3. Article III:4 of the GATT 1994

40. The United States appeals the Panel's finding that, by reason of its "fair market value rule," the ETI Act accords less favourable treatment to imported products than to like United States' products and is, therefore, inconsistent with Article III:4 of the GATT 1994.

41. The United States recalls that the "no less favourable treatment" standard under Article III:4 has been interpreted by panels and the Appellate Body to require effective equality of opportunities between imported products and domestic products. Since it applied an exclusively de jure test in its analysis, the Panel could have found an inconsistency with Article III:4 only if it demonstrated, in the text of the measure itself, an "incontrovertible linkage between the text and the imported products whose internal use allegedly is affected by the measure".⁴¹ The United States considers that the Panel did not establish such a linkage.

42. The United States contends that an analysis under Article III:4 should focus upon whether the measure in question is directed, on the one hand, toward particular categories of imports or imports in general, or, on the other hand, whether it is a measure of "general application". Unlike measures in past cases involving Article III:4, the ETI Act focuses entirely on income derived from property for use outside the United States; within this general framework, the ETI Act establishes various parameters and limitations on its application, one of which is the fair market value rule.

43. The United States submits that in its analysis of the fair market value rule, the Panel erroneously equated this rule with a domestic content or domestic value-added requirement. This characterization is "plainly incorrect"⁴² because the ETI Act does not refer to United States' content nor does it predicate eligibility for the tax exclusion upon manufacture in the United States. The United States emphasizes that, in fact, the fair market value rule can be satisfied without any portion of the fair market value of a product being derived from United States' sources.

44. The United States argues that, in finding the fair market value rule to be inconsistent with Article III:4 of the GATT 1994, the Panel failed to establish a meaningful causal link between that rule and the alleged discrimination against imports and improperly extended the findings of the panel report in Canada – Certain Measures Affecting the Automotive Industry ("Canada – Autos ")⁴³ to a very different situation. Moreover, the Panel ignored the findings of the Appellate Body in Korea – Measures Affecting Imports of Fresh, Chilled and Frozen Beef ("Korea – Various Measures on Beef ").⁴⁴ Whereas in Korea – Various Measures on Beef, the Appellate Body rejected speculative conclusions by the panel as to possible competitive effects that might result from the differential treatment established under the relevant measure and focused, instead, on the actual effects of the measure, the Panel in this case employed similar speculation in finding that the fair market value rule necessarily places imported products at a comparative disadvantage vis-à-vis like domestic products in the United States' market. The Panel unreasonably assumed that despite the variety of ways in which qualifying foreign trade property could be produced, producers would necessarily source their production in the United States. The Panel compounded this flawed analysis by further incorrectly assuming that, having decided to produce goods in the United States, producers would inherently prefer using United States components to imported components as a means of meeting the fair market value requirement.

4. Withdrawal of the FSC Subsidies

45. The United States, finally, requests us to set aside the Panel's finding that the ETI Act’s transition rules are inconsistent with the full withdrawal of the FSC subsidies. Providing transitional relief is customary in the United States (and in other countries) when tax laws upon which taxpayers have relied in structuring transactions are changed. The United States contends that failure to maintain a consistent practice of transition relief would impose significant and unjustified additional transaction costs on taxpayers.

B. Arguments of the European Communities – Appellee

1. Subsidies Contingent Upon Export under the SCM Agreement

(a) Article 1.1(a)(1)(ii): Revenue Foregone that is "Otherwise Due"

46. The European Communities considers that the United States' appeal does not focus on the Panel’s reasoning on the existence of a financial contribution within the meaning of Article 1 of the SCM Agreement, but rather criticizes certain isolated elements of the Panel's findings and responds to arguments which the Panel did not even make.

47. According to the European Communities, the Panel did not base its conclusion on the notion that Section 61 of the IRC was the normative benchmark, or say that any exception to it would be a subsidy. Rather, in analyzing the ETI Act, the Panel looked at the "overall situation as an integrated whole."⁴⁵ In the view of the European Communities, the United States is also wrong to criticize the Panel for distinguishing between broad and specific exclusions, and for observing that even if income attributable to foreign transactions might be a "category," the United States is not in fact excluding all of that "category". The European Communities similarly rejects the criticism by the United States that the Panel wrongly created an "overall rationale and coherence corollary" to the SCM Agreement. Rather, the Panel examined the "overall rationale and coherence" of the ETI Act only after concluding that the ETI Act resulted in the foregoing of revenue otherwise due.

