WORLD TRADE
ORGANIZATIONWT/DS108/R
8 October 1999
(99-4118)
Original:  English
UNITED STATES – TAX TREATMENT FOR
"FOREIGN SALES CORPORATIONS"
REPORT OF THE PANEL
The report of the Panel on United States – Tax Treatment for "Foreign Sales Corporations"  is being
circulated to all Members, pursuant to the DSU.  The report is being circulated as an unrestricted
document from 8 October 1999, pursuant to the Proced ures for the Circulation and Derestriction of
WTO Documents (WT/L/160/Rev.1).  Members are reminded that, in accordance with the DSU, onlyparties to the dispute may appeal a panel report.  An appeal shall be limited to issues of law covered in
the Panel report and legal interpretations developed by the Panel.  There shall be no ex parte
communications with the Panel or Appellate Body concerning matters under consideration by the
Panel or Appellate Body.
Note by the Secretariat:  This Panel Report shall be adopted by the Dispute Settlement Body (DSB) within 60 days after the
date of its circulation unless a party to the dispute decides to appeal or the DSB decides by consensus not to adopt the report .
If the Panel Report is appealed to the Appellate Body, it sh all not be considered for adoption by the DSB until after the
completion of the appeal.  Information on the current status of the Panel Report is available from the WTO Secretariat.WT/DS108/R
Page i
TABLE OF CONTENTS
Page
I. INTRO DUCTION ................................................................................................................. ...1
II. FACTUAL ASPECTS ............................................................................................................. .1
III. FINDINGS AND RECOMMENDATIONS RE QUESTED BY TH E PARTIES................3
A. FINDINGS OF LAW ............................................................................................................3
B. RECOMMENDATIONS .......................................................................................................4
IV. MAIN ARGUMENTS OF  THE PART IES ............................................................................4
A. PRELIMINARY OBJECTIONS .............................................................................................4
1. Statement of available evidence – Article 4.2 of the SCM Agreement .......8
2. Appropriate tax forum – Footnote 59 of the SCM Agreement .................19
3. Specificity of claims – Article 6.2 of the DSU..............................................27
4. Scope of measures at issue............................................................................29
B. WHETHER FSC MEASURES ARE SUBSIDIES CONTINGENT UPON EXPORT
PERFORMANCE WITHIN THE MEANING OF ARTICLE 3.1( A) OF THE SCM AGREEMENT ...31
C. WHETHER FSC MEASURES ARE SUBSIDIES CONTINGENT UPON USE OF DOMESTIC
OVER IMPORTED GOODS WITHIN THE MEANING OF ARTICLE 3.1( B) OF THE SCM
AGREEMENT ................................................................................................................208
D. WHETHER FSC MEASURES ARE IN VIOLATION OF THE AA ...........................................213
E. ARGUMENTS RELATING TO THE PANEL 'S RECOMMENDATIONS ...................................228
F. CONCLUDING ARGUMENTS .........................................................................................230
V. ARGUMENTS PRESENTED BY THIRD P ARTIES.......................................................235
A. BARBADOS ..................................................................................................................235
B. CANADA ......................................................................................................................236
C. JAPAN ..........................................................................................................................239
VI. INTERIM REVIEW .............................................................................................................2 45
VII. FINDINGS................................................................................................................... ..........248WT/DS108/R
Page ii
A. REQUESTS FOR PRELI MINARY RU LINGS.........................................................248
1. Statement of Available Evidence ...............................................................248
2. Appropriate Tax Forum .............................................................................251
3. Specificity of the Request for Establishment of a Panel ..........................2534. Related Measures ........................................................................................255
B. CLAIMS UNDER ARTICLE 3.1(a)  OF THE SCM AGREEMENT ........................255
1. Overview of the parties' arguments...........................................................255
2. Order in which the issues will be addressed .............................................256
3. Existence of a subsidy: FSC exemptions ...................................................2574. Contingency upon Exportation: FSC Exemptions...................................276
5. Administrative Pricing Rules .....................................................................282
6. Conclusion....................................................................................................284
C. CLAIMS UNDER ARTICLE 3.1(b)  OF THE SCM AGREEMENT ........................284
D. CLAIMS UNDER THE AGREEM ENT ON AGRIC ULTURE ................................284
1. Overview of the Parties' Arguments..........................................................284
2. Article 10.3 and the Burden of Proof.........................................................285
3. Claim Under Article 3.3 of the Agreement on Agriculture .....................287
4. Claim Under Article 8 of the Agreement on Agriculture ........................293
VIII. CONCLUSIONS AND RECOMMENDAT IONS..............................................................293WT/DS108/R
Page 1
I. INTRODUCTION
1.1 On 18 November 1997, the European Communities requested consultations with the
United States under Article 4 of the Understanding on Rules and Procedures Governing the
Settlement of Disputes ("DSU"), Article XXII I:1 of GATT 1994, and Article 4 of the Agreement on
Subsidies and Countervailing Measures ("SCM Agreement") with respect to "Sections 921-927 of theInternal Revenue Code and related measures establishing special tax treatment for "Foreign Sales
Corporations" ("FSCs")".
1
1.2 On 4 March 1998, the European Communities requested the consultations "to be extended
also to include consultations under Article 19 of the Agreement on Agriculture" ("AA").2
1.3 The European Communities and the United States held consultations on 17 December 1997,
10 February 1998, and 3 April 1998, but failed to reach a mutually satisfactory solution.  On
1 July 1998, the European Communities requested the establishment of a panel under Article 6 of the
DSU, Article 4 of the SCM Agreement, Articl e 19 of the AA, and Article XXIII of GATT 1994.3
1.4 At its meeting on 22 September 1998, the Dispute Settlement Body ("DSB") established a
panel in accordance with Article 6 of the DSU with the following standard terms of reference:
"To examine, in the light of the relevant provisions of the covered agreements cited
by the European Communities in document WT/DS108/2, the matter referred to the
DSB by the European Communities in document WT/DS108/2, and to make such
findings as will assist the DSB in making the recommendations or in giving the
rulings provided for in those agreements."4
1.5 Barbados, Canada, and Japan reserved their rights to participate in the panel proceedings as
third parties.
1.6 On 9 November 1998, the parties to the dispute agreed on the composition of the Panel as
follows:
Chairman: Mr. Crawford Falconer
Members: Mr. Didier Chambovey
Professor Seung Wha Chang
1.7 The Panel met with the parties on 9-10 February 1999 and 16 March 1999.  It met with the
third parties on 10 February 1999.
II. FACTUAL ASPECTS
2.1 A FSC is a corporation created, organised, and maintained in a qualified foreign country or
US possession outside the customs territory of the United States under the specific requirements of
Sections 921-927 of the US Internal Revenue Code.  A FSC obtains a US tax exemption on a portion
of its earnings ("foreign trade income"), which means the gross income of a FSC attributable to"foreign trading gross receipts".  Foreign trading gross receipts means the gross receipts of any FSC
which are generated by qualifying transactions, which generally involve the sale or lease of “export
property”.  Export property is:
                                                     
1 See the European Communities' request for consultations, WT/DS108/1 (28 November 1997).
2 WT/DS108/1/Add.1 (12 March 1998).
3 WT/DS108/2 (9 July 1998).
4 WT/DS108/3 (11 November 1998).WT/DS108/R
Page 2
• property held for sale or lease;
• manufactured, produced, grown, or extracted in the United States;
• by a person other than a FSC;
• sold, leased, or rented for use, consumption, or disposition outside the United States;
and
• with no more than 50 per cent of its fair market value attributable to imports.5
2.2 A FSC must meet certain requirements of foreign presence.6  For example, a FSC must
maintain an office outside the customs territory of the United States.  That office must be equipped to
transact the FSC's business.  Also, in order for a FSC, other than a small FSC, to be treated as having
foreign trading gross receipts for the taxable y ear, the management of the corporation during the
taxable year must take place outside the United States, and the corporation can have foreign trading
gross receipts from any transaction only if economic processes with respect to the transaction take
place outside the United States.7
2.3 A portion of the “foreign trade income” is deemed to be “foreign source income not
effectively connected with a trade or business in the United States” and is therefore not taxed in the
United States8; this untaxed portion is referred to as the “exempt foreign trade income”.9  T h e
remaining portion is taxable to the FSC.  Dividends  paid by the FSC out of exempt and non-exempt
income to the shareholder (ordinarily, the “related  supplier”) generally qualify for a full dividends-
received deduction.10
2.4 Special rules apply for agricultural cooperatives. Under certain circumstances, all of the
foreign trade income  that a FSC owned by a related qualified cooperative earns from the sale of
agricultural or horticultural products will be treated as exempt foreign trade income.11  However, no
dividends-received deduction is permitted on a portion of the foreign trade income of a shareholder of
an agricultural cooperative.12
2.5 With respect to the functions for which the FSC is responsible, in the case of a sale of export
property to a FSC by a person described in Section 482 of the IRC ( i. e., by a related supplier),
income is to be allocated to FSCs under one of th ree methods.  One of these methods uses the prices
actually charged between the FSC and the “related supplier” ( i.e., the United States parent), subject to
the standard United States transfer pricing rules in Section 482 of the Internal Revenue Code.13  The
other two methods are “administrative pricing” rules, which FSCs and their parents are allowed to
apply for the allocation of income between them.14
                                                     
5 Certain exceptions to this definition of export property may be found in Section 927(a)(2) of the IRC.
They are: (a) property leased or rented by a FSC for us e by any member of a controlled group of corporations of
which such FSC is a member; (b) patents, inventions, models, designs, formulas, or processes whether or notpatented, copyrights (other than films, tapes, records, or similar reproductions, and other than computer software(whether or not patented), for commercial or home use), good will, trademarks, trade brands, franchises, or other
like property; (c) oil or gas (or any primary product thereof); (d) products the export of which is prohibited or
curtailed to effectuate the policy set forth in paragraph (2)(C) of section 3 of the Export Administration Act of1979 (relating to the protection of the domestic economy); and (e) any unprocessed timber which is a softwood.For purposes of subparagraph (e), the term "unprocessed timber" means any log, cant, or similar form of timber.
6 Section 922(a) of the IRC.
7 Section 924(b) of the IRC.
8 Such income is generally exempt from tax under section 882 of the Internal Revenue Code, if it is
earned by a corporation resident outside the United States.
9 See Section 923(a) of the IRC.
10 Section 926(a) and 245(c) IRC.
11 See Section 923(a)(4) of the IRC.
12 See Section 245(c)(2)(B) of the IRC.
13  Exhibit EC-1.
14 See Sections 925(a) (1) and (2) of the IRC.WT/DS108/R
Page 3
2.6 The first administrative pricing rule apportions  23 per cent of the total combined taxable
income (that is, net income earned by the related su pplier and the FSC together) derived from the sale
of export property by the FSC and the remaining 77 per cent to its related supplier.  This rule further
provides that 15/23 (approximately 65 per cent) of the FSC's foreign trade income is exempt from US
tax.15  Thus, this rule provides an exemption for 15 per cent (23 per cent x 15/23) of the total
combined taxable income earned in the transaction.
2.7 The second administrative pricing rule allows the FSC to take 1.83 per cent of the total
foreign trading gross receipts from the sale of export property as foreign trade income, not to exceed
twice the amount allocable to the FSC under  the combined taxable income method; i.e., 46 per cent of
the total combined (net) income earned in FSC transactions.16  This rule further provides that 15/23
(approximately 65 per cent) of the FSC's foreign trad e income is exempt from US tax.  Thus, this rule
provides an exemption for up to 30 per cent (46%  x 15/23) of the total combined taxable income
earned in the transaction.  This 30 per cent exemption amount is only available, however, in limited
circumstances.  Because the ceiling for the gross receipts method is linked to the combined taxable
(net) income method, it is not mathematically possible to receive the full 30 per cent exemption unlessthe profit margin on a transaction is 4 per cent or less.  At a profit margin of 8 per cent or more, the
exemption amount under the gross receipts method will be no more than 15 per cent under any
circumstances.
2.8 A FSC must either itself perform or pay for specific economic processes related to the
relevant export transaction.  By statute, in order to qualify for the partial tax exemption, a FSC that
uses administrative pricing rules must perform, contract, or pay for all of the distribution activities
attributable to the export transaction.
17  These include the solicitation (other than advertising),
negotiation, or making of the contract for the relevant FSC export transaction.  At least one of these
three important activities must be performed outside the United States.  Additionally, the FSC must
take responsibility for all of the following distribution activities, which must also be performed
predominantly outside the United States:
(a) Advertising and sales promotion;
(b) Processing of customer orders and arranging for delivery;(c) Transportation of goods involved in the transaction to the customer;
(d) Determination and transmittal of final invoice or statement of account, and receipt of
payment; and,
(e) Assumption of credit risk.
18
III. FINDINGS AND RECOMMENDATIONS REQUESTED BY THE PARTIES
A. FINDINGS OF LAW
3.1 The European Communities requests the Panel to make the following findings of law:
3.2 That, by maintaining the tax exemptions and special administrative pricing rules contained in
the FSC scheme, the United States has violated:
a) Article 3.1(a) of the SCM Agreement by granting subsidies contingent in law upon
export performance;
                                                     
15 See Sections 923(a)(3) and 291(a)(4) of the IRC.
16 See Section 925(d) of the IRC.
17  See Section 925(c) of the IRC.
18  Section 924(d) and (e) of the IRC.WT/DS108/R
Page 4
b) Article 3.1(b) of the SCM Agreement by granting subsidies contingent in law upon
the use of domestic over imported goods; and
c) Articles 3 and 8 read in conjunction with Articles 9.1(d), 10.1, and 10.3 of the AA by
granting export subsidies to agricultural goods in excess of its reduction commitments
under that Agreement (e. g. wheat, maize, soya beans, and cotton);
d) And that, by doing so, it has nullified and impaired benefits accruing to the European
Communities under those agreements.
3.3 The United States  requests the Panel to make the following findings of law:
That neither the FSC tax exemption nor the FSC administrative pricing rules violate:
a) Article 3.1(a) of the SCM Agreement;
b) Article 3.1(b) of the SCM Agreement; or
c) Articles 3 and 8 read in conjunction with Articles 9.1(d), 10.1, and 10.3 of the AA;
and
d) That neither the FSC tax exemption nor the FSC administrative pricing rules nullify
or impair benefits accruing to the European Communities under the SCM Agreement
or the AA.
B. RECOMMENDATIONS
3.4 In its first oral  and second written submissions, the European Communities  requests the
Panel to recommend that the United States withdraw the two FSC subsidies before the beginning of
the next tax year (fiscal year 2000).
3.5 The United States  maintains that it is premature to address questions of implementation, an
issue which could be taken up, if necessary, during the interim review process.  The United States
further maintains that the time-frame suggested by  the European Communities is inappropriate and
unrealistic.
3.6 In its second oral submission to the Panel, the European Communities requests the Panel to
recommend that the United States withdraw the tw o FSC subsidies by 1 October 1999 in the absence
of an appeal and, in any event, before 1 October 2000 (the beginning of its fiscal year 2001).
IV. MAIN ARGUMENTS OF THE PARTIES
A. PRELIMINARY OBJECTIONS
4.1 In its Request for Preliminary Findings, the United States  requests that the Panel:
(1) dismiss the European Communities' claims under Article 3 of the SCM Agreement
due to the European Communities' failure to include in its request for consultations a
statement of available evidence with regard to the existence and nature of the subsidy
in question, as it was required to do by Article 4.2 of the SCM Agreement;
(2) dismiss or defer the European Communities' complaint due to the
European Communities' failure to raise transfer pricing concerns regarding the FSC,
in the first instance, in an appropriate tax forum, as it was required to do by
footnote 59 of the SCM Agreement;WT/DS108/R
Page 5
(3)  find that, by failing to identify the agricultural products covered by its claims under
the AA, the European Communities' request for the establishment of a panel failed to
comply with Article 6.2 of the DSU; and that because of this failure, the
European Communities' claims under the AA should be dismissed; and
(4) find that the measures at issue in this dispute are limited to Section 921-927 of the USInternal Revenue Code (the FSC statute).
The European Communities  makes the following general comments:
4.2 A number of the objections raised by the United States are matters which the United States
ought to have raised before the establishment of the Panel, during the consultations or at the meeting
of the DSB at which the request for the establishment of the Panel was considered.  It did not do so,
and the European Communities was led to believe that the United States had no objections to the
information which the European Communities had provid ed about the nature of its complaint or to the
jurisdiction of a panel to hear this case.  The United  States is in any event estopped from raising these
objections now.  Raising these issues after the Panel has been established obstructs the efficient
conduct of dispute settlement.
4.3 A WTO Member against whom the establishment of a Panel is requested has at least two
formal occasions at which to raise objections as to the jurisdiction of a dispute settlement panel and
the regularity of the procedure leading up to the estab lishment of the panel.  This is at the meetings of
the DSB.  Objections raised at this time can and do lead to a withdrawal of the request and arectification of any defect.
4.4 In the present case, no objections were made at the meetings of the DSB when the
establishment of this Panel was discussed.  Indeed, at the meeting of the DSB at which this Panel was
established, the representative of the United States, after referring to her statement at the previous
meeting of the DSB on 23 July 1998, stated that:
“She only wished to state that the European Communities' reinstitution of a matter
considered by the United States as resolved was a legally unwarranted and
commercially unjustified action which would not prove helpful to the multilateral
trading system or to the United States bilateral relationship with the European
Communities and its member States.  The United States was confident to prevail onthe merits of this case and would state its arguments before the panel.”
4.5 The European Communities therefore considers th at raising procedural objections to the
jurisdiction of the Panel and the regularity of th e pre-establishment procedure instead of arguing on
the merits is deliberately obstructive of the dispute settlement process and an abuse of procedure. The
first, second, and third of the United States requests for preliminary findings should therefore bedismissed already for this reason.
4.6 The European Communities requests the Panel to reject the requests by the United States for
“preliminary findings” and other rulings at its first meeting or as soon as possible thereafter.
The United States  makes the following general comments:
4.7 In the United States' Request for Preliminary Findings and the First US Submission
19, the
United States objected to the European Communities' failure to provide a “statement of available
evidence with regard to the existence and nature of the subsidy in question” and its failure to identify
the agricultural products at issue in its claims under the AA.  These failings were in violation of the
                                                     
