151. It is clear to us that the measure addresses situations where United States citizens and residents have engaged in certain economic activities in a "foreign" State. We note that a taxpayer will be treated as having foreign trading gross receipts, which give rise to exempt QFTI, only if the transaction generating these receipts satisfied the "foreign economic process requirement" in Section 942(b) IRC.¹³¹

152. Under this requirement, certain aspects of the transaction must take place outside the United States. First, the taxpayer must have "participated outside the United States" in one of the following activities: the "solicitation", "negotiation" or "making" of the contract, other than participation in advertising. Second, at least 50 percent of certain of the transaction costs must be attributable "to activities performed outside the United States." The relevant costs are those pertaining to the following five categories of activity: "advertising and sales promotion"; "the processing of customer orders and the arranging for delivery"; "transportation outside the United States in connection with delivery to the customer"; "the determination and transmittal of a final invoice or statement of account or the receipt of payment"; and, "the assumption of credit risk".¹³²

153. The foreign economic process requirement focuses on activities of the taxpayer in respect of making and executing the sale or lease of the qualifying property. While we agree with the European Communities that the measure addresses only a limited range of economic activities, we also agree with the United States that these activities occur in a "foreign" State, as they must take place outside the United States. It is, therefore, clear to us that the foreign economic process requirement establishes a link between some part of the qualifying transactions covered by the ETI measure and a "foreign" State.

154. However, the fact that a transaction involves some foreign element, such as the "foreign economic process", does not necessarily mean that all of the income generated by such a transaction will be "foreign-source income" within the meaning of footnote 59 to the SCM Agreement. The sale or lease of property may give rise to taxable income attributable to a variety of activities, of which only some may occur in a "foreign" State. Thus, a sale or lease transaction may give rise to income attributable to activities such as research and development, manufacturing, advertising, selling, transport, and administration. In our view, under footnote 59 to the SCM Agreement, the "foreign-source income" arising in such a transaction is only that portion of the total income which is generated by and properly attributable to activities that do occur in a "foreign" State.¹³³ Conversely, the portion of the total income generated by and properly attributable to activities that occur within the State of residence is domestic-source income in that State. Thus, where sales or lease income combines domestic- and foreign-source income, not all of the income is foreign-source, just as not all of the income is domestic-source.

155. Under Section 942(a)(1) IRC, "foreign trading gross receipts" are the entirety of the receipts earned by the taxpayer in transactions covered by the measure. "Extraterritorial income" is defined in Section 114(e) IRC as the gross income attributable to foreign trading gross receipts of the taxpayer. "Foreign trade income" is defined in Section 941(b)(1) IRC as the (net) taxable income attributable to foreign trading gross receipts of the taxpayer. Under the ETI measure, as we read the statutory provisions, all of the receipts from a qualifying transaction involving qualifying property are treated as foreign trading gross receipts; all of the gross income earned in such a transaction is treated as extraterritorial income; and all of the (net) taxable income earned in such transaction is treated as foreign trade income.

156. We said earlier that the exempt income under the measure is only QFTI and that the amount of QFTI is calculated, at the choice of the taxpayer, using one of three different formulae set forth in Section 941(a)(1) IRC. Under one of these formulae, the amount of QFTI is equal to 15 percent of the (net) foreign trade income of the taxpayer¹³⁴ (the "15 percent rule"), while under a second, QFTI is equal to 1.2 percent of foreign trading gross receipts (the "1.2 percent rule").¹³⁵ Thus, under these two formulae, QFTI is a fixed percentage of either the net amount or the gross amount of all of the income earned by the taxpayer in any qualifying transaction. Under these formulae, QFTI, therefore, includes a percentage of the income earned by the taxpayer from the activities that, cumulatively, generated the totality of the income. In other words, in calculating QFTI under these formulae, the measure does not purport to distinguish, except on an "rule of thumb" basis, between domestic- and foreign-source income according to whether activities generating the income occurred in the United States or in a "foreign State". Instead, QFTI is a fixed percentage of an amount that bundles together both domestic- and foreign-source income.

157. This may be illustrated by way of examples which are based on an example of the operation of the measure given in the United States' House Report.¹³⁷ The first example involves two separate sales transactions. We assume that a United States corporation manufactures property in the United States and sells it to an unrelated distributor in the United States, without satisfying the foreign economic process requirement. We assume that the sales price was $80, generating $30 of profit for the manufacturer. At the oral hearing, the United States confirmed that, in such a transaction, the manufacturer will have no extraterritorial income and no QFTI. All of the $30 profit will be gross income under Section 61(a) IRC. We next assume that the same distributor sells this same property to a foreign buyer, for use outside the United States, in a transaction satisfying the foreign economic process requirement. The sales price is $100, generating $20 of profit. At the oral hearing, the United States confirmed that the distributor will have $20 of extraterritorial income and, assuming this is all taxable income, the QFTI will equal $3 using the 15 percent rule in Section 941(a)(1)C) IRC.