48. In its response to the United States' additional written memorandum, the European Communities considers that the United States is arguing that the domestic tax rules against which the ETI Act must be assessed are the rules that apportion income between domestic and foreign sources so that each part can be taxed differently, and that the ETI Act operates as a "rule of thumb" to achieve a result similar to that which would be achieved under the normal United States' source rules. The European Communities submits that the ETI Act benefits are nevertheless subsidies when regarded as derogations from the source rules. The European Communities also points out that the ETI Act source rules differ from other source rules of the United States tax code and that taxpayers can elect to their advantage which system to use on a case-by-case basis.

49. As to the alleged failure of the Panel to apply the "but for" test, the European Communities recalls that, as the Appellate Body pointed out in paragraph 91 of its original Report, the "but for" test is not treaty language and could be easily circumvented by a Member through manipulation of its tax system. In any case, the Panel did in fact apply the "but for" test when it stated that, in the absence of the ETI Act, extraterritorial income would be "gross income" and thus would be taxed.⁴⁶ The European Communities adds that even if there may be some cases where a taxpayer could avoid paying some tax in the absence of the ETI Act, it is nonetheless clear that the ETI Act shelters income from tax that would otherwise (at least in many cases) be taxed.

(b) Article 3.1(a) of the SCM Agreement: Export Contingency

50. The European Communities submits that a subsidy contingent upon export performance necessarily treats export sales better than domestic sales. Such "better treatment" is the very rationale for prohibiting export-contingent subsidies. The European Communities disputes the United States' argument that the criteria set out in the ETI Act are "export neutral" simply because there is an alternative to exporting for qualifying for the tax exemption. The ETI Act embodies a bundle of two sole contingencies for two categories of beneficiaries, each of which stipulates a sole means to obtain the tax subsidy. For one of these categories of beneficiaries, namely those producing goods within the United States, it is necessary to export if they are to obtain the subsidy. For a measure to be inconsistent with Article 3.1(a) of the SCM Agreement, it is sufficient to demonstrate that in one, or in some cases, the receipt of the subsidy is contingent upon export performance. The European Communities insists that the prohibition of export-contingent subsidies under Article 3.1(a) of the SCM Agreement is absolute and must be respected in all cases.

51. The European Communities adds that the alleged "alternative" for obtaining the ETI benefit, that is, the relocation of production abroad by United States producers, is not one that realistically will be used. This confirms that, in analyzing the Act, it is proper to focus on the alternatives available for goods which have already been produced, or continue to be produced, in the United States. In this context, the only means for such producers to obtain the ETI tax benefit is to export such goods.

52. The European Communities also agrees with the Panel's reasoning that the former FSC measure cannot be cured merely by extending it to non-export transactions. The Panel correctly found that, as regards the measure at issue – the ETI Act – the only way to eliminate the export contingency would be to extend the availability of the subsidy to include domestic sales as well.

(c) Footnote 59 to the SCM Agreement: Double Taxation of Foreign-Source Income

53. According to the European Communities, the Panel made clear that the issue of burden of proof was academic and had no impact on the other findings of the Panel, and that even if the European Communities bore the burden of proving that the ETI Act did not fall within the scope of the fifth sentence of footnote 59, it had discharged that burden. In any event, the European Communities also agrees with the Panel’s finding on the burden of proof relating to this issue.

54. The European Communities supports the view of the Panel that, although it may not be possible to design a measure that "entirely, exclusively or precisely" avoids double taxation and, therefore, such precision is not required by the fifth sentence of footnote 59, a Member has nevertheless an obligation to identify the type of income that may be subject to double taxation and to approximate the boundaries of its measure to it. The United States has made no attempt to do this. Rather, the United States includes in the exempted category under the ETI Act income that could not legitimately be taxed in another jurisdiction.

55. The European Communities contests the United States' claim that the Panel has imposed a "permanent establishment" requirement as a necessary feature of a double taxation measure. The Panel did not articulate any such principle; indeed, it stated the opposite. The United States further alleges that the Panel held that a country could not institute a measure to avoid double taxation if it has an extensive system of bilateral tax treaties. However, in the view of the European Communities, the Panel merely considered relevant the fact that the ETI Act does not target those situations where such bilateral agreements were not in place.

56. The European Communities also contends that the United States' objection relating to the application of an alleged "reasonable legislator" standard is without merit. The Panel did not apply any such standard. Rather, the Panel considered whether the character of the ETI Act as a measure to avoid the double taxation of foreign-source income was "reasonably discernible". In the view of the European Communities, the Panel’s test was legally correct and its assessment of the facts is beyond the scope of appellate review.

