VII. Findings

A. Claims of The Parties

1. The claim of the European Communities is that both the Transitional System and the New Chilean System are inconsistent with Chile's obligations under GATT Article III:2, second sentence.
2. The European Communities claims that³⁴⁷:

1. the Transitional System, which is applicable through 30 November 2000, is contrary to GATT Article III:2, second sentence, because it provides for the imposition of lower internal taxes on pisco than on other directly competitive or substitutable imported spirits, which fall within the tax categories of "whisky" and "other spirits", so as to afford protection to Chile's domestic production;
2. the New Chilean System, which will become applicable as of 1 December 2000, is also contrary to Article III:2, second sentence, because it results in the imposition of lower taxes on pisco with an alcohol content of 35° or less than on other directly competitive or substitutable imported spirits which have a higher alcohol content, so as to afford protection to Chile's domestic production. ³⁴⁸

3. In response, Chile claims that this Panel should reject the unwarranted and intrusive interpretation of the reach of Article III that the European Communities has put forward in this dispute, and that in keeping with the plain language and the history of Article III, the Panel should find that the New Chilean System is fully consistent with Article III:2, second sentence.
4. Chile also argues that to the extent that the Panel considers the Transitional System to be at issue notwithstanding the short time in which it will remain in effect, it would be appropriate for the Panel to find that pisco is not directly competitive or substitutable with other distilled spirits in Chile, and hence that the Transitional System also conforms with Article III:2, second sentence.

B. Interpretation of Article III:2

5. Article III:2 provides two standards for examining complaints about a Member's internal taxation laws. The first sentence of Article III:2 provides:

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 in turn provides:

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.

6. 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. ³⁴⁹

7. 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 ³⁵⁰ and whether the taxation differences are applied so as to afford protection to the domestic industry.
8. In Japan � Taxes on Alcoholic Beverages II, the Appellate Body considered the overall interpretation of Article, and stated that:

The broad and fundamental purpose of Article III is to avoid protectionism in the application of internal tax and regulatory measures. More specifically, the purpose of Article III is to ensure that internal measures are "not applied to imported or domestic products so as to afford protection to domestic production." ³⁵¹

9. According to the Appellate Body, the terms of Article III:1 must be given their ordinary meaning, in light of the overall object and purpose of the WTO Agreement. Taking this approach, the Appellate Body affirmed that Article III:1 contains a general principle, while Article III:2 provides for specific obligations regarding internal taxes and internal charges. The Appellate Body stated that:

Article III:1 articulates a general principle that internal measures should not be applied so as to afford protection to domestic production. This general principle informs the rest of Article III. The purpose of Article III:1 is to establish this general principle as a guide to understanding and interpreting the specific obligations contained in Article III:2 and in other paragraphs of Article III. ³⁵²

10. The Appellate Body noted that Article III:2, second sentence, unlike the first sentence, specifically invokes Article III:1. In this regard, the Appellate Body noted that three issues must be addressed to determine whether an internal tax measure is inconsistent with Article III:2, second sentence:

1. the imported products and the domestic products are "directly competitive or substitutable products";
2. the directly competitive or substitutable imported and domestic products are "not similarly taxed"; and
3. the dissimilar taxation of the directly competitive or substitutable imported domestic products is "applied so as to afford protection to domestic production". ³⁵³

11. We also note that the burden of proof in cases such as this has been discussed at length by the Appellate Body in United States -- Shirts and Blouses. ³⁵⁴ It is up to the European Communities as complainant to present evidence sufficient to establish the case that the Chilean measures in question are inconsistent with Chile's obligations under Article III. If they do so, it is then necessary for Chile to bring forward evidence and arguments to disprove the claim. At that point, it is up to a panel to carefully weigh all the evidence and reach its conclusions based upon the results of that weighing.

