(b) Old Chilean System: Background

57. The United States argues that an examination of the tax system immediately preceding the present Transitional System helps to show the protective structure of both the present regime and the regime to take effect in the year 2000. The EC�s account of the debate in the Chilean government concerning the Old Chilean System and the process of adopting the Transitional System and the New Chilean System demonstrates that protectionist forces prevailed in their effort to ensure that the new systems would create the same protective effect as the Old Chilean System they were introduced to replace. ³³⁴
58. The "Old" Chilean System, established by Decree-Law 825/1974, was in effect from June 1979 to 30 November 1997. It explicitly classified all distilled spirits into three particular product categories: pisco, whisky, and "other spirits". Prior to its termination it applied an ad valorem tax rate of 25% to pisco, 70% to whisky, and 30% to all other spirits. ³³⁵
59. According to the United States, the Old Chilean System taxed imports and domestic products in a dissimilar fashion, thus satisfying the second element of the Appellate Body�s approach to the second sentence of Article III:2. The magnitude of the difference between the rates for whisky and pisco speaks for itself; the 5% differential in the tax rates applied to pisco and other imported distilled spirits is also beyond de minimis. Given the tight competition between distilled spirits, for example those that are used with mixers (e.g., pisco and Puerto Rican rum), even a small variation in price such as a 5% difference in taxation can sufficiently skew purchasing decisions.
60. Turning to the third element of the Appellate Body�s analysis, that of protective application, the United States argues that because pisco has a 73.8% share of the Chilean distilled spirits market as of 1996, ³³⁶ the higher relative taxes on all other distilled spirits could be expected to afford protection to pisco. Furthermore, all pisco is by definition domestic. According to Chilean Law No. 18,455/85 and Law-Decree 78/1986, "pisco" is a protected geographical indication that can only be used for Chilean-made pisco. Therefore, the dissimilar taxation of the Old Chilean System was applied so as to afford protection to domestic production.
61. The United States argues that the Old Chilean System resulted in the taxation of 89.1% of all domestic spirits at the lowest rate, 10.6% of all domestic spirits at the median rate, and a mere 0.3% of all domestic spirits at the highest rate. In turn, the Old Chilean System taxed 53.8% of all imported spirits at the highest rate, 46.2% of all imported spirits at the median rate, and no imported spirits at the lowest rate. ³³⁷
62. The highest tax rate, applied almost exclusively to imports, was 180% greater than the lowest rate. In the Japan � Taxes on Alcoholic Beverages II and Korea � Taxes on Alcoholic Beverages cases, the differences in the arbitrary rates and their relative effects on imports and domestic products were themselves evidence of a protective structure; in the case of the Old Chilean System, the structure was also arbitrary in that it established different tax rates for the three product categories, with no discernible rationale.

(c) Transitional System

63. The United States notes that the present tax system is a transition from the old to the new one. Established by Law 19,534, it will remain in place until 30 November 2000. Even Chilean government officials recognized the discriminatory nature of the Old Chilean System, and the features duplicated in the transitional regime permit a similar conclusion with respect to this substitute.
64. According to the United States, an examination of the Transitional System reveals that pisco and directly competitive or substitutable imported distilled spirits are also not "similarly taxed". The Transitional System maintains the same, distinct product categories as the Old Chilean System for pisco, whisky and other spirits. And although the Transitional System reduces the tax rate for whisky from 70% to 53% over a span of three years, the tax discrimination remains, since whisky is still taxed much more than pisco (25%) and other spirits (30%).
65. With respect to the third element of the analysis, the Transitional System's design, architecture and structure reveals a measure that again taxes 89.1% of all domestic spirits at the lowest rate, 10.6% of all domestic spirits at the median rate, and a mere 0.3% of all domestic spirits at the highest rate. Similarly, it taxes 53.8% of all imported spirits at the highest rate, 46.2% of all imported spirits at the median rate, and no imported spirits at the lowest rate. In fact, the only difference between the Old Chilean System and the Transitional System is the magnitude of the dissimilar taxation: While the medium tax rate remains 20% greater than the lowest tax rate, the highest tax rate is reduced from 180% greater than the lowest rate to 112% greater than the lowest rate. Yet despite this reduction, the tax differential remains grossly disproportional. As with the Old Chilean System, the application of taxes based solely on the identification of directly competitive or substitutable products, the fact that the protected product is exclusively domestic, and the magnitude of the tax differentials between imports and domestic products, together establish a protective structure.

