D. "so as to afford protection to domestic production"

1. Overview

389. The European Communities first notes that in Japan - Taxes on Alcoholic Beverages II, the Appellate Body provided the following approach for establishing whether dissimilar taxation of directly competitive or substitutable products is applied "so as to afford protection to domestic production":

[W]e believe that an examination in any case of whether dissimilar taxation has been applied so as to afford protection requires a comprehensive and objective analysis of the structure and application of the measure in question on domestic as compared to imported products. We believe it is possible to examine objectively the underlying criteria used in a particular measure, its structure, and its overall application to ascertain whether it is applied in a way that affords protection to domestic products.

Although it is true that the aim of a measure may not be easily ascertained, nevertheless its protective application can most often be discerned from the design, architecture and revealing structure of a measure. The very magnitude of the dissimilar taxation in a particular case may be evidence of such protective application .� Most often, there will other factors to be considered as well. In conducting this inquiry, panels should give full consideration to all the relevant facts and all the circumstances in any given case. ²⁰³

390. The European Communities goes on to state that an example of how this approach is to be applied is provided by the analysis made by the Appellate Body in Canada � Periodicals. ²⁰⁴ In that case, the Appellate Body concluded that the "design and the structure" of the measure was to afford protection to domestic production on the basis of the following factors:

1. the magnitude of the tax differential;
2. several statements by the Canadian authorities recognising that the protection of domestic production was one of the measures' policy objectives; and
3. the demonstrated actual protective effect of the measures.

391. The European Communities points out that similarly, in Korea � Taxes on Alcoholic Beverages, ²⁰⁵ the panel based its finding that the measures afforded protection to domestic production on the following elements:

1. the magnitude of the tax differentials;
2. the structure of Korea's Liquor Tax Law, and more specifically the lack of rationality of the product categorisation; and
3. the fact that there was virtually no imported soju, so that the beneficiaries of the measure were almost exclusively domestic producers.

392. Chile first responds that given that the taxation is not dissimilar, it is not surprising that the European Communities likewise fails to demonstrate the third element of a violation of Article III -- that the dissimilar taxation operates so as to afford protection to domestic production. In fact, since the European Communities needs to demonstrate all three elements of a violation of Article III:2, second sentence, the Panel could forego a decision on the first and third elements in the interest of judicial economy. Considerations of judicial economy may be especially pertinent here, since a system that does not discriminate based on nationality and uses neutral, objective standards cannot be considered protectionist in any event.
393. Chile also replies that there is no precedent for holding inconsistent with GATT 1994 a system of taxation that does not discriminate based on nationality and that employs strictly objective criteria for any differentiation in taxes. Indeed, the same panels that condemned the Japanese system � and even the European Communities itself in arguing those cases, observed that distinctions based on objective and neutral criteria are permissible under Article III:2.
394. Chile further states that Article III does not prohibit a tax or regulation simply because, as a result of the application of objective criteria, some or even many imported products are by some measures treated worse than some or many like or competing domestic products. The drafting history of Article III makes this clear. In the latter stages of the drafting of what became Article III of the GATT, the negotiating Sub-Committee responsible for this Article reported that:

The Sub-Committee was in agreement that under the provisions of Article 18 [Article III of the GATT], regulations and taxes would be permitted which, while perhaps having the effect of assisting the production of a particular domestic product (say, butter) are directed as much against the domestic production of another product (say, domestic oleomargarine) of which there was a substantial domestic production as they are against imports (say, imported oleomargarine). ²⁰⁶

395. In the view of Chile, the logic of this unanimous understanding of the negotiators is compelling. All WTO Members make tax and regulatory distinctions that fall unevenly by some measures among products that might be considered like or directly competitive or substitutable in the sense of Article III. Sometimes these distinctions will mean that many domestic products will, by some measures, be taxed or regulated more favorably than many like or competing imports. But that is not a violation of Article III, where criteria for the distinctions are objective and neutral.
396. Chile also argues that past panels have repeatedly acknowledged these considerations, noting also that Article III is not intended to be used as a tool for harmonizing the tax systems of the WTO Members, ²⁰⁷ and that WTO Members retain almost complete freedom with respect to domestic policies that do not distinguish between the origin or destination of goods. ²⁰⁸ In United States - Malt Beverages, the panel noted that:

The purpose of Article III is not to harmonize the internal taxes and regulations of contracting parties, which differ from country to country. ²⁰⁹

397. Chile further argues that in Japan � Taxes on Alcoholic Beverages I, the panel affirmed this principle with respect to Article III:2, noting that this Article "prohibits only discriminatory or protective taxation of imported products but not the use of differentiated taxation methods as such ..." ²¹⁰ The panel went on to say "that Article III:2 does not prescribe the use of any specific method or system of taxation ..." ²¹¹ This position was also endorsed by the Appellate Body in Japan - Taxes on Alcoholic Beverages II. ²¹²
398. Chile notes that the EC argument against the Chilean system ignores these precepts of Article III, and instead asks the Panel to strike down an objective and neutral tax system merely because a result of the application of that system is that those EC beverages of high alcohol content (and high price) will face higher taxes than those Chilean beverages (primarily certain kinds of pisco) that are of relatively low alcohol strength (and low price). In making this argument with respect to the New Chilean System, the European Communities ignores that many European products, including those most similar to pisco, will benefit from the same lower rates of tax, while other European products could be adapted for the Chilean market merely by diluting with water the current relatively high strength of the products -- as the European Communities has suggested could be done by pisco producers. Equally, the European Communities ignores that under the New Chilean System many Chilean distilled spirits, including Chilean whisky, brandy and gin and very substantial quantities of pisco that are marketed at relatively high prices and alcohol strength, will face the highest rate of taxation.
399. Chile concludes that the New Chilean System thus presents precisely the kind of regulatory system that Article III is not intended to condemn:

1. there is no distinction in taxation based on origin or on type;
2. many imports can benefit from the lowest tax and all others could be easily diluted for that purpose;
3. many domestic products of Chile will face the highest tax rates under the New Chilean System; and
4. the objective standards mean that foreign producers can readily adapt their products to lower their taxes by a simple process.

400. Chile adds that the Appellate Body has properly noted that "Article III protects expectations not of any particular trade volume but rather of the equal competitive relationship between imported and domestic products". ²¹³ Foreign and domestic producers have an equality of competitive opportunities, as they have an equal opportunity to adapt their production, if they so choose, in the way implicitly preferred under the New Chilean System, i.e., by reducing alcohol content.

2. Transitional System

401. The European Communities argues that the following facts and circumstances regarding the "design, structure and architecture" of the transitional system, as well as its "overall application on domestic as compared to imported products" constitute evidence that it is applied "so as to afford protection" to Chile's domestic production:

1. the very magnitude of the tax differentials;
2. the absence of any legitimate policy purpose for applying a lower tax rate to pisco;
3. the fact that pisco is, by law, a domestic product;
4. the fact that pisco accounts for the vast majority of the Chilean production of distilled spirits;
5. the fact that almost all whisky, as well as a significant proportion of the main liquors falling within the category of "other spirits" are imported; and
6. the admission by the Chilean authorities that the adoption of Law 19,534 was necessary because the system in place was "discriminatory".

402. In the view of the European Communities, in Japan - Taxes on Alcoholic Beverages II, the Appellate Body observed that the very magnitude of the difference in taxation between Japanese shochu and other distilled spirits was sufficient evidence to conclude that the Japanese Liquor Tax Law was applied so as to afford protection to the domestic production of shochu. ²¹⁴
403. The European Communities then argues that the same is true in the present dispute. The tax differential between pisco and whisky is so large that it can only be explained by the purpose to afford protection to pisco.
404. The European Communities also points out that in Japan - Taxes on Alcoholic Beverages II, the taxes in dispute were specific taxes per litre of beverage instead of ad valorem taxes. This makes it extremely difficult to compare the tax differentials at issue in the two cases. Nevertheless, it is worth noting that, according to the complainants, in Japan - Taxes on Alcoholic Beverages II the differences in specific taxes translated into a difference in tax/price ratios between shochu and whisky of between 10 % and 32 % of their retail sales price. ²¹⁵
405. The European Communities further notes that according to the explanations provided by Chile during the consultations, the tax differentials between pisco, on the one hand, and whisky and "other spirits", on the other hand, purport to serve two different objectives:

1. Protection of public health: it was sought to create a disincentive for the consumption of spirits with a higher alcohol degree, in order to reduce the negative social impact associated with excessive alcohol consumption;
2. Fiscal policy: those liquors, which are subject to higher taxes, are those with the characteristic of luxury goods. The higher tax applied to those goods fulfils the objective that indirect taxes apply in a differentiated manner to luxury goods as a mechanism of income redistribution. Those taxes, known as "luxury taxes", are applied also to other products, both in Chile and in other countries.

406. The European Communities then maintains that it is obvious, however, that the application of a much lower rate to pisco than to whisky and "other spirits" cannot be justified by either of those two alleged objectives.
407. The European Communities further explains that in the first place, pisco does not always have a lower alcohol content than whisky or "other spirits". Approximately 10 % of the sales of pisco have 40° or more. Moreover, the remaining 90 % of pisco has between 30° and 35° , i.e., only 5 to 10 degrees less than most imported spirits. It is manifestly disproportionate to attach to such a small difference in strength a tax differential of as much as 28 to 45 percentage points ad valorem. Finally, the category of "other spirits" includes many liquors (e.g., most liqueurs) that have a lower alcohol content than pisco.
408. The European Communities then argues that the Chile claim that the application of a lower rate to pisco is justified for reasons of income distribution is also spurious. Pisco is not inherently less expensive than other spirits. Moreover, there is evidence that pisco is consumed by all social groups and not just by the less affluent. ²¹⁶ Similarly, whisky and the other liquors are widely consumed across social boundaries. ²¹⁷ In any event, previous panels have established that this type of consideration cannot provide a valid justification for taxing dissimilarly two directly competitive or substitutable products.
409. In support of this argument, the European Communities points out that in Japan � Taxes on Alcoholic Beverages I, Japan claimed that the tax differentials at issue in that case were not contrary to Article III:2 because they were based on "... the tax-bearing ability on the part of consumers of each category of liquor". The panel rejected this defence in the following terms:

The Panel was of the view that the use of product and tax differentiations with the view of maintaining or promoting certain production and consumption patterns could easily distort price-competition among like or directly competitive products by creating price differences and price-related consumer preferences which would not exist in case of non-discriminatory internal taxation consistent with Article III:2. The Panel noted that the General Agreement did not make provision for such a far-reaching exception to Article III:2 and that the concept of "taxation according to tax bearing ability of prospective consumers" of a product did not offer an objective criterion because it relied on necessarily subjective assumptions about future competition and inevitably uncertain consumer responses ... ²¹⁸