57. With respect to the meaning of "foreign-source" income in the fifth sentence of footnote 59, the European Communities observes that income derives from economic activities. Therefore, foreign-source income means income derived from foreign economic activities. "Income" is not the same as "payment". The fact that a payment comes from abroad does not mean that the income is generated abroad. The ETI Act, however, does not require that the economic activities giving rise to the excluded income take place abroad. Therefore, the definition of extraterritorial income in the ETI Act bears no relation to the determination of foreign-source income, and the ETI Act is not a measure falling within the scope of footnote 59. Furthermore, the European Communities notes, the ETI Act is optional for United States taxpayers, as they can choose between the ETI Act and the other source rules of the IRC.

58. For all these reasons, the European Communities considers that the Panel correctly found that the ETI Act is not a measure to avoid the double taxation of foreign-source income and is therefore not covered by the fifth sentence of footnote 59 to the SCM Agreement. It follows that the Appellate Body need not reach the issue of footnote 5 to the SCM Agreement. In any event, the European Communities does not consider that the phrase "measures referred to in Annex I as not constituting export subsidies" in footnote 5 includes measures falling within the scope of the fifth sentence of footnote 59. Thus, footnote 5 to the SCM Agreement does not assist the United States.

2. Export Subsidies under the Agreement on Agriculture

59. The European Communities notes that the United States' arguments under the Agreement on Agriculture depend entirely on its arguments under the SCM Agreement. Accordingly, the European Communities requests us to uphold the Panel's finding under the Agreement on Agriculture for the same reasons it has asked the Appellate Body to uphold the Panel's finding under the SCM Agreement.

3. Article III:4 of the GATT 1994

60. The European Communities observes that the United States' appeal with regard to Article III:4 of the GATT 1994 is limited to the Panel’s interpretation of the terms "affecting" and "less favourable treatment" within this provision. The word "affecting" has, since the inception of GATT 1947, consistently been interpreted broadly, and was interpreted by the Appellate Body in European Communities – Regime for the Importation, Sale and Distribution of Bananas ("EC – Bananas III ")⁴⁷ as meaning to "have an effect on" the conditions of competition. The Panel applied the same interpretation and correctly concluded that the fair market value rule "affects" the use of imported products because it modifies the conditions of competition between domestic and imported goods. Whereas use of domestic "articles" will contribute to qualifying for the tax exemption, the use of foreign "articles" will never do so.

61. Thus, the European Communities considers that the Panel correctly found that less favourable treatment is accorded by reason of the fair market value rule. All other conditions being equal, United States producers will always have an incentive to use inputs of domestic origin. In certain cases, due to the cost structure of their production, use of domestic inputs will be necessary in order to obtain the tax benefit. The European Communities agrees with the Panel that such an incentive is sufficient to establish inconsistency with Article III:4 of the GATT 1994.

4. Withdrawal of the FSC Subsidies

62. The European Communities contends that the United States does not address any of the Panel’s reasons or rely upon any provision of the covered agreements in support of its appeal on this issue. The United States' sole argument seems to be that transition rules are essential to the orderly shift from one set of tax rules to another. The European Communities responds that the findings in the original proceeding took this fact into account and, in stipulating that the FSC subsidies must be
withdrawn at the latest with effect from 1 October 2000, allowed the United States a grace period to introduce the required changes.

C. Claims of Error by the European Communities – Appellant

1. Article 10.3 of the DSU: Third Party Rights

63. The European Communities requests us to reverse the Panel's finding that third parties are not entitled to receive all of the parties' written submissions to the meeting of the Panel, but only the first written submissions. The European Communities submits that Rule 9 of the Working Procedures adopted by the Panel, and the Panel's subsequent denial of the European Communities' request to change this rule, conflict with Article 10.3 of the DSU and the rights of third parties set out therein.

64. The European Communities recognizes that panels have a certain discretion to establish their own working procedures. However, panels may not derogate from binding provisions of the DSU. Article 10.3 provides that third parties shall receive "the submissions"; it does not draw any distinction between different types of submissions. Rule 9 of the Panel's Working Procedures, and the practice in Article 21.5 proceedings of requiring that only the first written submissions be provided to the third parties, are also inconsistent with Article 10.1 of the DSU, which requires panels "fully" to take into account the interests of Members, including third parties.

65. Furthermore, the European Communities submits that the approach taken by the Panel to third party rights in this case fails to ensure that third parties will be fully informed about the arguments exchanged by the time of the substantive panel meeting. The European Communities disagrees with the Panel's conclusion that, since Article 10.3 of the DSU refers to the "first meeting" of the panel and since panels "ordinarily" meet twice, the DSU intends to limit third party access to the first written submissions of the parties in all cases. Rather, Article 10.3 is intended to ensure that third parties are familiar with the current state of the debate and can meaningfully contribute to it. The European Communities observes that nothing in the DSU requires a panel to hold two meetings and that Article 10.3 is drafted in general terms to be applicable in all cases, regardless of how many meetings are held.