19 Request by the United States for Preliminary Findings (4 December 1998); First Submission of the
United States of America (25 January 1999).WT/DS108/R
Page 6
requirements of Article 4.2 of the SCM Agreement and Article 6.2 of the DSU.20  In addition, because
the European Communities has failed to specify any “related measures”, it necessarily has limited its
claims to the FSC statute itself.
4.8 Because of these procedural failings, it was not until the European Communities presented its
First Submission to the Panel on 21 December 1998 (“First European Communities Submission”) thatthe United States first learned the European Communitie s' theory of its case and its perceptions of the
purpose and operational effects of the FSC.  That submission revealed for the first time that the
European Communities based its claims on a legal premise that the United States finds to be
remarkable;  namely, that the principle that Members may, but need not, tax income generated from
foreign economic activities – a principle originally proposed by European Communities memberStates and endorsed by the European Communities itself – is not a part of the SCM Agreement or
otherwise applicable to this case.  The First Eu ropean Communities Submission revealed that, at the
very least, the European Communities and the United States have fundamentally different views of
the legal framework within which this dispute should be decided.
4.9 The First European Communities Submission further revealed an European Communities
perception of the FSC and of the purpose underlying its enactment that is totally different from that
which the Congress of the United States articulated at the time the FSC was adopted.  Accordingly,
the European Communities has made numerous arguments that, in the view of the United States, are
irrelevant in light of the legislative purpose that Congress sought to achieve through the FSC.  When
combined with entirely different views of key legal provisions – the meaning of the term “arm’s
length” in footnote 59, for example – the arguments of the First European Communities Submission
and the arguments of the United States in its First Submission do not address common issues.
4.10 Because such fundamental differences were never exposed and addressed during the
consultations phase of this case, the real issues before the Panel will be joined, if at all, only very late
in the Panel process.  Both this rebuttal brief and the European Communities' simultaneous rebuttal
brief, rather than engaging one another on the fine points and implications of the opposing parties’
main arguments, will in many respects still be atte mpting to define the basic issues in this case.  One
resulting risk is that the central issues will not ha ve been explored and tested as fully as they might
have been had the true issues been identified earlier in the process.
4.11 More important, perhaps, is that the procedural failings in the early stages of this dispute have
effectively foreclosed – as subsequent submissions to this Panel have confirmed – meaningful
consultations on the complex issues of this case.  Because the fundamental differences in the views ofthe European Communities and the United States on the controlling legal standard emerged only
through submissions to the Panel, it was not possible to engage that issue and explore the implications
of the two contrasting views during the consultati on process.  Similarly, because it was only the
European Communities' submission on the merits to this Panel that surfaced what, in the view of the
United States, is a fundamental misperception by the European Communities of the purpose andrationale of the FSC, there was no opportunity during the consultation period to engage in a dialogue
about those basic, primarily factual, differences.
4.12 The consultation process is an integral part of the WTO dispute settlement process.  The
requirements that a complaining Member must identify  the measures at issue, indicate the legal basis
for its complaint, and provide a statement of the available evidence on the nature of any allegedsubsidy are all mandatory steps in making a request for consultations, which the complaining Member
is required to do.  Their obvious purpose is to en able the parties to engage in informed, meaningful
consultations.  In this case, consultations took place without any statement of available evidence or
                                                     
20 To clarify matters for the Panel, the United States hereby confirms that, in light of the discussion that
took place at the first meeting of the Panel, it has withdrawn its objection concerning theEuropean Communities' failure to identify non-scheduled  agricultural products.  The United States continues to
maintain, however, that the European Communities' failure to identify scheduled  agricultural products in its
request for the establishment of a panel violated Article 6.2 of the DSU.WT/DS108/R
Page 7
disclosure of the legal basis and factual assumptio ns that emerged for the first time in the First
European Communities Submission.  Although a Panel cannot monitor consultations or force them to
be substantive, a Panel at least can ensure that the required preconditions to consultations are satisfied.
4.13 These procedural preconditions, and the consultation process for which they are intended to
prepare the way, are singularly important in the context of this dispute.  This is a particularly complexcase.  As reflected in the first submissions of the parties and the questioning that took place at the first
meeting of the Panel, questions relating to the co ntrolling legal standard are themselves complicated
and implicate provisions of the SCM Agreement that have lineages that stretch back decades.  The tax
provisions of the FSC are also complex, as they must be construed and understood in the context of
the tax system of the United States, of the Tax Legislation Cases  decided by a GATT panel in the
1970s, of the GATT Council Decision of 1981, of the Congressional purpose of implementing and
adhering to that Decision, and of provisions of the SCM Agreement that incorporate many years of
prior practice.  It would be difficult to posit a case in which careful consultations would have been
more important.
4.14 The significance of the European Communities' procedural failings is reinforced, finally, by
the last procedural requirement that the United States has referenced and that the European
Communities has failed to honour.  In contrast to the treatment of most other types of disputes,
footnote 59 of the SCM Agreement specifically requires that when a Member believes that another
Member is acting contrary to the “arm’s length” principle of footnote 59, those Members shall attempt
to resolve their differences through an alternative forum specialized in the technical aspects of the
dispute.  The language used in footnote 59 – that Members “shall normally” seek to resolve such
differences in an alternative forum – has been construed by a panel in another context to be amandatory requirement.
21
4.15 This unusual provision deferring to more specialised facilities and mechanisms – which first
appeared in footnote 2 to the Illustrative List at tached to the Tokyo Round Subsidies Code and for
which there does not appear to be any comparable provision in the realm of the WTO – has direct
applicability to the technical dispute before this Panel.  Not only are the intricate details of the taxprovisions at issue in this case complex, but also the implications that any final Panel decision on the
merits may have on the varied tax systems of the WTO’s more than 130 Members could be very far-
reaching.  Issues of such scope deserve the concentrated attention of specialised fora.
4.16 In the context of the procedural issues in this case, the provision of footnote 59 referring
Members to alternative fora reinforces the importance of detailed, substantive consultations.  If theSCM Agreement goes so far as to urge Members to take such issues to more specialised fora, that
provision, even if this Panel were to deem it non-binding, plainly underscores the importance of
enforcing the procedural provisions designed to lead to informed, detailed consultations before asking
a Panel to decide the matter on its merits.
4.17 For all of these reasons, the United States believes that this Panel should decline to decide the
merits of this case at this time.  The European Communities' procedural failings here have prevented
meaningful consultations.  The issues are just now being joined.  The factual claims and counter-
claims have not yet been explored or reconciled, and the parties have had no meaningful dialogue on
the implications of the issues of this case for both worldwide and territorial tax systems.  The
United States therefore urges, first, that this matter  be dismissed in order to allow the Parties to first
address the issues raised, as footnote 59 requires, through bilateral or multilateral tax mechanisms and
authorities.  Alternatively, the United States urges that this case be dismissed in order to assure that
                                                     
21  United States - Imposition of Anti-Dumping Duties on Imports of Stainless Steel Hollow Products
from Sweden , ADP/47, Report of the Panel issued 20 August 1990 (unadopted), paragraph 5.20, in which the
panel, referring to the phrase “shall normally” as used in Article 5.1 of the Tokyo Round Antidumping Codewith respect to the “on behalf of” requirement, stated that “[t]he plain language in which this provision is
worded, and in particular the use of the word ‘shall’, indi cates that this is an essential procedural requirement for
the initiation of the investigation to be consistent with the Agreement.”WT/DS108/R
Page 8
the merits of this dispute, if not otherwise resolved, come to a WTO panel only after the procedural
requirements designed to facilitate meaningful consultations have been satisfied.
1. Statement of available evidence – Article 4.2 of the SCM Agreement
The United States  argues as follows:
4.18 In making its request for consultations in this dispute, the European Communities failed to
include a “statement of available evidence” as required by Article 4.2 of the SCM Agreement.  As a
result, the European Communities' claims under Article 3 of the SCM Agreement are not properly
before the Panel and should be dismissed.
4.19 The general rules governing requests for dispute settlement consultations are found in
Article 4.4 of the DSU, which provides as follows:
"All such requests for consultations shall be notified to the DSB and the relevant
Councils and Committees by the Member which requests consultations.  Any request
for consultations shall be submitted in writing and shall give the reasons for the
request, including identification of the measures at issue and an indication of the legalbasis for the complaint."
4.20 Thus, under Article 4.4, a valid request for consultations must meet the following
requirements:
(1) The request must be notified to the DSB and the relevant Councils and Committees
by the Member requesting consultations.
(2) The request must be submitted in writing.(3) The request must identify the measures at issue.(4) The request must identify the legal basis for the complaint.
These four requirements are not at issue here.
4.21 However, Article 4.2 of the SCM Agreement adds a fifth requirement in the case of requests
for consultations concerning alleged prohibited subsidies, a requirement that the European
Communities did not satisfy.  Specifically, Article 4.2 provides as follows:  “A request forconsultations under paragraph 1 shall  include a statement of available evidence with regard to the
existence and nature of the subsidy in question.” (Emphasis added)
4.22 The European Communities invoked Article 4 of the SCM Agreement as the basis for both its
consultations and panel requests with respect to the SCM Agreement.  Accordingly, the obligation to
include a “statement of available evidence” under Article 4.2 is mandatory , as the drafters of the SCM
Agreement made clear by using the term “shall”.
22  Therefore, by the terms of Article 4.2, any request
for consultations under Article 4.1 must  include a statement of available evidence.
4.23 As noted, the requirement of Article 4.2 to include a statement of available evidence applies
to this proceeding.  Under Appendix 2 to the DSU, Article 4.2 is identified as a special or additional
rule and procedure.  As such, under Article 1.2, first sentence, of the DSU, the requirements forconsultation requests in Article 4.4 of the DSU “apply subject to” the requirements of Article 4.2 of
                                                     
22 Such an interpretation accords to Article 4.2 the ordinary meaning of its terms in their context,
consistent with the customary principles of treaty interpretation as set forth in Article 31 of the Vienna
Convention on the Law of Treaties .  See, e.g., Japan – Taxes on Alcoholic Beverages , WT/DS8/AB/R, Report of
the Appellate Body adopted 1 November 1996, p. 11.WT/DS108/R
Page 9
the SCM Agreement.  Thus, a request for consultations that complies with Article 4.4 of the DSU, but
that fails to include a statement of available evidence as required by Article 4.2 of the SCM
Agreement, is not a proper request.23
4.24 In its recent decision in the Guatemala Cement  case, the Appellate Body interpreted the
relationship between the general provisions of the DSU and the “special or additional rules andprocedures” listed in Appendix 2.  Th e Appellate Body stated as follows:
"[T]hese special or additional rules and procedures “shall prevail” over the provisions
of the DSU “[t]o the extent that there is a difference  between” the two sets of
provisions (emphasis added).  Accordingly, if there is no “difference”, then the rules
and procedures of the DSU apply together with  the special or additional provisions of
the covered agreement."
24
4.25 Because Article 4.2 of the SCM Agreement adds to and is otherwise consistent with
Article 4.4 of the DSU, it must be read together with Article 4.4.  Together, these two provisions
establish the requirements for consultation requests concerning claims under Article 3 of the SCM
Agreement.  These requirements are mandatory, and should be enforced in this dispute.
4.26 As is by now well-established, the provisions of the various WTO agreements must be
interpreted in accordance with Article 31 of the Vienna Convention on the Law of Treaties  (“VCLT ”),
paragraph 1 of which provides as follows:  “A trea ty shall be interpreted in good faith in accordance
with the ordinary meaning to be given to the terms of  the treaty in their context and in the light of its
object and purpose.”  An application of Article 31(1) of the VCLT  to Article 4.2 of the SCM
Agreement reveals that the European Communities' request for consultations failed to satisfy the
requirements of Article 4.2.
4.27 The ordinary meaning of the term “evidence” is as follows:  “Facts or testimony in support of
a conclusion, statement or belief.”25  Thus, based on its ordinary meaning, and as applied to this
dispute, Article 4.2 required the European Communities to include in its request for consultations a
statement of available facts  from which one could conclude that the FSC provisions constitute a
prohibited subsidy.  The European Communities was required to do something more than merelyassert the ultimate conclusion.
4.28 This result is reinforced by considering the context of Article 4.2, which under Article 31(2)
of the VCLT  includes other provisions of the SCM Agreement.
26  Article 11.2 of the SCM Agreement,
which deals with the contents of countervailing duty applications, provides as follows:
4.29 "An application under paragraph 1 shall include sufficient evidence of the existence of (a) a
subsidy and, if possible, its amount, (b) injury within the meaning of Article VI of GATT 1994 as
interpreted by this Agreement, and (c) a causal link between the subsidized imports and the alleged
injury.  Simple assertion, unsubstantiated by relevant evidence, cannot be considered sufficient to
meet the requirements of this paragraph." (Underscoring  added)
                                                     
23  This conclusion is reinforced by Article 30 of the SCM Agreement, which provides that the
provisions of the DSU “shall apply to consultations  and the settlement of disputes under this Agreement, except
as otherwise specifically provided herein. ” (Emphasis added)
24 Guatemala - Anti-Dumping Investigation Regarding Portland Cement from Mexico ,
WT/DS60/AB/R, Report of the Appellate Body adopted 25 November 1998, paragraph 65 (emphasis in
original).
25  The New Shorter Oxford English Dictionary  (1993).
26  Brazil - Measures Affecting Desiccated Coconut , WT/DS22/AB/R, Report of the Appellate Body
adopted 20 March 1997, p. 18, in which the Appellate Body interpreted Article 32.3 of the SCM Agreement in
conjunction with Articles 10 and 32.1 of that agreement.WT/DS108/R
Page 10
4.30 The second sentence of Article 11.2 makes clear that the drafters of the SCM Agreement
carefully distinguished between an “assertion” and “evidence.”
4.31 Nothing in the European Communities' initial reque st for consultations even purports to be a
statement of available evidence .27  Instead, the pertinent part of the European Communities' request
contains simply a conclusory legal assertion, merely citing the provisions of the SCM Agreement onwhich the European Communities relies.  As demonstrated above, assertions  are not evidence .
Therefore, the European Communities' request failed to satisfy the requirements of Article 4.2.
4.32 Likewise, the European Communities' second reque st for consultations with the United States
did not contain a statement of available evidence.  Rather, this second request merely sought to extend
the ongoing consultations to include consultations under Article 19 of the AA.
28  This second
consultation request did not refer to or modify the European Communities' claims under Article 3 of
the SCM Agreement, and, thus, did not cure the defect in the European Communities' initial request
for consultations.
4.33 In short, the European Communities' two requests for consultations in this dispute contain no
information whatsoever as to the evidence avai lable to the European Communities regarding the
existence and nature of the alleged subsidy in question.  As such, the European Communities' claims
under Article 3 of the SCM Agreement do not conform to the requirements of Article 4.2 of that
agreement.
4.34 In view of the mandatory requirement of Article 4.2 of the SCM Agreement, and the
European Communities' failure to meet it, the Panel should dismiss the European Communities'
prohibited subsidy claims.  Any other result would render Article 4.2 ineffective, an outcome that the
Appellate Body repeatedly has stated is not acceptable under applicable rules of treaty interpretation.29
4.35 Moreover, the Appellate Body recently clarified in the clearest possible terms that a
complainant in a WTO dispute is not free to disregard procedural requirements.  In the Guatemala
Cement  case, the Appellate Body threw out an entire dispute that had been fully litigated before a
panel because Mexico had failed to specify, as it was required to do by Article 6.2 of the DSU,
whether it was challenging Guatemala’s prelimin ary or final anti-dumping determination on cement
from Mexico.30  According to the Appellate Body, “the Panel did not consider whether Mexico had
properly identified a relevant anti-dumping measure in its panel request and, therefore, it erred in
finding that this dispute was properly before it.”31
4.36 The clear requirement of Article 4.2, the European Communities' failure to satisfy that
requirement, and the Appellate Body’s teachings in the Guatemala Cement  case require the Panel to
dismiss the European Communities' claims under Article 3 of the SCM Agreement.  The
European Communities' consultations request was fatally flawed, and therefore the
European Communities' panel request with respect to the SCM Agreement is also fatally flawed.
4.37 The European Communities' failure to include a statement of available evidence has deprived
(1) the United States of its right  to learn of the existence of such evidence in advance of the
consultations held in this matter, and (2) the dispute settlement system of the benefits that Article 4.2
was designed to provide.  By requiring a complain ant to include a statement of available evidence in
its request for consultations, Article 4.2 creates conditions that are more favourable to Members
reaching a mutually acceptable resolution of a dispute.  It does so by allowing for a more thorough
                                                     