158. In this first example, the manufacturer made $30 of profit and the distributor $20. Of this total of $50 of profit, only the distributor's $20 of profit is extraterritorial income. The exempt QFTI is a portion of distributor's sales and distribution profits, and does not include any profits made by the manufacturer. The United States explained that the 15 percent rule is intended to allocate the sales and distribution income earned in a transaction, in this example by the distributor, between the domestic portion (85%), and the foreign portion attributable to the activities involved in completing the foreign economic process (15%).¹³⁸ Thus, the $3 of QFTI is the amount the United States treats as exempt foreign-source income in this example, with the remaining $47 treated as United States domestic-source income.

159. Our second example is taken directly from the House Report itself, and uses the figures given in that Report. It involves precisely the same transactions as our first example, with the same sales prices and profits for the manufacturer and distributor. However, in this case the manufacturer and distributor are related parties. By virtue of Section 942(b)(4) IRC, the manufacturer is deemed to have satisfied the foreign economic process requirement in its transaction with the related distributor because the distributor satisfied this requirement in the subsequent transaction with the foreign buyer. In other words, because the manufacturer and distributor are related, the measure deems the foreign economic process requirement to have been met in the sales transaction between the related parties, when, in fact, it was not met. At the oral hearing, the United States confirmed what is stated in the House Report, namely that as a result of the "deeming" provision in Section 942(b)(4) IRC, the manufacturer's $30 of profit is treated as extraterritorial income and, assuming this is all taxable income, the manufacturer's QFTI will equal $4.50 using the 15 percent rule in Section 941(a)(1)(C) IRC. The distributor will also still have $3 of QFTI. Thus, the related parties have a total of $7.50 of exempt QFTI, which the United States regards as foreign-source income.¹³⁹ The remaining $42.50 of profit is treated as domestic-source income. We will comment on this example below.

160. The third example involves only one transaction: the direct sale, by a United States corporation, of property which that corporation manufactured in the United States, to an unrelated foreign buyer for use outside the United States. In this example, we assume that the transaction satisfies the foreign economic process requirement. We assume also that the sales price was $100, generating $50 of profit for the manufacturer. Thus, like the last two examples, the total profit from all activities is $50. However, unlike the last two examples, the entire $50 profit is earned by the manufacturer. At the oral hearing, the United States confirmed that, in this example, the manufacturer will have $50 of extraterritorial income and, again assuming that this is all taxable income, it will have $7.50 of QFTI using the 15 percent rule. The United States argues that the $7.50 represents foreign-source income of the manufacturer, while the remaining $42.50 is taxed in the United States as domestic-source income.

161. The differences in tax treatment among these three examples are revealing. In each example, precisely the same total amount of profit ($50) is earned from precisely the same activities (manufacture, sales and distribution). Moreover, the nature and extent of the foreign-based activities are identical in each example. Yet, in these examples, the allocation between domestic- and foreign-source income that arises from the application of the ETI measure is very different. Indeed, in the second and third examples, the amount of income treated as exempt foreign-source income is more than twice the amount of such income in the first example.

162. The reason for the noteworthy difference in the exempt income between the first and third example is, as we said earlier, that QFTI is calculated as a fixed percentage of all of the income earned by the taxpayer in any qualifying transaction from the cumulation of activities which generated the income.¹⁴⁰ In the first example, QFTI was 15 percent of the entire $20 of income earned by the distributor from the cumulation of its sales and distribution activities; QFTI did not, however, include any of the $30 of profits earned by the manufacturer, in a separate transaction, from its activities. By contrast, in the third example, because the sale was made directly by a manufacturer, QFTI was 15 percent of the entire $50 of income earned by it from the cumulation of all of its activities, including manufacturing, sales and distribution. Thus, in the third example, QFTI bundles together, as exempt foreign-source income, 15 percent of the manufacturing income from the transaction, as well as 15 percent of the sales and distribution income.

163. The difference in tax treatment between the first and second examples is explained by Section 942(b)(4) IRC, which provides that the transaction between the related manufacturer and distributor is deemed to satisfy the foreign economic process requirement because this requirement is satisfied in the subsequent sale by the distributor to the unrelated foreign buyer. Thus, in the absence of Section 942(b)(4) IRC, the domestic manufacturing income of the related parties would not be included in the calculation of QFTI. Yet, through the deeming provision, the measure allows the related parties to bundle together, in the calculation of QFTI, all of the profits earned by them, including profits earned in a purely domestic transaction between the related parties inter se. Thus, as in the third example, QFTI includes, in the second example, as exempt foreign-source income, 15 percent of the manufacturing income, as well as 15 percent of the sales and distribution income.

