(b) Legislative Objective (Cont.)

470. Chile further explains that consumer health is one of the considerations that led to higher taxation of higher alcohol strength beverages in Chile, as Chile assumes is the case in other countries, including the European Communities and the United States. Health is not the only objective however, or Chile would have imposed still higher taxes on beverages over 40� alcohol, a step that would have led to even higher taxation of European whisky.
471. Chile then maintains that increasing the ad valorem tax rate as alcohol content increases has both health benefits (by discouraging consumption of high alcohol products) and "social" benefits (because it makes the tax system more progressive). Chile points out these considerations to enhance the Panel's understanding of the Chilean law, but Chile does not claim an Article XX exception, which in any case is unnecessary given the conformity of Chile's law with Article III.
472. Chile states that doubtless, different beginning and ending points for the tax might have been chosen, especially if health had been the only motivating factor for the New Chilean System. However, Chile was also seeking to reduce the tax on whisky in response to the trade complaints of the European Communities, to reform the old system based on type of distilled spirits and to maintain both gross tax revenues, and to avoid making the system more regressive in the distribution of the relative tax burden on different income groups in Chile.
473. Chile further explains that the system finally enacted addressed all these objectives. Most importantly for purposes of this proceeding, the New Chilean System also conforms with Article III. The New Chilean System does not discriminate between domestic and foreign products. The identical scale of taxation, based entirely on objective criteria is applied to all products, whether or not those products are like, directly competitive, or substitutable.
474. The European Communities contends that Chile's manifest inability to reconcile the tax distinctions with the stated policy objectives of the New Chilean System provides further confirmation that, in reality, those distinctions are applied with the exclusive purpose to afford protection to its domestic production.
475. In the view of the European Communities, in essence, Chile argues that the policy objectives of its New Chilean System are none of the EC's business and should not be examined by this Panel. The European Communities has acknowledged that it is for each Member to choose its own taxation objectives. At the same time, it is obvious that the inadequacy of a tax system to achieve its self-stated objectives is highly probative that the system is in fact being applied so as to afford protection to domestic production. This type of analysis is part of the examination of the "design, the architecture and the revealing structure" of tax measures which panels have been enjoined to conduct by the Appellate Body. ²³⁵
476. The European Communities explains that its intention in making this argument was simply to demonstrate that the New Chilean System is objectively inapt to serve the taxation goals stated by Chile itself. Additional confirmation of this is provided by the fact that, to the EC's best knowledge, no other country in the world applies the same system, even though many countries pursue similar taxation objectives. The inadequacy of the New Chilean System to achieve Chile's purported policy goals evidences that, in reality, that tax system has been designed with the exclusive purpose to continue to afford protection to Chile's domestic production of spirits. The European Communities does not exclude, however, that there may be other taxation methods which permit Members to attain the policy goals stated by Chile without affording protection to Chile's domestic production.
477. The European Communities further claims that it is only in response to a question from the Panel that Chile has eventually acceded to explain in some detail its purported taxation objectives. The response furnished by Chile fully explains its reluctance to let the Panel address this question.
478. The European Communities goes on to state that Chile acknowledges that the tax differentials cannot be explained by health protection reasons, because in that case the tax rate should have continued to increase above 40° . To this, it should be added that, if health considerations played a genuine role, alcohol contained in pisco would not be taxed less than alcohol contained in low strength liqueurs. Furthermore, health considerations cannot explain the huge tax differential between spirits of 35° and spirits of 39° .