2. Conditional Appeals

66. Should we reverse the Panel's findings, the European Communities requests us to address claims in respect of which the Panel exercised judicial economy. The conditional appeals made by the European Communities relate to the following claims that it made before the Panel:

(a) that the tax exemption accorded, under the ETI Act, to income earned in transactions relating to goods produced outside the United States is contrary to Article 3.1(a) of the SCM Agreement in that it is contingent on export performance by virtue of the "fair market value rule";⁴⁸
(b) that the ETI Act provides subsidies which are specifically related to exports within the meaning of item (e) of the Illustrative List of Export Subsidies in Annex I to the SCM Agreement;⁴⁹
(c) that the "fair market value rule" in the ETI Act renders the subsidies granted in respect of goods produced in the United States (and the subsidies granted in respect of goods produced outside the United States if they are not contrary to Article 3.1(a)), contingent upon the use of United States' goods over imported goods, contrary to Article 3.1(b) of the SCM Agreement;⁵⁰ and
(d) that the United States, by failing to withdraw the FSC subsidies and to comply with the rulings and recommendations of the DSB by the end of the period of time allowed by the DSB, has also failed to comply with its obligations under Article 21 of the DSU.⁵¹

67. The European Communities requests us to consider these claims only if we reverse the findings which led the Panel to exercise judicial economy. In such case, the European Communities refers us to the arguments made by it before the Panel in respect of these claims.

D. Arguments of the United States – Appellee

1. Article 10.3 of the DSU: Third Party Rights

68. The United States claims that the Panel did not err when it declined to find that the rights of third parties include access to the parties' rebuttal submissions, and requests us to uphold the Panel's findings. Article 10.3 of the DSU does not require that anything submitted by the parties prior to the single meeting with the Panel must be made available to third parties. Rather, the Panel correctly concluded that Article 10.3 presupposes a context where there is more than one panel meeting.

69. To the United States, Article 10.3 is ambiguous when considered in the context of anything other than standard panel procedures. The Panel merely construed an ambiguous provision in accordance with the principles of Article 31 of the Vienna Convention on the Law of Treaties ("Vienna Convention").⁵² The Appellate Body has held that the DSU, and in particular its Appendix 3, leave panels a margin of discretion to deal with specific situations that may arise in a particular case. In the view of the United States, the Panel's decision in this case was reasonable and was well within its margin of discretion.

2. Conditional Appeals

70. The United States submits that the conditions on which the European Communities appeals the various remaining issues are unclear. The European Communities states that the Appellate Body would need to consider them if it reversed "any of the findings of the Panel on the claims that the Panel did address."⁵³ (emphasis added) However, the United States considers it difficult to comprehend how the Appellate Body’s reversal of certain findings would trigger a consideration of all of the claims identified by the European Communities, because considerations of judicial economy would continue to apply. Moreover, the Appellate Body's reversal of certain findings by the Panel would be dispositive of one or more such claims.

71. With respect to each of the European Communities' claims, the United States refers to the arguments made in its submissions to the Panel. With respect to the European Communities' claims under Article 3.1(b) of the SCM Agreement, the United States adds that the European Communities erroneously alleges that Article 3.1(b) is violated if there is "even a slight bias in favour of domestic goods"⁵⁴ or if a contingency on the use of domestic over imported goods "is not precluded."⁵⁵ The United States recalls that the European Communities advanced a similar standard in the Canada – Autos⁵⁶ case, and neither the panel nor the Appellate Body accepted it.

E. Arguments of the Third Participants

1. Australia

72. Australia agrees with the Panel's findings that the ETI Act provides prohibited export subsidies contrary to Article 3.1(a) of the SCM Agreement. Australia therefore requests us to uphold the Panel's conclusions that the United States has not implemented the recommendations and rulings of the DSB.

2. Canada

73. Canada asks us to sustain the Panel's findings under the SCM Agreement. Under the United States tax rules, if income fails to qualify as excluded extraterritorial income within the meaning of the ETI Act, it remains subject to taxation. Accordingly, there is a foregoing of government revenue otherwise due within the meaning of Article 1.1(a)(1)(ii) of the SCM Agreement. Canada also agrees with the findings of the Panel that the subsidy is de jure contingent on export performance by reason of the requirement in the ETI Act of use outside the United States. Furthermore, the Panel correctly determined that "the parameters of the ETI Act do not even roughly approximate the parameters of a measure to avoid the double taxation of foreign-source income" ⁵⁷; accordingly, the ETI Act falls outside the scope of footnote 59. Finally, Canada requests us to reverse the finding of the Panel that third parties are not entitled to receive all the main parties’ submissions preceding a single panel meeting.