C. "directly competitive or substitutable"

1. General

12. The complainant in this case has not argued that any of the imported or domestic products are "like". We shall, therefore, proceed exclusively under Article III:2, second sentence, which is concerned with the question of direct competitiveness or substitutability.
13. As a prerequisite to the analysis of the evidence presented, it is important to establish the correct interpretation of the term "directly competitive or substitutable". In this regard, the Panel is guided by Article 31 of the Vienna Convention on the Law of Treaties ("Vienna Convention"), that summarizes the international law rules for the interpretation of treaties. Article 31.1 of the Vienna Convention provides 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. Article 31.2 provides further, that the context includes the full text, the preamble, the annexes and any mutually agreed interpretive language. Article 31.3 provides that account shall also be taken of any subsequent practice or interpretations as well as relevant rules of international law.
14. The category of "directly competitive or substitutable" products is broader than the "like product" category covered under the first sentence. The Appellate Body in Japan � Taxes on Alcoholic Beverages II stated that how much broader this category should be "is a matter for the panel to determine based on all the relevant facts in that case". ³⁵⁵ It will be important to look at not only such matters as physical characteristics, common end-uses, and tariff-classifications, but also at the market. The Appellate Body also stated that it is appropriate to examine elasticity of substitution as a means of examining the relevant markets.
15. The Appellate Body in Japan � Taxes on Alcoholic Beverages II agreed with the reasoning of the panel with regard to the analysis of directly competitive or substitutable products. That panel made two important observations. First, the panel noted that the responsiveness of consumers to various products offered in the market may vary from country to country. ³⁵⁶ Second, the panel cautioned that differences in responsiveness of consumers to various products should not be influenced or determined by internal taxation because "a tax system that discriminates against imports has the consequence of creating or even freezing preferences for domestic goods." ³⁵⁷ The Appellate Body stated that no single criterion is decisive in determining whether any two products are "directly competitive or substitutable".
16. The question for us to decide is whether, in Chile, the domestic and imported products at issue in this case are directly competitive or substitutable. This requires evidence of the relationship between the products, including, in this case, comparisons of their end-uses, physical characteristics, channels of distribution and prices.
17. There have been two relatively recent disputes dealing with taxes on alcoholic beverages, Japan � Taxes on Alcoholic Beverages II and Korea � Taxes on Alcoholic Beverages. The findings in these two cases can offer, in our view, instructive guidance on the determination of the various questions at issue in this dispute. However, we are mindful of the statement of the Appellate Body in Japan � Taxes on Alcoholic Beverages II, that these disputes must be determined on a case-by-case basis taking into account the conditions prevailing in the particular market at issue.
18. Consequently, we will draw guidance from the general analyses used in these two earlier cases, among others, but the determination of the central question whether the two categories of products are directly competitive or substitutable will be based on the facts and circumstances prevailing in this case.
19. The definition of "like" products is narrow for purposes of Article III:2. The definition of "directly competitive or substitutable" products is broader. The question is how much broader. In this regard, we note the analysis of the panel in Korea � Taxes on Alcoholic Beverages concerning the negotiating history of Article III:2, second sentence. That panel stated:

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. Other examples provided were domestic linseed oil and imported tung oil and domestic synthetic rubber and imported natural rubber. 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. ³⁵⁸

2. Evidentiary matters

(a) Potential competition

20. The European Communities submitted that Article III:2, second sentence, is concerned not only with tax differentials between products that are actually competitive or substitutable in a given market, but also with tax differentials between products that are potentially competitive or substitutable. The European Communities further argued that the notion of potential competition must be deemed to include not only competition that would exist "but for" the tax measures at issue, but also competition that could reasonably be expected to develop in the near future. ³⁵⁹
21. It is well established in GATT jurisprudence, that Article III does not protect export volumes but, instead, protects competitive opportunities. In this regard the Appellate Body stated in Japan � Taxes on Alcoholic Beverages II that:

[I]t 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. ³⁶⁰

22. We agree with the panel in Korea �Taxes on Alcoholic Beverages (which reasoning was upheld by the Appellate Body) ³⁶¹ when it stated that:

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 future based on the evidence presented. How much weight we will give to 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 scope of the inferences to be drawn. 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. ³⁶²

23. The Appellate Body further explained in its Findings in that case that:

In view of the objectives of avoiding protectionism, requiring equality of competitive conditions and protecting expectations of equal competitive relationships, we decline to take a static view of the term "directly competitive or substitutable." The object and purpose of Article III confirms that the scope of the term "directly competitive or substitutable" cannot be limited to situations where consumers already regard products as alternatives. If reliance could be placed only on current instances of substitution, the object and purpose of Article III:2 could be defeated by the protective taxation that the provision aims to prohibit. ³⁶³

24. We agree that 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 or substitutable now or can reasonably be expected to become directly competitive or substitutable in the near future.
25. In the case before us, as in the Korea case, potential competition is relevant for several reasons. Until 30 November 1997, whisky faced very high rates of taxation (45 percentage points higher than pisco). We must take into consideration the possibility that the current level of actual competition between pisco and other spirits is less than the level that could have developed under equal tax conditions. It is possible that the tax system in question (in conjunction with other measures not at issue, such as previously higher duties) may have inhibited consumers from choosing imports.

