6.8 In the view of the Panel, Articles 31 and 32 VCLT provide the relevant criteria in the light of which Article III:2 should be interpreted. The Panel recalled that Articles 31 and 32 VCLT state:

6.10 In this respect, the Panel noted that no formal subsequent agreement as to the interpretation of Article III:2 exists among the WTO Members. The Panel noted that other GATT and WTO panels have interpreted Article III and that panel reports adopted by the GATT CONTRACTING PARTIES and the WTO Dispute Settlement Body constitute subsequent practice in a specific case by virtue of the decision to adopt them. Article 1(b)(iv) of GATT 1994 provides institutional recognition that adopted panel reports constitute subsequent practice. Such reports are an integral part of GATT 1994, since they constitute "other decisions of the CONTRACTING PARTIES to GATT 1947". The Panel noted that Article 1(b)(iv) does not provide a hierarchy among "other decisions of the CONTRACTING PARTIES to GATT 1947". Moreover, the Panel noted that the panel report on "European Economic Community - Restrictions on Imports of Dessert Apples - Complaint by Chile" ⁸² (hereinafter "the 1989 Panel") had concluded that:

6.11 The Panel proceeded on the basis of the interpretative rule of the VCLT by turning first to the wording of Article III:2. The Panel noted that Article III:2 is concerned with two different factual situations: Article III:2, first sentence, is concerned with the treatment of like products, whereas Article III:2, second sentence, is concerned with the treatment of directly competitive or substitutable products, i.e., products other than like products, since no mention of like products is made in Article III:2, second sentence. In the Panel's view, the inclusion of the words "moreover" and "otherwise" in the second sentence of Article III:2 makes this point clear. The Interpretative Note ad Article III:2 further clarifies this distinction by providing an example where the first sentence of Article III:2 is not violated whereas the second is, thus confirming the existence of two distinct obligations in Article III:2.

6.12 The Panel, having established the basis for interpretation of Article III:2, turned to an examination of its elements. The Panel noted that while Article III:2, second sentence, contains a reference "to the principles set forth in paragraph 1", no such reference is contained in Article III:2, first sentence. The Panel recalled that according to Article III:1, WTO Members recognize that domestic legislation "should not be applied ... so as to afford protection to domestic production". In this context, the Panel felt that it was necessary to examine the relationship between Article III:2 and Article III:1. The Panel noted that the latter contains general principles concerning the imposition of internal taxes, internal charges, and laws, regulations and requirements affecting the treatment of imported and domestic products, while the former provides for specific obligations regarding internal taxes and internal charges. The words "recognize" and "should" in Article III:1, as well as the wording of Article III:2, second sentence, ("the principles"), make it clear that Article III:1 does not contain a legally binding obligation but rather states general principles. In contrast, the use of the word "shall" in Article III:2, both sentences, makes it clear that Article III:2 contains two legally binding obligations. Consequently, the starting point for an interpretation of Article III:2 is Article III:2 itself and not Article III:1. Recourse to Article III:1, which constitutes part of the context of Article III:2, will be made to the extent relevant and necessary.

6.13 The Panel then turned to other contextual elements that have to be taken into account, as required by Article 31 VCLT. The Panel noted in this respect the relationship between Articles II and III of GATT 1994. The Panel concluded, as had previous panels that dealt with the same issue, that one of the main purposes of Article III is to guarantee that WTO Members will not undermine through internal measures their commitments under Article II. The Panel noted in this respect that an adopted panel report that had dealt with this issue had stated that:

6.14 In light of the foregoing, the Panel then proceeded to an analysis of how the legal obligations imposed by Article III:2, first sentence, should be interpreted. In this context, the Panel recalled the divergent views of the parties to the dispute: the Panel noted that, with respect to like products, the Community essentially argued in favour of a two-step procedure whereby the Panel should establish first whether the products in question are like and, if so, then proceed to examine whether taxes imposed on foreign products are in excess of those imposed on like domestic products. The Community had stated that physical characteristics of the products concerned, their end-uses, as well as consumer preferences could provide relevant criteria for the Panel to judge whether the products concerned were like. The Panel noted in this respect, that complainants have the burden of proof to show first, that products are like and second, that foreign products are taxed in excess of domestic ones.

