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Korea - Taxes on Alcoholic Beverages

Report of the Panel

(Continued)


    C. Main Issues

    1. Interpretation of Article III:2

  1. Article III:2 provides two standards for examining complaints about a Member's internal taxation laws. The first sentence of Article III:2 provides:
  2. The products of the territory of any Member imported into the territory of any other Member shall not be subject, directly or indirectly, to internal taxes or other internal charges of any kind in excess of those applied, directly or indirectly, to like domestic products.

    The second sentence provides:

    Moreover, no Member shall otherwise apply internal taxes or other internal charges to imported or domestic products in a manner contrary to the principles set forth in paragraph 1.

    Paragraph 1 of Article III provides:

    The Members recognize that internal taxes and other internal charges, and laws, regulations and requirements affecting the internal sale, offering for sale, purchase, transportation, distribution or use of products, and internal quantitative regulations requiring the mixture, processing or use of products in specified amounts or proportions, should not be applied to imported or domestic products so as to afford protection to domestic production.

    The meaning of the second sentence in light of its reference to the first sentence is further clarified in Ad Article III as follows:

    A tax conforming to the requirements of the first sentence of paragraph 2 would be considered to be inconsistent with the provisions of the second sentence only in cases where competition was involved between, on the one hand, the taxed product and, on the other hand, a directly competitive or substitutable product which was not similarly taxed. 346

  3. Thus, the first sentence of Article III:2 examines whether products of an exporting country are taxed in excess of the taxes on the "like" domestic product. The second sentence examines whether products of an exporting country are taxed similarly to domestic products which are "directly competitive or substitutable." Both sentences first examine the relationship between the domestic and imported products; however, the second sentence involves additional and different inquiries with respect to two other elements; namely, an examination of the extent of the difference in taxation 347 and whether the taxation differences are applied so as to afford protection to the domestic industry.
  4. The general approach in past Article III:2 cases has been to examine first whether any of the products at issue are "like." However, previous cases have found that the category of like products is a subset of those products which are directly competitive or substitutable. 348 It therefore seems more logical to us to approach the issue by examining the broader category first.
  5. Before beginning to analyze the evidence presented, we must first decide how the term "directly competitive or substitutable" should be interpreted. Article 31 of the Vienna Convention summarizes the international law rules for the interpretation of treaty language. It provides in paragraph 1 that terms shall be interpreted in good faith in accordance with the ordinary meaning of the terms in their context and in light of the object and purpose of the treaty. According to paragraph 2, the context includes the full text, the preamble, the annexes and any mutually agreed interpretive language. Paragraph 3 provides that account shall also be taken of any subsequent practice or interpretations as well as relevant rules of international law.
  6. The Appellate Body in Japan � Taxes on Alcoholic Beverages II stated that "like product" should be narrowly construed for purposes of Article III:2. It then noted that directly competitive or substitutable is a broader category, saying: "How much broader that category of 'directly competitive or substitutable products' may be in a given case is a matter for the panel to determine based on all the relevant facts in that case." 349 Article 32 of the Vienna Convention provides that it is appropriate to refer to the negotiating history of a treaty provision in order to confirm the meaning of the terms as interpreted pursuant to the application of Article 31. A review of the negotiating history of Article III:2, second sentence and the Ad Article III language confirms that the product categories should not be so narrowly construed as to defeat the purpose of the anti-discrimination language informing the interpretation of Article III. The Geneva session of the Preparatory Committee provided an explanation of the language of the second sentence by noting that apples and oranges could be directly competitive or substitutable. 350 Other examples provided were domestic linseed oil and imported tung oil 351 and domestic synthetic rubber and imported natural rubber. 352 There was discussion of whether such products as tramways and busses or coal and fuel oil could be considered as categories of directly competitive or substitutable products. There was some disagreement with respect to these products. 353
  7. This negotiating history illustrates the key question in this regard. It is whether the products are directly competitive or substitutable. Tramways and busses, when they are not directly competitive, may still be indirectly competitive as transportation systems. Similarly even if most power generation systems are set up to utilize either coal or fuel oil, but not both, these two products could still compete indirectly as fuels. 354 Thus, the focus should not be exclusively on the quantitative extent of the competitive overlap, but on the methodological basis on which a panel should assess the competitive relationship.
  8. At some level all products or services are at least indirectly competitive. Because consumers have limited amounts of disposable income, they may have to arbitrate between various needs such as giving up going on a vacation to buy a car or abstaining from eating in restaurants to buy new shoes or a television set. However, an assessment of whether there is a direct competitive relationship between two products or groups of products requires evidence that consumers consider or could consider the two products or groups of products as alternative ways of satisfying a particular need or taste.
  9. The Panel in Japan � Taxes on Alcoholic Beverages II noted that the 1989 Japanese tax reform had eliminated the distinctions between various grades of whisky. The result was that domestic whisky production declined relatively. Its market share fell and both shochu and foreign-produced whisky's market share rose. The Panel stated:
  10. In the Panel's view, the fact that foreign produced whisky and shochu were competing for the same market share [held by domestic whisky] is evidence that there was elasticity of substitution between them. 355