27  WT/DS108/1
28  WT/DS108/1/Add. 1
29  See, e.g.,  United States - Standards for Reformulated and Conventional Gasoline , WT/DS2/AB/R,
Report of the Appellate Body adopted 20 May 1996, p. 23 (“An interpreter is not free to adopt a reading thatwould result in reducing whole clauses or paragraphs of a treaty to redundancy or inutility.”).
30  Guatemala - Anti-Dumping Investigation Regarding Portland Cement from Mexico , supra .
31  Id., paragraph 88.WT/DS108/R
Page 11
airing of the factual basis on which the complaining party requested consultations and by providing a
preview of the evidence the complaining party is likely to rely on if the matter is presented to a panel.
4.38 Article 4.3 of the SCM Agreement makes this point explicitly, stating that “[t]he purpose of
the consultations is to clarify the facts of the situation and to arrive at a mutually agreed solution.”
This objective of clarifying the facts cannot be fulfilled when, as in this case, the party requestingconsultations fails to comply with an express requir ement that it state what facts are available to it.
4.39 In light of the European Communities' failur e to comply with Article 4.2 of the SCM
Agreement, fundamental fairness requires that the European Communities not be given the
inappropriate advantage of relying on evidence during the Panel’s proceedings that it was required to
identify in its consultation request.  As the Appellate Body has stated:
4.40 "[A]ll parties engaged in dispute settlement under the DSU must be fully forthcoming from
the very beginning both as to the claims involved in a dispute and as to the facts relating to those
claims.  Claims must be clearly stated.  Facts must be disclosed freely.  This must be so in
consultations as well as in the more formal setting of panel proceedings.  In fact, the demands of due
process that are implicit in the DSU made this especially necessary during consultations.  For theclaims that are made and the facts that are established during consultations do much to shape the
substance and the scope of subsequent panel proceedings."
32
4.41 The Appellate Body’s reasoning is particularly pertinent to the present dispute.  Had the
European Communities complied with Article 4.2, the United States would have been afforded a more
meaningful opportunity to assess the strength or weakness of the European Communities' allegations,
the United States would have had the opportunity to comment on the European Communities'
evidence during consultations, and, accordingly, the consultations between the EuropeanCommunities and the United States might have resulted in a mutually agreeable resolution of the
dispute.
4.42 To fail to dismiss the European Communities' claims with respect to the SCM Agreement
would, in effect, permit the European Communities (or any other WTO Member) to ignore Article 4.2
with impunity.  Article 4.2 would be reduced to redundancy or inutility, an outcome that, as notedabove, is contrary to basic principles of public international law.
4.43 Because the European Communities' request for consultations did not contain a statement of
available evidence, as required by Article 4.2 of the SCM Agreement, the Panel should dismiss the
European Communities' claims under Article 3 of the SCM Agreement.
The European Communities  responds as follows:
4.44 The United States does not seem to be arguing that Article 4.2 of the SCM Agreement
requires a statement of available evidence in a separate document .  Nor can it argue that there must be
a separate section in any request for consultations under Article 4 of the SCM Agreement (or indeed
Article 7 of the SCM Agreement, which contains in  Article 7.2 a similar provision to Article 4.2)
using the words “available evidence”.  Nothing in the wording of Article 4.2 of the SCM Agreement
requires this.  The practice under Article 4.2 of the SCM Agreement, including consultation requests
made by the United States, support this.  The European Communities refers the Panel to the
United States requests for consultations In Brazil - Certain Measures Affecting Trade And Investment
In The Automotive Sector
33;  Indonesia – Certain Measures Affecting The Automobile Industry34;
                                                     
32  India - Patent Protection for Pharmaceutical and Agricultural Chemical Products , WT/DS50/AB/R,
Report of the Appellate Body adopted 16 January 1998, paragraph 94.
33 There were two requests. See documents WT/DS52/1-G/L/99-G/SCM/D5/1-G/TRIMS/D/2
(14 August 1996) and WT/DS65/1-G/L/139-G/SCM/D10/1-G/TRIMS/D/6 (17 January 1997).
34 Document WT/DS59/1-G/L/117-G/TRIMS/D/5-G/SCM/D8/1-IP/D/6 (15 October 1996).WT/DS108/R
Page 12
Australia - Subsidies Provided to Producers and Exporters of Automotive Leather35;  Canada -
Measures Affecting the Importation of Milk and the Exportation of Dairy Products36;  European
Communities - Measures Affecting the Exportation of Processed Cheese37; Belgium - Certain Income
Tax Measures Constituting Subsidies38;  Netherlands - Certain Income Tax Measures Constituting
Subsidies39;  Greece - Certain Income Tax Measures Constituting Subsidies40;  Ireland - Certain
Income Tax Measures Constituting Subsidies41;  France - Certain Income Tax Measures Constituting
Subsidies.42  The only one of these requests which expressly refers to “evidence” is the United States
second request for consultations in Australia - Subsidies Provided to Producers and Exporters of
Automotive Leather43 which, significantly, involves a complex case of de facto export subsidy and the
evidence provided by the United States related to the export contingency.
4.45 Article 4.2 of the SCM Agreement, just like Article 7.2 of the SCM Agreement in the case of
actionable subsidies, is a specific application to the case of subsidies of the general principle set out in
the second sentence of Article 4.4 of the DSU that “[a]ny request for consultations shall be submitted
in writing and shall give the reasons for the request, in cluding identification of the measures at issue and
an indication of the legal basis for the complaint.”  The purpose of these provisions is to ensure that theproblem that is to be the subject of the consultations is clearly explained. The reason why Article 4.2
of the SCM Agreement (and Article 7.2 of the SCM Agreement) specifically provide for the available
evidence to be stated is that in subsidy cases the factual circumstances will often be important for
understanding the problem.
4.46 The European Communities did provide a statement of available evidence.  We are not
concerned in this case with a disguised subsidy arising out complex factual circumstances in a
particular sector but with a straightforward subsidy arising out of a generally applicable law.  TheEuropean Communities referred to the relevant United States legal provisions – Sections 921 to 927
of the IRC.  That was the available evidence.
4.47 In contrast to the case of Australia - Subsidies Provided to Producers and Exporters of
Automotive Leather,  referred to above, the FSC scheme is a case where the export contingency
derives from the law and therefore no further “evidence” is required than the law itself.  The same isalso true of the requirement to use domestic over imported goods.
4.48 The United States insists that “evidence” means facts and claims that the
European Communities' request contains none.  It bases this claim on an obvious error.  It refers to the
legal claim (the “conclusory legal assertion”) as being the pertinent part of the request for
consultations.  The facts referred to by the European Communities are stated before the legal claim inthe earlier part of the request for consultations.
4.49 The facts of this case are the United States law, and the European Communities' request for
consultations did refer to it, as this was the available evidence.  The United States must be presumed
to know its own law and is presumably not arguin g that the European Communities should have set
out the text of the law in its request.
4.50 The European Communities' approach in this case of referring to the legal provisions and not
setting out the detail in the request for consultations was also followed by the United States in its
requests for consultations under Article 4 of the SCM Agreement.
                                                     
35 There were two requests. See documents WT/DS106/1-G/SCM/D17/1 and WT/DS126/1-
G/SCM/D20/1.
36 WT/DS103/1-G/L/192-G/AG/GEN/12-G/SCM/D15/1-G/LIC/D/13 (13 October 1997)
37 WT/DS104/1
38 WT/DS127/1
39 WT/DS128/1
40 WT/DS129/1
41 WT/DS130/1
42 WT/DS131/1
43 WT/DS126/1-G/SCM/D20/1WT/DS108/R
Page 13
4.51 The United States, ignoring the fact that the European Communities did refer to the available
evidence, continues its false reasoning by invoking Article 11.2 of the SCM Agreement.  It relies on
the distinction made in this provision between “sufficient evidence” and “simple assertion” and
suggests that the European Communities has merely stated its conclusion that the FSC scheme is a
prohibited export subsidy and not provided evidence.
4.52 This argument is misguided for a number of reasons.  The United States attempts to justify
reference to Article 11.2 of the SCM Agreement as part of the context  of Article 4.2 of the SCM
Agreement within the meaning of Article 31(2) of the VCLT .  The European Communities doubts
whether Article 11.2 of the SCM Agreement, which occurs in Part V of the Agreement relating to
countervailing duty proceedings, can be considered part of the context of Article 4.2, which is inPart II dealing with prohibited subsidies.
44
4.53 Parts II and V of the SCM Agreement involve very different proceedings and remedies.  This
is particularly clear in relation to Articles 4.2 and 11.2 of the SCM Agreement.  Article 4.2 relates to
consultations between States on prohibited subsidies, whereas Article 11.2 deals with the evidence to
be produced by complainants to domestic competent authorities in order to justify the opening of acountervailing duty investigation. There is no justif ication for comparing the requirements for the
holding of consultations between WTO Members to the requirements for the initiation of a
countervailing duty investigation.
4.54 Article 11.2 requires applicants to provide “sufficient evidence” of a series of facts. The
purpose of stating that “simple assertion, unsubstantiated by relevant evidence, cannot be considered
sufficient to meet the requirements of this paragraph” is merely to make clear that applicants in
countervailing duty cases need to annex documentary proof of their assertions.
4.55 Indeed, the quoted sentence is explaining what is meant by “sufficient” for the purposes of
Article 11.2, not what is “evidence”.  Article 4.2 does not refer to “sufficient evidence” but to
“available evidence”.
4.56 The different contexts of Articles 4 and 11 also make clear that the “statement of available
evidence” to be contained in a request for consultations within the meaning of Article 4.2 is referringto a description of the problem  whereas the “sufficient evidence” to be included in a domestic
application to an administrative authority within  the meaning of Article 11.2 is referring to supporting
documentation .
4.57 The practice under Article 4.2, including that of the United States, demonstrates, if anyone
should ever doubt this, that WTO Members do not annex documentary evidence to their requests for
consultations in order to justify their statements.
4.58 Even if ( quod non ), the European Communities had not fully complied with Article 4.2, there
would still be no basis for the Panel to accept the United States request to dismiss the claims under
Article 3 of the SCM Agreement.
4.59 According to WTO case law, a complainant does not need to establish the adequacy of
consultations, only the fact that they have been held or at least requested.
45  The state of the law was
                                                     
44 See Oppenheim’s International Law  9th Edition (1996) Volume 1 at page 1273, footnote 12, where it
is stated that “the context is the treaty as a whole . . . unless the part of the treaty under consideration is self
contained.”
45 Reports of panel on European Communities — Regime For The Importation, Sale, And Distribution
Of Bananas , WT/DS27/ECU, WT/DS27/GTM, WT/DS27/HND, WT/DS27/MEX, 1997, paragraph 7.19.WT/DS108/R
Page 14
well expounded by the panel in Korea - Taxes on Alcoholic Beverages46 where the panel stated at
paragraph 10.19 that:
“In our view, the WTO jurisprudence so far has not recognized any concept of
"adequacy" of consultations.  The only requirement under the DSU is that
consultations were in fact held, or were at least requested, and that a period of sixtydays has elapsed from the time consultations were requested to the time a request for
a panel was made.  What takes place in those consultations is not the concern of a
panel.  The point was put clearly by the Panel in Bananas III , where it was stated:
Consultations are . . . a matter reserved for the parties.  The DSB is not involved; no
panel is involved; and the consultations are held in the absence of the Secretariat.While a mutually agreed solution is to be preferred, in some cases it is not possible
for parties to agree upon one.  In those cases, it is our view that the function of a
panel is only to ascertain that the consultations, if required, were in fact held . . . 
47
We do not wish to imply that we consider consultations unimportant.  Quite thecontrary, consultations are a critical and integral part of the DSU.  But, we have nomandate to investigate the adequacy of the consultation process that took place
between the parties and we decline to do so in the present case.”
4.60 This does not render Article 4.2 of the SCM Agreement “ineffective,” as argued by the
United States in paragraph 34 of its Request, any more than the above quoted principles established in
past DSU cases renders Article 4.5 of the DSU “ineffective”.
4.61 The United States cites the Appellate Body report in the case India - Patent Protection for
Pharmaceutical and Agricultural Chemical Products
48, in support of its contention that the Article 3
claims should be dismissed because of the alleged defect in the request for consultations.  It is true
that the Appellate Body stressed the importance of openness during both the panel and consultation
phases, and the European Communities entirely shares these sentiments.  But India - Patent
Protection does not support the United States position in this case – quite the reverse.  In that case, the
Appellate Body did not consider that the failure of India to disclose all relevant facts (the existence ofan administrative procedure) could have any consequences for the panel process, even though it had
prevented the United States from making a claim it otherwise would have made.
4.62 In any event, the fact that such provisions cannot be relied on as a defence to a WTO violation
in panel proceedings does not reduce them to “redundancy and inutility” as the United States argues
in paragraphs 34 and 41 of its Request.  The procedural rules referred to here are intended to havetheir effectiveness during the consultation phase.  It is clear from the cases referred to above that the
only matter relating to the conduct of consultations that may be verified by a panel is “that
consultations were in fact held, or were at least requested, and that a period of sixty days has elapsed
from the time consultations were requested to the time a request for a panel was made” and that a
panel has “no mandate to investigate the adequacy of the consultation process that took place betweenthe parties.”
49
4.63 Article 4.2 of the SCM Agreement, like Article 4 of the DSU, applies to and has legal effects
in the consultation phase, not the panel phase.  The United States’ remedy, if it felt that the European
Communities had not presented the available evidence, would have been to request further
information and possibly to have declined to enga ge in consultations until the European Communities
had done so.  The United States did not ask for any further information, unsurprisingly since it was
                                                     
46 Reports WT/DS75/R and WT/DS84/R (31 July 1998) upheld on appeal WT/DS75/AB/R and
WT/DS84/AB/R (18 January 1999).
47 The panel’s footnote (343) refers to paragraph  7.19 of the Bananas III panel report.
48 India - Patent Protection for Pharmaceutical and Agricultural Chemical Products , WT/DS50/AB/R,
Report of the Appellate Body adopted 16 January 1998. The United States quoted paragraph 94.
49 See paragraph 7.19 of the Report in Korea - Taxes on Alcoholic Beverages  quoted above.WT/DS108/R
Page 15
fully aware of the FSC scheme.  On the contrary, the United States accepted the consultations and did
not even ask for any further particulars.  The United States also did not contest the adequacy of the
consultations before the DSB.  It cannot therefore in any event do so now.
4.64 The principle that panels should not be concerned with the adequacy of consultations
discussed above also disposes of the United States argument based on the recent report of theAppellate Body in the Guatemala Cement  case
50 in support of its contention that the
European Communities' claims under Article 3 of the SCM Agreement should be dismissed.
4.65 The Appellate Body came to the conclusion it did in that case because Mexico had failed to
specify, in its request of the establishment of a panel , the measure that it was challenging, as it was
required to do by Article 6.2 of the DSU.  The United States Request for dismissal of theEuropean Communities' claims under Article 3 of the SCM Agreement is based on an alleged defect
in the request for consultations, not in the request for a panel.
4.66 The United States argues that the alleged defect in the consultation request has deprived it of
its right to learn of the existence of evidence against it and undermines the dispute settlement system.
This is an entirely unmeritorious claim.  First, as explained above, the request for consultations didcontain the available evidence and the United States never complained during the consultations that it
did not.  Secondly, the United States was well aware of the features of the FSC scheme, indeed was
better aware than the European Communities.  Thirdly, the European Communities held three rounds
of consultations with the United States on the FSC.  The United States had ample opportunity to ask
questions and did ask questions about the legal and economic basis of the European Communities'
case and its political wisdom (which the European Communities answered) but did not ask for further
evidence about the existence and nature of its own FSC scheme.  The United States has absolutely nobasis for claiming that it has been deprived of its right to learn of the existence of evidence against it
or that the dispute settlement system has been undermined.
4.67 The European Communities has shown above that it did refer to the available evidence in its
request for consultations and that in any event the United States is misguided in its view that the
remedy for an alleged failure on the part of the European Communities to do so is the dismissal of theEuropean Communities' claims under Article 3 of the SCM Agreement.
4.68 The European Communities therefore asks the Panel to dismiss the claim.
The United States  rebuts the European Communities' response as follows:
4.69 The First European Communities Submission includes eighteen exhibits.  Excluding certain
exhibits that relate solely to the procedural history of this dispute (EC-13-15) and one exhibit that
relates to the European Communities' claims under the AA (EC-16), the remainder of the exhibits are
offered as evidence in support of the European  Communities' claims that the FSC constitutes a
prohibited subsidy under the SCM Agreement.  With only a few exceptions, these exhibits predate the
European Communities' 18 November 1997 request for consultations, in some cases by more than adecade.
51  Therefore, these documents clearly were available to the European Communities long
before it requested consultations.  However, these documents are not mentione d, or even alluded to, in
the European Communities' request for consultations.  As stated in the United States' Request for
Preliminary Findings, there is nothing in the Eu ropean Communities' request for consultations that
can be construed as a statement of available evidence.
4.70 Moreover, while these exhibits do not lend factual support relevant to the controlling legal
standard i.e., whether the FSC results in domestic-source income, as opposed to foreign-source
                                                     