3. India

74. India requests that we uphold the Panel's findings under the SCM Agreement. The United States argues that when virtually any type of income could be excluded from tax, such exclusion would form part of the prevailing domestic standard for taxation, and would therefore not involve the foregoing of revenue. According to India, such an interpretation would render Article 1.1(a)(1)(ii) meaningless and would seriously undermine the WTO disciplines on subsidies.

75. India also considers that the Panel was correct in finding that the ETI Act grants subsidies contingent upon export performance. While it might be true that by expanding the scope of the subsidy, certain non-exporting firms could qualify for tax benefits under the ETI Act, the fact remains that United States-based producers must export in order to obtain the subsidy.

76. India considers that for a measure to fall within the scope of footnote 59, it is not sufficient that such a measure may incidentally serve in a particular set of circumstances to avoid double taxation. If this were so, any WTO Member could grant export subsidies and escape sanction under WTO rules simply by declaring that its measures are measures to avoid double taxation.

4. Japan

77. Japan believes that the Panel's findings under the SCM Agreement should be upheld. The ETI Act excludes only a limited portion of a potential category of foreign trade income from taxation and the narrow character of this exclusion gives rise to the foregoing of revenue otherwise due in terms of Article 1.1(a)(1)(ii) of the SCM Agreement. The subsidy in this case is contingent upon export. Mere co-existence of one class of activities eligible for benefits under the Act does not change the status of the subsidy for the other class to which the benefits are available only upon exportation.

78. Japan also requests us to uphold the Panel's finding that the ETI Act is not a measure to avoid double taxation within the meaning of the fifth sentence of footnote 59 to the SCM Agreement. The mere fact that some income excluded from taxation under the Act may potentially be subject to double taxation is not sufficient to make it a measure to "avoid the double taxation of foreign-source income" within the meaning of footnote 59.

79. Japan recalls that a measure violates Article III:4 of the GATT 1994 when an imported product is accorded less favorable treatment than the like domestic product. A measure can accord less favorable treatment even where there are no specific legal requirements to use domestic goods. Notwithstanding the fact that the ETI Act covers goods produced both within and outside the United States, the scope of the exclusion permitted under the ETI Act for United States-produced goods is wider than the exclusion permitted for foreign-produced goods. In Japan's view, so long as such disparity in treatment between imported products and domestic products exists, Article III:4 of the GATT 1994 is violated.

IV. Issues Raised in this Appeal

80. This appeal raises the following issues:

(a) whether the Panel erred in finding, in paragraphs 8.30 and 8.43 of the Panel Report, that the ETI measure – which is described in paragraphs 12-25 of this Report – involves the foregoing of revenue which is "otherwise due" and thus gives rise to a "financial contribution" within the meaning of Article 1.1(a)(1)(ii) of the SCM Agreement;

(b) whether the Panel erred in finding, in paragraphs 8.75 and 9.1(a) of the Panel Report, that the ETI measure includes subsidies "contingent … upon export performance" within the meaning of Article 3.1(a) of the SCM Agreement;

(c) whether the Panel erred in finding, in paragraphs 8.107 and 9.1(a) of the Panel Report that the ETI measure, viewed as a whole, does not fall within the scope of footnote 59 of the SCM Agreement as a measure taken to avoid the double taxation of foreign-source income;

(d) whether the Panel erred in finding, in paragraphs 8.122 and 9.1(c) of the Panel Report, that the ETI measure involves export subsidies inconsistent with the United States' obligations under Articles 3.3, 8 and 10.1 of the Agreement on Agriculture;

(e) whether the Panel erred in finding, in paragraphs 8.158 and 9.1(d) of the Panel Report, that the ETI measure is inconsistent with the United States' obligations under Article III:4 of the GATT 1994 because it accords less favourable treatment to imported products as compared with like products of United States origin;

(f) whether the Panel erred in finding, in paragraphs 8.170 and 9.1(e) of the Panel Report, that the United States has not fully withdrawn the subsidies found, in
US – FSC, to be prohibited export subsidies under Article 3.1(a) of the SCM Agreement, and in finding that the United States has, therefore, failed to implement the recommendations and rulings of the DSB made pursuant to Article 4.7 of the SCM Agreement; and

(g) whether the Panel erred in its interpretation of Article 10.3 of the DSU in declining, in its decision of 21 February 2001, reproduced in paragraph 6.3 of the Panel Report, to rule that all the written submissions of the parties filed prior to the only meeting of the Panel must be provided to the third parties.