    Imported whisky and shochu may each have been competing independently with domestic whisky. We would agree with that panel that showing such indirect competition may provide evidentiary support for a finding of direct competitiveness. However, such a showing is insufficient on its own. To use a hypothetical case for illustration, it is possible that in some markets distilled beverages could be shown to compete with wine; beer could also be shown to compete with wine. However, such evidence does not reveal whether the relationship is direct or indirect. More would need to be shown in such a case to establish that distilled beverages and beer are directly competitive or substitutable with respect to each other in that market.

  11. In our view, it is also the case that quantitative analyses, while helpful, should not be considered necessary. In examining the Korean market, a determination of the precise extent of the competitive overlap is complicated by the fact that, as the 1987 and 1996 panels noted in the Japan � Taxes on Alcoholic Beverages I and II, the intervention of government policies can cause distortions, including understatement, of the quantitative extent of the competitive relationship. Indeed, there must be some concern that a focus on the quantitative extent of competition instead of the nature of it, could result in a type of trade effects test being written into Article III cases. That is, if a certain degree of competition must be shown, it is similar to showing that a certain amount of damage was done to that competitive relationship by the tax policies in question. The Appellate Body stated:
  12. Moreover, it is irrelevant that the "trade effects" of the tax differential between imported and domestic products, as reflected in the volumes of imports, are insignificant or even non-existent, Article III protects expectations not of any particular trade volume but rather of the equal competitive relationship between imported and domestic products. 356

  13. The question for us to decide is whether in Korea the domestic and imported products are directly competitive or substitutable. This requires evidence of the direct competitive relationship between the products, including, in this case, comparisons of their physical characteristics, end-uses, channels of distribution and prices. 357
  14. 2. Evidentiary issues

    (i) Cross-price elasticity

  15. The Appellate Body approved the panel's decision in Japan � Taxes on Alcoholic Beverages II to look not only at products' physical characteristics, common end-uses, and tariff classifications, but also at the market place. It approved the examination of the economic concept of "substitution" as one means of examining the relevant markets. The use of cross-price elasticity of demand was approved but it was specifically noted that it is not the decisive criterion. 358 While a high degree of cross-price elasticity of demand would tend to support the argument that there is a direct competitive relationship, it is only one evidentiary factor. If there is a high quantitative level of competition between products, it is likely that the qualitative nature of the competition is direct. However, the lack of such evidence may be due to the governmental measures in question. As noted, both panels in Japan � Taxes on Alcoholic Beverages I and II made the observation that government policies can influence consumer preferences to the benefit of the domestic industry. It was stated that:
  16. a tax system that discriminates against imports has the consequence of creating and even freezing preferences for consumer goods. In the Panel's view, this meant that the consumer surveys in a country with such a tax system would likely understate the degree of potential competitiveness between substitutable products. 359

    This is particularly a problem if the products involved are consumer items that are so-called experience goods which means that consumers tend to purchase what is familiar to them and experiment only reluctantly. This issue will be discussed further below. Thus the question is not of the degree of competitive overlap, but its nature. Is there a competitive relationship and is it direct? It is for this reason, among others, that quantitative studies of cross-price elasticity are relevant, but not exclusive or even decisive in nature.