6.15 The Panel further took note of the statements by Japan that essentially argued that the Panel should examine the contested legislation in the light of its aim and effect in order to determine whether or not it is consistent with Article III:2. According to this view, in case the aim and effect of the contested legislation do not operate so as to afford protection to domestic production, no inconsistency with Article III:2 can be established. The Panel further took note of the statement by the United States that essentially argued that, in determining whether two products that were taxed differently under a Member’s origin-neutral tax measure were nonetheless "like products" for the purposes of Article III:2, the Panel should examine not only the similarity in physical characteristics and end-uses, consumer tastes and preferences, and tariff classifications for each product, but also whether the tax distinction in question was "applied ... so as to afford protection to domestic production": that is, whether the aim and effect of that distinction, considered as a whole, was to afford protection to domestic production. According to this view, if the tax distinction in question is not being applied so as to afford protection to domestic production, the products between which the distinction is drawn are not to be deemed "like products" for the purpose of Article III:2. The Panel noted that the United States and Japan reached opposite results by applying essentially the same test. Japan concluded that its legislation did not have the aim or effect of affording protection, while the United States concluded that the categorization made in that legislation did have such an aim and effect. Lastly in this context, the Panel noted that the United States also argued that independently of the legal test chosen and applied, the Panel should find that Japan in this case is in violation of its obligations under Article III:2. It was also the view of Japan that independently of the legal test chosen and applied, the Panel should find that Japan is not in violation of its obligations under Article III:2.

6.16 The Panel first turned to the test proposed by Japan and the United States. The Panel noted, in this respect, that the proposed aim-and-effect test is not consistent with the wording of Article III:2, first sentence. The Panel recalled that the basis of the aim-and-effect test is found in the words "so as to afford protection" contained in Article III:1. ⁸⁶ The Panel further recalled that Article III:2, first sentence, contains no reference to those words. Moreover, the adoption of the aim-and-effect test would have important repercussions on the burden of proof imposed on the complainant. The Panel noted in this respect that the complainants, according to the aim-and-effect test, have the burden of showing not only the effect of a particular measure, which is in principle discernible, but also its aim, which sometimes can be indiscernible. The Panel also noted that very often there is a multiplicity of aims that are sought through enactment of legislation and it would be a difficult exercise to determine which aim or aims should be determinative for applying the aim-and-effect test. ⁸⁷ Moreover, access to the complete legislative history, which according to the arguments of the parties defending the aim-and-effect test, is relevant to detect protective aims, could be difficult or even impossible for a complaining party to obtain. Even if the complete legislative history is available, it would be difficult to assess which kinds of legislative history (statements in legislation, in official legislative reports, by individual legislators, or in hearings by interested parties) should be primarily determinative of the aims of the legislation. ⁸⁸ The Panel recalled in this respect the argument by the United States that the aim-and-effect test should be applicable only with respect to origin-neutral measures. The Panel noted that neither the wording of Article III:2, nor that of Article III:1 support a distinction between origin-neutral and origin-specific measures.

6.17 The Panel further noted that the list of exceptions contained in Article XX of GATT 1994 could become redundant or useless because the aim-and-effect test does not contain a definitive list of grounds justifying departure from the obligations that are otherwise incorporated in Article III. ⁸⁹ The purpose of Article XX is to provide a list of exceptions, subject to the conditions that they "are not applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail, or a disguised restriction of international trade", that could justify deviations from the obligations imposed under GATT. Consequently, in principle, a WTO Member could, for example, invoke protection of health in the context of invoking the aim-and-effect test. The Panel noted that if this were the case, then the standard of proof established in Article XX would effectively be circumvented. WTO Members would not have to prove that a health measure is "necessary" to achieve its health objective. ⁹⁰ Moreover, proponents of the aim-and-effect test even shift the burden of proof, arguing that it would be up to the complainant to produce a prima facie case that a measure has both the aim and effect of affording protection to domestic production and, once the complainant has demonstrated that this is the case, only then would the defending party have to present evidence to rebut the claim. ⁹¹ In sum, the Panel concluded that for reasons relating to the wording of Article III as well as its context, the aim-and-effect test proposed by Japan and the United States should be rejected.

6.18 The Panel turned at this point to the relevance of the two GATT panel reports that, according to the arguments of Japan and the United States, have espoused the aim-and-effect test. With respect to the panel report on "United States - Taxes on Automobiles" (US Auto Taxes), ⁹² the Panel noted that the report remains unadopted and that, for the reasons stated in paragraph 6.10, it did not have to take it into account since it does not constitute subsequent practice. At any rate, for the reasons mentioned in paragraphs 6.16 and 6.17, the Panel was not persuaded by the reasoning contained in the panel report on US Auto Taxes. With respect to the 1992 Malt Beverages report, the Panel first noted that it interpreted the term "like product" as it appears in Article III:2 in a manner largely consistent with the interpretation of the 1987 Panel Report that had previously interpreted the same term. The Panel noted that the 1992 Malt Beverages report, when interpreting the term "like product", took into account the product's end-uses, consumer tastes and habits, and the product's properties, nature and quality. However, the 1992 Malt Beverages report also considered whether product differentiation is being made "so as to afford protection to domestic production". ⁹³ The Panel was not in a position to detect how the 1992 Malt Beverages panel weighed the different criteria that it took into account in order to determine whether the products in dispute were like. In the Panel's view, however, an interpretation of the term "like product" as it appears in Article III:2, first sentence, that conditions likeness on the criterion whether a domestic legislation operates so as to afford protection to domestic production, is inconsistent with the wording of Article III:2, first sentence. The Panel recalled its conclusions reached in this respect in paragraphs 6.16 and 6.17. For this reason, the Panel decided not to follow the interpretation of the term "like product" as it appears in Article III:2, first sentence, advanced by the 1992 Malt Beverages report in so far as it incorporates the aim-and-effect test.