V. Article 1.1 of the SCM Agreement: "Foregoing Revenue" that is "Otherwise Due"
 

81. The Panel found that the ETI measure "results in the foregoing of revenue which is 'otherwise due' and thus gives rise to a financial contribution within the meaning of Article 1.1(a)(1)(ii) of the SCM Agreement."⁵⁸

82. In appealing this finding, the United States asserts that the Panel misinterpreted and misapplied the applicable legal standard under Article 1.1(a)(1)(ii), and also mischaracterized the relevant provisions of the IRC.⁵⁹ The United States argues that the Panel failed to apply properly the appropriate comparison, as outlined by the Appellate Body in US – FSC, which involves comparing a contested tax measure against a "prevailing domestic standard". According to the United States, the ETI measure establishes a general rule of United States taxation whereby the income excluded from taxation is "outside U.S. taxing jurisdiction".⁶⁰ The United States emphasizes that the ETI measure involves the allocation of income from certain foreign sales transactions according to its source. The allocation of such income into domestic and foreign portions, it states, is "a longstanding normative principle of our system of taxation."⁶¹ The United States argues that the ETI measure reformulates the method by which the United States implements this principle, although still in a manner that is consistent with this principle. In this connection, the United States mentions that, traditionally, it has permitted the foreign portion of income from certain foreign sales transactions to be allocated outside the United States' taxing jurisdiction, and excluded from tax, through the use of a foreign-incorporated subsidiary of a United States taxpayer.

83. Furthermore, according to the United States, a Member may exclude from taxation a category of income, consistently with the SCM Agreement, even if it does not exclude all of the income in that category. The United States contends that when a particular category of income is excluded from taxation, a Member may choose to exclude, for revenue and other policy considerations, only a portion of that category of income.

84. The United States also contends that the Panel erred in its identification of the relevant domestic standard because it misconstrued the concept of "gross income" and ignored other provisions of the IRC that are relevant to this dispute. Consequently, the Panel erred in finding that, in the absence of the ETI measure, extraterritorial income would be "gross income" and would be taxed. According to the United States, under the IRC, "gross income" is the starting point for calculating taxable income, but "gross income" by itself is not necessarily subject to tax because a taxpayer can make "deductions " from it. The Panel thus erred in determining that the prevailing rule of taxation in the United States is that "gross income" is taxable.

85. Before turning to examine the Panel's finding under Article 1.1(a)(1)(ii), certain preliminary observations regarding the SCM Agreement and Article 1.1 thereto should be made. Article 1.1 of the SCM Agreement sets out a definition of a "subsidy" for the purposes of that Agreement. Although this definition is central to the applicability and operation of the remaining provisions of the Agreement, Article 1.1 itself does not impose any obligation on Members with respect to the subsidies it defines. It is the provisions of the SCM Agreement which follow Article 1, such as Articles 3 and 5, which impose obligations on Members with respect to subsidies falling within the definition set forth in Article 1.1. As we said in our Report in Canada – Measures Affecting the Export of Civilian Aircraft – Recourse by Brazil to Article 21.5 of the DSU ("Canada – Aircraft (Article 21.5 – Brazil) "):

… the granting of a subsidy is not, in and of itself, prohibited under the SCM Agreement. Nor does granting a "subsidy", without more, constitute an inconsistency with that Agreement. The universe of subsidies is vast. Not all subsidies are inconsistent with the SCM Agreement.⁶² (emphasis added)

86. In other words, Article 1.1 of the SCM Agreement does not prohibit a Member from foregoing revenue that is otherwise due under its rules of taxation, even if this also confers a benefit under Article 1.1(b) of the SCM Agreement. However, if a Member's rules of taxation constitute or provide a subsidy under Article 1.1, and this subsidy is specific under Article 2, the Member must abide by the obligations set out in the SCM Agreement with respect to that subsidy, including the obligation not to "grant [] or maintain" any subsidy that is prohibited under Article 3 of the Agreement. It was in this context that we said in our Report in US – FSC, that, in principle, a Member is free not to tax any particular category of income it wishes, even if this results in the grant of a "subsidy" under Article 1.1 of the SCM Agreement, provided that the Member respects its WTO obligations with respect to the subsidy.⁶³