164. We note that our examples, like the one in the House Report, calculate QFTI using the 15 percent rule. However, if the taxpayer elected to calculate QFTI using the 1.2 percent rule, similar anomalies in the allocation of income as either domestic- or foreign-source would arise. Under this formula also, QFTI would be a portion of the combined domestic- and foreign-source income earned through the cumulation of activities that generated the foreign trading gross receipts of which 1.2 percent is QFTI.¹⁴¹

165. We have said that, under footnote 59 to the SCM Agreement, "foreign-source income" is income which is generated through activities linked with a "foreign" State. Although the ETI measure ensures that transactions giving rise to exempt QFTI have some link with a "foreign" State, through compliance with the foreign economic process requirement, two of the measure's allocation rules (the 15 percent and 1.2 percent rules) do not distinguish, on a proper basis, between income generated by activities that occur in the United States and income from activities that occur elsewhere. Rather, under these two rules, QFTI is a fixed portion of all of the income earned by the taxpayer in relevant transactions, including income generated by activities that occur in the United States, such as manufacturing income in our examples. As we have said, income generated by activities that do not have a link with a "foreign" State is not properly regarded as "foreign-source income" within the meaning of footnote 59, but as domestic-source income.

166. Accordingly, in our view, in the calculation of QFTI using the 1.2 and 15 percent rules set forth in Section 941(a)(1)(B) and (C) IRC ¹⁴², the ETI measure fails to distinguish between income which can give rise to foreign-source income – that is, sales and distribution income attributable to the foreign economic processes – and income which cannot, such as income attributable to United States' manufacturing activities. As a result, under these two formulae, the ETI measure improperly combines domestic-source income and foreign-source income in the calculation of QFTI. We, therefore, consider that, when taxpayers elect to use either of these two formulae, the ETI measure results systematically in a misallocation of domestic- and foreign-source income.

167. Furthermore, as we saw in the second example, through Section 942(b)(4) IRC, related parties are able to "sweep into" the calculation of QFTI income from purely domestic transactions, involving in that example domestic-source manufacturing income.¹⁴³ In the absence of this provision, the separate transactions between the manufacturer and related distributor, and between the distributor and unrelated foreign buyer, would have operated as a means of separating out some domestic- and foreign-source income in these separate transactions. In other words, the domestic-source income in the first transaction would not be included in the calculation of QFTI. However, the result of the deeming provision in Section 942(b)(4) IRC is to misallocate domestic-source income from the first transaction as foreign-source income.¹⁴⁴

168. Finally, with respect to the two formulae we have just examined – namely, the 1.2 percent rule or 15 percent rule – we note that the last sentence of this provision states that the amount determined under the 1.2 percent rule shall in no case exceed 200 percent of the amount determined under the 15 percent rule. This last sentence of Section 941(a)(1) suggests to us that there could be situations where the QFTI claimed by a taxpayer under the 1.2 percent rule could be as much as 200 percent of the QFTI computed for the same transactions under the 15 percent rule. This reinforces our view that the approach embodied in the ETI measure can lead to very different allocations of income between domestic-and foreign-source in respect of precisely the same transaction. This implies to us that the different formulae for calculating QFTI result in a misallocation of income as between the domestic-and foreign-source and, through the election which the taxpayer can make between these formulae, allows the taxpayer to obtain the maximum benefit from the misallocation.

169. The third and final formula for calculating QFTI addresses "foreign sales and leasing income" ("FSLI") and is set forth in Section 941(c)(1) IRC. This provision states that QFTI may be 30 percent of the taxpayer's FSLI. The definition of FSLI contains some noteworthy differences from the allocation rules under the two formulae we have just examined. Whereas the first two formulae base the calculation of QFTI on combined domestic- and foreign-source income, in contrast, the definition of FSLI, under Section 941(c)(1)(A) IRC, does not. Under this provision, FSLI is limited to the "foreign trade income properly allocable to activities" that are "performed … outside the United States" in satisfaction of the foreign economic process requirement described in Sections 942(b)(2)(A)(i) and 942(b)(3) IRC.¹⁴⁵

170. Thus, under this third formula, FSLI is a portion of foreign trade income.¹⁴⁶ We recall that, under Section 941(b) IRC, foreign trade income bundles together both domestic- and foreign-source income. However, in contrast, FSLI is only that portion of foreign trade income "properly allocable" to foreign sales and distribution activities. We note that, although the IRC does not define the words "properly allocable", the Senate and House Reports indicate that those words limit FSLI to foreign trade income "associated with sales activities" described in the foreign economic process requirement.¹⁴⁷ We envisage that the application of such a rule requires the taxpayer to establish that, in fact, the "alloca[tion]" made is, indeed, "proper". Interpreted in this way, FSLI is not the entirety of the taxpayers' sales and leasing income, but is only the portion "properly allocable" or attributable to foreign activities. By requiring such a process of separating domestic- and foreign-source income, on the basis of the locus of the activities generating the income, Section 941(a)(1)(A) IRC includes in the calculation of FSLI only income which may properly be regarded as "foreign-source income" under footnote 59 of the SCM Agreement. In other words, Section 941(c)(1)(A) IRC separates out, or unbundles, the domestic- and foreign-source income that are combined in foreign trade income.