6.19 The Panel, having decided not to apply the aim-and-effect test proceeded to develop the legal test that it would apply in this case in order to determine whether Japan had acted inconsistently with its obligations under Article III. More specifically, in the view of the Panel, the wording of Article III:2, first sentence, requires it to make three determinations: (i) whether the products concerned are like, (ii) whether the contested measure is an "internal tax" or "other internal charge" (not an issue in this case) and (iii) if so, whether the tax imposed on foreign products is in excess of the tax imposed on like domestic products. If these three determinations are in the affirmative, such a tax would result in the WTO Member imposing it being in violation of the obligation contained in Article III:2, first sentence. Moreover, in the Panel's view, the only relevant contextual elements supported this interpretation. The Panel recalled in this respect its conclusions reached in paragraph 6.12 concerning the limited relevance of Article III:1 to the interpretation of Article III:2. The Panel further recalled that past GATT panels had followed this approach. ⁹⁴ Thus, the Panel decided to proceed on the basis outlined in this paragraph.

6.20 The Panel noted that the term "like product" appears in various GATT provisions. The Panel further noted that it did not necessarily follow that the term had to be interpreted in a uniform way. In this respect, the Panel noted the discrepancy between Article III:2, on the one hand, and Article III:4 on the other: while the former referred to Article III:1 and to like, as well as to directly competitive or substitutable products (see also Article XIX of GATT), the latter referred only to like products. If the coverage ⁹⁵ of Article III:2 is identical to that of Article III:4, a different interpretation of the term "like product" would be called for in the two paragraphs. Otherwise, if the term "like product" were to be interpreted in an identical way in both instances, the scope of the two paragraphs would be different. This is precisely why, in the Panel's view, its conclusions reached in this dispute are relevant only for the interpretation of the term "like product" as it appears in Article III:2.

6.21 The Panel noted that previous panel and working party reports had unanimously agreed that the term "like product" should be interpreted on a case-by-case basis. ⁹⁶ The Panel further noted that previous panels had not established a particular test that had to be strictly followed in order to define likeness. Previous panels had used different criteria in order to establish likeness, such as the product's properties, nature and quality, and its end-uses; consumers' tastes and habits, which change from country to country; and the product's classification in tariff nomenclatures. ⁹⁷ In the Panel's view, "like products" need not be identical in all respects. However, in the Panel's view, the term "like product" should be construed narrowly in the case of Article III:2, first sentence. This approach is dictated, in the Panel's view, by two independent reasons: (i) because Article III:2 distinguishes between like and directly competitive or substitutable products, the latter obviously being a much larger category of products than the former; and (ii) because of the Panel's conclusions reached with respect to the relationship between Articles III and II. As to the first point, the distinction between "like" and "directly competitive or substitutable products" is discussed in paragraph 6.22. As to the second point, as previous panels had noted, one of the main objectives of Article III:2 is to ensure that WTO Members do not frustrate the effect of tariff concessions granted under Article II through internal taxes and other internal charges, it follows that a parallelism should be drawn in this case between the definition of products for purposes of Article II tariff concessions and the term "like product" as it appears in Article III:2. This is so in the Panel’s view, because with respect to two products subject to the same tariff binding and therefore to the same maximum border tax, there is no justification, outside of those mentioned in GATT rules, to tax them in a differentiated way through internal taxation. This does not mean that the determination of whether products are "like" should be based exclusively on the definition of products for tariff bindings, but in the Panel’s view, especially where it is sufficiently detailed, a product’s description for this purpose is in this case an important criterion for confirming likeness for the purposes of Article III:2. The Panel noted that its proposed interpretation does not unduly restrict the possibility offered to WTO Members to challenge internal taxes that discriminate against foreign products, since Article III:2, second sentence, effectively prohibits the taxation of "directly competitive or substitutable products" "so as to afford protection to domestic production". As explained in the next paragraph, the phrase "directly competitive or substitutable products", should be interpreted more broadly than the phrase "like products". In the Panel's view, its interpretation of Article III:2, first sentence, is in accordance with the requirements of Article 31 VCLT.

