordance with the provisions of Article 4.4 of the DSU must identify the "measure(s)" at issue. However, the request of the United States did not mention the specific measure for small-volume producers described in paragraph 4.1 above. Nor did the United States raise this issue with Japan in the course of the bilateral consultations. The lack of identification of this measure in the request for consultations, as well as the failure to raise the issue in the bilateral consultations, constituted a case of non-compliance with Article 4 of the DSU. Japan submitted further that Article 6.2 of the DSU requires that the request for the establishment of a panel must identify the specific measures at issue. The lack of identification of this measure in the US request for the establishment of the present Panel also constituted failure to abide by the DSU. Japan noted also that it is a GATT practice that a panel would not render judgment on matters not raised during consultations or not included in the request to establish the panel. This practice, in Japan's view, should not be ignored because it is intended to encourage the parties to a dispute to attempt to obtain satisfactory adjustment before having recourse to the panel procedure and because it is important also for the interests that third parties may have in the dispute. Japan, therefore, requested the Panel to consider the interim measure under the Special Taxation Measures Law as being beyond the terms of reference of the present Panel.

4.4 In case the Panel decides to rule on this issue, Japan submitted that the Panel should find the measure to be a temporary measure to ensure compliance with the recommendations of the 1987 Panel Report, and therefore consistent with Japan's obligations under GATT 1994. Historically, this interim measure was introduced as part of the overall package for compliance with the recommendations of the 1987 Panel Report. It has served to alleviate adjustment costs felt by small scale manufacturers. The measure was extended in 1994 in order to facilitate the amendment which removed distortions arising out of price changes since the 1989 amendment. In other words, Japan suggested that this interim measure is part of the process to ensure and maintain compliance with Article III, and has no distortional effect or protective intent. In response to the reference by the United States to the 1992 Malt Beverages report, Japan responded that in that case, the federal and state measures found inconsistent with Article III were permanent measures, inherently distortional to trade. Japan noted, however, that most of these measures are still in place. Similarly, Japan noted that the Community has a permanent mechanism to reduce the tax rate applicable to small breweries. By virtue of this mechanism, Austria, Belgium, Denmark, Finland, Germany, Luxembourg and the Netherlands apply a reduced tax rate to small breweries, and Austria, Germany and Spain give a tax benefit to small manufacturers of distilled liquors. The United States noted in response that Japan�s measure was hardly "interim" at this point, and had been routinely renewed in 1994: there were no guarantees that it would not be renewed repeatedly into the indefinite future.

4.5 For the Community, since the specific tax rates applied to shochu have remained at a much lower level than the rates applicable to other "like" or "directly competitive or substitutable" products, Japan has failed to implement in full the recommendations of the 1987 Panel Report. Consequently, the Community claimed that the Liquor Tax Law is inconsistent with Article III:2, first and second sentences, of GATT 1994 (worded identically to Article III:2 of GATT 1947). In view of the time already elapsed since the adoption of the 1987 Panel Report and of the regulatory changes implemented in the meantime, the Community argued that it was more appropriate to request the establishment of a new panel to examine and find that the Liquor Tax Law, as it stands now, is inconsistent with the obligations of Japan under GATT 1994 rather than requesting the full implementation of the 1987 Panel Report under GATT 1947. Nonetheless, to the extent that the claims contained in the Community request reiterate some of the claims already examined by the 1987 Panel Report, the findings of that panel report should be accorded a special precedential value. According to the Community, the following findings of the 1987 Panel Report, in particular, should provide decisive guidance to this Panel:

4.6 For Canada, Article 3.2 of the DSU makes clear that a panel "serves ... to clarify existing provisions of [covered] agreements". In so clarifying these provisions, Canada considers that Article XVI:1 of the Agreement Establishing the WTO ("WTO Agreement") provides clear guidance to a panel and the DSB respecting the legal value of reports adopted by the CONTRACTING PARTIES under GATT 1947. Article XVI:1 of the WTO Agreement provides:

For Canada, in this case, neither the WTO Agreement nor the Multilateral Trade Agreements "otherwise provide". Canada considers that there is a strong factual nexus between the 1987 Panel Report and the current dispute. Accordingly, for Canada, in determining the consistency of the Liquor Tax Law with Article III:2, second sentence, the Panel and the DSB are, at a minimum, to be directed by the 1987 Panel Report. In Canada's view, the 1987 Panel Report is particularly authoritative in determining the consistency of the Liquor Tax Law with Article III:2 second sentence. In addition, in Canada's view, it can be argued that since the 1987 Panel Report was adopted by the CONTRACTING PARTIES, it forms now an integral part of the WTO Agreement through Article 1(b)(iv) of GATT 1994. ⁷ Consequently, for Canada, while previous panel reports do not constitute "legislative text", there is an argument to be made, in the circumstances of this case, that since the Liquor Tax Law still contains provisions identical to those found inconsistent with Article III by the 1987 Panel Report now integrated into GATT 1994, and since that panel considered the same products which are at issue in the current dispute, examined the same enactment that regulates the taxation of alcoholic beverages and considered the same issue of whether different specific rates of tax imposed on different categories of distilled liquors is consistent with Article III:2, second sentence, the factors articulated in the 1987 Panel Report are determinative of whether the Liquor Tax Law is inconsistent with Article III:2, second sentence, of GATT 1994.