479. In the view of the European Communities, Chile also admits that the tax distinctions are not necessary in order to preserve the previous level of tax revenues. That objective could have been achieved as well by applying a flat ad valorem rate at an appropriate level on all alcoholic beverages. Or, in case the concern with health protection was real, by applying a flat specific rate on alcohol content, also at an appropriate level.
480. According to the European Communities, in view of the above, it must be concluded that the very peculiar features of the New Chilean System are considered necessary by Chile in order to achieve the third policy objective mentioned in its response to the Panel, namely the objective that the new system should not be more "regressive" than the previous one. As shown below, this justification is spurious.
481. The European Communities then argues that the only alternative to the New Chilean System which appears to have been considered by Chile's Ministry of Finance is the application of a pure ad valorem rate at 34% (hereafter, the "Alternative System"). Chile does not argue that the Alternative System would be "regressive", in the sense that the poor would pay a higher share of their income than the rich. Rather, Chile's contention is that the Alternative System would be less "progressive" than the New Chilean System, because the poor would contribute a larger portion of the tax proceeds. The difference, nevertheless, is very small. According to the estimates of the Ministry of Finance, under the New Chilean System the three lowest income quintiles would pay between 24.2 % and 24.8 % of the total tax revenue. Under the Alternative System, those quintiles would contribute between 25.4 % and 26.2 % of the total tax revenue. ²³⁶
482. The European Communities further argues that at any rate, Chile's contention that the chosen system is less "progressive" is based on two erroneous assumptions.
483. The European Communities first explains that Chile assumes that there is a direct correlation between alcohol content and price. Yet the European Communities has already demonstrated that there is no such correlation. Chile's own data provide further confirmation of this. Contrary to Chile's claims, it is not only certain imported "speciality liqueurs" which are more expensive than high strength spirits. One of the tables given by Chile shows that, for example, pisco of 35° is more expensive than aguardiente of 50° , brandy of 38° and rum of 40° and as expensive as gin of 40° .
484. The European Communities goes on to state that on Chile's own construction, even if there existed now a correlation between alcohol content and price (quod non), such correlation would be broken as a result of the systematic dilution of high strength spirits in order to escape the highest tax rates (unless Chile is arguing that diluted premium Scotch will be sold at the same price as cheap pisco corriente). Thus, eventually the New Chilean System would be as "regressive" as a pure ad valorem system. Further, if imported high strength spirits were diluted to 35° , the New Chilean System could not, unlike the Alternative System, achieve the objective of maintaining the same level of tax revenues.
485. In the view of the European Communities, the second mistaken assumption is that the consumption patterns of the different income groups are not affected by the level of the taxes applied to each type of spirit, and therefore, by their level of prices. In other words, Chile assumes that the tastes of the poor will remain forever different from the tastes of the rich. As admitted by Chile itself, that assumption is "arbitrary".
486. The European Communities explains that if the Alternative System appears to be more "regressive" than the New Chilean System in the analysis made by the Ministry of Finance, it is simply because the burdens on each income group are calculated on the basis of their spending patterns under the old tax system in force in 1996, when whisky was taxed at 70 % and pisco at 25 %. In view of that tax differential, it is hardly surprising if in 1996 the two top income quintiles accounted for a large portion of the consumption of whisky. If in 1996 the taxes on whisky (and consequently the prices) had been lower, consumption of whisky by the remaining income quintiles would have accounted for a higher percentage.
487. The European Communities concludes that, in sum, Chile's attempted justification rests on purely circular reasoning. Whisky is taxed at a higher rate because it is considered to be the drink of the rich. Yet, the reason why it is assumed to be the drink of the rich is because in the past the poor drank less whisky compared to pisco than the rich. But one of the reasons why the poor drank less whisky compared to pisco than the rich was precisely because whisky was taxed much more heavily than pisco.
488. The European Communities further argues that the same type of argument now made by Chile was raised by Japan in Japan � Taxes on Alcoholic Beverages I. It was rejected by the panel in categorical terms:

The Panel noted the Japanese submission that � generally "taxes on liquors are levied according to the tax bearing ability on the part of consumers of each category of liquor". 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 differences which would not exist in case of non-discriminatory internal taxation consistent with Article III:2. The Panel noted that the General Agreement does 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 unnecessarily subjective assumptions about future competition and inevitably uncertain consumer responses. ²³⁷

489. In conclusion, the European Communities states that, in sum, the New Chilean System that has the clear effect of favouring pisco, the local spirit, over other types of spirits imported from the European Communities and other Members. Furthermore, the "structure", the "design" and the "architecture" of the system cannot be rationally explained except as being pre-ordained to achieve precisely that protective effect. The inescapable conclusion is that the New Chilean System is applied "so as to afford protection to domestic production", contrary to Chile's obligations under GATT Article III:2.

(c) Percentage of Less Taxed Products in Domestic Products

490. The European Communities claims that as shown in Table 3 above, approximately 90 % of pisco is bottled at 35° or less and is therefore eligible for the lowest applicable tax rate of 27 % ad valorem. Furthermore, there is nothing that prevents Chile's pisco manufacturers from replacing their current production of pisco of more than 35° by pisco bottled at a lower strength so as to benefit from the lowest tax rate.
491. In the view of the European Communities, the only other spirit types with a significant volume of sales that may qualify for the lowest tax rate are liqueurs and aguardiente, virtually all of which are domestically produced. It can be estimated that, together, pisco, liqueurs and aguardiente of 35° or less may account for as much as 75 % to 85 % of Chile's total production of distilled spirits. Thus, the New Chilean System will continue to favour a large majority of Chile's production of distilled spirits.
492. The European Communities argues that finally, Chile has failed to rebut the EC's evidence showing that the New Chilean System is applied "so as to afford protection to domestic production". Under the New Chilean System, more than 95 % of imports will be taxed at the highest tax rate. In contrast, between 75 and 85 % of domestic spirits (including 90 % of pisco) will be taxed at the lowest rate. Moreover, sales of domestic spirits with a minimum alcohol content of more than 35° represent only 6 % of domestic production. ²³⁸ Thus, potentially nearly all domestic production qualifies for the lowest tax rate. The mere fact that some domestic products fall within the more taxed category is not sufficient, in light of previous panel reports, to exclude a finding of protective application. What really matters is that the vast majority of Chile's domestic production falls within the most favoured category.
493. The European Communities notes that Chile claims that domestic production accounts for 70 % of the spirits subject to the highest tax rate. That figure, however, is deceptive. The supporting tables ²³⁹ shows that only 26 % of domestic production consists of spirits with a minimum alcohol content of more than 39° . Furthermore, domestic brands of high strength spirits of more than 39° such as gin, vodka, rum or whisky are generally low quality products positioned at the low end of the market. So-called "Chilean whisky" is a case in point. According to the International Wine and Spirits Record, the largest part of Chile's "whisky" production is used for re-filling bottles of imported brands. ²⁴⁰ This is not the type of "domestic production" which a Government may be interested in protecting.
494. Chile replies that in assessing effects of the New Chilean System, the European Communities asks the Panel to look only at existing EC production that would face high taxes and existing Chilean production that would face relatively lower taxes. As just noted, that ignores both the EC production that would face low taxes if exported to Chile and the substantial Chilean production that will face relatively high taxes. ²⁴¹ The European Communities already produces grappa, for example, a spirit distilled from grapes that is quite similar to pisco, and it could readily be marketed in Chile, if the EC producers so chose. In addition, nothing under Chilean law prevents the EC producers of spirits from diluting their products to a lower alcohol strength and commercializing them in Chile provided that they comply with the provisions of the Chilean law regarding health and food. In that very real sense, the European Communities has the equality of competitive opportunities which it claims to seek. Very simply, the New Chilean Law applies to and affects domestic producers of spirits in the same manner as it applies to and affects importers of alcoholic beverages. It in no way prevents foreign producers of spirits from importing any low alcohol content spirits benefiting from a lower level of taxation on the basis of their alcohol content.
495. The European Communities further responds that Chile also argues that the New Chilean System is "neutral" because there are some imports in the less taxed category. The actual fact, however, is that imports of spirits with a minimum alcohol content of 40° account for 95 % of imports. In practice, the only imported products which could benefit from the lowest tax rate in the New Chilean System are certain types of low strength liqueurs. ²⁴²
496. In the view of the European Communities, Chile's assertions to the effect that in previous cases the favoured product was always one that "could be only domestic" misrepresent the findings of those reports. For example, just like Chile in this case, Japan claimed that its tax system was "neutral" because shochu was not an "inherently" Japanese product. ²⁴³ Indeed, there were imports of shochu into Japan. ²⁴⁴ Furthermore, the panel accepted the evidence submitted by Japan according to which shochu was produced in substantial quantities outside Japan, in countries such as Korea, China, Singapore and even the United States. ²⁴⁵ Similarly, in Korea � Taxes on Alcoholic Beverages, the panel based its conclusion that the measures were protective on the fact that the current volume of imports of soju were very small, and not on the fact that soju was an "inherently" Korean product. ²⁴⁶
497. The European Communities continues to state that in the same vein, Chile argues that in United States � Malt Beverages, the small breweries exception was found to violate Article III:2 because "only small US breweries could qualify". This is a gross misrepresentation of the panel's findings. The panel did not condemn the small brewery exception because it was not available to foreign products, but because beer from small breweries is "like" beer from large breweries, and Article III:2, first sentence, does not tolerate any tax differential between "like" products:

The Panel further noted that the parties disagreed as to whether or not the tax credit in Minnesota were available in the case of imported beer from small foreign breweries. The Panel considered that beer produced by large breweries is not unlike beer produced by small breweries �. Therefore, in the view of the Panel, even if Minnesota were to grant the tax credits on a non-discriminatory basis ... there would still be an inconsistency with Article III:2, first sentence. ²⁴⁷

498. In the view of the European Communities, Chile's argument turns upside down the well-established principle that Article III is concerned with the protection of competitive opportunities and not of actual trade flows. ²⁴⁸ The thrust of that principle is that in order to establish a violation of Article III:2, it is not necessary to show that a measure has actually restricted imports. A violation of Article III:2 may be found even if there are no imports at all. It is sufficient to show that the measure may limit potential imports. Chile subverts this principle by arguing that the fact that actual imports are restricted is irrelevant, if potential imports of a different product are not.
499. Further, the European Communities states that Chile's argument does not take into account the specific nature of the products at issue. Spirits are not commodities. Spirits are "experience goods", ²⁴⁹ whose consumption is largely based on habit. For that reason, market penetration tends to be slow and requires considerable marketing efforts. It may require some time and advertising expenditure to convince a hardened pisco drinker to switch to whisky, just as it may require some time and advertising to convince a smoker of Camel to try Marlboro. Even though all distilled spirits and liqueurs are, by reason of their physical characteristics and potential end-uses, "directly competitive or substitutable" products, currently the main competitive threat to pisco comes from whisky and the other high strength spirits which are already present in the Chilean market. It could take many years before other (low strength) spirits which are currently not exported to Chile, or only so in small quantities, could represent a comparable threat for pisco. Thus, the New Chilean System does afford effective protection to pisco even if it does not protect pisco against potential imports of low strength spirits.
500. Chile further responds that the European Communities itself has made an analogy between type names such as whisky, vodka, shochu, etc, and brandnames, such as Camel or Marlboro cigarettes. The analogy is correct, at least insofar as the laws would prevent a whisky producer from calling his product vodka, just as the intellectual property laws of most countries would prevent Camel from calling its cigarettes Marlboros, or, for that matter, a sparkling wine producer from Italy or Chile calling its product Champagne in the European Communities.
501. According to Chile, the panels in the Korean and Japanese cases decided that tax distinctions based on such type distinctions are not permissible, if the two types of product are directly competitive or substitutable and if they are dissimilarly taxed, and if that dissimilar taxation creates a favoured group that is essentially all produced domestically. In other words, a distinction that may be perfectly acceptable, indeed mandated for purposes of marketing products under a certain name, cannot be used to justify tax or regulatory distinctions under Article III if the named products are otherwise directly competitive or substitutable and the other tests of an Article III violation are met.
502. Chile states that it does not contest that thesis. Indeed, distinctions based on intellectual property, or subjective classification systems could be very harmful to a developing country such as Chile if used to discriminate against Chilean products. Products that may qualify to be treated differently for intellectual property or similar purposes may still be directly competitive or substitutable for Article III purposes.
503. Chile claims that in this dispute, however, the European Communities is not simply asking the Panel to prohibit tax distinctions based on type names. Indeed, Chile has done that, eliminating all distinctions based on types of distilled spirits. The European Communities is asking this Panel to take the interpretation of Article III significantly farther so as to create an affirmative obligation for WTO members to ensure that their internal taxes accommodate precisely the same marketing standards that the European Communities insists are insufficient to make the products not directly competitive or substitutable. For the European Communities, it is not sufficient to abandon tax distinctions that are based on concepts such as types or brands. The European Communities argues that the tax laws and regulations must not have the effect of diminishing whatever marketing or intellectual property value is thought to be associated with the name or brand.
504. Chile further contends that this theory would go too far as a matter of interpretation of Article III. It is one thing to say that qualitative distinctions, even though sought by the industry and mandated by law or regulation, are not necessarily sufficient to justify tax or regulatory distinctions that otherwise would violate Article III. It is quite another thing to say that Article III carries an implicit obligation affirmatively to protect or enhance such an intellectual property right or subjective classification system.
505. In the view of Chile, primarily at the urging of the European Communities and other developed countries, the WTO now includes the TRIPS Agreement. The European Communities is free, if it wishes, to seek to negotiate further intellectual property rights and protections, such as a right to market under type names like whisky with high minimum alcohol requirements and immunity from adverse tax consequences flowing from that high alcohol content. But there is no basis for attributing such an obligation to Article III of GATT 1994.
506. Chile reiterates that in the meantime, under the New Chilean System, EC producers will have the same choice as Chilean producers and all third-country producers of alcoholic beverages. They can sell products that already are of low alcohol strength at the lowest rate of taxation. They can sell high alcohol products without dilution, but also without discrimination between domestic and imported product and, in the case of whisky, at a substantially lower tax rate than has prevailed. They can also elect to dilute their high alcohol products with a relatively small amount of water and similarly benefit from low taxation. Despite the EC's protestations. Chile cannot fail to note that dilution with water is hardly an onerous process for a product that, in the EC's words, is already "99% water and alcohol" and whose last stage of production is already dilution with water to the desired alcohol strength. Further, the European Communities itself has noted the large tendency for consumers themselves to dilute their product with water, ice, or various mixers.
507. Chile notes that, even after dilution, Chile's intellectual property laws will protect the EC's trademarks in Chile, whether those producers market their brands as whisky or some other product. Chile has a chart demonstrating various diluted alcoholic beverages on sale in Chilean supermarkets, using their brandnames and the alcoholic beverage with which they are mixed, as indicated in Table 38.