171. We note, however, that rules on "proper alloca[tion]" in Section 941(c)(1)(A) IRC do not apply to income derived from the lease or rental of QFTP. In the case of income derived from the "lease or rental" of QFTP, FSLI is simply the "foreign trade income" derived from these transactions.¹⁴⁸ We recall that foreign trade income bundles together domestic- and foreign-source income ¹⁴⁹, in other words, the process of separating domestic- and foreign-source income that we consider is contemplated by the words "properly allocable" does not apply to FSLI which is lease or rental income.

172. However, the provisions relating to FSLI include "special rules for leased property" in Section 941(c)(2) IRC for the calculation of foreign trade income. These special rules apply in two situations. First, where qualifying property is leased by the manufacturer and, second, where qualifying property which has been leased is sold by the manufacturer. In these two situations, FSLI is determined as if the manufacturer had acquired the property from a third party at an arm's length price. The Senate and House Reports explain that:

This limitation is intended to prevent foreign sales and leasing income from including profit associated with manufacturing activities.¹⁵⁰ (emphasis added)

173. We agree that, under the "special rules for leased property", the use of the arm's length rule effects a separation of manufacturing income from all other income.¹⁵¹ The amount of FSLI is all of the income, less manufacturing income, earned through the lease transaction, or through the sale of leased property. FSLI, therefore, combines or bundles together the remaining income, irrespective of the locus of the activities that generated this income. The remaining FSLI could combine income generated by domestic activities and income generated by foreign activities. As a result the
calculation of FSLI for leased property could result in a misallocation of domestic-source income as foreign-source income.

174. To our minds, the inclusion of certain restrictions in calculating FSLI – the "properly allocable" rule and the exclusion of manufacturing income – makes all the more striking the omission of any such restrictions where QFTI is calculated using the other two formulae, that is, the 1.2 percent and 15 percent rules. We find it particularly incongruous that one part of the ETI measure expressly requires a "proper alloca[tion]" of foreign-source income, on the basis of activities "performed … outside the United States", while the remainder of the measure does not. We also find it noteworthy that, in one part of the ETI measure, a restriction is included specifically "to prevent" an exemption being granted to "profit associated with manufacturing activities" – which activities will often take place within the United States – while under the 1.2 percent and 15 percent rules no such limitation is provided to exclude domestic-source manufacturing income.

175. We turn now to two other aspects of the ETI measure which we consider similarly result in domestic-source income being treated as exempt foreign-source income. First, for taxpayers with declared foreign trading gross receipts of up to $5,000,000, Section 942(c)(1) IRC dispenses entirely with the foreign economic process requirement. Thus, a portion of the taxpayers' income is treated as exempt foreign-source income even though it has not been established – and need not be established – that the taxpayer undertook any activities outside the United States. However, in the absence of an established link between the income of such taxpayers and their activities in a "foreign" State, we do not believe that there is "foreign-source income" within the meaning of footnote 59 of the SCM Agreement.

176. The United States argued, at the oral hearing, that, in the case of "small" taxpayers with foreign trading gross receipts of only up to $5,000,000, the burden under the foreign economic process requirement is too great to justify imposing this requirement.¹⁵² At the oral hearing, the United States also asserted that, where the exception in Section 942(c)(1) IRC applies, there is in any event a link with a foreign State because, in these cases, the qualifying property in the transaction must be used outside the United States.¹⁵³ In our view, however, sales income cannot be regarded as "foreign-source income", under footnote 59, for the sole reason that the property, subject-matter of the sale, is exported to another State, for use there. The mere fact that the buyer uses property outside the United States does not mean that the seller undertook activities in a "foreign" State generating income there. Such an interpretation of footnote 59 would, in effect, allow Members to grant a tax exemption in favour of export-related income on the ground that the exportation by itself of the property renders the income "foreign-source". In our view, this reading would allow Members easily to evade the prohibition on export subsidies in Article 3.1(a) of the SCM Agreement and render this prohibition meaningless.

177. Accordingly, where and to the extent that the "$5,000,000"exception in Section 942(c)(1) IRC applies, the measure grants a tax exemption in favour of income which is not demonstrated to be "foreign-source income" within the meaning of footnote 59 to the SCM Agreement. Rather, this income remains domestic-source.

178. Second, the measure treats domestic-source income as exempt foreign-source income in connection with the performance of services "related and subsidiary" to the sale or lease of qualifying property under Section 942(a)(1)(C) IRC. Under this provision, the performance of certain services in connection with qualifying property, for example repair or maintenance services, can generate foreign trading gross receipts and, hence, exempt QFTI.

179. The IRC does not state expressly that these subsidiary and related service activities need to be performed outside the United States. We note that the rules contained in the Code of Federal Regulations, which applied to the FSC legislation, continue to apply to the provisions of the measure regarding foreign trading gross receipts.¹⁵⁴ According to these regulations, subsidiary and related services "may be performed within or without the United States."¹⁵⁵ (emphasis added)

180. The measure, in conjunction with these regulations, therefore, exempts QFTI derived by a United States citizen or resident from the performance of services within the United States. The activities which generate the services income may occur entirely in the United States. In our view, such income has no link with any "foreign" State which could lead to that State taxing the income and therefore, is not "foreign-source income" within the meaning of footnote 59 to the SCM Agreement. Rather it is domestic-source income.