4.7 The United States argued that in drawing up their findings, GATT 1947 panels had determined the relevant facts, interpreted the law and applied the law to the facts before them. Their findings were relevant therefore to the particular facts that were presented to the Panel during its proceedings. They might not be relevant at some later date if the facts had changed, and the interpretation of the law might also change over time due to improved understanding or other factors. For instance, the panel report on "EEC - Restrictions on Imports of Dessert Apples - Complaint by Chile made in 1980", ⁸ detailed findings concerning the supply-management régime for apples in the Community. In 1989, a related panel ⁹ examined the same supply-management régime, re-analyzed the facts and the law, and came to rather different conclusions. As another example, one panel has found that tomato paste was "perishable" in the sense of the Note ad Article XI(2)(c), ¹⁰ and another found that tomato ketchup and sauce were not. ¹¹ In the GATT 1947 system, panel reports were an input for the interpretative process, but not an independent source of binding norms. Panels were not authorized to, and did not, legislate. If the conclusions and reasoning of the first panel report on apples from Chile had become absolutely binding by virtue of its adoption by the CONTRACTING PARTIES, the second panel report would have been precluded. This view was confirmed by paragraph (x) of the 1982 Ministerial Decision on Dispute Settlement: "It is understood that decisions in this process cannot add to or diminish the rights and obligations provided in the General Agreement." ¹² This mandate was recognized and incorporated in the last sentence of Article 3.2 of the WTO Dispute Settlement Understanding: "Recommendations and rulings of the DSB cannot add to or diminish the rights and obligations provided in the covered agreements". It would be unnecessary for the Panel to find that GATT 1947 panel reports are just as binding as the text of the GATT 1994 itself, and such a finding would have far-reaching and unpredictable consequences. It would provoke needless controversy and constitutional argument. The Panel could accomplish all that it needed simply by drawing on the 1987 report, not by using it as a source of binding norms. For the United States, the 1987 Panel Report did offer excellent guidance on the facts of the present dispute, and its legal analysis had been completed by the 1992 Malt Beverages panel. The United States urged the Panel to complete the job started by the 1987 panel: to find that Japan�s taxes are discriminatory and inconsistent with Article III:2 and to recommend that Japan remove the full extent of the discrimination.

4.8 Japan submitted that the 1987 Panel Report should not guide the deliberations of the present Panel. First, for Japan, the purpose of Article 1(b)(iv) of GATT 1994 is for GATT 1994 to inherit the provisions and other legal structure of GATT 1947. Consequently, the legal status of the 1987 Panel Report remains the same as any adopted panel report under GATT 1947; Japan noted the limited precedential effect of panel reports under GATT 1947. According to Japan, this limited precedential value is best described in the panel reports on "EEC - Restrictions on Imports of Dessert Apples - Complaint by Chile" ¹³ and "EEC - Restrictions on Imports of Dessert Apples - Complaint by the United States". ¹⁴ In the case initiated by Chile, the panel noted: "[The Panel] would take into account the 1980 Panel report and the legitimate expectations created by the adoption of this report, but also other circumstances of this complaint. The Panel, therefore, did not feel it was legally bound by all the details and legal reasoning of the 1980 Panel report. ... [Earlier panel reports did not] relieve it of the responsibility under its terms of reference, to carry out its own thorough examination". ¹⁵

4.9 Second, Japan argued that the interpretation of Article III by the 1987 Panel Report has been overturned by a later panel in the 1992 Malt Beverages report and Japan submitted that the Community and Canada strongly supported the adoption of the report at the time. Specifically, this later report introduced a new test, that of "aim and effect", into the determination of the likeness between product categories. This Malt Beverages report abandoned the analysis of the 1987 Panel Report which relied heavily on the physical similarities and the end-use of products. On the issue of "like" products, the 1992 Malt Beverages report concluded that the issue should be judged ultimately by referring to the purpose of Article III; it laid down criteria that are evidently different from those used in the 1987 Panel Report's interpretation of Article III:2. As the 1992 Malt Beverages report was adopted in the form of a decision by the CONTRACTING PARTIES, Japan argued that the previous interpretations of Article III were modified and thus the 1987 Panel Report does not provide appropriate guidance for the interpretation of Article III today. For Japan, the 1992 Malt Beverages report agreed, in its paragraph 5.26, with the 1987 Panel Report only to the extent of examining physical properties and customs classifications of the products concerned as part of its overall consideration of the like products issue. Then the 1992 Malt Beverages report decided that the "like product" determination should be made considering whether a tax system is applied "so as to afford protection to domestic production".