Table 38 ²⁵⁰

Diluted Alcoholic Beverages

Beverage	Alcohol Content	Brandname	Origin
Margarita	13	Careye's	Mexico
Vodka and peach	25	Artic	Italy
Vodka and coconut	25	Artic	Italy
Vodka and melon	25	Artic	Italy
Vodka and apple	25	Artic	Italy
Vodka and pineapple	30	Artic	Italy
Vodka and cranberry	30	Artic	Italy
Lemon rum	35	Finlandia	Finland
Pisco sour	22	La Serena	Chile
Pisco sour	22	Capel	Chile
Pisco sour	22	Control	Chile
Pina colada	20	Mitjans	Chile
Whisky and cola	8	Jack Daniel's	U.S.A.
Cola de mono	16	Vina Mendoza	Chile

To continue with Percentage of More Taxed Products in Imported Products

²³⁵ Appellate Body Report on Japan - Taxes on Alcoholic Beverages II, supra., p. 29.

²³⁶ The European Communities notes that the analysis made by Chile's Ministry of Finance obscures how small is the difference by focusing on the differences in the percentage by which the tax burden on the three lowest income quintiles increases in the New Chilean System and the Alternative System, compared to the old system.

²³⁷ Panel Report on Japan - Taxes on Alcoholic Beverages I, supra., para. 5.13.

²³⁸ Ibid.

²³⁹ Chile First Submission, Annex III.

²⁴⁰ EC Exhibit 19, p.43.

²⁴¹ Chile argues that local production accounts for 71.6% of the alcoholic beverages with alcohol content of more than 39� in 1995, which will be subject to the highest rate of taxation under the New Chilean System.

²⁴² The European Communities notes as regards grappa that it should be noted that in the European Communities its minimum alcohol content is 37.5 % vol. Therefore, it would have to be diluted in order to benefit from the lowest tax rate in Chile.

²⁴³ See Panel Report on Japan - Taxes on Alcoholic Beverages II, supra., paras. 4.19 and 4.175-4.179.

²⁴⁴ Ibid., para. 4.177.

²⁴⁵ Ibid., para. 6.35.

²⁴⁶ Panel Report on Korea - Taxes on Alcoholic Beverages, supra., para. 10.102.

²⁴⁷ Panel Report on United States - Malt Beverages, supra., para. 5.19.

²⁴⁸ Appellate Body Report on Japan - Taxes on Alcoholic Beverages II, supra., p.16.

²⁴⁹ See Panel Report on Korea - Taxes on Alcoholic Beverages, supra., para. 10.75.

²⁵⁰ Chile Oral Statement at the Second Substantive Meeting, Table I-A.