50 Guatemala - Anti-Dumping Investigation Regarding Portland Cement from Mexico ,
WT/DS60/AB/R, Report of the Appellate Body adopted 25 November 1998, paragraph 65 (emphasis in
original).
51  For example, the document contained in Exhibit EC-6 was published in 1985 .WT/DS108/R
Page 16
income, being exempted from taxation to a "significant" extent – it is clear that, from the
European Communities' perspective, these materials are central to the case it seeks to make.  As but
one example, the First EC Submission, which contains the European Communities' factual arguments
on transfer pricing, dwells at length on the OECD Guidelines.  However, the European Communities'
request for consultations does not even allude to the OECD Guidelines, which were published in1995.
4.71 The European Communities does not dispute the applicability of Article 4.2, but instead
argues that its identification of the challenged measures is, in and of itself, a statement of available
evidence.  This position is untenable.  By listing Section 921 to 927 of the US Internal Revenue Code,
the European Communities may have complied with the general rule governing requests forconsultations, Article 4.4 of the DSU, which requires "identification of the measures at issue."
Article 4.2 of the SCM Agreement, however, requires more.  It imposes an additional obligation to
provide a statement of available evidence.  To equate the two rules would ignore the obvious
differences in their language.  It also would be inconsistent with the Guatemala Cement  case, in
which the Appellate Body ruled that a special or additional rule, such as Article 4.2, and a generalrule, such as Article 4.4, must be applied in a complementary manner, and that a complainant must
comply with both rules.
4.72 The examples cited in Exhibit EC-19 do not support the European Communities' position.
The European Communities ignores the fact that in the five consultation requests by the United States
involving European tax subsidies – WT/DS127 through WT/DS131 – each consultation request
separately identified the measure and then sepa rately identified the information on which the
United States was relying; namely, unofficial translations of the measures in question and secondarysources describing the measures.  There is no such separate identification of the measure and the
evidence in the European Communities' request for consultations concerning the FSC.
4.73 In addition, even assuming that the European Communities' characterization of these
examples is accurate, they do not constitute a "subsequent practice" within the meaning of
Article 31(3)(b) of the Vienna Convention on the Law of Treaties  that would allow the Panel to ignore
the plain language of Article 4.2 requiring that a request for consultations include a statement of
available evidence.
4.74 In its 25 January submission, the European Communities also engages in a discussion of
Article 11.2 of the SCM Agreement that leads it to the conclusion that Article 4.2 does not require
Members to annex documentary evidence to their requests for consultations.  This discussion is bothirrelevant and inaccurate.  It is irrelevant because the United States has not argued that the European
Communities was required to annex documentary evidence to its consultation request – Article 4.2
simply requires a "statement" of the available evidence.  Instead, what the United States did argue in
its submission of 4 December 1998 is that the ordinary meaning of the term "evidence" – which the
European Communities has not contested – is "facts or testimony in support of a conclusion,statement or belief", and that the assertion of a conclusion – which is all that the European
Communities consultation request contained – cannot constitute a "statement of available evidence"
within the meaning of Article 4.2.  The United States then cited Article 11.2 merely as contextual
support for the ordinary meaning of the term "evidence" and for the simple proposition that the
drafters of the SCM Agreement understood the difference between an "assertion" and "evidence".
4.75 The European Communities' discussion of Article 11.2 is, moreover, inaccurate because the
European Communities asserts that Article 11.2 does not form part of the context of Article 4.2.  This
position is at odds with numerous panel and Appellate Body reports, such as the Reformulated
Gasoline case, in which the Appellate Body, at page 18, stated that the context of GATT
Article XX(g) included all of GATT 1994.  In addition, the European Communities offers no support
for its suggestion that either Part II or Part V of the SCM Agreement is "self-contained".  Indeed,
footnote 35 of the SCM Agreement demonstrates the inter-relationship between the various parts ofthe agreement.WT/DS108/R
Page 17
4.76 Stripped of its irrelevancies and inaccuracies , the European Communities' argument amounts
to nothing more than an assertion that because it id entified the FSC statute and referred to unidentified
"related measures" as the challenged measures, as it was required to do by DSU Article 4.4, the
United States should have known that this identification also constituted the requisite "statement of
available evidence" under Article 4.2 of the SCM Agreement.  Essentially, the EuropeanCommunities is asserting that the United States should have known that a reference to the FSC statute
as the challenged measure constituted the European Communities' statement of available evidence,
because the United States should have agreed with  the European Communities that the FSC statute is,
on its face, a prohibited subsidy.  Obviously, an interpretation of Article 4.2 that requires a responding
Member to accept the complainant's characterization of the challenged measure as a prohibitedsubsidy cannot be correct.
4.77 In the view of the United States, all of this is nothing more than an ex post facto argument
designed to conceal the fact the European Communities simply ignored Article 4.2.  If the "available
evidence" truly was limited to the FSC statue, then the European Communities could have made a
"statement" to that effect.  The European Communities did not do so, and now argues essentially thatthe United States should have known that the European Communities was relying solely on the FSC
statute as its evidence.  However, Article 4.2 required that the European Communities make a
statement, and that it make that statement in a sufficiently clear manner so that United States did not
have to guess at the evidence on which the European Communities was relying.  In addition, the
European Communities' arguments never address the question of what constituted the statement of
available evidence with respect to the as yet unidentified "related measures".
4.78 Moreover, the First EC Submission makes it abundantly clear that the evidence available to
the European Communities consisted of much more than the FSC statute.  The European
Communities would have this Panel believe for example, that the European Communities did not
discover the OECD Transfer Pricing Guidelines, on which it relies extensively, until after it submitted
its request for consultations.
4.79 Although claiming that it acted in conformity with Article 4.2, the European Communities
goes on to argue – remarkably – that its transgression should be excused because the United States did
not bring the European Communities' failure to comply with its obligations to its attention during
consultations.  Nowhere in the DSU or the SCM Agreement is it required that a responding party must
identify for the complaining party the procedures with which it must comply.  Instead, each party is
responsible for meeting its own obligations, especially when they are plainly established in the text ofthe relevant WTO Agreement.
4.80 The European Communities also argues that the Panel should not be concerned if the
European Communities failed to comply with a mandatory rule pertaining to requests for
consultations, because panels should not be concerned with the adequacy of consultations.  Whatever
may be the merits of this contention, it is irrelevant to the issue before this Panel.  The United States isnot asking this Panel to examine what transpired during  the consultations – although the European
Communities spends a good deal of time talking about that very topic.  Instead, the United States is
asking the Panel to examine what transpired before  the consultations; namely, the compliance of the
European Communities' request for consultations with Article 4.2 of the SCM Agreement.  None of
the factors invoked by the panel in the Korea Liquor case, such as the absence during consultations of
the DSB, the panel, and the Secretariat, applies to the examination of a document.  Moreover, even
the Korea Liquor panel, on which the European Communities relies, acknowledged that it could
consider whether consultations were requested.  If a panel can consider whether consultations were
requested, it should be able to consider whether consultations were properly  requested.
4.81 In this regard, the United States cannot resist pointing out the inconsistency in the
European Communities' arguments.  For example, the European Communities' 25 January submission
is rife with statements to the effect that the cons ultations served as an adequate substitute for the
statement of available evidence missing from the European Communities' consultation request.WT/DS108/R
Page 18
However, in the very same submission, the European Communities tells the Panel that it cannot
concern itself with what transpired at consultations.
4.82 Finally, the European Communities asserts that Article 4.2 cannot be enforced by dispute
settlement panels.  Instead, the European Communities argues that Article 4.2 is either self-enforcing
or not enforceable at all.  According to the European Communities, a recipient of a defective requestfor consultations must insist on being provided with a statement of available evidence or refuse to
participate in consultations.  Not only does this argument improperly shift the burden of ensuring that
a complaining party meet its WTO procedural obligations to the responding party, but it also ignores
the fact that refusing to participate in consulta tions is unlikely to induce the complaining party to
identify its evidence.  Instead, the failure of a responding party to participate in consultations simplypermits the complaining party to immediately request the establishment of a panel, as expressly
provided in Article 4.3 of the DSU.  And, accord ing to the European Communities, once a panel is
established, the panel is powerless to address the complainant's failure to comply with Article 4.2.
4.83 In the view of the United States, the same logic that requires panels to scrutinize panel
requests dictates panel scrutiny of consultation requests.  Because of the "reverse consensus" rule inthe WTO dispute settlement system, panels are established automatically regardless of whether a
complainant has complied with WTO procedures in the process leading up to panel establishment.
This led the Appellate Body in the Bananas  case, at paragraph 142, to conclude that "it is incumbent
upon a panel to examine the request for the establishm ent of the panel very carefully to ensure its
compliance with both the letter and the spirit of Article 6.2 of the DSU".  The same logic equally
requires panel scrutiny of consultation requests.
4.84 Indeed, if one carries the European Communities'  logic to its extreme, a complainant could
make an oral request for consultations that does not identify a measure or an agreement (e.g., "I want
to consult with you"), and there is nothing that either the responding Member or a panel can do about
it.  The responding Member can refuse to consult,  but this simply gives the complainant the option of
having a panel established sooner rather than later.  Once the panel is established, there is nothing,
according to the European Commun ities, that the panel can do about the deficient consultation
request.
4.85 The United States submits that there is nothing in either the DSU or the SCM Agreement that
requires such a result.  In the context of this case, the European Communities' request for
consultations failed to comply with Article 4.2 of the SCM Agreement, and this Panel has the
authority to address that failure by dismissing the European Communities' claims under Article 3 ofthe SCM Agreement.
The European Communities  further responds as follows:
4.86 The United States attempts to substantiate its claim that the European Communities did not
make a sufficient statement of available evidence in its request for consultations by referring in itsFirst Written Submission to the fact that most of the exhibits to the European Communities' First
Written Submission pre-date that the request for consultations of 18 November 1997.  Apart from the
basic legal provisions, which the European Communities did refer to in its request for consultations,
the documents annexed to the European Communities' First Written Submission were gathered after
the request for consultations was made.  Indeed many of them were provided to the EuropeanCommunities by the United States during the consultations.  If anything, this confirms the
European Communities' position.  The European Co mmunities cannot have been expected to refer to
documents it did not have!
4.87 The European Communities was aware of the existence of the OECD pricing guidelines when
it made its request for consultations but did not and does not consider them to be “evidence”.  The fact
that the FSC scheme provides for the use of specia l administrative pricing rules is evident from the
law itself.  The OECD guidelines are in the nature of a supporting argument; theEuropean Communities' case that the FSC scheme gives rise to two subsidies is valid even if theWT/DS108/R
Page 19
OECD guidelines did not exist.  In any event, as  a public document well known to the United States,
its existence and content does not need to be proved.
The United States  further rebuts the European Communities response in its Oral Statement at the
First Meeting of the Panel as follows:
4.88 While it is not necessary to look behind the text of the procedural provisions we have been
discussing where, as here, they impose clear requirements, it is important to remember that procedural
requirements exist for a reason.  In the case of Article 4.2 of the SCM Agreement, the inclusion by the
drafters of the requirement to include a statement of available evidence undoubtedly was designed to
render consultations more meaningful than might otherwise be the case.  The European Communities'failure to comply with Article 4.2 is particularly troubling in light of the highly technical and complex
issues that have been raised.  Had the European Communities been more forthcoming with the
evidence on which it was relying, perhaps this panel proceeding could have been avoided.
2. Appropriate tax forum – Footnote 59 of the SCM Agreement
The United States  argues as follows:
4.89 The provisions of the SCM Agreement relating to  exemptions of direct taxes expressly direct
WTO Members to resolve certain issues raised by such exemptions in an appropriate tax policy
forum, not the WTO.  The explicitness of this unusual language suggests that the preference for a non-
WTO forum reflects important institutional consider ations and that until such preferred alternative
mechanisms are exhausted, the text implies, WTO dispute settlement should be avoided.
4.90 The European Communities' allegations in this case relate directly to the provisions on
exemptions of direct taxes.  Specifically, the European Communities has alleged that the FSC regime
provides a subsidy that is prohibited by Article 3.1(a) of the SCM Agreement.
52  Article 3.1(a), in
turn, references the Illustrative List of Export Subs idies contained in Annex I to the Agreement.  The
paragraph of the Illustrative List that corresponds to the European Communities' claim is
paragraph (e), which states that the “full or partial exemption, remission, or deferral specificallyrelated to exports, of direct taxes” is a probable export subsidy for purposes of the SCM Agreement.
Subsection (e) is both qualified and further explained in footnote 59 of the Agreement.
4.91 Footnote 59, which deals with exemptions of direct taxes, clearly indicates the intent of WTO
Members that certain disputes over direct taxes in export transactions should not be resolved before
the WTO in the first instance, but instead should be resolved through mechanisms specific to the tax
area.  The footnote provides that “[a]ny Member may draw the attention of another Member to
administrative or other practices which contravene [the] principle [of arm’s length pricing] and which
result in a significant saving of direct taxes in export transactions.”  However, the text further
provides that:
"[I]n such circumstances the Members shall normally attempt to resolve their
differences using the facilities of existing bilateral tax treaties or other specific
international mechanisms , without prejudice to the rights and obligations of Members
under GATT 1994 . . . " (emphasis added).
4.92 This language is not an expression of concurrent jurisdiction.  The language directing
complainants to alternative channels is mandatory – “Members shall normally attempt to resolve their
differences . . .” (emphasis added).  Although the “without prejudice” language makes clear that a
Member does not sacrifice its WTO rights by referring the matter to an alternative forum, it also
makes clear that WTO Members should exhaust alternative available tax fora before attempting to
resolve the issue through the WTO dispute settlement process.
                                                     
52  WT/DS108/2WT/DS108/R
Page 20
4.93 The forum preference, or exhaustion, language is grounded in sound policy considerations
and reflects the risks of attempting to treat issues of fundamental tax policy as trade issues.  As
recognised in the 1981 Council Decision, WTO rules are not intended to mandate one particular tax
system over another or to penalise countries for choosing one tax system over another.  Footnote 59
acknowledges that when disagreements over technical transfer pricing practices or fundamental taxpolicy do arise, recognised bilateral channels for reso lving tax issues or international entities that deal
with tax policy issues are better equipped alternatives than the WTO.
53
4.94 Indeed, the likely purpose of footnote 59 was in part to avoid a repeat of the complications
and controversies that arose from the GATT’s last foray into the field of basic tax policy – the cases
against the DISC and the territorial tax regimes of three members of the European Communities.  Thereasoning and the results of those cases were strongly criticized by both the United States and the
European Communities.  The disagreements were ultimately resolved, and the panel decisions
adopted, only by the negotiation of a special “understanding” that in 1981 was adopted by the
Contracting Parties and incorporated into a GATT Council Decision.  That Council Decision
articulates the principles that continue to govern similar disputes today.
4.95 In this case, the European Communities has failed to avail itself of the “facilities of bilateral
tax treaties or other specific international mechanisms” to address its concerns over the FSC.  First,
the European Communities has failed to raise the FSC issues about which it now complains in the
international forum that is now immersed in  those issues.  The Organization for Economic
Cooperation and Development (“OECD”) has been th e international forum primarily responsible for
addressing international tax issues since its formation in 1961.  A host of such issues is currently
before the OECD.
54  These active OECD projects confirm that the OECD is the appropriate
international mechanism for addressing issues such  as the ones that the European Communities seeks
to raise in this case.
4.96 All of the European Communities Member States are members of the OECD.55  Moreover, an
OECD Protocol specifically provides for European Communities participation in OECD activities.56
Notwithstanding the availability of this obviously appropriate “international mechanism,” the
European Communities has failed to avail itself of this forum.
4.97 Nor have European Communities Members States invoked the bilateral tax treaty competent
authority process through which tax disputes are routinely addressed.  “Competent authority” is a term
defined under bilateral income tax treaties.  Under tax treaties, the term refers to the official
representatives of national tax administrations that communicate with each other on a regular,bilateral basis in order to resolve disputes, including those relating to proper treatment where two
countries assert jurisdiction over the taxation of a specific taxpayer’s income and to extend mutual
administrative assistance in tax matters, including the exchange of information.  Competent authority
is often invoked when resolving issues raised under bilateral tax treaties and is often called upon to
assist in resolving cross-border transfer pricing issues.
                                                     
53 Similarly, in another paragraph of footnote 59, Members disavow any intention to regulate tax
policies designed to ameliorate double taxation by more than one taxing authority: "[P]aragraph (e) [of theAnnex I list of subsidies] is not intended to limit a Member from taking measures to avoid the double taxation offoreign-source income earned by its enterprises or the enterprises of another Member."
54  In particular, the OECD is deeply involved in transfer pricing.  For example, the OECD issued
comprehensively updated transfer pricing guidelines in July 1995, and remains the international entity mostinvolved with respect to this issue.  See US Exhibit 2 (table of contents of OECD Transfer Pricing Guidelines).
Other examples of the OECD’s areas of competence include Tax Avoidance and Evasion, Harmful TaxCompetition, Double Taxation, Taxation of Electronic Commerce, Taxation of Financial Instruments and GlobalTrading, and Consumption Taxes.
55  Attached as US Exhibit 3 is a list, found on the OECD’s Web Page, of OECD members.
56  Attached as US Exhibit 4 is a copy, found on the OECD’s Web Page, of the OECD Convention and
the relevant Protocol.WT/DS108/R
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4.98 Until the European Communities has exhausted the alternative channels to which footnote 59
expressly refers, it has failed to comply with the ve ry provision that it likely will now seek to invoke.
Under these circumstances, the panel should dismi ss or defer the European Communities' complaint
until such time as the European Communities has “attempt[ed] to resolve” the issues it raises through
“the facilities of existing bilateral tax treaties or other specific international mechanisms.”
The European Communities  responds as follows:
4.99 The second United States request for a preliminary finding is broader than the first.  It asks
the Panel to find on the basis of hortatory wording in a footnote to the Illustrative List to the SCM
Agreement that the European Communities is “p recluded from invoking WTO dispute settlement
procedures with the respect to the FSC” until it has exhausted alleged alternative channels for the
resolution of tax disputes57, whereas the first claim only requested the dismissal of the claims under
Article 3 of the SCM Agreement.
4.100  The United States is in fact attempting to impose a requirement on the European
Communities to address its complaint about the export subsidies arising out of the FSC scheme to atax forum.  For the European Communities it is cl ear that the present dispute is about a prohibited
export subsidy and is not a tax dispute.
4.101  Footnote 59 is attached to Item (e) of the Illustrative List of Export Subsidies in Annex I to
the SCM Agreement. It states in relevant part that:
“The Members reaffirm the principle that prices for goods in transactions between
exporting enterprises and foreign buyers under their or under the same control should
for tax purposes be the prices which would be charged between independententerprises acting at arm's length. Any Member may draw the attention of another
Member to administrative or other practices which may contravene this principle and
which result in a significant saving of direct taxes in export transactions. In such
circumstances the Members shall normally attempt to resolve their differences using
the facilities of existing bilateral tax treaties or other specific internationalmechanisms, without prejudice to the rights and obligations of Members under GATT
1994, including the right of consultation created in the preceding sentence.”
4.102  The first point to note about this text is that it is deliberately couched in non-obligatory
language.  It allows a Member to “draw the attention” of another Member to transfer pricing practices
of enterprises and then provides that Members sh all “normally attempt to resolve their differences”
using tax mechanisms.  This is however expressly “without prejudice to the rights and obligations
under GATT 1994”.
4.103  The European Communities does not agree with view expressed in paragraph 48 of the
United States Request that:
“the likely purpose of footnote 59 was in part to avoid a repeat of the complications
and controversies that arose from the GATT's last foray into the field of basic tax
policy – the cases against the DISC and the territorial tax regimes of three members
of the European Communities.”
4.104  On the contrary, it is necessary not to lose sight of the fact that footnote 59 is a comment on
Item (e) of the Illustrative list, the purpose of whic h is to make quite clear that exemptions from direct
taxes do constitute subsidies, at least when “specifically related to exports” and are therefore covered
by GATT/WTO disciplines.
                                                     