4.10 Third, Japan submitted that the subject matter of the present dispute is different from the one considered by the 1987 Panel Report. As other parties to the dispute recognize, the Liquor Tax Law was amended after 1987, and the present structure of the legislation is fundamentally different from the pre-1989 régime. Fourth, Japan argued further that the 1987 Panel Report based its key findings on incorrect or irrelevant assumptions. For Japan, the problem is most pronounced in the following part of the findings, which was quoted by all other parties to the present dispute:

Japan submitted that the first and second factors no longer exist in the current law and that the statements of the Panel in the third and fourth points were not based on facts. First, it was not true that shochu was produced almost exclusively in Japan. Nor is Japan the largest manufacturer of shochu. Shochu is widely produced in Southeast and East Asia. Second, consumers do not mix shochu with whisky or brandy under normal circumstances. Moreover, the increase in imports of Western-style liquors does not by itself prove the existence of substitutability, or the cross-price elasticity of demand, between shochu and other distilled liquors. For all these reasons, Japan argued that the present Panel cannot rely on the reasoning and conclusions of the 1987 Panel Report.

4.11 The Community submitted that it agreed with Japan's views on the precedential value of panel reports. However, the Community argued that Japan had taken the position that subsequent panel reports should be analyzed on the basis of the lex posterior principle because panel reports are adopted by the CONTRACTING PARTIES. In the Community's view, this was a thoroughly misguided view of such decisions. For the Community, panel reports do not lose their character of decisions on individual cases because they have become part of the "acquis gattien" under Section 1 (b) (iv) of GATT 1994. Nor should panel reports lose this trait because they have been adopted by the CONTRACTING PARTIES. Moreover, as there is no rule of stare decisis as between panel reports, the present panel would not be bound by the 1992 Malt Beverages report in any case.

4.12 The Community argued that assessing compliance with Article III:2 imposes two different tests for the first and second sentences. Under the first sentence of Article III:2, the examination of the conformity of a system of internal taxation involves a two-step analysis: first, it must be determined whether the domestic product and the imported product are "like", having regard to their physical characteristics and end-uses; and second, it must be ascertained whether the imported product is subject to internal taxes in excess of those applied to the domestic product. For the Community, once it has been established that the two products are "like" and that the imported product is subject to higher taxes, a finding that Article III:2, first sentence, has been infringed is automatic. It is not necessary to show that the difference in taxation affords protection to the domestic product; under the first sentence, unlike the second sentence of Article III:2, such protective effect is irrefutably presumed in all cases. For the Community this was in accordance with the 1987 Panel Report. Whether or not the tax differential has a protectionist aim is also irrelevant. The examination of the aim of the measure only becomes relevant in order to determine whether the infringement of Article III:2, first sentence, may be justified under one of the general exceptions of GATT Article XX.

4.13 In this context and in response to the suggestion that an aim-and-effect test is to be favoured under Article III, the Community responded that the aim-and-effect test is inconsistent with the ordinary meaning of the words and the specific purpose of Article III:2 and with the general objectives of Article III. Nor does the aim-and-effect test incorporate any proportionality requirement. Moreover, the burden of proof, which in GATT Article XX and the WTO Agreement on Technical Barriers to Trade ("TBT Agreement") lies with the respondent, is subtly but effectively shifted to the complainant. Given the extreme difficulty of positively proving a protectionist purpose (as opposed to refuting the proof that a measure does not have a specific non-protectionist purpose), the mere invocation by a defendant of a non protectionist purpose may suffice in practice to exclude the application of Article III:2. In this context, and unlike situations which would be dealt with through exceptions under Article XX, the aim-and-effect test would confront panels with the situation of having to adjudicate a dispute without a clearly defined standard of review. In response to the allegation that such a strict reading of the first sentence of Article III:2 would result in legitimate, non-protectionist policies being found inconsistent with Article III:2, the Community argued that it may be possible to introduce two kinds of flexibility into the interpretation of Article III:2. The first flexibility is formed by the notion of discrimination in the case of graduated systems of taxation of like products. This form of flexibility seems to have been envisaged by the 1987 Panel Report. The second flexibility is formed by the dividing line between like products and directly competitive and substitutable products. These two flexibilities, together with the general exceptions of Article XX, may offer sufficient scope to deal adequately with all situations covered by Article III:2, first sentence. In the present case, no such reference to any of the two flexibilities is necessary. The Community concluded that spirits are like products to shochu A and B, and since the Liquor Tax Law applies a higher tax rate on the category of spirits than on each of the two like products, it automatically violates GATT Article III:2, first sentence.