181. There is one final aspect of the measure to be highlighted. The measure provides rules that exempt a portion of income as QFTI so as to avoid, the United States argues, the double taxation of foreign-source income. The measure does not, however, displace the rules the United States otherwise applies to avoid the double taxation of foreign-source income. These other rules involve the grant of tax credits with respect to foreign-source income on which the taxpayer has paid tax in a "foreign" State.¹⁵⁶ Both the ETI measure and these rules continue to be available, and taxpayers with foreign trading gross receipts under the ETI measure have a choice, on a transaction-by-transaction basis, to opt either for an exemption of a portion of their income as QFTI or to have the income taxed under the other rules with tax credits granted to offset the taxes due in the United States.¹⁵⁷ Moreover, if a taxpayer elects to have income from a transaction taxed under the ETI measure, the taxpayer also has a choice as to the formula to be used to calculate the amount of QFTI.

182. As we said earlier, taxpayers will obviously opt to use the rules which result in the most favourable tax treatment for them. In making its choices, the taxpayer will naturally decide whether the tax which is due on exempt QFTI is greater than the tax credits which it could claim if it did not elect to take a tax exemption under the ETI measure.¹⁵⁸

183. Under the ETI measure, the taxpayer can obtain a tax exemption even for income that is domestic-source income. The taxpayer will not have foreign tax credits with respect to this domestic-source income. In these circumstances, with no tax credits to surrender, the taxpayer would very likely opt for an exemption under the ETI measure of income that includes domestic-source income. The measure operates, in these circumstances, as a means to provide export subsidies for income earned from domestic activities. Correspondingly, the greater the amount of genuine "foreign-source income" included in QFTI, the more likely it is that the taxpayer will have tax credits to give up, and the less likely it becomes that the ETI measure will be used by the taxpayer.

184. In conclusion, our examination discloses that the measure at issue is an extremely complex instrument. We set out to review whether the measure was "tak[en] … to avoid the double taxation of foreign-source income" within the meaning of footnote 59 to the SCM Agreement. The ETI measure, viewed as a whole, does not permit us to conclude that this measure exempts only "foreign-source income". Rather, in some situations, the ETI measure exempts QFTI which is foreign-source income ¹⁵⁹; in other situations, the ETI measure exempts QFTI which is not foreign-source ¹⁶⁰; and, in yet other situations, the measure exempts QFTI which is a combination of both domestic- and foreign-source income.¹⁶¹

185. Certainly, if the ETI measure were confined to those aspects which grant a tax exemption for "foreign-source income", it would fall within footnote 59. However, the ETI measure is not so confined. Rather, in several important respects, two of the three basic allocation rules of the ETI measure, the (1.2 and 15 percent rules) provide an exemption for domestic-source income.¹⁶² We have said that avoiding double taxation is not an exact science and we recognize that Members must have a degree of flexibility in tackling double taxation. However, in our view, the flexibility under footnote 59 to the SCM Agreement does not properly extend to allowing Members to adopt allocation rules that systematically result in a tax exemption for income that has no link with a "foreign" State and that would not be regarded as foreign-source under any of the widely accepted principles of taxation we have reviewed.

186. For these reasons, even though parts of the ETI measure may be regarded as granting a tax exemption for foreign-source income, we find that the United States has not met its burden of proving that the ETI measure, viewed as a whole, falls within the justification available under the fifth sentence of footnote 59 of the SCM Agreement. Accordingly, we uphold the Panel's finding in paragraphs 8.107 and 9.1(a) of the Panel Report.

VIII. Article 10.1 of the Agreement on Agriculture: Export Subsidies

187. The United States appeals the Panel's finding that:

… the United States has acted inconsistently with its obligations under Article 10.1 of the Agreement on Agriculture by applying the export subsidies, with respect to both scheduled and unscheduled agricultural products, in a manner that, at the very least, threatens to circumvent its export subsidy commitments under Article 3.3 of the Agreement on Agriculture.¹⁶³

188. The Panel reached this conclusion because it considered that its reasoning under the SCM Agreement was "also applicable as regards whether the Act gives rise to subsidies contingent upon export performance within the meaning of Article 1(e) of the Agreement on Agriculture for the purposes of Article 10.1 of the Agreement on Agriculture."¹⁶⁴

189. The United States argues that the ETI measure does not involve export subsidies under Article 1(e) of the Agreement on Agriculture because the measure is not a prohibited export subsidy under Article 3.1(a) of the SCM Agreement.¹⁶⁵ For this reason alone, the United States contends that the Panel erred in finding that the United States had acted inconsistently with its obligations under Articles 10.1 and 8 of the Agreement on Agriculture.