57 Paragraphs 53 and 54 of the US Request.WT/DS108/R
Page 22
4.105  The European Communities takes the part of footnote 59 quoted above to be a reminder to
Members of the existence of tax mechanisms which may provide a better forum for resolving
difficulties resulting from arm’s length pricing disputes than WTO dispute settlement.  However it is
left to the discretion of the Member concerned whether to do so.  This intention is clearly expressed
through the use of the word “normally” and the express statement that the reference to taxmechanisms is “without prejudice to the rights and obligations of Members”.
4.106  As mentioned above, the European Communities  is complaining about the FSC scheme
because it results in export subsidies, not as an aberrant tax practice.  It is not complaining that the
right of European Communities Member States to tax is being impaired or that the income of
European Communities persons is being doubly or unfairly taxed.  It is rather complaining that theUnited States is exempting income from the export of United States goods from tax that it would
normally collect.  The European Communities is al so complaining that the availability of special
administrative pricing rules for the FSCs compounds the export subsidy and, since it is only available
on the export of United States goods, can also be considered an export subsidy.  However the
European Communities is not complaining about avai lability of special administrative pricing rules as
such, only their effect as an export subsidy.  That is why the European Communities brings its
complaint to this Panel and not to a tax forum.  A tax forum might be more appropriate if the
United States were to apply the special administrative pricing rules of the FSC scheme to all
transactions between related enterprises, including domestic and import transactions, and not just to
transactions involving the export of United States goods.  However that is not the case.  Since the
European Communities is complaining about an export subsidy, the WTO is the appropriate forum.
4.107  Not only is the WTO the appropriate forum for export subsidy complaints, it is also clear that
the alternatives mentioned by the United States would not be appropriate.  The United States mentions
first the OECD and then the bilateral tax treaties and the European Communities will follow the same
order.
4.108  The United States describes the OECD as “the international forum that is now immersed in
[tax] issues” and “the international forum primarily responsible for addressing international tax issuessince its formation in 1961.”  It refers in a footno te to the OECD’s involvem ent in Transfer Pricing,
Tax Avoidance and Evasion, Harmful Tax Competit ion, Double Taxation, Taxation of Electronic
Commerce, Taxation of Financial Instruments and Global Trading, and Consumption Taxes.
4.109  The European Communities does not disagree with the United States statements quoted in the
last paragraph.  The European Communities does no t agree however that the OECD is the appropriate
forum to deal with a complaint about an export s ubsidy that is prohibited by the SCM Agreement.
The persons participating in the various groups and committees mentioned by the United States are
tax experts and their knowledge and abilities, great as they may be, are not suited to examining export
subsidies, still less whether there is a violation of a WTO Agreement.  They would also no doubt be
the first to recognise that this would not be an appropriate task for them to undertake.  The same canbe said for the OECD itself.
4.110  The United States claims that the other facility to which the European Communities or its
Member States should have had recourse is the “bilateral tax treaty competent authority process.”
58  It
is misleading to suggest that this procedure is applicable for a number of reasons.  The European
Communities will explain its position by referring to the OECD Model Tax Convention, on whichmost bilateral tax treaties are based and which is annexed as Exhibit EC-20.
4.111  First, bilateral tax treaties only apply to the residents of the contracting parties.  This is made
clear in Article 1 of the OECD Model Tax Conventi on.  The European Communities assumes that the
United States does not consider FSCs to be resident in the United States.  Accordingly, the bilateral
tax treaties between the United States and European Communities Member States are simply not
applicable to FSCs except in the rare cases (if any exist) where an FSC may be resident in the relevant
                                                     
58 Paragraph 51 of the US Request for Preliminary Rulings.WT/DS108/R
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Member State.  Indeed it would surely be unacceptable for an European Communities Member State
to seek to regulate with its bilateral tax treaty with the United States the bilateral tax relationship
between the United States and an FSC haven such as Barbados.
4.112  Second, that the purpose of bilateral tax treaties is to avoid double taxation and to protect the
tax base of the parties by preventing tax evasion.  They do not provide a basis for one country toobject to the tax practices of another when there is no issue of double taxation or loss of tax revenue
for that country.
4.113  Third, that, in any event, the purpose of what the United States refers to as the “competent
authority process” under a tax treaty is to resolve specific cases of application of the treaty.  The
process is set out in Article 25 of the OECD Model Tax Convention where it is called the “mutualagreement procedure”.  It is immediately apparent from paragraph 1 of this provision that the
procedure is set in motion at the request of an individual taxpayer who “considers that the actions of
one or both of the Contracting States result or will result for him in taxation which is not in
accordance with the provisions of” the convention.  In other words, the purpose is to resolve specific
disputes with taxpayers.  Competent authorities are also mentioned elsewhere, e.g. in Article 26 of theModel Convention on exchange of information, but now here are they given authority to deal with a
dispute such as the present.  The competent authorities would not therefore be the appropriate forum
for attempting to resolve a difference of views concerning the FSC scheme, even if one were to
consider that the FSC scheme comes at all within the scope of the bilateral tax treaties between the
United States and the Member States of the European Communities.
4.114  The United States refers to an alleged requ irement for the European Communities to exhaust
alternative “channels” available to it before resorting to dispute settlement.  The use of the vague term“channels” masks an important feature of the relevant sentence of footnote 59, which directs Members
to “normally attempt to resolve their differences using the facilities  of existing bilateral tax treaties or
other specific international mechanisms .”
4.115  Even if the OECD and bilateral tax treaties may provide an opportunity to discuss  issues such
as the FSC if all participants agree (and it is not clear that the United States would agree), this cannotbe considered a “facility” or a “mechanism” for “resolving differences”.  The language used in
footnote 59 refers to something more than an opportunity to discuss.  It was probably intended to refer
some kind of dispute resolution mechanism
59.  For a “mechanism” or a “facility” to exist there must at
the very least be a legal basis for the matter to be raised and resolved.
4.116  If, contrary to what is submitted above, the terms “facilities” and “mechanisms” in
footnote 59 should be taken to include a simple opportunity to discuss problems, the European
Communities would also mention that its Member States did attempt, unsuccessfully, to discuss FSCs
with the United States from a tax point of view.  This is described at paragraph 113 of the
European Communities' First Written Submission, where it is also explained that the discussions
terminated with the failure of the United States to respond to a detailed note submitted to it.  Ifexhaustion of an opportunity to discuss is required to bring dispute settlement proceedings under the
SCM Agreement, then the condition is in any event satisfied.
4.117  If the fourth sentence from footnote 59 to the SCM Agreement did constitute a requirement to
“exhaust alternative available tax fora before attempting to resolve the issue through the WTO dispute
settlement process” as claimed by the United States in paragraph 46 of its Request, it would have beenmentioned in Appendix 2 to the DSU.  It is howev er conspicuous by its absence from Appendix 2.  By
contrast, footnote 35 to the SCM Agreement, which regulates the parallel application of
countervailing duty action and dispute settlement, is referred to in Appendix 2 to the DSU.  This
                                                     
59 Such a mechanism does exist between EC Member States in the form of a Convention on the
elimination of double taxation in connection with the adjust ment of profits of associated enterprises published in
the Official Journal of the European Communities OJ L 225 of 20 August 1990 at page 10.WT/DS108/R
Page 24
demonstrates that footnote 59 to the SCM Agreement was not intended to constitute a special rule
applicable in the conduct of dispute settlement.
4.118  Even if ( quod non ) there were some basis for the United States jurisdictional argument based
on footnote 59 that the European Communities is “precluded” from pursuing dispute settlement until
it had exhausted alleged “alternative channels,” this would apply as much to consultations as to thepanel procedure.  Therefore the United States should have raised it during consultation phase.  It did
not and so should not in any event be allowed to do so now.
4.119  For the sake of good order, the European Communities finally draws the attention of the
Panel to the fact that footnote 59 only relates Item (e) of the Illustrative List and is not therefore
relevant for any of the other provisions invoked by the European Communities and in particular notfor the first part of Article 3.1(a) of the SCM Agreement, Article 3.1(b) of the SCM Agreement, and
the AA.
4.120  In addition, an argument based on the above quoted part of footnote 59 to Item (e) relates
only to the issue of transfer pricing.  It can therefore only be relevant for what the European
Communities terms in its first written submission the “s pecial administrative pricing rule subsidy” and
not the “tax exemption” subsidy.
4.121  For the above reasons, the United States request that the Panel find that the European
Communities is precluded from invoking dispute settlement until it has exhausted its alleged
“alternative channels” is unfounded and should be rejected.
The United States  rebuts the European Communities' response as follows:
4.122  The First EC Submission is incorrect in implying that the European Communities has
satisfied the procedural requirements of footnote 59 of the SCM Agreement.  The European
Communities alleges that, beginning in January 1997, "formal contact" was made with US authorities.
The European Communities never raised the matter at all.  Instead, officials of three European
Communities member States and officials of the US Department of the Treasury met in Washington.
Thereafter, officials of four EC member States and Treasury officials met on the margins of meetingsof the OECD Committee on Fiscal Affairs.  At these meetings, it was agreed by all participants that
the meetings were not held pursuant to any treaty or other international agreement, nor were they in
any way a formal or informal consultation concerning the matters discussed.  At no time has the
European Communities or an European Communities member State formally invoked the "facilities
of existing bilateral tax treaties or other specific  international mechanisms" within the meaning of
footnote 59 of the SCM Agreement.  For example, at no time has the European Communities or any
European Communities member State referred its concerns regarding the FSC to the OECD.
4.123  The First European Communities Submission establishes that the issue of transfer pricing is
central to the European Communities' case.  According to the European Communities, the FSC
administrative pricing rules constitute a subsidy in and of themselves.
60  If that is the
European Communities' belief, then that demonstr ates all the more why the European Communities
should have first raised this transfer pricing issue in an appropriate tax forum, as it was required to do
by footnote 59 of the SCM Agreement.  The highly unusual language of footnote 59 is expressed in
mandatory terms, and reflects the concern of the drafters about attempting to resolve technical issues
of tax policy in a trade forum.  As indicated above, the European Communities never has satisfied thisrequirement of footnote 59; the contacts referred to in the First European Communities Submission
were all informal discussions with representatives of a few European Communities member States.
There have never been formal contacts between the United States and the European Communities or
its member States with respect to the FSC administrative pricing rules, and at no time  has the
European Communities or a member State formally invoked the facilities of existing bilateral tax
treaties or other specific international mechanisms within the meaning of footnote 59.  Therefore, the
                                                     
60 First EC Submission, paragraphs 127-128.WT/DS108/R
Page 25
European Communities has failed to comply with footnote 59, and its claims regarding the FSC
administrative pricing rules should be dismissed or deferred until it has.
4.124  The European Communities claims that footnote 59 is "couched in non-obligatory language".
This is, at best, a half-truth.  It is true that the third sentence of footnote 59 (which is referred to in the
last sentence as a "right of consultation") does not compel a Member to "draw the attention" ofanother Member to a transfer pricing concern.  However, if a Member chooses to do so, as the
European Communities has done in this case, footnote 59 requires that the Members concerned "shall
normally attempt to resolve their differences" by using one of the other referenced fora.  The
European Communities ignores the mandatory word "shall" and chooses instead to focus on the word
"normally".  While the United States does not disagree with the proposition that there may be someunusual situations where recourse to these other fora is not practicable, the European Communities
has made no showing that recourse to these other fora was impracticable in this case.  Indeed, taking
the European Communities at its word that it has been deeply concerned about the FSC for over
14 years, it is implausible to believe that during all that time it never was practicable for the European
Communities to formally raise its concerns in an other forum, such as the OECD, where transfer
pricing issues have been deliberated by tax specialists in enormous detail.
4.125  The European Communities asserts that its failure to resort to other fora is excused because it
"is complaining about the FSC scheme because it results in export subsidies, not as an aberrant tax
practice" and that it "is not complaining about availability of special administrative pricing rules  as
such, only their effect as an export subsidy".  The United States fails to see the relevance of this point.
The text of footnote 59 clearly indicates that the draf ters recognized that transfer pricing practices that
contravene the arm's length principle of the second sentence of footnote 59, and that result in a
significant saving of direct taxes in export transactions, can give rise to an export subsidy.  However,
the text also indicates that the drafters recognized th at those practices could give rise to both trade and
tax concerns.  In such circumstances, the drafters, no doubt taking a lesson from the tortuous history
of the Tax Legislation Cases , expressed an institutional preference  for referring such matters, in the
first instance, to appropriate tax fora.  Notably, the drafters did not provide that Members shouldresort to such alternative fora only if the tax concerns could be separated from the trade concerns.
4.126  The European Communities opines that the OECD  is not an appropriate forum for dealing
with a complaint about an export subsidy.  Th is position is very odd, because in the First EC
Submission, the European Communities argues that the OECD Guidelines serve as a benchmark for
determining whether the FSC administrative pricing rules comply with the arm's length principle of
footnote 59.  Although the United States does not agree with the proposition that the OECD
Guidelines have been incorporated into the SC M Agreement or that those Guidelines necessarily
would dictate the outcome of discussions in the OECD, that does appear to be the
European Communities' view.  That being the case, the European Communities cannot argue, in one
breath, that the OECD's expertise is dispositive of its subsidy claim, and then, in the next breath,argue that the OECD's expertise is irrelevant.
4.127  With respect to bilateral tax treaties, the Eu ropean Communities argues that the competent
authority process would not be appropriate for addres sing the transfer pricing issues involved in this
case because (1) bilateral tax treaties generally apply only to the residents of the signatories;  (2)
bilateral tax treaties do not provide a basis for one country to object to the tax practices of anotherwhen there is no issue of double taxation or loss of tax revenue for that country;  and (3) the purpose
of the mutual agreement procedure under a tax treaty is to resolve specific cases of application of the
treaty in a specific taxpayer dispute with a country.
4.128  The United States does not share the European Communities' overly restrictive view of the
utility of the competent authority process in transfer pricing matters, as this process both in aim and
practice extends beyond specific cases of double taxation or tax evasion.  As a matter of routine,
competent authorities consult extensively.  Their consultations can and often do extend to the properadministration of the tax laws of the parties and to types of transactions in which the interaction
between two tax systems results in non-taxation, includi ng transactions involving entities establishedWT/DS108/R
Page 26
in low-tax jurisdictions.  On transfer pricing matte rs, competent authorities have substantial expertise
stemming from their administration of provisions in corporated into all income tax treaties dealing
with the allocation of profits between associated ente rprises.  Obviously, the drafters of footnote 59
fully appreciated the transfer pricing expertise of competent authorities, and deliberately required
potential disputants to fully avail themselves of such  expertise in an effort to resolve their differences
over whether certain practices have contravened the principles embodied in footnote 59 and, by
reference, the 1981 GATT Council Decision.
4.129  The European Communities suggests that the drafters of footnote 59 could not have intended
recourse to bilateral tax treaties or the OECD, because the drafters "probably intended to refer [to]
some kind of dispute resolution mechanism".  The European Communities offers no support for thisproposition, and the reference of footnote 59 to "the facilities of existing bilateral tax treaties or other
specific international mechanisms" seems to us to mean nothing more than that Members should
attempt to work out a mutually acceptable solution in another forum before invoking the dispute
settlement provisions of the WTO.  That is not an alien concept.  Indeed, DSU Article 4.7 provides
that mutually acceptable solutions through discussion are to be preferred to litigation.  The onlynoteworthy difference between footnote 59 and Article 4.7 is that footnote 59 directs that such
discussions take place, in the first instance, in an appropriate tax forum.
4.130  The European Communities argues that footnote 59 does not apply to this dispute because it
is not listed as a special or additional rule in the DSU.  Here, the United States simply will note that
with respect to its claims under the AA, the European Communities has invoked Article 10.3 for the
proposition that the burden of proof in this case somehow shifts to the United States.  However,
Article 10.3 is not identified in the DSU as a special or additional rule.  Thus, there is a fundamentalinconsistency in the European Communities' position.
4.131  The European Communities attempts to excuse it s procedural failings by arguing that it was
incumbent upon the United States to raise its objections during consultations.  This is simply a
recycling of the European Communities' arguments regarding Article 4.2 of the SCM Agreement in
which it attempts to obscure its own shortcomings by suggesting that the United States bore anobligation to bring the European Communities' failures to its attention at a moment that was more
convenient for the European Communities.
4.132  Finally, the European Communities asserts that this particular United States objection
implicates only the European Communities' claims under Article 3.1(a) of the SCM Agreement.  The
United States disagrees.  If the FSC administrative pricing rules are consistent with item (e) andfootnote 59, then they are neither prohibited by Arti cle 3.1(a) nor by Article 3.1(b).  This is because
the FSC administrative pricing rules would not involve the foregoing of revenue that is "otherwise
due" within the meaning of Article 1.1(a)(1)(ii), and because footnote 5 would render the FSC
administrative pricing rules immune from any othe r prohibition in the SCM Agreement.  Similarly,
the FSC administrative pricing rules would not violate the AA because, given the absence of anythingto the contrary in the AA, item (e) and footnote 59 establish the standard for determining whether the
administrative pricing rules constitute an export subsidy under that Agreement.
4.133  In other words, in order to establish that the FSC administrative pricing rules violate
Article 3.1(b) or the AA, the European Communities must establish that those rules are inconsistent
with footnote 59.  Footnote 59, in turn, requires that, as a threshold matter, the European Communitiesfirst raise its concerns in an appropriate tax fo rum.  This is true regardless of whether the
European Communities' claim is based on Article 3.1(a), Article 3.1(b), or the export subsidy
provisions of the AA.  Any other result would frustrate the clear intent of the drafters of footnote 59
that subsidy-related transfer pricing concerns be ra ised, in the first instance, in an appropriate tax
forum.
The European Communities  further responds as follows:WT/DS108/R
Page 27
4.134  The United States attempts to strengthen its argument by referring to the
European Communities' First Written Submission and alleging that “According to the
European Communities, the FSC administrative pricing rules constitute a subsidy in and of
themselves.”  This is of course a misrepresentation of the European Communities' position.  The
European Communities is complaining that the spec ial administrative pricing rules for the FSC give
rise to an export subsidy since they are only available for the export of United States goods  -  not “ in
and of themselves ”.
4.135  The European Communities also explained that the alternative “channels” mentioned by the
United States (the OECD and bilateral tax treaties) were not available for dealing with the
European Communities' complaint and could not resolve it.  The only available and appropriate forumwas the WTO.
4.136  To the extent that the United States is simply arguing that these alternative channels provide
an opportunity to discuss the issues (rather than resolve it), the European Communities would point
out that its Member States did hold informal di scussions on the FSC and these discussions included
persons who were Competent Authorities. If this is what is required, the European Communities hasfulfilled the requirement.
4.137  Finally, on this point it is worth repeating th at if footnote 59 to the SCM Agreement did
constitute a requirement to “exhaust alternative available tax fora before attempting to resolve the
issue through the WTO dispute settlement process” as claimed by the United States, it would have
been mentioned in Appendix 2 to the DSU.  It is  not, although footnote 35 to the SCM Agreement,
which regulates the parallel application of countervailing duty action and dispute settlement, is.  This
demonstrates that footnote 59 to the SCM Agreement was not intended to constitute a special ruleapplicable in the conduct of dispute settlement.
The United States  further rebuts the European Communities response in its Oral Statement at the
First Meeting of the Panel as follows:
4.138  With respect to the procedural requirements of footnote 59, this provision obviously reflects
the drafters' decision to tread cautiously with resp ect to issues involving the relationship between tax
and trade rules.  The European Communities' failure to follow this procedural requirement frustrates
that objective by immediately dropping into the Panel's lap complex and technical transfer pricing
issues that should have been subject to an  initial airing in an appropriate tax forum.
3. Specificity of claims – Article 6.2 of the DSU
The United States  argues as follows:
4.139  Under Article 6.2 of the DSU, a request for the establishment of a panel must, inter alia ,
“identify the specific measures at issue.”  Nothing in the AA alters this requirement.
61
4.140  Depending on the nature of the alleged WTO violation in question, it may or may not be
necessary under Article 6.2 to identify the products that are subject to the measure in dispute.  For
example, in the case of a prohibited subsidy clai m under Article 3 of the SCM Agreement concerning
a non-agricultural product, an identification of the product(s) subject to the alleged prohibited subsidy
would not be necessary.  This is because Article 3 prohibits export subsidies with respect to any non-
agricultural product.
4.141  However, the situation is different in the case of allegations involving the provision of export
subsidies to agricultural products, because the AA does not prohibit the maintenance of export
                                                     