4.14 For the Community, the application of the second sentence of Article III:2 involves a different test: first, it must be determined whether the imported product and the domestic product are "substitutable or directly competitive" in the light not only of their physical characteristics and end-uses, but also of other criteria such as their cross-price elasticity, their availability in the same trade channels, etc., determined in an ex-post manner (i.e., by taking into account not only actual competition but also potential competition); second, it must be established whether an internal tax is applied "so as to afford protection to domestic production", which does not involve any application of the so-called aim-and-effect test. The Community considers that the aim-and-effect test is not warranted by the ordinary meaning of the words "so as to afford protection", and is contrary to the purpose of Article III:2 and, more generally, to the basic objective of Article III. For the Community, the existence of a protectionist purpose is never a necessary condition for a finding that Article III:2 has been infringed. The aim of the measure only becomes relevant under the first sentence of Article III:2, in order to determine whether it may be justified under Article XX. For the Community, the protectionist effect of a measure is the only relevant criteria for assessing whether the measure is "so as to afford protection". A protectionist purpose only becomes relevant to the extent that it may provide an indication of protectionist effect. The Community therefore concluded that (1) shochu and other distilled spirits are directly competitive and substitutable products, and (2) since Japan does not dispute that the tax rates on shochu A and shochu B are much lower than the rates on spirits, whisky/brandy and liqueur, in terms of taxation per litre of beverage and of taxation per litre of pure alcohol, and since a comparison of tax/price ratios is irrelevant and not a proof of tax neutrality, then the Liquor Tax Law has the effect of affording protection to shochu and therefore is inconsistent with the second sentence of Article III:2.

4.15 Canada considers that at its core, Article III:2, second sentence, is designed to protect the competitive relationship between imported and domestic products. In Canada's view, this is made clear in the "United States - Taxes on Petroleum and Certain Imported Substances" ("Superfund") ¹⁷ report, the 1987 Panel Report and the 1992 Malt Beverages report. Canada considers that these reports make clear that an organizing principle in considering whether a measure affords protection to domestic production is whether the internal fiscal measure at issue distorts the competitive relationship between imported and domestic products. For Canada, Article III:2 second sentence, together with Article III:1 and the Interpretative Note ad Article III, Paragraph 2, set out four tests that must be met for a panel to determine that in its application to Canadian whisky and shochu, the Liquor Tax Law is inconsistent with Article III:2, second sentence. These four criteria are: (1) whether whisky is a "directly competitive or substitutable product" with shochu; (2) whether the taxes levied pursuant to the Liquor Tax Law are "internal taxes or other internal charges"; (3) whether whisky and shochu are "not similarly taxed", even in using the tax/price ratio yardstick suggested by Japan; and (4) whether the taxes levied pursuant to the Liquor Tax Law afford protection to domestic production of shochu.

4.16 The United States began its discussion of Article III:2 with the observation that GATT panels had addressed taxes or regulations like those at issue in the present case, which are origin-neutral on their face, only on a very few occasions. In each such case, the analysis of whether a violation had occurred, had turned not on the tax�s trade effects, but, on whether the tax was targeting imports as such. GATT panel findings over the years had confirmed that the first sentence of Article III:2 requires that imports be provided equivalent opportunities; the second sentence addressed situations where the targeting of imports is more subtle. The United States emphasized that WTO Members retain the right to enact and maintain taxes and regulations that do not, on their face, discriminate against imports, and which classify similar products into distinct categories, but only if the categories are objective and based on neutral fiscal or regulatory policies. The central concern of Article III was the targeting of imports as such for special treatment. Therefore, in determining whether two products subject to different treatment are "like products", it was necessary to consider whether such product differentiation is being made "so as to afford protection to domestic production" as provided in Article III:1. If the aim and effect, or purpose and effect, of the distinction was to target imports as such, the imported and domestic products should be deemed to be "like products" and a tax measure which treats the imported product less favourably than the domestic product would be inconsistent with Article III:2, first sentence. The United States further emphasized that this aim-and-effect test would apply only in the small subset of Article III cases that involve origin-neutral legislation. The aim-and-effect test would have no application in cases that involve measures that discriminate on the basis of origin.