(d) New Chilean System

66. The United States notes that the New Chilean System, also established by Law 19,534, is scheduled to take effect on 1 December 2000. While this regime is not yet in effect, it is nevertheless the proper subject of these proceedings as it is a mandatory measure the details of which have already been determined. ³³⁸
67. The New Tax System will differ from the Old and Transitional Systems in that it will tax on the basis of alcohol content. Distilled spirits with an alcohol content of 35 degrees or less will be taxed at 27% ad valorem. Yet for distilled spirits with an alcohol content of over 35 degrees, the rate will escalate in 4 percent increments for each additional degree of alcohol, topping off at the 47% rate for spirits bottled at over 39 degrees alcohol content.
68. The United States notes that the EC submission demonstrates that despite eliminating the explicit product categories found in the two previous regimes, the New Chilean System will maintain dissimilar taxation between domestic and imported distilled spirits: 89.6% of all pisco sold is bottled at 35 degrees or lower, whereas whisky, vodka, rum, gin and tequila by law must all be bottled at 40 degrees or higher. The New Chilean System thus will continue to ensure that a tax rate of 27% is to be applied to most domestic spirits, while a 47% rate be applied to most imported spirits.
69. As for protective application, the United States notes that the New Chilean System will differ from past systems by relying on apparently neutral criteria, i.e. alcohol content and value. However, these criteria will continue to afford protection to domestic production. The vast majority of products to which the lowest tax rate will apply will still be pisco, an inherently domestic product which is also the major distilled spirit sold in Chile, while the highest tax rate will still apply to most imported products.
70. The United States argues that in the context of the facts and circumstances of this case, Chile�s use of alcohol content for taxation purposes is an effort to perpetuate the relatively higher rates applied to imports. The alcohol content of most imported spirits is well known, and in fact fixed by Chilean law. By statute, Chile requires that whisky, rum, vodka, gin and tequila be at least 40 degrees in alcohol content. The same law dictates that brandy must be a minimum of 38 degrees, pisco must be a minimum of 30 degrees, and liqueurs can range from 25 degrees and upwards, depending on the type of liqueur. ³³⁹ Thus, for example, whisky can only be sold as "whisky" in Chile if it is subject to the maximum tax rate possible.
71. The United States further argues that, as a result of well-established industry practices and legal standards required by many of the major distilled spirits markets, most international whisky producers bottle their product at a minimum alcohol content of 40 degrees. Similarly, most international producers of rum, vodka, gin and tequila bottle their products at around 40 degrees (typically no lower than 37.5 degrees). ³⁴⁰ Producers generally prefer to maintain the same alcohol content, regardless of market requirements, because of the fact that alcohol strength contributes to each product�s characteristics and taste. Thus, by pegging the tax rates to alcohol content, the Chilean regime will apply its rates on the basis of a well-known, inherent attribute of each product and will thereby continue to protect pisco from competition from whisky and other imports.
72. According to the United States, further evidence of the Chilean law�s protective structure is the arbitrary choice of 35 degrees as the dividing line between a straight ad valorem rate of 27% and rates that increase considerably. Very few imported spirits are bottled under 35 degrees alcohol content; indeed, most imported spirits are legally required to be over this 35 degree threshold. As pisco is the only major distilled spirits category with the flexibility to fall below the threshold, and in fact most are bottled at an alcohol content of 35 degrees or less, pisco will once again be effectively singled out for preferential tax treatment.
73. The United States argues that the steeply increasing tax rates on imports of over 35 degrees alcohol content, compared to the flat rate applied to pisco below that threshold, can only be explained as taxation applied to afford protection to pisco. Although one GATT panel properly found that gradual increases in rates may support the determination that a progressive tax structure is non-protectionist in its structure, ³⁴¹ in this case the four percent tax increase for each additional degree of alcohol content will create a disproportionate increase in tax for spirits with 40 degrees alcohol content or more. Thus when comparing two bottles of spirits with equal value, the tax on the 40 degrees spirit will be 74% greater than the tax on the 35 degrees spirit. Moreover, the EC submission describes evidence of the anticipated discriminatory effect of the new tax regime and the protective purpose of the threshold, as revealed from the drafting process of the new legislation. ³⁴²
74. The United States further argues that the protectionist structure is further evidenced by the overall relative impact of the new regime on imports and domestic products. The New Chilean System will tax the vast majority, 83.9%, of all domestic spirits at the lowest possible rate, and only 12.3% of all domestic spirits at the highest possible rate. Conversely, the new regime will tax 94.5% of all imported spirits (a share higher than the previous two regimes) at the highest possible rate, but only a mere 4.5% of all imported spirits at the lowest possible rate. ³⁴³
75. The United States observes that the 12.3% of all domestic spirits to be taxed at the highest possible rate, stated above, will consist mostly of pisco reservado and gran pisco, two brands of pisco. ³⁴⁴ However, one must bear in mind that pisco is the only major distilled spirits category given the flexibility by law to be bottled at 35 degrees alcohol content or below. Thus, while the domestic producers of pisco may purport to bottle a small portion of their production (10.4%) at 40 degrees or more, they can at any time choose to reduce the alcohol content of these brands and still retain the identity of "pisco". On the other hand, Chile does not provide this freedom to the producers of the major imported spirits, therefore ensuring that in the New Chilean System, whisky, rum, gin, vodka and tequila will all be "locked" into the highest tax rate imposed.
76. According to the United States, the New Chilean System is promulgated to provide continued protection to domestic spirits. In the US view, Chile would have the Panel conclude that its New Chilean System is non-discriminatory simply because it will allow some imported spirits to enjoy the lowest tax rate possible while imposing the highest tax rate on a few of its domestic products. However, the products in these circumstances are few and far between, and act as no more than mere token gestures. In short, Chile will again fail to provide non-discriminatory treatment for its distilled spirits market.
77. The United States concludes that Old Chilean System applied its lowest tax rate to 89.1% of all domestic spirits and its highest tax rate to 53.8% of all imported spirits. This uncontested discriminatory treatment between domestic and imported spirits continues in the transitional tax regime which, while lowering the magnitude of the tax differential (between the highest tax rate and the lowest tax rate) from 180% to 112%, is a mirror image of the Old Chilean System. Then in the year 2000, the New Chilean System will further forward this tradition of dissimilar treatment by providing its lowest tax rate to 83.9% of all domestic spirits, while imposing its highest tax rate on 94.5% of all imported spirits. Furthermore, the New Chilean System will effectively increase the ad valorem tax for most U.S. imports from 30% to 47%. ³⁴⁵ It is obvious that all three tax regimes operate with the same practical effect. ³⁴⁶ And in all cases, the exclusive carve-out of preferential tax treatment for domestic production is clear.