61 Article 19 of the AA simply states that the general dispute settlement rules apply to disputes under
that Agreement.  In addition, no provision of the AA is identified as a special or additional rule and procedure inAppendix to the DSU.WT/DS108/R
Page 28
subsidy programmes per se .  Instead, the AA permits the use of export subsidies in accordance with
the obligations set forth in that Agreement.  The nature of those obligations will differ depending on
the particular agricultural product in question.  Thus, a particular export subsidy may constitute a
violation of the AA in the case of “Product X,” but not in the case of “Product Y.”
4.142  Therefore, in the case of a request for a panel involving claimed violations of the export
subsidy provisions of the AA, it is not enough for the request to identify the alleged export subsidy.
Instead, the request must identify the particular agricultural products that are alleged to receive an
export subsidy in violation of the AA.  Only then will the panel request fulfill its mandatory function
of “form[ing] the basis for the terms of reference of the panel pursuant to Article 7 of the DSU . . .
and . . . inform[ing] the defending party and the third parties of the legal basis of the complaint.”62
4.143  The Appellate Body reached a similar conclusion in the European Communities  LAN  case.  In
that case, which involved an alleged violati on of Article II:1 of GATT 1994, the Appellate Body
stated:
"We note that Article 6.2 of the DSU does not explicitly require that the products to
which the "specific measures at issue" apply be identified.  However, with respect tocertain WTO obligations, in order to identify "the specific measures at issue", it may
also be necessary to identify the products subject to the measures in dispute."
63
4.144  In that case, the Appellate Body went on to find,  as had the panel, that the panel request had
adequately identified the products at issue.
4.145  In contrast to the European Communities  LAN  case, where the litigants disagreed over the
specificity of the product description included in the panel request, in the instant case, the
European Communities' request for a panel contained no product identification or descriptionwhatsoever.  As a result, because the FSC is not prohibited per se  by the AA (assuming arguendo  that
the FSC is an export subsidy at all), it was not until the United States received the First European
Communities Submission that the United States learned the nature of the case against it; i.e., that the
European Communities was challenging the alleged provision of the FSC with respect to exports of
wheat, cotton, soybeans, and maize.  It is as if the European Communities accused the United Statesof violating Article II:1 of GATT 1994 without specifying the product or the tariff binding in
question.
4.146  Under Article 6.2 of the DSU, a defending party is not expected to have to wait until the
complainant files its first submission to learn of the specific WTO violations that it allegedly has
committed.
64  Therefore, because the European Communities' request for a panel failed to “identify
the specific measures at issue,” the Panel should dismiss the European Communities' claims under the
AA.65
                                                     
62  European Communities - Customs Classification of Certain Computer Equipment , WT/DS62/AB/R,
Report of the Appellate Body adopted 22 June 1998, paragraph 69, quoting from  European Communities -
Regime for the Importation, Sale and Distribution of Bananas , WT/DS27/AB/R, Report of the Appellate Body
adopted 25 September 1997, paragraph 142.
63  Id., paragraph 67 (italics in original).
64  Of course, even this statement assumes that the First European Communities Submission, as opposed
to some later European Communities submission, establishes the subject matter of this proceeding.  TheEuropean Communities may add additional agricultural products to its claims as this case moves along.  Sufficeit to say that at this point, given the European Communities' failure to comply with Article 6.2, neither theUnited States nor this Panel knows the full or final scope of the European Communities' claims under the AA.
65 In its second submission to the Panel, the United St ates remarks: To clarify matters for the Panel, the
United States hereby confirms that, in light of the discus sion that took place at the first meeting of the Panel, it
has withdrawn its objection concerning the European Communities' failure to identify non-scheduled
agricultural products.  The United States continues to maintain, however, that the European Communities'WT/DS108/R
Page 29
The European Communities  responds as follows:
4.147  The United States requests that the Panel dismiss the European Communities' claims under
the AA on the grounds that the European Communities has not specified the agricultural products
concerned. It claims that since the AA does not proh ibit export subsidies generally, but only if they
exceed certain limits, Article 6.2 of the DSU requires the products concerned to be specified.  It
claims that “it is as if the European Communities accused the United States of violating Article II:1 of
GATT 1994 without specifying the product or the tariff binding in question”.
4.148  The European Communities does not agree.  Article 6.2 of the DSU requires identification of
the specific United States measures at issue and the legal basis for the complaint.  The measure atissue here is the FSC scheme and the legal basis for the complaint is the violation of the AA.  The
situation is not comparable to a breach of a tariff binding where the measure (the applied tariff) relates
to a particular product.
4.149  The European Communities is complaining about the fact that the FSC scheme can lead to
circumvention of reduction commitments under th e AA.  The four products were mentioned as
concrete examples of where this might happen, as the European Communities expressly stated at
paragraph 168 of the European Communities' First Written Submission.
4.150  The main reason why the European Communities mentions these examples is that it is
invoking reversal of the burden of proof provided for in Article 10.3 of the AA for these products and
wanted to limit the burden on the United States to just those four products which the United States
exports to the European Communities.
4.151  The European Communities' conclusion on the AA contains an error and is perhaps
ambiguous.  It would be clearer if it read:
“The European Communities requests the Panel to find that by maintaining the tax
exemptions and special administrative pricing rules contained in the FSC scheme, the
United States has violated:
. . .Articles 3 and 8 read in conjunction with Articles 9.1(d), 10.1, and 10.3 of the
Agreement on Agriculture by granting export subsidies to agricultural goods in
excess of its reduction commitments under that Agreement (e.g. wheat, maize, soya
beans, and cotton).”
4.152  The European Communities asks the Panel to read  the relevant part of the conclusion to the
European Communities' First Written Submission as thus corrected.
4. Scope of measures at issue
The United States  argues as follows:
4.153  In its request for establishment of a panel, the document that established the Panel’s terms of
reference, the European Communitie s identified the measures at issue as “Sections 921-927 of the
[US] Internal Revenue Code and related measures ... .”  Although the phrase “related measures” is not
without ambiguity, in the view of the United States, such a request would satisfy WTO standards if
(1) the unspecified measures were subsidiary or closely related to the measures specified in the panel
                                                                                                                                                                    
failure to identify scheduled  agricultural products in its request for the establishment of a panel violated Article
6.2 of the DSU.WT/DS108/R
Page 30
request, and (2) if the unspecified measures were identified in the first submission of the
complainant.66
4.154  In this dispute, however, the European Communities has yet to identify what its other “related
measures” are.  Instead, in the First European Communities Submission, the European Communities
continues to assert that “the measures subject of this proceeding” are “Sections 921-927 of the US
Internal Revenue Code and related measures”.67  However, the European Communities still does not
tell either the Panel or the United States what these other “related measures” are.  At most, the
European Communities makes a cryptic reference to regulations of the US Internal Revenue Service
relating to the FSC, stating as follows:  “The European Communities considers that it is the
United States primary legislation that creates the violations of the WTO Agreements and does notexpect that it will be necessary to refer to these regulations.”
68
4.155  With due respect, what is relevant is not the European Communities' litigation “needs,” but
rather that basic considerations of due process entitled the United States to know with certainty, as of
the date on which the European Communities filed its first submission, which of its measures the
European Communities was challenging.69  With respect to the European Communities' “related
measures”, the United States has been denied the opportunity to make an initial submission because
the European Communities has not identified what those measures are or why they violate any of the
WTO agreements.70
4.156  Basic principles of due process entitled the United States to know no later than the date on
which it filed its first submission the identity of the measures that allegedly violate United States
obligations under the WTO.  At this point, it simply is too late for the European Communities to
introduce other measures into this dispute.
4.157  The United States only can speculate as to whether the European Communities' failure to
identify its “related measures” is due to litigation tactics or a continuing inability to determine the
basis of its case.  Regardless of the reason, the Panel should not reward this failure by permitting the
European Communities to subsequently identify these “related measures” and present arguments
concerning them, all the while denying the United States an opportunity to present a defense.  Instead,the Panel should make a preliminary finding at the first meeting of the Panel that the measures at issue
in this dispute are limited to Sections 921-927 of the US Internal Revenue Code.
The European Communities  responds as follows:
4.158  The United States complains that the European Communities' request for establishment of a
panel identified the measures at issue as “Sections 921-927 of the US Internal Revenue Code and
related measures ... “ and claims that the European Communities has not specified what it means by
“related measures” in its First Written Submission.  It therefore asks
71 the Panel to make a preliminary
finding at the first meeting of the Panel that the measures at issue in this dispute are limited to
Sections 921-927 of the US Internal Revenue Code.
                                                     
66  One prior panel reached a similar conclusion.  Japan - Measures Affecting Consumer Photographic
Film and Paper , WT/DS44/R, Report of the Panel adopted 22 April 1998, paragraphs 10.1-10.11.
67  First EC Submission, paragraph 2.
68  Id., paragraph 23.
69  In this regard, the Appellate Body repeatedly has emphasized the importance of due process
considerations in the WTO system.  See, e.g., United States - Restrictions on Imports of Cotton and Man-Made
Fibre Underwear , WT/DS24/AB/R, Report of the Appellate Body adopted 25 February 1997, at 15; and Brazil -
Measures Affecting Desiccated Coconut , WT/DS22/AB/R, Report of the Appellate Body adopted
20 March 1997, at 22.
70  As the Appellate Body has recognized, “[a] fundamental tenet of due process is that a party be
provided with an opportunity to respond to claims made against it.”  Australia - Measures Affecting Importation
of Salmon , WT/DS18/AB/R, Report of the Appellate Body adopted 6 November 1998, paragraph 278.
71 Paragraph 75 of the US First Written Submission.WT/DS108/R
Page 31
4.159  This claim is entirely unfounded.  This case is about the tax treatment of FSCs.  The European
Communities has explained that it is complaining about the tax exemption subsidy and the transfer
pricing subsidy accorded to United States exported goods and that this is contained in a body of law it
has described as “the FSC scheme”.  This is also the case of the local content requirement. The
European Communities has explained in detail what the FSC scheme is, how it works and that it isinstituted by Sections 921-927 of the US Internal Revenue Code. The European Communities has also
identified many other provisions of United States law which relate to it.  It is wrong to say that the
European Communities has not identified the “r elated measures”. The European Communities can
provide a list of related provisions if the Panel wishes.
4.160  The United States request to limit the measures at issue in this dispute to Sections 921-927 of
the US Internal Revenue Code must be rejected.
B. 
WHETHER FSC MEASURES ARE SUBSIDIES CONTINGENT UPON EXPORT PERFORMANCE WITHIN
THE MEANING OF ARTICLE 3.1( A) OF THE SCM AGREEMENT
The European Communities  argues in its First Submission as follows:
Factual Background
The US Tax System
4.161  Official US explanation of the FSC scheme and the other elements of the US tax system
relevant to an understanding of its background can be found in the exhibits to this submission.  A
policy explanation is contained in the testimony of Joseph J. Guttentag, International Tax Counsel,Department of the Treasury, to the Committee on Finance to the US Senate on July 21 1995 (Exhibit
EC-2).  A briefer and more focussed explanation confined to the FSC scheme is contained in
“Foreign Sales Corporations – A Tax Incentive for US Exporters” published by the US Office of the
Chief Counsel for International Commerce, US Department of Commerce
72 (Exhibit EC-3).  There is
also useful information in the reports of the Department of the Treasury entitled The Operation and
Effect of the Foreign Sales Corporation Legislation .  These were supposed to be published
periodically pursuant to Section 804(a) Tax Reform Act 1984 but only two exist, that for the period
1 January 1985 to 30 June 1988 (Exhibit EC-4), published in January 1993, at and that for 1 July 1992
to 30 June 1993, published in November 1997 (Exhibit EC-5).  References will be made to these
publications as appropriate in the following explanation as elsewhere in this submission.
4.162  The US has an advanced and sophisticated tax system which has evolved complex sets of
rules which seek to eliminate or at least reduce both double taxation and tax avoidance.
4.163  Like in most countries, liability to US income taxes is based on both the residence of the
taxpayer and the source of the income.  Thus, the United States taxes its citizens and residents
(including US corporations) on both domestic and foreign source income73, and it eliminates or
reduces international double taxation by allowing a credit for foreign taxes paid or accrued on foreign
source income.74  The US tax system is widely considered unusual in the way that it taxes the income
of its citizens, taxing them regardless of where in the world they may be resident.75  However when it
comes to taxing companies the US system is in reality similar to that of other countries.
                                                     