6.22 The wording of Article III and of the Interpretative Note ad Article III make it clear that a distinction must be drawn between, on the one hand, like, and, on the other, directly competitive or substitutable products. Such an approach is in conformity with the principle of "effective treaty interpretation" as laid down in the "general rule of interpretation" of the Vienna Convention on the Law of Treaties. The Panel recalled in this respect the conclusions of the Appellate Body in its report on "United States - Standards for Reformulated and Conventional Gasoline" where it stated that "an interpreter is not free to adopt a reading that would result in reducing whole clauses or paragraphs of a treaty to redundancy or inutility." ⁹⁸ In the view of the Panel, like products should be viewed as a subset of directly competitive or substitutable products. The wording ("like products" as opposed to "directly competitive or substitutable products") confirmed this point, in the sense that all like products are, by definition, directly competitive or substitutable products, whereas all directly competitive or substitutable products are not necessarily like products. Giving a narrow meaning to "like products" is also justified by the inescapability of violation in case of taxation of foreign products in excess of like domestic products. ⁹⁹ Moreover, in the Panel’s view, the wording makes it clear that the appropriate test to define whether two products are "like" or "directly competitive or substitutable" is the marketplace. The Panel recalled in this respect the words used in the Interpretative Note ad Article III, paragraph 2, namely "where competition exists": competition exists by definition in markets. In the view of the Panel, to define a precise cut-off point that distinguishes between, on the one hand, like, and on the other, directly competitive or substitutable products requires an arbitrary decision. The Panel decided therefore, to consider criteria on a case-by-case basis in order to determine whether two products are like or directly competitive or substitutable. The Panel recalled, in this respect, that previous panels had pronounced in favour of a case-by-case approach when defining like or directly competitive or substitutable products. ¹⁰⁰ In the view of the Panel, descriptions used in the context of tariff classifications and bindings whilst by themselves not providing decisive guidance on likeness, can be used nevertheless in considering the content of "like products" in the context of Article III:2, first sentence. Such an approach is in line with previous panel reports that concluded that the purpose of Article III was to avoid that "the value of the bindings under Article II of the Agreement and of the general rules of non-discrimination as between imported and domestic products could be easily evaded." ¹⁰¹ Previous panels that dealt with the same issue have used a series of criteria in order to define likeness or substitutability. ¹⁰² In the view of the Panel, the wording of the term "directly competitive or substitutable" does not suggest at all that physical resemblance is required in order to establish whether two products fall under this category. This impression, in the Panel’s view, was further supported by the words "where competition exists" of the Interpretative Note; competition can and does exist among products that do not necessarily share the same physical characteristics. In the Panel’s view, the decisive criterion in order to determine whether two products are directly competitive or substitutable is whether they have common end-uses, inter alia, as shown by elasticity of substitution. The wording of the term "like products" however, suggests that commonality of end-uses is a necessary but not a sufficient criterion to define likeness. In the view of the Panel, the term "like products" suggests that for two products to fall under this category they must share, apart from commonality of end-uses, essentially the same physical characteristics. In the Panel’s view its suggested approach has the merit of being functional, although the definition of likeness might appear somewhat "inflexible". Flexibility is required in order to conclude whether two products are directly competitive or substitutable. In the Panel’s view, the suggested approach can guarantee the flexibility required, since it permits one to take into account specific characteristics in any single market; consequently, two products could be considered to be directly competitive or substitutable in market A, but the same two products would not necessarily be considered to be directly competitive or substitutable in market B. The Panel proceeded to apply this approach to the products in dispute in the present case.

6.23 The Panel next turned to an examination of whether the products at issue in this case were like products, starting first with vodka and shochu. The Panel noted that vodka and shochu shared most physical characteristics. In the Panel's view, except for filtration, there is virtual identity in the definition of the two products. The Panel noted that a difference in the physical characteristic of alcoholic strength of two products did not preclude a finding of likeness especially since alcoholic beverages are often drunk in diluted form. The Panel then noted that essentially the same conclusion had been reached in the 1987 Panel Report, which

6.24 The Panel then proceeded to examine whether vodka is taxed in excess of the tax imposed on shochu under the Japanese Liquor Tax Law. The Panel noted that what was contested in the Japanese legislation was a system of specific taxes imposed on various alcoholic drinks. In this respect, it noted that vodka was taxed at 377,230 Yen per kilolitre - for an alcoholic strength below 38° - that is 9,927 Yen per degree of alcohol, whereas shochu A was taxed at 155,700 Yen per kilolitre - for an alcoholic strength between 25° and 26° - that is 6,228 Yen per degree of alcohol. ¹⁰⁴ The Panel further noted that Article III:2 does not contain any presumption in favour of a specific mode of taxation. Under Article III:2, first sentence, WTO Members are free to choose any system of taxation they deem appropriate provided that they do not impose on foreign products taxes in excess of those imposed on like domestic products. The phrase "not in excess of those applied ... to like domestic products" should be interpreted to mean at least identical or better tax treatment. The Japanese taxes on vodka and shochu are calculated on the basis of and vary according to the alcoholic content of the products and, on this basis, it is obvious that the taxes imposed on vodka are higher than those imposed on shochu. Accordingly, the Panel concluded that the tax imposed on vodka is in excess of the tax imposed on shochu.