4.17 The United States suggested that an examination of a measure�s aim or purpose should focus, inter alia, on the legislation�s wording and stated rationale, its preparatory work if any, statements by legislators, structural incentives, the treatment of products distinguished, the arbitrariness of distinctions drawn and ex ante knowledge that the distinction would discriminate between domestic and imported products. The United States argued that a measure could be said to have the aim of affording protection if analysis of the circumstances in which it was adopted, in particular an analysis of the instruments available to achieve the declared policy goal, demonstrated that a change in competitive opportunities in favour of domestic products was a desired outcome and not merely an incidental consequence of the pursuit of a legitimate policy goal. The examination of the effects should focus on the qualitative alteration of the conditions of competition, such as targeting of imports and evidence of cross-elasticity of demand between the favoured and disfavoured categories. The United States pointed out that Article III was one element of an interlocking system of obligations under GATT, the implications of which had been developed with great consistency in interpretations in panel reports of the previous ten years. This system included a number of basic propositions: a) the equivalence imparted to national treatment obligations under Article III:2 and Article III:4, which meant that a Member could not accomplish with regulation what it could not legally accomplish with taxation, or vice versa; b) the equivalence between "like product" in Article III and in Article I:1; c) the ban on border adjustment of taxes (such as direct taxes) or regulations not imposed on a product as such; and d) the restrictive interpretation given to the exceptions contained in Article XX. Within the context of this system, the aim-and-effect test offered the only acceptable approach to the legal analysis of origin-neutral taxation or regulation. The present case, which was limited to Article III:2 and included no claims under Article III:4 or Article XX, was the wrong occasion for a Panel to reopen and reconsider the aim-and-effect test and the complex of interlocking legal interpretations in this area.

4.18 Drawing on the analysis of origin-neutral taxation followed in the 1992 Malt Beverages report and in the panel report on "United States - Taxes on Automobiles" ("US Auto Taxes"), ¹⁸ the United States argued that Japan�s taxes on distilled spirits had the aim and effect of affording protection to domestic production of shochu. Citing writings by those who had drafted the present definition of shochu for the 1962 amendment of the Liquor Tax Law, the United States argued that in 1962 the definition of shochu was drafted so as to exclude imported distilled spirits and formed part of a system favouring shochu through the tax rate. Moreover, no neutral justification for the distinctions in taxation had been offered by Japan. For this reason and because white and brown spirits have similar physical characteristics and end-uses, the United States argued that white and brown spirits are "like products" in the sense of the first sentence of Article III:2, and therefore the difference in tax treatment between shochu and vodka, rum, gin, and other white spirits and whisky/brandy and other brown spirits is inconsistent with Article III:2, first sentence. In the alternative, the United States argued that all white spirits are "like products" in terms of Article III:2, first sentence, and all distilled spirits are "directly competitive and substitutable" in terms of Article III:2, second sentence, for the same reasons. In the latter case, the United States submitted that the difference in taxation exceeds any de minimis level because that difference materially alters the conditions of competition between domestic and imported products. In the present case the change in conditions of competition is illustrated by factors such as the demonstrated effect on consumption choices and cross-price elasticity of demand. Since domestic shochu has such a large share of the domestic market for distilled spirits, the protection given to shochu has had the effect of protection for domestic production. In the US view, there is also cross-price elasticity of demand between shochu and other distilled spirits. There was clear evidence of the discriminatory effect of the tax favouritism shown to shochu by the Japanese political system: the tax differential causes a change ceteris paribus in the conditions of competition; it also has a negative impact on trading opportunities for imported whisky, other brown spirits and non-shochu white spirits. Consequently, the difference in the tax treatment between shochu and other distilled liquors in the Liquor Tax Law is inconsistent with Article III:2.

4.19 Japan, based its argumentation on the test provided by the adopted 1992 Malt Beverages panel report, as well as the unadopted US Auto Taxes panel report, that the consistency with Article III:2 of a different treatment of products should be judged in light of paragraph 1 of the Article, in particular the language "not be applied ... so as to afford protection to domestic production", and that whether or not the tax at issue is designed "so as to afford protection to domestic production" should then be judged by the "aim" and "effect" of affording protection, and stated that since the Liquor Tax Law has neither the aim nor effect of affording protection to domestic production, the law is not inconsistent with Article III:2. With the 1989 reform, the priority in policy purposes of Japan's distilled liquor taxation system was shifted from "vertical equity" to "neutrality" and "horizontal equity" with a view to broadly equalize tax/price ratios across liquor categories. In pursuit of these two trade-neutral policy purposes, the 1989 tax reform does not have the aim or effect of protecting domestic production. The aim and the intent of the legislation are not protectionist: they are to equalize the tax burden across tax categories. Nor does the Liquor Tax Law have the effect of protecting domestic production. In Japan's view, the "effect" of protection must be judged by whether the tax distorts the competitive relationship between imported and domestic products. For Japan, the Liquor Tax Law does not distort the competitive relationship between imported and domestic products for the following reasons. First, the tax/price ratio of all tax categories are roughly the same. In terms of the examination of the tax burden, the tax/price ratios is the superior yardstick because it better indicates the impact on consumers' choice than the ratio of tax over a certain quantity of products or alcohol contained and it is common practice to employ a tax/price ratio in comparing the burden of an excise tax. Second, shochu is produced outside Japan in large quantities. Indeed in examining whether or not the category in question is almost exclusively domestic, what needs to be examined is not import ratios but rather whether the domestic product is produced in other countries, and whether the imported product is also domestically produced. Third, there is no directly competitive or substitutable relationship (no cross-price elasticity) between shochu and imported liquors, precluding, therefore, any possibility of protective effects. Moreover, Japan added that protective distortion exists only when the three above mentioned cumulative requirements are met, which, in Japan's view, is not the case with the Liquor Tax Law. Therefore, the Liquor Tax Law does not distort any competitive relationship and does not have any protective effect. Japan concluded that the regulatory distinctions made by the Liquor Tax Law do not have the aim or effect of affording protection to domestic production. Consequently, the Liquor Tax Law is not inconsistent with Article III:2. Japan argued that it was not asking the Panel to grant an exception for legitimate domestic purposes to an otherwise non-neutral tax. Japan is requesting the Panel to find that the mechanism Japan has chosen to pursue trade neutrality is within the scope of freedom each WTO Member has in choosing a taxation system of its own under GATT Article III:2.