    (ii) Evidence from outside the Korean market

  17. Other elements of evidence besides cross-price elasticity are relevant to the analysis. In our view, another element of relevant evidence is the nature of competition in other countries. We are mindful of the admonition of the Appellate Body in the case of Japan -- Taxes on Alcoholic Beverages II, that these disputes must be evaluated on a case-by-case basis taking into account the conditions in the market in question. However, as we are looking at the nature of competition in a market that previously was relatively closed and still has substantial tax differentials, such evidence of competitive relationships in other markets is relevant. Similarly, we consider it relevant as to how Korean manufacturers of soju are marketing their beverages outside Korea. According to Korea, the panel should strictly limit its view to what happens in the Korean market place. Nothing that happens outside Korea can be considered relevant in determining whether the products in question are directly competitive or substitutable within Korea. Also, Korean manufacturer's export marketing efforts are to be given no weight. In our view, this is an overly restrictive approach and does not accord with market realities. It is true that the question to be answered concerns the Korean market, but that in no way implies that what happens in regard to the same products outside of the Korean market is irrelevant to assessing the actual and potential market conditions within Korea.
  18. In some cases, the only market evidence available may be with respect to non-domestic markets due to the tax, duty and regulatory structure in the country in question. Sometimes, the only reasonable manner of assessing what the market situation would be absent such policy structures is to look at other markets and make a judgement as to whether the same patterns could prevail in the case at hand. However, we do not need to decide such a stark issue in this case; there is considerable evidence available as to what is taking place within the Korean market. We do not need, in this case, to give substantial weight to conditions in markets outside Korea, but such factors are relevant and should be taken into consideration in determining the nature of the competitive relationships involved here. 360 As noted above, the panels stated in Japan � Taxes on Alcoholic Beverages I and II that systems of government tax policies may have the effect of freezing consumer preferences in place in favour of the domestic product. To completely ignore such evidence from other markets would require complete reliance on current market information which may be unreliable, due to its tendency to understate the competitive relationship, because of the very actions being challenged. Indeed, the result could be that the most restrictive and discriminatory government policies would be safe from challenge under Article III due to the lack of domestic market data.
  19. (iii) Potential competition

  20. Another question that has arisen is the temporal nature of the assessment of competition. All parties agree that the Panel should look at both actual and potential competition. However, Korea argues that potential competition does not include future competition. They argue that at most, the Panel must make a "but for" decision. That is, but for the taxes would the products be directly competitive or substitutable at the present moment. Korea further argues that if the market changes, then the complainants are within their rights to raise the matter again at some time in the future.
  21. Korea's arguments in this regard are not persuasive. We, indeed, are not in the business of speculating on future behaviour. However, we do not agree that any assessment of potential competition with a temporal aspect is speculation. It depends on the evidence in a particular case. Panels should look at evidence of trends and changes in consumption patterns and make an assessment as to whether such trends and patterns lead to the conclusion that the products in question are either directly competitive now or can reasonably be expected to become directly competitive in the near future. It is not evident why such an assessment is any more speculative in nature than the "but for" analysis itself. Such an analysis also requires making an assessment about what would happen in the theoretical case of the tax differentials being removed. In our view, the approach suggested by Korea is too static. It would be a profoundly troubling development in GATT/WTO jurisprudence if Members were forced to return to dispute settlement on the same laws over and over only because the market in question had not yet changed enough to justify a finding at a particular moment. Such an interpretation would be contrary to the settled law that competitive expectations and opportunities are protected. 361 As noted above, the Appellate Body in Japan -- Taxes on Alcoholic Beverages II stated:
  22. Article III protects expectations not of any particular trade volume but rather of the equal competitive relationship between imported and domestic products. 362

    According to the 1949 Working Party Report on Brazil Internal Taxes:

    [The majority of the working party] argued that the absence of imports from contracting parties during any period of time that might be selected for examination would not necessarily be an indication that they had no interest in exports of the product in affected by the tax, since their potentialities as exporters, given national treatment, should be taken into account. 363

  23. Similarly, the panel in the 1987 case of United States -- Taxes on Petroleum and Certain Imported Substances stated:
  24. For these reasons Article III:2, first sentence, cannot be interpreted to protect expectations on export volumes; it protects expectations on the competitive relationship between imported and domestic products. 364

    The Shorter Oxford English Dictionary defines "potential" as follows:

    potential 1. possible as opposed to actual; capable of coming into being; latent. 365