87. The issue we examine under Article 1.1 with respect to the disputed measure is, therefore, a threshold issue that, by itself, does not determine whether the United States has acted inconsistently with its obligations under the SCM Agreement. With this in mind, we now turn to examine Article 1.1(a)(1)(ii) of the SCM Agreement. Pursuant to this provision, there is a "financial contribution by a government" where "government revenue that is otherwise due is foregone or not collected". We considered the meaning of this phrase in our Report in US – FSC, where we stated:

… the "foregoing" of revenue "otherwise due" implies that less revenue has been raised by the government than would have been raised in a different situation, or, that is, "otherwise". Moreover, the word "foregone" suggests that the government has given up an entitlement to raise revenue that it could "otherwise" have raised. This cannot, however, be an entitlement in the abstract, because governments, in theory, could tax all revenues. There must, therefore, be some defined, normative benchmark against which a comparison can be made between the revenue actually raised and the revenue that would have been raised "otherwise". We, therefore, agree with the Panel that the term "otherwise due" implies some kind of comparison between the revenues due under the contested measure and revenues that would be due in some other situation. We also agree with the Panel that the basis of comparison must be the tax rules applied by the Member in question. … What is "otherwise due", therefore, depends on the rules of taxation that each Member, by its own choice, establishes for itself.⁶⁴ (italics in original, underlining added)

88. There are several elements in this statement that bear repeating. The first is that, under Article 1.1(a)(1)(ii), a "financial contribution" does not arise simply because a government does not raise revenue which it could have raised. It is true that, from a fiscal perspective, where a government chooses not to tax certain income, no revenue is "due" on that income. However, although a government might, in a sense, be said to "forego" revenue in this situation, this alone gives no indication as to whether the revenue foregone was "otherwise due". In other words, the mere fact that revenues are not "due" from a fiscal perspective does not determine that the revenues are or are not "otherwise due" within the meaning of Article 1.1(a)(1)(ii) of the SCM Agreement.

89. A second element which emerges from our earlier Report is that the treaty phrase "otherwise due" implies a comparison with a "defined, normative benchmark". The purpose of this comparison is to distinguish between situations where revenue foregone is "otherwise due" and situations where such revenue is not "otherwise due". As Members, in principle, have the sovereign authority to determine their own rules of taxation, the comparison under Article 1.1(a)(1)(ii) of the SCM Agreement must necessarily be between the rules of taxation contained in the contested measure and other rules of taxation of the Member in question. Such a comparison enables panels and the Appellate Body to reach an objective conclusion, on the basis of the rules of taxation established by a Member, by its own choice, as to whether the contested measure involves the foregoing of revenue that would be due in some other situation or, in the words of the SCM Agreement, "otherwise due".

90. In our Report in US – FSC, we recognized that it may be difficult to identify the appropriate normative benchmark for comparison under Article 1.1(a)(1)(ii) because domestic rules of taxation are varied and complex.⁶⁵ In identifying the appropriate benchmark for comparison, panels must obviously ensure that they identify and examine fiscal situations which it is legitimate to compare. In other words, there must be a rational basis for comparing the fiscal treatment of the income subject to the contested measure and the fiscal treatment of certain other income. In general terms, in this comparison, like will be compared with like. For instance, if the measure at issue involves income earned in sales transactions, it might not be appropriate to compare the treatment of this income with employment income.

91. In identifying the normative benchmark, there may be situations where the measure at issue might be described as an "exception" to a "general" rule of taxation. In such situations, it may be possible to apply a "but for" test to examine the fiscal treatment of income absent the contested measure. We do not, however, consider that Article 1.1(a)(1)(ii) always requires panels to identify, with respect to any particular income, the "general" rule of taxation prevailing in a Member. Given the variety and complexity of domestic tax systems, it will usually be very difficult to isolate a "general" rule of taxation and "exceptions" to that "general" rule. Instead, we believe that panels should seek to compare the fiscal treatment of legitimately comparable income to determine whether the contested measure involves the foregoing of revenue which is "otherwise due", in relation to the income in question.⁶⁶

92. In addition, it is important to ensure that the examination under Article 1.1(a)(1)(ii) involves a comparison of the fiscal treatment of the relevant income for taxpayers in comparable situations. For instance, if the measure at issue is concerned with the taxation of foreign-source income in the hands of a domestic corporation, it might not be appropriate to compare the measure with the fiscal treatment of such income in the hands of a foreign corporation.