1. The Different Legal Analyses Suggested by the Parties for the Interpretation of Article III:2, First Sentence

4.20 In the view of the Community, the examination of the conformity of a system of internal taxation with Article III:2, first sentence, involves a two-step analysis: ¹⁹ Firstly, it must be determined whether the taxed imported and domestic products are "like"; secondly, it is necessary to establish whether the taxation is "discriminatory".

4.21 For the Community, based on the 1987 Panel Report, "like products" in terms of Article III:2 are not confined to identical products but may cover also other products, for instance if they serve substantially identical end-uses. ²⁰ More particularly, "minor differences in taste, colour and other properties (including different alcohol contents) do not prevent products from qualifying as "like products". ²¹ Differences in extract content level among alcoholic beverages have also been considered as minor. ²² The Community notes that the following criteria have been considered relevant in determining whether two products are like products: (1) the products' properties, nature and quality; (2) the products' end-uses in a given market; (3) the consumers' tastes and habits; and (4) the products' classification in the Harmonized System nomenclature. Factors such as differences in prices between the products or differences in local consumer traditions within a country have been found irrelevant for a like product" determination. ²³ The notion of "like products" is an objective one, exclusively related to the characteristics of the products. The purpose and the effects of a regulatory measure are totally alien to that notion.

4.22 The Community submitted that a system of taxation is "discriminatory" within the meaning of the first sentence of Article III:2 if, inter alia, the tax rate applied to the domestic product is lower than the tax rate applied to the like imported product. Any difference, however small, between the tax applied to the imported product and the tax applied to a domestic product violates Article III:2, first sentence, regardless of its effects on the volume of trade. Once it has been established that the two products are like and that the imported product is subject to higher taxes, a finding that Article III:2, first sentence, has been infringed is automatic. Unlike under the second sentence of Article III:2, it is not necessary to show that the difference in taxation affords protection to the domestic product because such protective effect is irrefutably presumed in all cases. In the Community's view, whether the tax differential has a protectionist aim is also irrelevant. The first sentence of Article III:2 thus lays down the evidentiary rule that tax discrimination between like products constitutes automatically a violation of Article III:2, first sentence. The examination of the aim of the measure only becomes relevant in order to determine whether the infringement of Article III:2, first sentence, may be justified under any of the general exceptions of Article XX. As further argued hereafter in paragraph 4.36 and following, in the Community's view the aim-and-effect test is inconsistent with the ordinary meaning of Article III:2, first sentence, and is contrary to the specific purpose of this provision as well as with the general objectives of Article III. Moreover, the aim-and-effect test effaces the clear textual difference between the first and the second sentences of Article III:2. The ordinary meaning of Article III:2 is that the first and the second sentences of this provision set out different legal requirements and that only the second sentence refers to the first paragraph of Article III. This results clearly from the use of the word moreover at the beginning of the second sentence as well as from the Note ad Article III:2, which provides that:

For the Community, this does not mean that the first sentence of Article III:2 has a purpose contrary to the general principle set forth in Article III:1. The reason why the first sentence of Article III:2 does not refer to Article III:1, is because the imposition of taxes on imported products in excess of those imposed on domestic products is presumed inherently protective and therefore contrary in all cases to the general principle set forth in Article III:1: in the case of tax discrimination between like products a demonstration of protectionist effect is not required. The aim-and-effect test nullifies this rule through the subterfuge of forcing the requirement "so as to afford protection" into the definition of "like product".