190. Before addressing the ETI measure we consider it useful to recall our findings regarding the FSC measure in our Report in US – FSC. In that Report, we held that, under the Agreement on Agriculture, just as in cases under Article 1.1(a)(1)(ii) of the SCM Agreement, a subsidy may arise where a government foregoes revenues that are otherwise due.¹⁶⁶ In that Report, the reasons which led us to hold, under the SCM Agreement, that the FSC measure involved the foregoing of revenue otherwise due, also led us to the same conclusion under the Agreement on Agriculture.¹⁶⁷

191. In its appeal in the original proceedings, the United States did not contest that, if the FSC measure involved a "benefit" under Article 1.1(b) of the SCM Agreement, it also involved a benefit under the Agreement on Agriculture. We reached the conclusion that the FSC measure "confer[red] upon the recipient the obvious benefit of reduced tax liability and, therefore, reduced tax payments". Accordingly, we found that the measure involved a subsidy under the Agreement on Agriculture.¹⁶⁸

192. We held, in US – FSC, that there was no reason to read the requirement of "contingent upon export performance" differently in the SCM Agreement and in the Agreement on Agriculture. Therefore, for the reasons that led us to conclude, under Article 3.1(a) of the SCM Agreement, that this subsidy was contingent upon export performance, we reached the same conclusion under the Agreement on Agriculture.¹⁶⁹

193. In consequence, we held that the FSC measure involved "subsidies contingent upon export performance" under Article 1(e) of the Agreement on Agriculture. As these subsidies had not been found to be listed in Article 9.1 of the Agreement on Agriculture, we examined whether they were inconsistent with Article 10.1 of that Agreement, as the European Communities claimed. We held that the subsidies were inconsistent with this provision.

194. In this appeal, the United States contends that the measure is not an export subsidy under Article 1(e) of the Agreement on Agriculture because, it argues, the measure is not an export subsidy under Article 3.1(a) of the SCM Agreement. We have rejected the United States' appeal regarding the proper characterization of the measure under Article 3.1(a) of the SCM Agreement. The Panel held, and we have upheld, that the measure involves the foregoing of revenues that are otherwise due under Article 1.1(a)(ii) of the SCM Agreement. As we indicated in US – FSC, where a government foregoes revenues that are otherwise due in relation to agricultural products, a subsidy may arise under the Agreement on Agriculture. The fiscal treatment of agricultural products, under the measure, is not materially different from the fiscal treatment of products falling within the scope of the SCM Agreement. Accordingly, we see no reason to reach any conclusion under the Agreement on Agriculture that differs from our conclusion under the SCM Agreement. The ETI measure also reduces the liability of United States citizens and residents to pay tax on income earned from qualifying transactions involving agricultural products.

195. In addition, for the reasons we have given in Part VI of this Report with respect to Article 3.1(a) of the SCM Agreement, the measure makes the grant of subsidies "contingent … upon export performance" where qualifying property is produced within the United States. We can see no reason to conclude otherwise under Article 1(e) of the Agreement on Agriculture, and none has been suggested to us. We, therefore, find that the measure also involves subsidies contingent upon export performance under Article 1(e) of the Agreement on Agriculture.

196. For these reasons, we uphold the Panel's finding that the measure involves export subsidies under Article 1(e) of the Agreement on Agriculture with respect to qualifying property produced within the United States. We also uphold the Panel's finding, in paragraphs 8.122 and 9.1(c), that the United States acted inconsistently with Articles 10.1 and 8 of the Agreement on Agriculture.¹⁷⁰

IX. Article III:4 of the GATT 1994

197. Before the Panel, the European Communities challenged the consistency with Article III:4 of the GATT 1994 of Section 943(a)(1)(C) IRC, which establishes, as one of the conditions of eligibility for the tax benefits under the ETI measure, that not more than 50 percent of the fair market value of qualifying property be attributable to articles produced or direct labour performed outside the United States (the "foreign articles/labour limitation" or "fair market value rule").¹⁷¹

198. The Panel found that:

… by reason of the foreign articles/labour limitation, the Act accords less favourable treatment within the meaning of Article III:4 of the GATT 1994 to imported products than to like products of US origin … ¹⁷²

199. This finding was based on the following three findings by the Panel: (i) that the imported and domestic products at issue are "like products" ¹⁷³; (ii) that the measure is a "law, regulation, or requirement affecting their internal sale, offering for sale, purchase, transportation, distribution, or use"¹⁷⁴ ; and (iii) that, by conferring an advantage upon the use of domestic products but not upon the use of imported products, the measure accords less favourable treatment to imported products in relation to like products of United States origin.¹⁷⁵

200. In its appeal under Article III:4 of the GATT 1994, the United States does not challenge the Panel's finding on "like products". Rather, the United States confines its appeal to the Panel's findings: that the measure is a "law, regulation, or requirement affecting their internal sale, offering for sale, purchase, transportation, distribution, or use"; and that the measure provides "less favourable treatment" to imported products as compared with like products of United States origin. (emphasis added)