72 Available on the Internet at http://www.ita.doc.gov/legal/fsc.htlm.
73 The US has developed a comprehensive set of sour ce rules for determining what is considered US or
foreign source income.  Under these rules, which are also used for allocating deductions, income is firstcategorised according its nature and type and then is  characterised as sourced within or without the US
74 See Testimony of Joseph J.  Guttentag, International Tax Counsel, Department of the Treasury, at
p.3.  (Exhibit EC-2).
75 This approach of taxing worldwide income of individuals regardless of their resident status is also for
example by the Philippines and Bulgaria.WT/DS108/R
Page 32
4.164  In defining which corporations are considered domestic for tax purposes, the US tax code (the
Internal Revenue Code or “IRC”) adopts the - purely formal - nationality principle76 under which “US
corporations” are those organised under the laws of the United States, any individual state or the
District of Columbia.
4.165  A US corporation conducting operations abroad through a separately incorporated foreign
corporation pays no US tax on the foreign corporation’s foreign-source earnings which are not
effectively connected with a trade or business in the United States77 until those earnings are
repatriated to the United States through a dividend or otherwise (the “deferral” principle).  The
deferral principle provides a good incentive for taxpayers to shift their investments in low-taxing
jurisdictions obtaining an unlimited deferral, and in practice tax-free earnings, as long as they do notrepatriate their profits.  To prevent abuses, a number of exceptions to the deferral rule have been
introduced that are directed at certain types of mobile or low-taxed foreign income.  The exception
which is relevant for an understanding of the FSC  scheme is the controlled foreign corporations
provisions of Subpart F of the IRC.
78  These provisions require the US shareholders that own stock in
the controlled foreign corporation to include in its gross income its pro rata share of the foreign
corporations undistributed income, thus eliminating the benefits of deferral for such shareholders.79
Most other developed countries have similar legislation.  The foreign trade income of FSCs is
exempted from this regime.80
4.166  Double taxation arises when the same income of the same taxpayer is subjected to
comparable taxes both in the source country and in the country of residence for identical periods.
Many countries have unilateral mechanisms for preventing some or all of such double taxation.  In
addition, however, OECD countries and many non-member countries have a range of bilateral doubletaxation treaties to eliminate double taxation as well as to prevent tax evasion and to ensure non-
discrimination.  Tax treaties prevent double taxation by allocating the right to tax various categories
of income between the two countries concerned.  Generally, where income can be taxed in the State of
source, the State of residence eliminates the double taxation.  The State of residence can accomplish
this either by exempting the income from the State of source (often referred to as the capital-import
neutrality principle) or by giving a credit for the tax paid there (the capital-export neutrality principle).
These two methods are defined in Articles 23 A and 23B of the OECD Model Tax Convention.
4.167  The US rules designed to avoid double taxation of income are inspired by a “capital-export
neutrality principle,”
81 under which the decision to invest locally or abroad should not be affected by
local or foreign tax considerations, namely the US investor should pay the same total (US and foreign)tax on all income, regardless of where the income is earned.  The US double taxation rules operate by
allowing a foreign tax credit (FTC) for foreign income taxes paid on foreign source income which is
subject to tax in the United States.  This effect ively mitigates or eliminates multiple taxation by
allowing a US taxpayer to deduct the amount of the foreign tax credit from US income taxes
otherwise payable on foreign source income, with certain limitations
82.  Because no US tax is payable
on the exempt part of FSC income, any foreign tax pa id on this income cannot give rise to a foreign
tax credit.
                                                     
76 Section 7701(a)(4) IRC.
77 See Section 882 IRC (tax on income of foreign corporations connected with a US business).
78 Sections 951-964 IRC.  The other exceptions are the foreign personal holding company provisions
(IRC secs.551-558), the foreign investment company provisions (IRC sec.1246-1247) and the passive foreign
investment company (PFIC) provisions (IRC secs.1291-1297).
79 See Testimony of Joseph J.  Guttentag, International Tax Counsel, Department of the Treasury, at p.5
et seq.  (Exhibit EC-2).
80 See Section 951(e) and 954(d) IRC and the explanations in the Testimony of Joseph J.  Guttentag,
International Tax Counsel, Department of the Treasury, at p.11.  (Exhibit EC-2).
81 See explanation in the Testimony of Joseph J. Guttentag, International Tax Counsel, Department of
the Treasury, at p.2.  (Exhibit EC-2).
82 See Sections 901 et seq.  IRC and the explanations in the testimony of Mr.  Guttentag (Exhibit
EC-2).WT/DS108/R
Page 33
4.168  An essential component of these rules is of course the application of certain rules to define the
source of the income to be taxed.  The development of source rules is very important for taxing
countries because taxpayers always have a strong incentive to manipulate them in order to have
domestic source taxable income characterised as foreign source non-taxed income.  The IRC contains
a comprehensive set of source rules.83  Under these rules, which are also used for allocating
deductions, income is first categorised according its nature and type and then is characterised as
sourced within or without the United States.84  Active income, which is defined as “effectively
connected with a US trade or business”, is taxed on a net basis, whereas passive income is taxed on a
gross basis, mainly through a withholding mechanism.
4.169  These rules are important to an understanding of the FSC scheme because the technique used
to exempt part of the income of FSCs from US tax is to deem it to be “foreign source income which is
not effectively connected with the conduct of a trade or business in the United States”85 which it
otherwise would be and then to exempt the parent  company from tax on the dividends attributable to
that income86.
The Introduction of the Domestic International Sales Corporation
4.170  In order to promote US exports at a time of increasing trade deficit87, the Nixon
administration introduced the Domestic International Sales Corporation (DISC) legislation in 197188
as part of a package of “new economic policy”.  The Original Act was called the “Deficit ReductionAct of 1971
89”.  Congress sought to generate additional exports, while keeping the loss of tax
revenues as low as possible.
4.171  DISCs are US corporations whose income derives from exportation.  They are required to be
incorporated in the United States and at least 95 per cent of the gross receipts of the corporation have
to consist of qualified export receipts.  US corporate tax is deferred on a portion of a DISC’s export-
related income.  Under the DISC regime, the profit s of a DISC are not taxed to the DISC, but are
taxed to the shareholders of the DISC when distribu ted or deemed distributed to them.  Each year, a
DISC is deemed to have distributed a portion of it s income, thereby subjecting that income to current
taxation in the hands of its shareholders.  Tax can generally be deferred on the remaining portion of
the DISC’s taxable income until (i) the income is ac tually distributed to the DISC shareholders, (ii) a
shareholder disposes of the DISC stock, (iii) the DISC is liquidated, (iv) the stock of the DISC is
distributed, exchanged or sold, (v) the corporation ceases to qualify as a DISC or (vi) the DISC
election is terminated or revoked.  In the typical ca se, a DISC is a wholly owned US subsidiary of a
US corporation, with the result that distributions and deemed distributions from DISCs are typically
subject to parent corporate tax and, eventually, to shareholder-level tax when distributed to
individuals.
                                                     
83 See Sections 861-865 IRC.
84 Categories of income include: interest, dividends, rentals and royalties, compensation for personal
services, sale of real property, sale of personal property, etc.
85 See Section 921(a) IRC.
86 Under Sections 926 and 245(c) IRC.  See explanation in the Testimony of Joseph J.  Guttentag,
International Tax Counsel, Department of the Treasury, at p.11.  (Exhibit EC-2).
87 See e.g.  the introduction to the legal article The Making of an Export Subsidy:  DISCs and FSCs in
compliance with the GATT  by Leif Weizman published in the "World Competition" Law Review Vol.  12 1989
N.3 page 57 at pages 57-58.  The first Treasury Report on FSCs (Exhibit EC-4) states that “after years of adiminishing trade surplus, Congress created the DISC program in 1971 in an effort to stimulate exports” (firstsentence of Section entitled “Detailed Description of the FSC Program” in Chapter 2 on page 3).  Obviouslythere are different ways of measuring the trade balance.
88 Now codified in Sections 991-997 IRC.
89 See footnote 1 to the Extract in Exhibit EC-6 from the General Explanation of the Revenue
Provisions of the Tax Reform Act 1984 prepared by the staff of the Joint Committee on Taxation.  Published in
Federal Taxes, 17 January 1985.WT/DS108/R
Page 34
4.172  The DISC scheme provided further tax benefits through special inter-company pricing rules
and certain rules on producers’ loans.  The availability of two alternative methods of allocation of
income to the DISC served to increase the DISC’s profit that would otherwise result under arm’s
length pricing.  It allowed a substantial part of the parent company’s profit to be attributed to the
DISC.
4.173  As is well known, the European Communities objected to the introduction of the DISC
legislation and succeeded in having it declared an illegal export subsidy contrary to Article XVI:4
GATT 1947.90  The report was adopted in December 1981 together with the reports in three retaliation
cases that the United States brought against three EC Member States.  They were adopted by the
GATT Council together with an understanding that stated:
 "The Council adopts these reports on the understanding that with respect to these
cases, and in general, economic processes (including transactions involving exported
goods) located outside the territorial limits of the exporting country need not be
subject to taxation by the exporting country and should not be regarded as export
activities in terms of Article XVI:4 of the General Agreement.  It is furtherunderstood that Article XVI:4 requires that arm's-length pricing be observed, i.e.,
prices for goods in transactions between exporting enterprises and foreign buyers
under their or the same control should for tax purposes be the prices which would be
charged between independent enterprises acting at arm's length.  Furthermore,
Article XVI:4 does not prohibit the adoption of measures to avoid double taxation of
foreign source income".
91
4.174  Although the United States claimed that its DISC legislation was compatible with the above
understanding, it was isolated and multinational trade negotiations on the Subsidies Code also
identified export related tax exemptions and deferral as prohibited under item (e) of the Illustrative
List to the Tokyo Round Subsidies Code.
4.175  Although the United States never officially conceded that the DISC scheme violated the
GATT, the Reagan Administration decided to remove the issue as an irritant in US trade relations byintroducing the FSC scheme and amending the DISC legislation to introduce an interest charge for
deferred taxes.  In addition, DISC benefits were limited to relatively small DISCs with taxable income
attributable to a maximum of $10 million of qualified export receipts.
The FSC Legislation
Introduction
4.176  It appears from the extract from the General Explanation of the Revenue Provisions of the
Tax Reform Act 1984  prepared by the staff of the Joint Committee on Taxation
92 (contained in
Exhibit EC-6) that the FSC legislation93 was designed to be functionally equivalent to the DISC94
while being easier to defend under the GATT.  The FSC legislation has some important technical
differences to the DISC legislation but the economic effect of the FSC, i.e. the promotion of exports
of products manufactured in the United States, and the means to achieve this goal, i.e. income tax
exemptions, remained the same.  This view is supported by a number of independent legal authors.95
                                                     
90Panel Report " US - Tax Legislation (DISC) ", L/3851, adopted on 7-8 December 1981, BISD
23S/98, 114.
91 BISD 28S/114.
92 Published in Federal Taxes, 17 January 1985.
93 The legislation is now codified in Sections 921 to 927 IRC (Exhibit EC-1).
94 See esp.  Explanation of Provisions, Section C.1 in fine on page 1043 of the  General Explanation of
the Revenue Provisions of the Tax Reform Act 1984 contained in Exhibit EC-6.
95 See e.g.: The Making of an Export Subsidy:  DISCs and FSCs in compliance with the GATT  by Leif
Weizman published in the "World Competition" Law Review Vol.  12 1989 N.3 page 57 at p.  81; DISCs and
FSCs: Providers of Economic Incentives for Wholly-owned Domestic Exporters by Caplan and Chametzky inWT/DS108/R
Page 35
These legal authors share the view of the Europe an Communities that the FSC scheme violates the
WTO rules96.
4.177  The European Communities, among others, never accepted the FSC legislation as compatible
with the GATT and continuously contested it.  It addressed a démarche to the United States Trade
Representative on 8 November 1983.97  The US Congress was perfectly aware of this when it adopted
the FSC legislation in the Tax Reform Act of 1984.98  The European Communities formally reserved
its rights in the GATT Council99 and formal consultations under Article XXII GATT were held
between the European Communities and the United States on the FSC legislation on 26 March 1985
in which Australia, Canada, Finland, Japan, New Zealand, Sweden and Switzerland participated (see
further below).
4.178  An good summary of the FSC legislation is contained in the document Exhibit EC-3 produced
by the Office of the Chief Counsel for Internatio nal Commerce of the US Department of Commerce
which is designed to provide US exporters with “an overview of the FSC tax incentive” for “export-
related income”.  The following account is largely based on it though reference will also be made to
the legislation in Exhibit EC-1 and other sources.
4.179  There are also two sets of FSC regulations which were published in the US Federal Register
on 12 December 1984.  One set of regulations, issued in question and answer form, contains other
FSC general requirements as well as definitions and the other clarifies the “foreign presence”
requirements.  These regulations are designed to facilitate the operation of FSCs and have apparently
been changed in 1998.  The European Communities considers that it is the US primary legislation that
creates the violations of the WTO Agreements and does not expect that it will be necessary to refer to
these regulations.
Definition of a FSC
4.180  A FSC is a corporation created or organised in certain foreign countries or US possessions to
obtain a US tax exemption on a portion of its earnings generated by the sale or lease of “export
property”.100  Export property is:
• any property;
• manufactured, grown, or extracted in the United States;
• by a person other than a FSC;
• sold, leased, or rented for use outside the United States; and
• with no more than 50 per cent of its fair market value attributable to imports.
                                                                                                                                                                    
Brooklyn Journal of International Law at page 12 and Addressing Tax Revolutions the Lack Empirical Validity
by Westin in 1997 in chapter III.  These articles are contained in Exhibit EC-7.
96 See: The Making of an Export Subsidy:  DISCs and FSCs in compliance with the GATT  by Leif
Weizman published in the "World Competition" Law Review Vol.  12 1989 N.3 page 57 (esp.  Conclusion
p. 81); An Analysis of the GATT-Compatibility of The New Foreign Sales Corporation by Ryan in the Santa
Clara Law Review Vol.  26, page 705-706 and conclusion page 717; Addressing Tax Revolutions the Lack
Empirical Validity  by Westin in 1997 Tax Analysts at paragraph 31.These articles are contained in Exhibit
EC-7.
97 The contents are sumarised in DISCs and FSCs: Providers of Economic Incentives for Wholly-owned
Domestic Exporters by Caplan and Chametzky in Brooklyn Journal of International Law at pages 14 to 16.
98 See Section B (Reasons for Change) in fine (page 1042) of the  General Explanation of the Revenue
Provisions of the Tax Reform Act  1984 in Exhibit EC-6.
99 C/M/180 page 5.
100 Section 927(a) defines FSC export property as property held for sale or lease which: (1) had been
manufactured, produced, grown, or extracted in the United States  by a “person” other than the FSC; (2) was
held primarily for sale, lease, or rental in the ordinary course of business for direct use, consumption, or
disposition outside the US; and (3) had, at the time of sale, lease, or rental by the FSC, not more than 50 per
cent of its fair market attributable to articles imported into the US.WT/DS108/R
Page 36
Formation Requirements
4.181  FSCs can be formed by manufacturers, export intermediaries, or groups of exporters, such as
export trading companies.  A FSC can function as a principal, buying and selling for its own account,
or as a commission agent.  It can be related to a manufacturing parent or can be an independentmerchant or broker.
4.182  A FSC must first meet certain basic formation requirements
101, the most notable of which is to
be set up a US possession or a foreign country approved by the United States as having an exchange
of information agreement.102  The vast majority of FSCs are set up in countries that do not tax them
(but impose only minimal annual franchise taxes and licence fees).
4.183  In order to benefit from the scheme, a FSC must (unless it is a “small FSC”103) meet several
“foreign management” tests throughout the year.  If it complies with those requirements, it is entitled
to an exemption on qualified export transactions in which it performs the required “foreign economic
processes”.
Foreign Management Requirements
4.184  Under the foreign management test a FSC will qualify for the exemption for a taxable year if
it meets three basic requirements:
• all meetings of shareholders and directors are held outside the United States;
• the principal bank account is maintained outside the United States; and
• all dividends, legal and accounting fees, officers' salaries, and directors' fees are
disbursed from a foreign bank account.
Foreign Economic Process Requirements
4.185  There are two foreign economic process requirements:
• the FSC must participate in the sales process; and
• the FSC must have a minimum percentage of foreign direct costs.
4.186  The FSC, or its agent, must comply with both of these requirements to earn income exempt
from tax from any export transaction or group of transactions.
Participation in the Sales Process
4.187  The first foreign economic process requirement is that the FSC, or its agent, must participate,
outside the United States, in any of the following in export transactions:
• solicitation (other than advertising),
• negotiation, or
• contracting.
4.188  As a general rule, the FSC must participate in only one of these three activities to obtain the
FSC tax exemption.  However, if the FSC seeks to use special administrative pricing rules (see
below), then the FSC, or its agent, must perform all of the activities attributed to such sale, to the
extent that they are performed.  However, only the single qualifying activity must take place outside
the United States.
                                                     
101 Section 922 IRC.
102 Section 927(e)(3) IRC.
103 Section 922(b) IRC.WT/DS108/R
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Foreign Direct Costs
4.189  The second foreign economic process requirement is that specific percentages of the
transaction costs must be "foreign direct costs," incurred by the FSC for activities it, or its agent,
performs outside the United States.  "Direct costs" for this purpose are: materials consumed in theactivity, labour costs directly associated with the activity, and incremental costs of facilities or
services incidentally related to the FSC activity.  The activities tested are grouped in the following
five categories:
• advertising and sales promotion;
• processing customer orders and arranging for delivery of the export property;
• transportation;
• assembling and transmission of a final invoice or statement of account and the receipt
of payment; and
• assumption of credit risk.
4.190  A FSC meets the foreign direct cost test if its foreign direct costs are either 50 per cent or
more of total direct costs for these five activities, or are 85 per cent or more of direct costs incurred in
each of any two of the five activities listed above.
The Significance of the Foreign Management and Foreign Economic Process
Requirements
4.191  The existence of the foreign management and foreign economic process requirements, limited
as they are, are fundamental to providing a fig leaf of justification to the FSC scheme.  In reality
however they are a sham.
4.192  The foreign management requirements can be dealt with easily with meetings being held by
telephone and service companies in the countries of incorporation dealing with the paperwork.
4.193  Although an FSC must incur the costs of the “foreign economic processes”, it need not
perform these activities itself.  An agent may perform these activities, and any person may serve as an
agent, irrespective of whether the agent is related (such as a parent or affiliate) or unrelated (such as a
bank, trust company, export trading company, or accounting firm in the foreign jurisdiction).
4.194  Indeed software packages and service companies exist which facilitate the paperwork of
running a FSC.  The running costs are estimated to be as low as US$2000 per year.
104
4.195  The sham character of FSCs is described in deta il in "Fantasy Islands". The authors point out
that in spite of some 3,600 FSCs formally established in the US Virgin Islands, none of these
corporations are visible. One of the largest FSC companies just employ seven people. They explain
that in reality the real work is still performed in the United States.
4.196  The “burden” of running FSCs is further reduced by the existence of special provisions for
“small FSCs.” A small FSC is generally the same as a FSC, except that the tax exemption for a small
FSC is limited to the income generated by $5 million or less in gross export revenues it does not have
to meet foreign management or foreign economic process requirements.  If a small FSC wants to use
the administrative pricing rules it must undertake the contracting, economic process, and management
activities.  However, none of the activities are required to be done offshore.  Small FSCs account for48 per cent of all FSCs.
4.197  In addition many US States, regional authoritie s, trade associations, or private businesses
sponsor “shared FSCs” for their companies, member s or customers.  A "shared FSC" is a FSC which
                                                     