    The same dictionary defines "expectation" as follows:

    expectation 1. The action of waiting for someone or something. . . .4. A thing expected or looked forward to. 366

  25. The interpretation proposed by Korea is not consistent with the standard meaning of the terms in question both of which clearly have a temporal element to their definitions. We will not attempt to speculate on what could happen in the distant future, but we will consider evidence pertaining to what could reasonably be expected to occur in the near term based on the evidence presented. How much weight to be accorded such evidence must be decided on a case-by-case basis in light of the market structure and other factors including the quality of the evidence and the extent of the inference required. To try to limit the inquiry as to what might happen this instant were the tax laws changed would involve us in making arbitrary distinctions between expectations now and those in the near future. Obviously, evidence as to what would happen now is more probative in nature than what would happen in the future, but most evidence cannot be so conveniently parsed. If one is dealing with products that are experience based consumer items, then trends are particularly important and it would be unrealistic and, indeed, analytically unhelpful to attempt to separate every piece of evidence and disregard that which discusses implications for market structure in the near future.

To continue with Products at issue


346 Ad Article III has equal stature under international law as the GATT language to which it refers, pursuant to Article XXXIV. See also Appellate Body Report on Japan -- Taxes on Alcoholic Beverages II, supra, at p. 24.

347 If the products are determined to be "like" then any taxation of the imported product in excess of the domestic product is prohibited. There is no de minimis possibility as there is under the second sentence where Ad Article III provides only that they must be "similarly taxed."

348 Panel Report on Japan -- Taxes on Alcoholic Beverages II, supra., at para. 6.22. This finding was not modified or reversed by the Appellate Body. See, Appellate Body Report, supra., at p. 23.

349 Appellate Body Report on Japan -- Taxes on Alcoholic Beverages II, supra., at p. 25.

350 EPCT/A/PV/9, at p. 7.

351 E/Conf.2/C.3/SR.11,p.1 and Corr. 2.

352 Ibid. at p. 3.

353 E/Conf.2/C.3/SR.40 at p. 2.

354 To follow on from these hypotheticals, it can be noted that some large power generation facilities may be convertible from coal to fuel oil or a series of power stations in a particular market could be set for replacement and alternative fuel sources might be under consideration. In such instances there may be direct competition. Hence the statements of the delegates that a review of the specific market structure is necessary to determine the nature of the competition.

355 Panel Report on Japan -- Taxes on Alcoholic Beverages II, supra., at para. 6.30.

356 Appellate Body Report on Japan -- Taxes on Alcoholic Beverages II, supra., at p. 16. Obviously, the expectation of competitive conditions must be a reasonable one.

357 These are the categories of evidence we have examined in this case to determine whether the products in question are directly competitive or substitutable. Obviously, the availability and probative value of categories of evidence may differ from case to case.

358 Appellate Body Report on Japan -- Taxes on Alcoholic Beverages II, supra., at p. 25.

359 Panel Report on.Japan � Taxes on Alcoholic Beverages II, supra., at para. 6.28, citing, Panel Report on Japan - Customs Duties, Taxes and Labelling Practices on Imported Wines and Alcoholic Beverages, adopted on 10 November 1987, BISD 34S/83, at para. 5.9.

360 See, Appellate Body Report on European Communities � Customs Classification of Certain Computer Equipment, supra., at para. 93.

361 We also note that a requirement of substantial current market presence would be a particularly high hurdle for less wealthy exporters.

362 Appellate Body Report in Japan Alcoholic Beverages II, supra., at p. 16 (emphasis added).

363 Brazilian Internal Taxes, BISD II/181 at p. 185, para. 16 (emphasis added).

364 United States -- Taxes on Petroleum and Certain Imported Substances, BISD 34S/136, at p. 158, para. 5.1.9 (emphasis added). We do not consider it a meaningful distinction on this issue that this quote refers to the first sentence of Article III:2 rather than the second sentence. To find otherwise would be to imply that one could refer to expectations with respect to determining the market conditions for examining like products but not for examining whether products are directly competitive or substitutable. Given that like products are a subset of directly competitive or substitutable products, this would be illogical.

365 L. Brown (ed), The New Shorter Oxford English Dictionary (Clarendon Press, 1993), Vol. 2 at p. 2310 (emphasis in the original).

366 Ibid. Vol. 1 at p. 885 (emphasis in original).