Table 1

	Old Regime		Transitional Regime		New Regime
	Domestic	Imported	Domestic	Imported	Domestic	Imported
Low Tax Rate	89.1%	0.0%	89.1%	0.0%	83.9%	4.5%
Median Tax Rate	10.6%	46.2%	10.6%	46.2%	3.8%	1.0%
High Tax Rate	0.3%	53.8%	0.3%	53.8%	12.3%	94.5%
TOTAL	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%

To continue with Interim Review

³³⁴ See EC First Submission, paras. 61-78.

³³⁵ Throughout the existence of Decree-Law 825/1974, the tax rates for whisky and for other distilled spirits fluctuated repeatedly; however, the tax rate for pisco remained steady at 25%.

³³⁶ See Table 9A in EC First Submission.

³³⁷ See Graph 1. To calculate the Chilean market shares of domestic and imported products in each tax regime (Graphs 1, 2 and 3), the United States utilises the 1996 sales data from the ISWR report, as provided in EC Exhibit 19, and Tables 1, 9A and 9B of EC First Submission. The 1996 data are the most recent and most complete available. Furthermore, the submission excludes from these calculations the "other" spirits category from the ISWR report, because the report is silent as to the identity and the alcohol content of the vast majority of these spirits. See EC Exhibit 19, p. 97. (Also, see U.S. Exhibit 2 for details of these calculations).

³³⁸ See Panel Report on United States - Taxes on Petroleum and Certain Imported Substances, supra., para. 5.2.2.

³³⁹ Chilean Decree 78/1986, implementing Law No. 18,455/85.

³⁴⁰ See U.S. Exhibit 3.

³⁴¹ See Panel Report on United States - Taxes on Automobiles, supra., para. 5.14.

³⁴² See EC First Submission, paras. 61-78.

³⁴³ The United States notes that these calculations for the new tax regime are made with the assumption that all liqueurs are taxed at the lowest rate possible, given their ability to be bottled at 35 degrees alcohol content or less (in reality, while most domestically produced liqueurs (e.g., creme de menthe, flavoured brandies) are bottled at below 35 degrees, most imported liqueurs (e.g., Drambuie, B&B) are bottled at above the threshold). Furthermore, these calculations exclude brandy because, with an ability to be bottled at 38 degrees alcohol content, it can be taxed at 39%, a median tax rate.

³⁴⁴ See U.S. Exhibit 2.

³⁴⁵ According to the United States, in the old and transitional regimes, approximately 61.4% of all U.S. exports to Chile (rum, gin and vodka) are categorized as "other distilled spirits", and taxed at the 30% rate. However, in the new regime, these spirits will be taxed at the maximum 47%, an increase in tax rate of 56.7%.

³⁴⁶ See Table 1 and U.S. Exhibit 4.