6.25 The Panel then addressed the argument put forward by Japan that its legislation, by keeping the tax/price ratio "roughly constant", is trade neutral and consequently no protective aim and effect of the legislation can be detected. In this connection, the Panel recalled Japan’s argument that its aim was to achieve neutrality and horizontal tax equity. ¹⁰⁵ The Panel noted that it had already decided that the existence or non-existence of a protective aim and effect is not relevant in an analysis under Article III:2, first sentence. To the extent that Japan's argument is that its Liquor Tax Law does not impose on foreign products (i.e., vodka) a tax in excess of the tax imposed on domestic like products (i.e., shochu), the Panel rejected the argument for the following reasons:

6.26 The Panel then turned to the arguments put forward by Japan concerning taxation systems in other countries. The Panel noted that its terms of reference were strictly confined to the Japanese legislation. The Panel could not, therefore, consider the domestic taxation systems of other countries since they lie outside its terms of reference.

6.27 Consequently, the Panel concluded that, by taxing vodka in excess of shochu, Japan is in violation of its obligation under Article III:2, first sentence.

6.28 The Panel then turned to an analysis of the issues arising under Article III:2, second sentence. In the view of the Panel, the wording of Article III:2, second sentence, requires it to make two determinations: (i) whether the products concerned (whisky, brandy, gin, genever, rum and liqueurs) are directly competitive or substitutable, and (ii) if so, whether the treatment afforded to foreign products is contrary to the principles set forth in paragraph 1 of Article III. In the view of the Panel, the complainants have the burden of proof to show first, that the products concerned are directly competitive or substitutable and second, that foreign products are taxed in such a way so as to afford protection to domestic production. The Panel recalled that the term "directly competitive or substitutable product", in accordance with its ordinary meaning, should be interpreted more broadly than the term "like product". In this sense the Interpretative Note ad Article III:2, second sentence, speaks about products "where competition was involved between..." them. The Panel noted, in this respect, that independently of similarities with respect to physical characteristics or classification in tariff nomenclatures, greater emphasis should be placed on elasticity of substitution. In this context, factors like marketing strategies could also prove to be relevant criteria, since what is at issue is the responsiveness of consumers to the various products offered in the market. Such responsiveness, the Panel recalled, may vary from country to country, ¹⁰⁸ but should not be influenced or determined by internal taxation. ¹⁰⁹ The Panel noted the conclusions in the 1987 Panel Report, ¹¹⁰ that a tax system that discriminates against imports has the consequence of creating and even freezing preferences for domestic goods. In the Panel’s view, this meant that consumer surveys in a country with such a tax system would likely understate the degree of potential competitiveness between substitutable products.

6.29 In examining whether the products at issue were directly competitive or substitutable, the Panel first noted that the 1987 Panel Report that dealt with this issue concluded that both "white" and "brown" spirits were directly competitive or substitutable products to shochu, according to Article III:2, second sentence. The Panel noted in this respect, that the 1987 Panel Report had reached its conclusion based essentially on the substitutability among the products in dispute as a result of "their respective prices, their availability through trade and their other competitive inter-relationships". ¹¹¹ Turning to the evidence in this case, the Panel noted that the complainants had submitted a study (the ASI study) that concludes that there is a high degree of price-elasticity between shochu, on the one hand, and five brown spirits (Scotch whisky, Japanese whisky, Japanese brandy, cognac, North American whisky) and three white spirits (gin, vodka and rum), on the other. ¹¹² Japan questioned the relevance of this ASI study by noting that consumers were not allowed to choose other than the mentioned eight products (for example, they were not allowed to choose, beer, sake or wine) and also argued that if choices are too limited even such disparate products as hamburger and ice cream could be argued to be directly competitive or substitutable products. In the Panel's view, however, price-elasticity between the mentioned products is not altered by the fact that consumers were presented with a limited choice. At best, the argument by Japan, if proven, could eventually lead to the conclusion that the three products mentioned by Japan have a greater degree of price-elasticity with shochu. It would not, however, in the Panel's view, amount to a rejection of the existence of a significant directly competitive or substitutable relationship between shochu and the examined eight products.

6.30 The Panel further noted that as a result of the 1989 Japanese tax reform, the distinction between "premium whisky", "first grade whisky" and "second grade whisky" was abolished. This tax reform disadvantaged domestically produced whisky, by substantially increasing the tax rate on second grade whisky compared to the other alcoholic beverages at issue in the present case. ¹¹³ The market share of domestic whisky including second grade fell from 26.7 per cent in 1988 to 19.6 per cent in 1990. This, according to the Community's evidence, led to a rise of both shochu's and foreign produced whisky's market shares in Japan. ¹¹⁴ This proves to the Community that there is elasticity of substitution between whisky and shochu. The Panel further noted that Canada and the United States provided evidence to the same effect, that is showing that elasticity of substitution between whisky and shochu was evident as a result of the 1989 Japanese tax reform. ¹¹⁵ The Panel took note that in its response, Japan argued that the combination of the expansion of shochu consumption and the declining whisky prices rather indicated the lack of a competitive relationship between the two commodities. In the Panel's view, Japan failed to take account of the fact that shochu and foreign whisky were in fact capturing the market share lost by domestically produced whisky. In the Panel's view, the fact that foreign produced whisky and shochu were competing for the same market is evidence that there was elasticity of substitution between them.