4.23 Canada did not raise any claim under Article III:2, first sentence. However, in response to questions from the Panel on the legal test arising out of Article III:2, first sentence, Canada stated that the negotiating history, the first Working Party Report on Brazilian Internal Taxes, ²⁴ and a plain reading of the wording of Article III:2, and the Note ad Article III, Paragraph 2, makes clear that unlike Article III:2, second sentence, Article III:2 first sentence does not refer to Article III:1 and is thus a self-contained obligation. Canada thus considers that Article III:1 should not be "read into" Article III:2, first sentence. For Canada, to interpret Article III:2, first sentence, by adding as a separate legal requirement the provisions of Article III:1 does not clarify a Member's rights and obligations but rather goes against the explicit wording of Article III:1 and Article III:2, first sentence, of GATT 1994. Canada further argued that a fair reading of the first sentence of Article III:2 as well as the object and purpose of Article III:2, make it clear that the sentence does not authorize permissible regulatory distinctions respecting discriminatory taxation on imported products that are "otherwise" "like" products. Canada thus considers that the words "aim and effect" should not ultimately be read into an analysis of Article III:2, first sentence. Article III:2, first sentence, is singularly designed to ensure that internal taxes are not applied discriminatorily on "like" products. Therefore it does not authorize permissible regulatory distinctions on products that are otherwise like to justify discriminatory internal taxation. The structure of GATT 1994 is equally useful in considering the context of Article III:2 in relation to the WTO Agreement. This structure shows, in Canada's view, that derogations from particular obligations for domestic policy reasons are permissible only when expressly stated. Thus, for example, Article II:2, Article III:3 and Article XI:2 of GATT each set out explicit permissible regulatory derogations from stated obligations.

4.24 The United States began by pointing out that GATT panel reports over the years have confirmed that the first sentence of Article III:2 requires that imports be provided equivalent opportunities. The central concern of Article III:2 is the targeting of imports as such for a special treatment. For the United States, in examining whether two products subjected to different regulatory or tax treatment are "like" or "directly competitive or substitutable", it is necessary to determine first whether the product differentiation is being made "so as to afford protection to domestic production". This determination requires a determination whether the distinction has the "aim and effect" of affording such protection. Physical characteristics are only a small sub-set of the legitimate distinctions that exist. However, in the US view, when a panel merely goes by its own perceptions of physical resemblance, uses, etc., it is implicitly, and non-transparently, judging the appropriateness of the tax or regulatory policies embodied in distinctions between products. Thus, the notion of "likeness" cannot be separated from the purpose with respect to which products are "like", and the objectives of the regulatory scheme that draws a distinction between two otherwise similar products.

4.25 The United States noted that the WTO Agreement recognizes that origin-neutral regulatory distinctions can be compatible with WTO principles even if these distinctions do not appear in Article XX of GATT 1994. Under the WTO Agreement on Technical Barriers to Trade ("TBT Agreement"), technical regulations are permitted where they fulfil "legitimate objectives". Technical regulations by their nature differentiate among otherwise like products. "Legitimate objectives" are not exhaustively defined in the TBT Agreement, but Article 2.2 of the TBT Agreement provides a partial list (i.e., national security requirements, prevention of deceptive practices, protection of human health or safety, animal or plant life or health, or the environment). There are many other legitimate objectives, and even those specifically listed in the TBT Agreement are not all found in Article XX. The TBT Agreement was about measures that make regulatory distinctions among what may otherwise be like products. In the US view, no one could read the TBT Agreement as prohibiting technical regulations, or find that they are per se inconsistent with Article III of GATT 1994 whenever imports are disproportionately affected, simply because the regulations in question are based on criteria other than those in Article XX. The United States further noted that the TBT Agreement is not an exception to GATT 1994.

4.26 As a result, argued the United States, WTO Members are permitted to make regulatory distinctions among products that might otherwise be considered "like", in pursuance of a legitimate objective other than trade protection. This is what the 1992 Malt Beverages report recognized in analyzing the regulatory regime for low alcohol and high alcohol beer. In the US view, that panel sought to avoid a result that would make even an unintentional coincidence between domestic regulation and the presence or absence of foreign competition in the market amount to a violation of Article III:2. Such a result would force policy harmonization and encroach on the policy options available to legislators and regulators to an extent unanticipated when GATT was drafted. The United States also pointed out that the European Court of Justice (ECJ) had reached similar conclusions in interpreting Article 95 of the EC Treaty. In its cases on fiscal incentives, the ECJ has determined that

The Court has limited permissible differentiation to cases in which the distinction drawn

4.27 The United States saw this analysis by the ECJ as remarkably similar to that in the 1992 Malt Beverages panel report. In specific cases, the ECJ had applied the rule permitting preferential tax treatment for the pursuit of "legitimate economic and social aims" to permit, for instance, tax exemptions for beer from small-volume breweries, ²⁷ preferential treatment of fruit-based spirits distilled by small cooperatives that use their own raw materials, ²⁸ higher taxes imposed on luxury goods, ²⁹ higher taxes on cars with larger engine displacement, ³⁰ lower taxes on natural sweet wines the production of which is traditional and customary ³¹ and lower taxes on game machines typically used by children. ³² The ECJ has in this way been able to draw the line between Community integration and member State fiscal sovereignty. It is therefore possible for an international tribunal to examine origin-neutral legislation and determine on the facts of each case, whether the measures in question are "such as to avoid ... protection of competing products".