(b) Product categories

26. The European Communities submitted that all pisco must be considered as a single product for the purposes of the determination whether it is directly competitive or substitutable with imported distilled spirits. The European Communities argued that the four varieties of pisco are distinguished solely in terms of alcoholic strength, and as such the difference does not warrant treating each of them as a distinct product for the purposes of Article III:2, second sentence since there is no correlation between the alcoholic strength of pisco and its quality/price.
27. The Appellate Body is of the view that the grouping of products is "a practical device to minimise repetition when examining the competitive relationship between a large number of differing products." ³⁶⁴ The Appellate Body has gone further to state that whether, and to what extent, products can be grouped is a question to be determined on a case-by-case basis. ³⁶⁵ In determining this question, a panel has to take into account the components of the products that are being grouped to determine whether there is enough similarity to warrant their being grouped together, notwithstanding some variation in composition, quality, function or price. ³⁶⁶
28. In the case before us Chile did not argue that the various types of pisco constituted different products for either analytical purposes or for determining whether the imports and pisco were directly competitive or substitutable. The European Communities also argued that the appropriate category of imported products for consideration is all distilled alcoholic beverages identified in HS 2208 as described in the request for establishment of a panel. Chile has not made any arguments to the contrary. This is the category of imported products identified as appropriate by the Appellate Body in Japan � Taxes on Alcoholic Beverages II. To take as the appropriate grouping of imports all products contained in HS 2208 does not, in this case, prejudge the matter as the panel and Appellate Body were concerned might happen in Korea � Taxes on Alcoholic Beverages. This is because, in effect, Chile argued that the whole category of pisco is sufficiently distinct from all other distilled alcoholic beverages that this is the proper basis for comparison with respect to the analysis of the issue of directly competitive or substitutable. Under Chilean law pisco is an appellation of origin referring to spirits made from grapes grown in a particular region of Chile. Thus pisco is exclusively a domestic product and reference to imports identified by HS 2208 does not include pisco. "Pre-judgment" is not an issue in this case.
29. We take the parties' positions in this case as strong evidence that the appropriate category of imports with respect to the Chilean market is all distilled alcoholic beverages identified in HS 2208 and the relevant domestic products for purposes of the issue of directly competitive or substitutable is all pisco. The Panel shall proceed accordingly.

To continue with Product comparisons

³⁴⁷ The European Communities notes that in its panel request, it also invoked a violation of GATT Article III:2, first sentence. Even though certain spirits exported from the European Communities to Chile (including in particular certain types of brandy) may be considered as being "like" to pisco, the European Communities has decided not to pursue that claim, given that those spirits are in any event "directly competitive or substitutable" with pisco.

³⁴⁸ The European Communities argues that the New Chilean System already constitutes mandatory legislation, and as such, it may be the subject of dispute settlement under the WTO Agreement, citing Panel Report on United States � Taxes on Petroleum and Certain Imported Substances, BISD 34S/136, paras 5.2.1-5.2.2.

³⁴⁹ 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 (hereafter, "Japan � Taxes on Alcoholic Beverages II"), adopted on 1 November 1996, WT/DS8/AB/R, WT/DS10/AB/R, WT/DS11/AB/R, p. 24.

³⁵⁰ 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."

³⁵¹ Appellate Body Report on Japan - Taxes on Alcoholic Beverages II, supra., p.16.

³⁵² Ibid., p 18.

³⁵³ Ibid., p. 24. See also Appellate Body Report on Canada � Certain Measures Concerning Periodicals (hereafter, "Canada � Periodicals"), adopted on 30 July 1997, WT/DS31/AB/R, pp 24-25 and Appellate Body Report on Korea � Taxes on Alcoholic Beverage, adopted on 17 February 1999, WT/DS75/AB/R, WT/DS84/AB/R, para. 107.

³⁵⁴ Appellate Body Report on United States � Measures Affecting the Imports of Woven Shirts and Blouses from India (WT/DS33/AB/R), pp. 12-17. See also Appellate Body Report on Korea � Taxes on Alcoholic Beverages, supra., paras. 155-158.

³⁵⁵ Appellate Body Report on Japan � Taxes on Alcoholic Beverages II, supra., p. 25.

³⁵⁶ Panel Report on Japan - Taxes on Alcoholic Beverages, adopted on 1 November 1996, WT/DS8/R, WT/DS10/R, WT/DS11/R, para. 6.28, citing Working Party on Border Tax Adjustments, para. 18.

³⁵⁷ Ibid., citing the Panel Report on Japan � Customs Duties, Taxes and Labelling Practices on Imported Wines and Alcoholic Beverages, BISD 34S/83 (hereafter, "Japan � Taxes on Alcoholic Beverages I").

³⁵⁸ Panel Report on Korea � Taxes on Alcoholic Beverages, supra., para. 10.38, citing EPCT/A/PV/9, p.7; E/Conf.2/C.3/SR.11,p.1 and Corr.2; and E/Conf.2/C.3/SR.40, p.2.

³⁵⁹ See EC First Submission at para. 102. We note that Chile did not address this issue.

³⁶⁰ Appellate Body Report on Japan � Taxes on Alcoholic Beverages II, supra., p.16.

³⁶¹ Appellate Body Report on Korea � Taxes on Alcoholic Beverages, supra., paras. 112- 124.

³⁶² Panel Report on Korea � Taxes on Alcoholic Beverages, supra., para. 10.50.

³⁶³ Appellate Body Report on Korea � Taxes on Alcoholic Beverages, supra., para. 120.

³⁶⁴ Ibid., para. 142.

³⁶⁵ Ibid., para. 143.

³⁶⁶ Ibid., para. 142.