6.31 The Panel noted Japan's argument that there is no elasticity of substitution between shochu and the rest of the alcoholic drinks in dispute in this case. If at all, according to Japan, the evidence the complainants provided to the Panel shows elasticity of substitution between shochu and beer. Japan based its argument on a survey conducted among consumers that showed, according to Japan, that in case shochu were not available 6 per cent of the consumers would switch to spirits whereas only 4 per cent to whisky; if whisky were not available, 32 per cent of the consumers would choose brandy and only 10 per cent would choose shochu. Japan submitted this survey to the Panel. The Panel did not accept Japan's argument on the grounds that Japan, in conducting this survey, failed to take into account price distortions caused by internal taxation. In other words, consumers' choices were sought within the existing price regime (which is the subject matter of the current dispute), and not independently of it. Moreover, in the Panel's view, the inadequacies of the survey notwithstanding, in case of non-availability of shochu, 10 per cent of the consumers would switch to spirits and whisky. This, in the Panel's view, was proof of significant elasticity of substitution between shochu, on the one hand, and whisky and spirits, on the other. The Panel noted that Japan further provided an econometric study in which no elasticity of substitution could be found between shochu, on the one hand, and spirits or whisky, on the other. This study attempted to evaluate the extent to which the relevant products are directly competitive. ¹¹⁶ In considering the study, the Panel took account of the views of the parties and of general econometric principles. The Panel noted that the extent to which two products are competitive in economics is measured by the responsiveness of the demand for one product to the change in the demand for the other product (cross-price elasticity of demand). The more sensitive demand for one product is to changes in the price of the other product, all other things being equal, the more directly competitive they are. This is related to the substitutability of one product for another (elasticity of substitution). Under national antitrust and trade law régimes, the extent to which products directly compete is measured by the elasticity of substitution. Formal statistical methods are employed to measure, with a reasonable degree of certainty, the magnitude and direction of variables, based on actual observations. The greater the number of observations, the greater the degree of certainty. In the case of product demand and product substitutability (i.e., the direct competitiveness of products), the relevant information includes prices, quantities, and incomes. Ideally, one would like to test for the relationship between the price of one product and the demand for another, all other things being equal. Under these conditions, relatively simple statistical methods can be employed. This is the approach taken in the Japanese econometric study. However, all other things are not equal. When working with a set of (potentially) substitutable products, it is necessary to recognize that underlying trends in the data may affect the apparent relationship between the variables examined (serial and autocorrelation). In addition, the variables may in actuality be closely related. For example, outside factors (i.e., those not measured directly) may affect the markets that are examined jointly (multicollinearity). Moreover, changes in income may affect demand in all of the product markets studied, and this effect may vary systematically across the markets. In statistical studies of related markets involving time series data (as in the present study), one could normally expect to encounter all of these problems. Relatively standard methods can be employed to control for serial and autocorrelation and multicollinearity. Failure to account for these effects can render the results of simple statistical analysis meaningless. According to the complainants, this is the case of the study submitted by Japan. The Panel accepted the validity of these criticisms and noted that Japan had not succeeded in rebutting the criticism advanced by complainants and thus Japan’s study did not refute the evidence of substitutability submitted by complainants.

6.32 The Panel then concluded that in deciding whether shochu and the other products in dispute were directly competitive or substitutable products, it noted that the products concerned were all distilled spirits and it would give particular emphasis to the following factors: the findings of the 1987 Panel Report; the studies put forward by the complainants (the ASI study) that contained persuasive evidence that there is significant elasticity of substitution among the products in dispute; the survey submitted by Japan that, notwithstanding the fact that it failed to take into account price distortions caused by internal taxation, still shows elasticity of substitution among the products in dispute; and, lastly, the evidence submitted by complainants concerning the 1989 Japanese tax reform which showed that whisky and shochu are essentially competing for the same market. In the view of the Panel, the conclusions of the 1987 Panel Report, buttressed by any of the other three factors, were sufficient for the Panel to conclude that shochu and the other products subject to dispute are directly competitive or substitutable according to Article III:2, second sentence.