4.28 On this comparison between the ECJ case law and GATT Article III, the Community argued that it is important to begin by pointing to a basic difference between GATT Article III:2 and the corresponding tax discrimination provision of the EC Treaty (Article 95). Article III:2 is covered by the general exception of GATT Article XX; Article 95 is not subject to any exception. The latter situation has certainly contributed to the ECJ�s acceptance of the EC Treaty's regulatory distinctions for tax purposes of its own invention (but largely corresponding to treaty exceptions to Article 30, which prohibits quantitative restrictions). For the Community, the WTO legislator has provided a number of exceptions in Article XX, to which panels can refer, and, indeed, regulatory distinctions for tax purposes between products which would normally be considered like should not be made on grounds other than those included in GATT Article XX.

TO CONTINUE WITH JAPAN - TAXES ON ALCOHOLIC BEVERAGES

⁴ Follow up on the panel report on "Japan - Customs Duties, Taxes and Labelling Practices on Imported Wines and Alcoholic Beverages", communication by Japan dated 27 January 1989, circulated on 2 February 1989, GATT Document L/6465.

⁵ Article 87 of the Taxation Special Measure Law, Law No. 26 of 1957, as amended; provision applying to producers of refined sake, shochu A, shochu B or certain types of wine.

⁶ Panel report adopted on 19 June 1992, BISD 39S/208, para. 2.7.

⁷ Article 1 of GATT 1994 reads as follows:

⁸ Panel report adopted on 10 November 1980, BISD 27S/98.

⁹ Panel report on "EEC - Restrictions on Imports of Dessert Apples Complaint by Chile" adopted on 22 June 1989, BISD 36S/93.

¹⁰ Panel report on "EEC - Programme of Minimum Import Prices, Licences and Surety Deposits for Certain Processed Fruits and Vegetables", adopted 18 October 1978, BISD 25S/68, 100, para. 4.10.

¹¹ Panel report on "Japan - Restrictions on Imports of Certain Agricultural Products", adopted 22 March 1988, BISD 35S/163, 240, para. 5.3.12.3.

¹² BISD 29S/13.

¹³ Panel report adopted on 22 June 1989, BISD 36S/93.

¹⁴ Panel report adopted on 22 June 1989, BISD 36S/135.

¹⁵ See note 13, para. 12.1 of the report.

¹⁶ 1987 Panel Report, para. 5.11.

¹⁷ Panel report adopted on 17 June 1987, BISD 34S/136.

¹⁸ Panel report dated 11 October 1994, DS31/R (not adopted).

¹⁹ 1987 Panel Report para. 5.5. See also Superfund, para. 5.1 and the panel report on "EEC - Measures on Animal Feed Proteins", adopted on 14 March 1978, BISD 25S/49, paras. 4.1 - 4.2.

²⁰ 1987 Panel Report, para. 5.5, referring to Superfund, para. 5.1.1, where the panel found that some of the imported and domestic products, albeit not identical, were like products since they served substantially the same uses.

²¹ 1987 Panel Report, paras. 5.6 and 5.9, referring to the panel report on "Spain - Tariff Treatment of Imports of Unroasted Coffee", adopted on 11 June 1981, BISD 28S/102.

²² 1987 Panel Report, para. 5.9 d).

²³ 1987 Panel Report, para. 5.9.b).

²⁴ GATT/CP.3/42, adopted 30 June 1949, BISD II/181.

²⁵ H. Hansen jun. and O.C. Balle GmbH & Co. v. Hauptzollamt Flensburg, Case 148/77, [1978] ECR 1806; cited, e.g., in Commission v. Italian Republic (regenerated petroleum products), Case 21/79, [1980] ECR 1, 12.

²⁶ John Walker & Sons Ltd v. Ministeriet for Skatter og Afgifter, Case 243/84, [1986] ECR 875.

²⁷ Bobie Getränkevertrieb GmbH v. Hauptzollamt Aachen-Nord, Case 127/75, [1976] ECR 1079.

²⁸ Hansen & Balle, note 22 above.

²⁹ Commission v. Italy, Case 319/81, [1983] ECR 601, paras. 14, 21.

³⁰ Commission v. Italian Republic, Case 200/85, [1986] ECR 3953.

³¹ Commission v. France (natural sweet wines), Case 196/85, [1988] CMLR 851.

³² Gabriel Bergandi v. Directeur général des impôts, Case 252/86, [1988] ECR 1343.