201. We note that the issues arising under Article III:4 of the GATT 1994 relate to the definition of "QFTP" in the measure, in particular the following requirement, which is contained in Section 943(a)(1)(C) IRC:

(C) not more than 50 per cent of the fair market value of [Qualifying Foreign Trade Property may be] attributable to -

(i) articles manufactured, produced, grown, or extracted outside the United States, and

(ii) direct costs for labour … performed outside the United States.¹⁷⁶

202. The European Communities' claim under Article III:4 of the GATT 1994, and the Panel's examination of the ETI Act, concern Section 943(a)(1)(C) solely as it relates to the production of qualifying property within the United States. We recall that, in examining export contingency under Article 3.1(a) of the SCM Agreement, we considered the ETI measure solely in relation to the conditions governing the grant of the subsidy for qualifying property produced within the United States. We do not, therefore, see that the Panel committed any error of law in adopting the same approach in its examination of the claim under Article III:4 of the GATT 1994.

203. Article III:4 of the GATT 1994 reads:

The products of the territory of any Member imported into the territory of any other Member shall be accorded treatment no less favourable than that accorded to like products of national origin in respect of all laws, regulations and requirements affecting their internal sale, offering for sale, purchase, transportation, distribution or use.

204. Article III:4 is one of a series of provisions in Article III which set forth obligations regarding "National Treatment on Internal Taxation and Regulation". In previous appeals, we have 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 'not be applied to imported and domestic products so as to afford protection to domestic production'". Toward this end, Article III obliges Members of the WTO to provide equality of competitive conditions for imported products in relation to domestic products. … Article III protects expectations not of any particular trade volume but rather of the equal competitive relationship between imported and domestic products.¹⁷⁷ (footnotes omitted)

205. We have also stated that, although this "general principle" is not explicitly invoked in Article III:4, nevertheless, it "informs" that provision.¹⁷⁸ In interpreting Article III:4 we are, therefore, guided by this principle.

206. With these general considerations in mind, we turn to the two issues raised by the United States in its appeal under Article III:4 of the GATT 1994.

Continue on to: Article 207

Notes

¹³¹ See infra, paras. 175-177, where we address the exception to this requirement in Section 942(c)(1) IRC.

¹³²  Sections 942(b)(2)(A)(ii) and 942(b)(3) IRC. As an alternative, the foreign economic process requirement may be satisfied where the costs attributable to activities performed outside the United States account for at least 85 percent of the costs in two of the five categories mentioned in paragraph 152. See Section 942(b)(2)(B) IRC.

¹³³  We note that Isenbergh states that, in the case of sale of goods by a producer, the income generated by the sales transaction is attributable to "easily distinguishable activities" which are "often combined", namely "production and sale" activities. Isenbergh indicates that in an international sales transaction, these production and sales activities may take place "in different countries". These activities, therefore, generate income that has different sources which are "compounded" unless the income from the different sources is separated. Isenbergh states that "ideally" the different "elements of the transaction" would be "disengaged" using arm's length pricing rules. The manufacturer would be treated as if it had sold the goods to an independent distributor at arm's length prices, who in turn resold the goods. This would "dissect" the transaction on the basis of the place where the different activities occurred. (J. Isenbergh, supra, footnote 79, Vol. I, para. 10.9, p. 10:16)

¹³⁴  Section 941(a)(1)(C) IRC.

¹³⁵  Section 941(a)(1)(B) IRC. We note that, under Section 941(a)(1)(A) IRC, QFTI may be 30 percent of the "foreign sales and leasing income" of the taxpayer. We will examine this formula below. See infra, paras. 172-178.

¹³⁶  At the oral hearing, the United States referred to the formulae for calculating the amount of QFTI as "rules of thumb".

¹³⁷  House Report, p. 20. The figures used in these examples are also based on the example given in the United States' House Report.

¹³⁸  United States' response to questioning at the oral hearing.

¹³⁹  The United States confirmed our understanding at the oral hearing.

¹⁴⁰  See supra, para. 25, for a description of the formulae used to calculate the amount of QFTI.

¹⁴¹  Where the taxpayer elects to use the 1.2 percent rule to calculate the tax exemption with respect to any transaction, Section 941(a)(3) IRC confines the exemption to the income earned in that single transaction. Any income earned in any other transaction, relating to the same property, cannot benefit from an exemption, even in the case of a second transaction between related parties. This provision, therefore, effectively excludes the application of the deeming rule for related parties in Section 942(b)(4) IRC, which allows income from more than one transaction to be included in the calculation of QFTI. See supra, paras. 159 and 163.

¹⁴²  See supra, paras. 25 and 156.

¹⁴³  See supra, para. 159.

¹⁴⁴  We acknowledge that, for certain purposes, related parties may be treated as a single economy entity. Yet, the application of the deeming rule here adds another situation where the ETI measure misallocates domestic- and foreign-source income.