6.33 The Panel turned to the question whether Japan was violating its obligations under Article III:2, second sentence. In this respect, the Panel recalled the Interpretative Note ad Article III:2 that states:

a) With respect to taxation per kilolitre of product the Panel noted that the amounts were: ¹²⁰

The Panel concluded that the amounts of tax are not similar and that the differences are not de minimis.

b) With respect to taxation per degree of alcohol the Panel noted that the amounts were: ¹²¹

The Panel concluded that the amounts of tax are not similar and that the differences are not de minimis. Since the Japanese taxes at issue were calculated on the basis of the alcohol content of the various products, the Panel considered this dissimilarity to be particularly dispositive for its analysis under Article III:2, second sentence.

c) The Panel noted that Japan's Liquor Tax Law does not provide for ad valorem taxation and this criterion is, consequently, irrelevant in this case.

d) With respect to the tax/price ratio, the Panel noted that the statistics submitted by Japan show that significant differences exist between shochu and the other directly competitive or substitutable products and also noted that there are significantly different tax/price ratios within the same product categories. Moreover, there were significant problems with the methodology for calculating tax/price ratios submitted by Japan, such that arguments based on that methodology could only be viewed as inconclusive. More particularly, although Japan had argued that the comparison of tax/price ratios should be done on a category-by-category basis, its statistics on which the tax/price ratios were based excluded domestically produced spirits and whisky/brandy from the calculation of tax/price ratios for spirits and whisky/brandy. Since the prices of the domestic spirits and whisky/brandy are much lower than the prices of the imported ones, this exclusion has the impact of reducing considerably the tax/prices ratios cited by Japan for those products. In this connection, the Panel noted that one consequence of the Japanese tax system was to make it more difficult for cheaper imported brands of spirits and whisky/brandy to enter the market. Moreover, the Panel noted that the Japanese statistics were based on suggested retail prices and there was evidence in the record that these products were often sold at a discount, at least in Tokyo. To the extent that the prices were unreliable, the resultant tax/price ratios would be unreliable as well.

The Panel consequently concluded that the products in dispute are not similarly taxed and the taxes on shochu are lower than the taxes on the other products subject to dispute, leading the Panel to the conclusion that protection is afforded to shochu inconsistently with Japan’s obligations under Article III:2, second sentence.

TO CONTINUE WITH JAPAN - TAXES ON ALCOHOLIC BEVERAGES

⁸² Panel report adopted on 22 June 1989, BISD 36S/93, para. 12.1.

⁸³ See the panel report on "EEC - Restrictions on Imports of Apples from Chile", adopted on 10 November 1980, BISD 27S/98.

⁸⁴ See the panel report on "Canada - Import, Distribution and Sale of Certain Alcoholic Drinks by Provincial Marketing Agencies", adopted on 18 February 1992, BISD 39S/27, paras. 5.30 - 5.31.

⁸⁵ See the panel report on "United States - Measures Affecting Alcoholic and Malt Beverage", adopted on 19 June 1992, BISD 39S/206, para. 5.9 (the "1992 Malt Beverages" report). See also the discussion in para. 6.21.

⁸⁶ See paras. 4.16 - 4.19 and 4.24ff. of the Descriptive Part.

⁸⁷ The Panel noted, in this respect, an interesting parallel with the legal status of "supplementary means" of interpretation of treaties -- that comprise preparatory work -- and their relevance for interpreting treaties. The Panel noted that according to Article 32 VCLT recourse to supplementary means of interpretation is required only as an exception in specific circumstances. The Panel noted in this respect the commentary of the International Law Commission: "The Commission considered that the exception must be strictly limited, if it is not to weaken unduly the authority of the ordinary meaning of the terms." The Panel further noted the statement of the International Law Commission that "...the preparatory work...does not, in consequence, have the same authentic character as an element of interpretation, however valuable it may sometimes be in throwing light in the expression of the agreement in the text. Moreover, it is beyond question that the records of treaty negotiations are in many cases incomplete or misleading, so that considerable discretion has to be exercised in determining their value as an element of interpretation. D. Rauschning and R.G. Wetzel, The Vienna Convention on the Law of Treaties, Travaux Préparatoires (Frankfurt: Alfred Metzner Verlag, 1978), pp. 255, 252. The Panel noted that considerable differences exist between preparatory work of international treaties and preparatory work of domestic legislation that preclude the automatic transposition of the reasoning of the International Law Commission to the case before it. Nevertheless, in the Panel's view, the analysis and reasoning of the International Law Commission could be relevant even in the context of preparatory work of domestic legislation.

⁸⁸ See para. 4.17 of the Descriptive Part.

⁸⁹ In this context, the Panel noted that the Appellate Body in its report on "United States - Standards for Reformulated and Conventional Gasoline", noted that "one of the corollaries of the ‘general rule of interpretation’ in the Vienna Convention is that interpretation must give meaning and effect to all the terms of a treaty. An interpreter is not free to adopt a reading that would result in reducing whole clauses or paragraphs of a treaty to redundancy or inutility". WT/DS2/AB/R, at p.23.

⁹⁰ See, for example, the panel report on "Thailand - Restrictions on Importation of and Internal Taxes on Cigarettes", adopted on 7 November 1990, BISD 37S/200.

⁹¹ See para. 4.32 of the Descriptive Part.

⁹² DS31/R, report dated 11 October 1994.