93. Against this background, we turn to the ETI measure. This measure lays down rules of taxation for United States citizens and residents, including both natural and legal persons. These rules also apply to foreign corporations which elect to be treated, for tax purposes, as United States corporations.⁶⁷ The ETI measure permits these taxpayers to elect to have the income they earn from certain transactions, involving certain property, taxed according to the rules set forth in the measure.⁶⁸ The property involved must be "qualifying foreign trade property" ("QFTP"), which, inter alia, must be "manufactured, produced, grown, or extracted within or outside the United States" and must be held primarily for use "outside the United States".⁶⁹ The measure applies, inter alia, to income earned from transactions involving the sale or lease of QFTP, and to income earned through the performance of certain services, including the performance of services "related and subsidiary" to the sale or lease of QFTP.⁷⁰ However, subject to limited exceptions, the measure applies to the income arising in a transaction only if the transaction also satisfies the "foreign economic process requirement" set out in Section 942(b) IRC. This requirement will be satisfied, generally speaking, where at least some of the activities comprising the transaction take place outside the United States.


Continue on to: Article 94

Notes



⁴¹ United States' appellant's submission, para. 253.

⁴² Ibid., para. 256.

⁴³ Panel Report, WT/DS139/R, WT/DS142/R, adopted 19 June 2000, as modified by the Appellate Body Report, WT/DS139/AB/R, WT/DS142/AB/R.

⁴⁴ Appellate Body Report, WT/DS161/AB/R, WT/DS169/AB/R, adopted 10 January 2001.

⁴⁵ Panel Report, para. 8.23.

⁴⁶ Panel Report, para. 8.25.

⁴⁷ Appellate Body Report, WT/DS27/AB/R, adopted 25 September 1997, DSR 1997:II, 591.

⁴⁸ European Communities' first submission to the Panel, para. 119; Panel Report, p. A-23.

⁴⁹ Ibid., para. 158; p. A-29.

⁵⁰ Ibid., paras. 183-184; p. A-34.

⁵¹ Ibid., para. 246; p. A-44.

⁵² Done at Vienna, 23 May 1969, 1155 U.N.T.S. 331; 8 International Legal Materials 679.

⁵³ European Communities' other appellant's submission, para. 4.

⁵⁴ European Communities' second submission to the Panel, para. 160; Panel Report, p. C-30.

⁵⁵ European Communities' response to Question 35 posed by the Panel, para. 101; Panel Report,
p. F-17.

⁵⁶ Panel Report, supra, footnote 43; Appellate Body Report, WT/DS139/AB/R, WT/DS142/AB/R, adopted 19 June 2000.

⁵⁷ Panel Report, para. 8.96.

⁵⁸ Panel Report, para. 8.43. (footnote omitted)

⁵⁹ We observe that the United States does not appeal the Panel's finding, in paragraph 8.48 of the Panel Report, that the financial contribution it found to exist under Article 1.1(a)(1)(ii) of the SCM Agreement confers a "benefit" within the meaning of Article 1.1 of that Agreement.

⁶⁰ United States' appellant's submission, para. 71. See also United States' additional written memorandum, p. 4.

⁶¹ United States' additional written memorandum, p. 2.

⁶² Appellate Body Report, WT/DS70/AB/RW, adopted 4 August 2000, para. 47.

⁶³ Supra, footnote 3, para. 90.

⁶⁴ Appellate Body Report, supra, footnote 3, para. 90.

⁶⁵ Appellate Body Report, supra, footnote 3, para. 91.

⁶⁶ We recognize that a Member may have several rules for taxing comparable income in different ways. For instance, one portion of a domestic corporation's foreign-source income may not be subject to tax in any circumstances; another portion of such income may always be subject to tax; while a third portion may be subject to tax in some circumstances. In such a situation, the outcome of the dispute would depend on which aspect of the rules of taxation was challenged and on a detailed examination of the relationship between the different rules of taxation. The examination under Article 1.1(a)(1)(ii) of the SCM Agreement must be sufficiently flexible to adjust to the complexities of a Member's domestic rules of taxation.

⁶⁷ Section 943(e) IRC. Thus, although the ETI measure applies to foreign corporations, these corporations are deemed for these purposes to be United States corporations and not foreign corporations. In our discussion below, we treat these foreign corporations as United States corporations.

⁶⁸ Section 942(a)(3) IRC. We have outlined the United States rules of taxation, including the ETI measure, in Section II of this Report.

⁶⁹ Qualifying foreign trade property is defined in Section 943(a)(1) and (2) IRC, while Section 943(a)(3) and (4) identifies property that is excluded from the definition.

⁷⁰ The transactions giving rise to income covered by the measure are described in Section 942(a)(1) IRC. We recall that we refer to sale and lease transactions as a shorthand reference to the "sale, exchange or other disposition" of QFTP, and to the "lease or rental" of this property. See Section 942(a)(1)(A) and (B) IRC.