¹⁴⁵  This method of determining FSLI does not apply to income derived from the "lease or rental" of QFTP. We examine below the calculation of FSLI in transactions involving the "lease or rental" of QFTP. See infra, paras. 170-174.

¹⁴⁶  We note that, under Section 941(c)(3)(B) IRC, only "directly allocable expenses" are to be "taken into account in computing foreign trade income" for purposes of FSLI. (emphasis added)

¹⁴⁷  Senate Report, p. 10; House Report, p. 24. (emphasis added)

¹⁴⁸  Section 941(c)(1)(B) IRC.

¹⁴⁹  See supra, paras. 155 and 166.

¹⁵⁰  Senate Report, p. 11; House Report, p. 24.

¹⁵¹  We note that Isenbergh considers that the use of arm's length pricing is an appropriate method for separating manufacturing income from sales income. (J. Isenbergh, supra, footnote 79, Vol. I, para. 10.9, p. 10:16) See also supra, footnote 133.

¹⁵²  We note that a taxpayer with no more than $5,000,000 of declared foreign trading gross receipts may have other gross receipts which are not declared as foreign trading gross receipts.

¹⁵³  Clearly, where the transaction involves the production of QFTP outside the United States, there would be other foreign links than the use outside the United States. We deal here with the United States' argument as it relates to property produced within the United States.

¹⁵⁴  Senate Report, p. 19; House Report, p. 33.

¹⁵⁵  26 CFR 1.924(a)–1T–(d).

¹⁵⁶  See supra, para. 100.

¹⁵⁷  We recall that, under Section 114(d) IRC, a taxpayer gives up tax credits attributable to income excluded from taxation under the ETI measure.

¹⁵⁸  See supra, para. 104 and footnote 80 thereto.

¹⁵⁹  See supra, para. 170, examining the rule that, where QFTI is calculated as 30 percent of FSLI, FSLI is the income "properly allocable" to certain foreign activities, other than in the case of "lease or rental" income.

¹⁶⁰  See supra, paras. 175-177, examining the exemption granted to certain taxpayers without satisfaction of the foreign economic process requirement and, paras. 178-180, examining the exemption granted for service-related income where the services are performed in the United States.

¹⁶¹  See supra, paras. 156-168, examining the rules whereby QFTI may be calculated either as 1.2 percent of total foreign trading gross receipts or as 15 percent of total foreign trading income.

¹⁶²  In addition, under the third formula for FSLI, there are circumstances where the ETI measure could grant a tax exemption for lease or rental income which includes domestic-source income. See supra, para. 173.

¹⁶³  Panel Report, para. 8.122.

¹⁶⁴  Panel Report, para. 8.116.

¹⁶⁵  United States' appellant's submission, paras. 247-248.

¹⁶⁶  Appellate Body Report, US – FSC, supra, footnote 3, para. 138.

¹⁶⁷  Ibid., para. 139.

¹⁶⁸  Appellate Body Report, US – FSC, supra, footnote 3, para. 140.

¹⁶⁹  Ibid., paras. 141-142.

¹⁷⁰  We note that the United States has not appealed any other aspect of the Panel's finding under Article 10.1 of the Agreement on Agriculture. In particular, the United States has not appealed the Panel's finding that it was appropriate to examine the European Communities' primary claim under Article 10.1 of the Agreement on Agriculture, without first examining its alternative claim under Article 9.1 of that Agreement. (Panel Report, para. 8.112 and footnote 219 thereto) Nor has the United States appealed the Panel's finding that the measure is "applied in a manner which results in, or which threatens to lead to, circumvention of export subsidy commitments" within the meaning of Article 10.1. (Panel Report, paras. 8.117-8.120) We note that the United States did not contest either of these issues before the Panel. (Panel Report, para. 8.112 and footnote 219 thereto; Panel Report, para. 8.121; and United States' first submission to the Panel, paras. 220-221; Panel Report, p. A-100)

¹⁷¹  See supra, para. 21. See also infra, para. 201, for the text of Section 943(a)(1)(C) IRC of the fair market value rule.

¹⁷²  Panel Report, para. 8.158.

¹⁷³  Ibid., para. 8.135.

¹⁷⁴  Ibid., para. 8.149.

¹⁷⁵  Ibid., para. 8.158.

¹⁷⁶  We refer to this provision as the "fair market value rule"; the Panel termed it the "foreign articles/labour limitation".

¹⁷⁷  Appellate Body Report, Japan – Alcoholic Beverages II, supra, footnote 116, at 109-110, quoting from Panel Report, United States – Section 337 of the Tariff Act of 1930, adopted 7 November 1989, BISD 36S/345, para. 5.10. We cited this statement in Appellate Body Report, European Communities – Measures Affecting Asbestos and Asbestos-Containing Products ("EC – Asbestos "), WT/DS135/AB/R, adopted 5 April 2001, para. 97, a dispute that also involved Article III:4 of the GATT 1994.

¹⁷⁸  Appellate Body Report, EC – Asbestos, supra, footnote 177, para. 98.