⁹³ See the 1992 Malt Beverages report, paras. 5.25 - 5.26.

⁹⁴ See for example, the panel report on "United States - Taxes on Petroleum and Certain Imported Substances", adopted on 17 June 1987, BISD 34S/136; the 1987 Panel Report; see also the panel report on "United States - Standards for Reformulated and Conventional Gasoline", WT/DS2/R, adopted on 20 May 1996.

⁹⁵ By the term "coverage", the Panel means whether Article III:4 regulates the treatment of both categories of products mentioned in Article III:2, namely both "like" and "directly competitive or substitutable" products.

⁹⁶ See, for example, the Working Party Report on "Border Tax Adjustments", L/3464, adopted on 2 December 1970, BISD 18S/97, p. 102, para. 18 (hereinafter "the 1970 Working Party report"); the panel report on "United States - Taxes on Petroleum and Certain Imported Substances", adopted on 17 June 1987, BISD 34S/136, pp.154-155, para. 5.1.1; the 1987 Panel Report, pp.113-115, para. 5.5-5.7; the 1992 Malt Beverages report, pp. 276-277, paras. 5.25 - 5.26.

⁹⁷ See the 1970 Working Party report on "Border Tax Adjustments", op. cit., at para. 18; the 1987 Panel Report at para. 5.6; the panel report on "United States - Taxes on Petroleum and Certain Imported Substances", op. cit., at para. 5.1.1; the panel report on "EEC - Measures on Animal Feed Proteins", adopted on 14 March 1978, BISD 25S/49, at para. 4.3.

⁹⁸ See WT/DS2/AB/R, at p.23.

⁹⁹ The panel report on "United States - Taxes on Petroleum and Certain Imported Substances", op. cit., at para. 5.1.9 made it clear that no de minimis defense can be raised in case of taxation of foreign products in excess of domestic like products. The Panel agreed with this statement.

¹⁰⁰ See footnote 96 and accompanying text.

¹⁰¹ See the panel report on "Italian Discrimination Against Imported Agricultural Machinery", adopted on 23 October 1958, BISD 7S/60 at p.64, para. 15; see also the 1987 Panel Report op. cit.

¹⁰² See footnote 96 and accompanying text.

¹⁰³ Para. 5.7. The same paragraph further reads: "... the Panel found that the traditional Japanese consumer habits with regard to shochu provided no reason for not considering vodka to be a 'like' product. ... Even if imported alcoholic beverages (e.g vodka) were not considered to be ‘like’ to Japanese alcoholic beverages (e.g shochu Group A), the flexibility in the use of alcoholic drinks and their common characteristics often offered an alternative choice for consumers leading to a competitive relationship.

¹⁰⁴ See para. 2.3 of the Descriptive Part for a complete description of the Japanese liquor tax rates.

¹⁰⁵ See para. 4.132ff. of the Descriptive Part.

¹⁰⁶ See paras. 4.100, 4.142-4, 4.159, 4.160-1 of the Descriptive Part.

¹⁰⁷ See paras. 4.100, 4.159, 4.160 and 4.165 of the Descriptive Part.

¹⁰⁸ See the 1970 Working Party report, op. cit., at para. 18.

¹⁰⁹ In this respect, note para. 5.7 of the 1987 Panel Report "since consumer habits are variable in time and space and the aim of Article III:2 of ensuring neutrality of internal taxation as regards competition between imported and domestic like products could not be achieved if differential taxes could be used to crystallize consumer preferences for traditional domestic products, the Panel found that the traditional Japanese consumer habits with regard to shochu provided no reason for not considering vodka to be a like product". (emphasis added).

¹¹⁰ See the 1987 Panel Report, op. cit., at para. 5.9.

¹¹¹ See the 1987 Panel Report, op. cit., para. 5.7.

¹¹² See paras. 4.171ff. of the Descriptive Part.

¹¹³ See para. 4.82 of the Descriptive Part.

¹¹⁴ The Panel noted that this rise was short-lived, since as of 1992 the Japanese economy entered into recession and there was a shift of demand towards the less expensive categories of liquors.

¹¹⁵ See paras. 4.73, 4.77-8, 4.90-2, 4.111, 4.113, 4.115, 4.117, 4.171-2, 4.174 of the Descriptive Part.

¹¹⁶ See paras. 4.83ff. of the Descriptive Part.

¹¹⁷ See the 1987 Panel Report, op. cit., para. 5.11.

¹¹⁸ The Panel decided that it did not have to further define "de minimis", because in this case the differences in taxation were significant.

¹¹⁹ See the panel report on "United States - Taxes on Petroleum and Certain Imported Substances", op. cit., para. 5.1.9; see also the panel report on "Italian Discrimination Against Imported Agricultural Machinery", op. cit., para. 12.

¹²⁰ See para. 2.3 of the Descriptive Part.

¹²¹ Based on calculations upon information included in para. 2.3 of the Descriptive Part.