410. The European Communities further notes that, in Japan � Taxes on Alcoholic Beverages II, the Appellate Body noted that Japanese shochu was insulated from imports of shochu originating in Korea and other third countries by tariff barriers. As a result, by applying a lower tax rate to shochu, Japan favoured exclusively domestic production. ²¹⁹
411. The European Communities then argues that Chilean pisco is even more effectively isolated from imports of like products. "Pisco" is a geographical denomination reserved by law to certain spirits produced in certain regions of Chile. Thus, the tax advantage provided to pisco benefits exclusively domestic products, not merely de facto (as in Japan � Taxes on Alcoholic Beverages II) but also de jure.
412. The European Communities goes on to claim that it may be estimated that pisco accounts for approximately 80 % of the Chilean production of distilled spirits, as shown in Tables 18 and 19 above. For comparison, in Japan � Taxes on Alcoholic Beverages II, sales of shochu represented, according to the complainants, "almost 80 %" of Japan's total production of distilled spirits. ²²⁰ Therefore, by applying a lower tax rate to pisco, Chile affords protection not just to its domestic production of pisco but more generally to the majority of its domestic industry of distilled spirits.
413. In the view of the European Communities, whereas pisco is an exclusively domestic product, approximately 95 % of whisky, the main spirit after pisco, as well as a substantial proportion of the liquors falling within the category of "other spirits" are imported. ²²¹
414. The European Communities further notes that as stated by the Appellate Body in Japan � Taxes on Alcoholic Beverages II ²²² in order to establish that a tax measure is applied "so as to afford protection to domestic production", it is not necessary to show that the legislators had the subjective intent of affording such protection. On the other hand, it is evident that where the existence of that intent can be clearly established, it may constitute additional evidence that the measures in dispute are applied in a protective manner.
415. The European Communities adds that in Canada - Periodicals, the Appellate Body relied upon some statements by the Canadian Government regarding the policy objectives of a measure as one of the factors supporting the finding that the measures at issue were applied "so as to afford protection to domestic production".²²³
416. The European Communities then claims that the Chilean Government (through its Minister of Foreign Affairs) as well as many legislators of all political parties recognised openly that the tax system in place until November 1997 had to be amended because it was "discriminatory" and favoured the pisco producers. The transitional regime provided in Law 19,534 will prolong that system into the year 2000. Consequently, the admission by the Chilean authorities that the system in force until November 1997 afforded protection to the pisco producers, also involves an admission that the Transitional System will continue to do so.
417. Chile responds that the purpose of the Transitional System was to allow time for domestic and foreign producers and distributors to prepare for the changes under the New Chilean System, and also to begin phasing in immediate benefits for whisky producers.
418. Furthermore, in Chile's view, pisco and the imported products are not directly competitive or substitutable and, therefore, the Panel need not reach this issue with respect to the Transitional System. Chile also indicates that the Transitional System is an issue of little practical consequence, as it will expire soon.

To continue with New Chilean System

²⁰³ Appellate Body Report on Japan - Taxes on Alcoholic Beverages II, supra., p. 29.

²⁰⁴ Appellate Body Report on Canada - Periodicals, supra., pp. 30-32.

²⁰⁵ Panel Report on Korea - Taxes on Alcoholic Beverages, supra., paras 10.101-10.102.

²⁰⁶ Reports of the Committees and Principal Sub-Committees, supra.

²⁰⁷ See Panel Report on Japan - Taxes on Alcoholic Beverages I, supra.

²⁰⁸ Panel Report on United States - Malt Beverages, supra., para. 5.25 and Panel Report on United States - Taxes on Automobiles, supra., para. 3.108.

²⁰⁹ Panel Report on United States - Malt Beverages, supra., para. 5.71.

²¹⁰ Panel Report on Japan - Taxes on Alcoholic Beverages I, supra., para. 5.9 b).

²¹¹ Ibid., para. 5.9 c).

²¹² See Appellate Body Report on Japan - Taxes on Alcoholic Beverages II, supra., p. 26.

²¹³ Ibid., p.16 (citations omitted).

²¹⁴ Ibid., p. 29.

²¹⁵ See Panel Report on Japan - Taxes on Alcoholic Beverages II, supra., para. 4.159.

²¹⁶ The European Communities refers to the 1997 SM survey, p. iv (EC Exhibit 21).

²¹⁷ Ibid.

²¹⁸ Panel Report on Japan - Taxes on Alcoholic Beverages I, supra., para. 5.13.

²¹⁹ Appellate Body Report on Japan - Taxes on Alcoholic Beverages II, supra., p. 31.

²²⁰ Panel Report on Japan - Taxes on Alcoholic Beverages II, supra., para. 4.95.

²²¹ Ibid.

²²² Appellate Body Report on Japan - Taxes on Alcoholic Beverages II, supra., p. 27.

²²³ Appellate Body Report on Canada - Periodicals, supra., pp. 30-31.