104 Source: Article from the South Florida Business Journal of 24 February 1997 entitled Foreign Sales
Corporations : A Middleman that Offers Tax Savings  by David Wallace.WT/DS108/R
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is "shared" by 25 or fewer unrelated exporter "shareholders", so as to reduce the costs while obtaining
the full tax benefit of a FSC.  Each exporter-shareholder owns a separate class of stock and each runs
its own business as usual.  The US Department of Commerce grants written Export Trade Certificates
to shared FSCs that allow US exporters to engage in joint export conduct with other US companies.
Certified exporters are virtually immune from all federal and state government antitrust action.105
The Location of FSCs
4.198  The artificiality of the FSC scheme is further evidenced by the fact that most FSCs are set up
in US possessions and of the remainder most are in location which specifically exempt them from tax.
4.199  According to US Treasury data106, US possessions host 74 per cent of all FSCs.  66 per cent
of all FSCs are located in the US Virgin Islands.
4.200  The situation of FSCs in US possessions is particularly worthy of note as an illustration of
how lacking in “foreign” character FSCs really are.
4.201  The main location for FSCs is the US Virgin Islands.  This is an organised, unincorporated
territory of the United States, administered by the Office of Territorial and International Affairs in theUS Department of Interior.  It elects a me mber to the US House of Representatives.
4.202  The tax legislation of the US Virgin Islands is contained in the US IRC.  Section 932 of the
IRC provides that the United States will be treated as including the Virgin Islands for purposes of
determining the US tax liability of US citizens or residents with Virgin Islands income.
4.203  According to the Naval Appropriations Act of 12 July 1921, “the income tax laws now in
force in the United States of America and those which may hereafter be enacted shall be held to be
likewise in force in the Virgin Islands of the United States.”
4.204  A Virgin Islands tax publication of July1992 states that “the 1984 Tax Equity and Fiscal
Responsibility Act (…) make the Virgin Islands a highly attractive location for US exporters desiring
to form FSCs.  US exporters can earn tax-exempt income by using V.I.  FSCs to perform some sales
activities outside the United States that a US company might otherwise perform” (emphasis added).
107
4.205  Another important location for FSCs is Barbados.  Apparently108, the Parliament of Barbados
enacted the Foreign Sales Act of 1984 which exempts FSCs from all taxes on income arising from its
operations except for income from investments made  in Barbados.  An FSC may engage in foreign
trade transactions from within Barbados only if it has obtained a licence to do so and only subsidiaries
of US corporations may obtain such a licence.  The licence for a FSC is US$1,000.  The licence fee
for a small FSC is US$500.
The US Tax Benefits of a FSC
4.206  A portion of the “foreign trade income” is deemed to be “foreign source income not
effectively connected with a trade or business in the United States” and is therefore not taxed in the
United States; this is referred to as the “exempt foreign trade income”.109  The remaining portion is
taxable to the FSC.  Dividends paid by the FSC  out of exempt and non-exempt income to the
shareholder (ordinarily, the “related supplier”) generally qualify for a full dividends received
                                                     
105 This immunity is granted through an Export Trade Certificate from the US Department of
Commerce under the Export Trading Act of 1982.
106 See Table 6.1 on page 20 of the Treasury Report for 1992-1993 in Exhibit EC-5.
107 See Exhibit EC-18.
108 See Exhibit EC-17.  The source of this information is http://www.ao-group.com/foreign.htm and
http://www.fgfsc.com/provibar.htm
109 See Section 923(a) IRC.WT/DS108/R
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deduction.110  Foreign trade income is gross income111 earned from the sale, lease, or rental of export
property.
4.207  A minimum of 30 per cent of a corporate held FSC’s foreign trade income is exempt from US
tax.  However, if the FSC buys from a related supplier and qualifies for the use of the special
administrative pricing rules, the rate of exemption rises to approximately 65 per cent.
4.208  Special rules apply for agricultural cooperatives.  All of the Foreign Trading Income of a FSC
owned by a related qualified cooperative from the sale of agricultural or horticultural products will be
treated as exempt foreign trading income.112
The Administrative Pricing Rules
4.209  Since FSCs are generally controlled subsidiaries of their parents the prices of transactions
between them (and therefore the allocation between them of the profit on the transaction) would
normally be required to be at arms length and controlled pursuant to Section 482 IRC.  FSCs and their
parents are however allowed to ignore this rule a nd apply special “administrative pricing” formulae
between them.113
4.210  This derogation is examined in more detail from a tax point of view below.  For present
purposes it is merely necessary to describe how they function and how important they are for the FSC
scheme.
4.211  The first administrative pricing rule apportions  23 per cent of the total foreign trade income
from an export transaction to the FSC and the remain ing 77 per cent to its related supplier.  This rule
further provides that 15/23 (approximately 65 per cent) of the FSC's foreign trade income is exempt
from US tax.  Thus, this rule provides an exemption for 15 per cent (23% x 15/23) of the total foreigntrade income earned in the transaction.
4.212  The second administrative pricing rule allows the FSC to take 1.83 per cent of the total gross
receipts from the export transaction as foreign trade income, not to exceed 46 per cent of the total
amount of foreign trade income.  This rule further provides that 15/23 (approximately 65 per cent) of
the FSC's foreign trade income is exempt from US tax.  Thus, this rule provides an exemption for upto 30 per cent (46% x 15/23) of the total foreign trade income earned in the transaction.
4.213  In general, the first rule produces greater tax savings for transactions with profit margins
above 8 per cent, while the second rule produces greater tax savings for transactions with profit
margins below 8 per cent.  Additionally, a FSC may group transactions together by contract,
customer, or product line to maximise its tax savings.
The Advantages of the Administrative Pricing Rules
4.214  The tax benefits achieved through FSCs are reported to be increasing through the use of
computers and software packages.  Exhibit EC-8 is an article from “Tax Notes International” entitled
A FSCful of Dollars: Maximizing FSC Benefits through Transaction Level Pricing
114 which
                                                     
110 Section 926(a) and 245(c) IRC.
111 “Foreign trading gross receipts” are defined in  Section 924(a) IRC to represent: (1) the sale,
exchange, or other disposition of export property (see abov e); (2) the lease or rental of export property for use
by the lessee outside the US; (3) services which are related and subsidiary to activities described in (1) or (2);(4) engineering or architectural services for construction  projects located (or proposed for location) outside the
US; and (5) the performance of managerial services fo r an unrelated FSC or DISC.  These receipts are earned
by, or allocated to, the FSC as a result of applying intercompany pricing rules.  Excluded is passive income.
112 See Section 923(a)(4) IRC.
113 See Sections 925(a) (1) and (2).
114 Pages 197 to 203, 15 July 1996.WT/DS108/R
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demonstrates how the flexibility built into the administrative pricing rules and in particular the scope
for applying them to different groups of transactions can be used to greatly increase benefits.
Eligibility for Administrative Pricing
4.215  The administrative pricing rules are exclusively available for FSC-related transactions.  They
are available on a transaction-by-transaction basis and can produce results that are quite different from
the results produced by the arm’s-length pricing rule of Section 482.
4.216  A FSC may use administrative pricing rules, with respect to a sale when the FSC or its agent
performs, to the extent they are performed, all of the activities attributed to such sale under:
- the "participation in the sales process" prong of the foreign economic process
requirement; and
- the "direct cost" prong of the foreign economic process requirement.
4.217  The FSC, or its agent, must comply with  both of the two foreign economic process
requirements to earn FSC income exempt from tax on any export transaction.  However, the FSC does
not need to perform all of these activities outside of the United States in order to obtain the benefits ofthe administrative pricing rules.
4.218  Similarly, a small FSC need not perform any economic process activities abroad to qualify as
a FSC.  However, to the extent economic process activities are performed, the small FSC or its agent
must perform these activities to qualify for administrative pricing.
Importance of the Administrative Pricing Rules
4.219  The administrative pricing rules are extremely advantageous since the amount of profit that
would be attributed to the FSC under the genera lly-applicable Section 482 IRC rules would be very
low in light of the limited role played by the FSC.  Their attractiveness is increased by the fact that
they can be applied ex post and transaction by transaction.  The result is that the vast majority of FSC
transactions use this method.
4.220  According to Joseph J. Guttentag, International Tax Counsel, Department of the Treasury in
his Testimony to the Committee on Finance to the US Senate on July 21 1995 (Exhibit EC-2),
“virtually every FSC, whether a commission FSC or a buy-sell FSC) that deals with a related party
determines its foreign trade income under on e of the two administrative pricing rules”.
115
Assessment of FSC Scheme from a Tax Perspective
Introduction
4.221  It is useful to briefly consider the FSC scheme from a tax law perspective.  The purpose of the
FSC scheme is to provide certain exemptions from the otherwise applicable tax rules of the US IRC to
the profits arising out of the export of US goods.  The basic exemptions comprised in the scheme arecontained in the following provisions:
First, the “foreign trade income” of FSCs is excluded from the controlled foreign
corporations provisions of Subpart F of the IRC, which would otherwise require such
income to be taxed in the United States as income of the parent (Sections 951(e) and
954(d) and (e) IRC).
                                                     
115 See the last paragraph on page 11 of the testimony.WT/DS108/R
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Second, the “exempt foreign trade income” of  the FSC is treated as “foreign source
income which is not effectively connected with the conduct of a trade or business
within the United States” and thus exempted from US tax which would otherwise be
due (Section 921(a) IRC).  The terms of Section 921(a) effectively exempts this
income from the charge to tax in Sections 882(a)(1) IRC for income of a foreigncorporation which is “effectively connected with the conduct of a trade or business
within the United States” and the rules in Section 864 IRC which would otherwise
make the income US source income.
Third the parent of the FSC is accorded a 100 per cent dividends received deduction
(i.e. exemption from US tax) for the dividends received from the FSC from “earningsor profits attributable to foreign trade income” (Section 245(c) IRC).  Section 926(a)
IRC provides that distributions from FSCs to their parents shall be treated as first
coming out of earnings and profits attributable to foreign trade income and thus
maximises this exemption.
4.222  However, the main economic benefit for exporters from the FSC scheme derives from the
availability of administrative pricing rules contained in Section 925 IRC.  These were originally
included in the DISC legislation and were carried over into the FSC scheme so as to maintain the
same level of benefits.  (In fact the level of benefits was increased due to the change from a system of
tax deferral to a system of tax exemption).  The importance of these provisions requires some
explanation.
Transfer Pricing
4.223  It is widely recognised by tax authorities that special rules are needed to deal with the transfer
of profits from one taxpayer to another and from one jurisdiction to another through transfer pricing.
An international consensus has built up about how to deal with these issues and is set out in the
OECD’s “ Transfer Pricing Guidelines for Multinat ional Enterprises and Tax Administrations ” (“the
Guidelines”) contained in Exhibit EC-11.
4.224  The administrative pricing rules of the FSC scheme are a major departure from the principles
applied by developed countries to deal with the problem of transfer pricing between related
companies as reflected in the Guidelines.
4.225  This governing principle set out in the Guidelines is the arm’s length principle.
116  T h i s
provides for prices practised between associated enterprises to be adjusted so as to reflect the pricesthat would have been practised between independent enterprises.
117
4.226  The Guidelines state that “ … the arm’s length principle is generally based on a comparison
of the conditions in a controlled transaction with the conditions in transactions between independent
enterprises”.  They go on to state that “In order for such comparisons to be useful, the economically
relevant characteristics of the situations being compared must be sufficiently comparable”.118
4.227  The Guidelines acknowledge that the existence of alternative methods of deriving an arm’s
length price may be appropriate, provided an attempt is made to ensure that the conclusion drawn on
any given case from use of alternative methods is consistent with the arm’s length principle.
4.228  Moreover, the alternatives the Guidelines envisage are alternative methods  to reach an arm’s
length price, not alternative  formulae  designed to allocate income/prof it returns.  The Guidelines draw
a clear distinction between application, as part of an authorised transfer pricing method, of formulae
developed after careful analysis of the particular facts and circumstances of the case and a method
                                                     
116 See the first sentence of paragraph 1.1 in Chapter 1 of the Guidelines in Exhibit EC-11.
117 See paragraph.  1.6 of the Guidelines in Exhibit EC-11.
118 See paragraph 1.15 of the Guidelines in Exhibit EC-11.WT/DS108/R
Page 42
which uses formulae predetermined for all taxpayers and which does not constitute proper application
of the arm’s length principle.
Section 482 of the IRC and the derogation in Section 925 of the IRC
4.229  The US has adopted the arm’s length principle for dealing with transfer pricing between
associated enterprises and this is set out in Section 482 IRC with rules for how the arm’s length
principle should be applied.  It provides for a full range of techniques to be employed based on the
latest understanding of the arm’s length prin ciple as set out in the OECD’s Guidelines.
4.230  In particular it should be noted that Section 482 IRC and the regulations adopted under it
allows for alternative methods to be employed, but this adoption is subject to approval of the US taxauthorities (the IRS), and is not at the taxpayer’s free choice.  By definition  the result achieved
through its application must be the arm’s length price applicable to the transaction concerned.
4.231  Section 925 IRC however allows the taxpayer to choose to adopt one of two alternative fixed
formula methods instead of the outcome that would be achieved under Section 482 (subject to
meeting relevant FSC conditions).  The ability of taxpayers to be able to choose an alternative
outcome – which is not subject to IRS approval as being consistent with the arm’s length principle
given the facts and circumstances of the case – means that an outcome which differs from the arm’s
length outcome is possible.
4.232  Indeed, Section 925 IRC provides that the transfer price shall be in an amount which allows
the FSC to derive taxable income “which does not exceed the greatest of”  the amount resulting from
each of the administrative pricing rules and Section 482 (emphasis added).  The emphasised words
reveal the intent of the legislation to allow the mo st advantageous result for the taxpayer to be used.
4.233  In fact the result achieved by Section 482 creates a “cap” on effective US tax liability, rather
than as a “floor” a suggested by US representatives when trying to justify the FSC scheme.
4.234  Accordingly, the availability of special admi nistrative pricing rules under Section 925 IRC is
a clear derogation from the arm’s length principle in Section 482 IRC.
The formulae do not approximate to the normal  return on the economic activity of FSCs
4.235  The only explanation for the special administrative pricing rules of Section 925 IRC is that
they are designed to provide the same level of tax exemption as was previously available under the
DISC scheme.  They have no basis in the economic activity conducted by FSCs.
4.236  FSCs cover a wide range of economic activity, from agricultural products to a full range of
manufacturing enterprises (including food, chemicals, electrical machinery and transportation
products).  Over the life-cycle, each of these industries will generate very different gross receipts, and
very different taxable incomes.  It seems unlikely that (say) an agricultural export agent would expect
to earn a normal income which represents the same share of total receipts as (say) an export agent
handling the export of freight locomotives.  The sa me can be said in relation to combined taxable
income.  The special administrative pricing rules of Section 925 IRC cannot deliver a sufficiently
close approximation to arm's length in such a wide variety of cases over time.
4.237  The availability of a choice between the two formulaic methods on a transaction by
transaction basis is also at odds with the manner in which pricing terms would be struck between
export agent and independent suppliers.  It is inconceivable that the agent/distributor would be offereda choice by an independent manufacturer and certainly not one which it could apply on a transaction
by transaction basis.  As a matter of arithmetic, the profit split formula will become beneficial for theWT/DS108/R
Page 43
FSC once the overall profit margin for the FSC and supplier reaches 8 per cent.119  Even if a margin of
1.83 per cent for the FSC alone were to represent a reasonable approximation of an arm’s length result
for the economic functions performed when overall profit margins were below 8 per cent, it is
difficult to see why the FSC should be able to opt fo r an ever increasing margin through the use of the
alternative formula once overall margins increased beyond 8 per cent.
4.238  In addition to these general arguments, use of standard industry data of this kind is rejected by
the OECD Guidelines which state that “ … in no event can unadjusted industry average returns
themselves establish arm’s length conditions”.  In this context it is notable that the formulae are
intended to span more than one industrial sector, which makes this rejection all the more pertinent.
Moreover, the Guidelines also reject the use of transactional profit methods which might overtax orundertax enterprises because their profits are less than or greater than the average.
120
Section 925 produces results which understate US taxation compared with application ofthe arm’s length standard
4.239  As shown above the alternatives to the definitive arm’s length standard of Section 482
provided in Section 925 IRC exist for no other purpose than to produce a more favourable result for
the US taxpayer.
4.240  This effect is maximised by the fact that Section 925 also permits the taxpayer to choose, on a
transaction by transaction basis, between the three alternative pricing methods.
4.241  The examples given in the Article from Tax Notes International entitled “ A FSCful of
Dollars: Maximizing FSC Benefits through Transaction Level Pricing ” in Exhibit EC-8
121 serves
further to illustrate the point.  These examples show that the two formulae give widely disparateresults one often being twice the other.  Even if the arm’s length result lay exactly between the two
methods the taxpayer would have considerable scope for departing from arm’s length because a free
choice of method is available.
4.242  Moreover, if the proposition that the formulae could never produce an outcome yielding less
tax than if Section 482 were applied were to hold true, then there should be no circumstances in which
the formulae should produce lower transfer prices.  Indeed, the alternative formulae ought to produce
the same outcome (or one which is sufficiently close to be able to ignore the difference as being
within the range of tolerance).  The examples clearly demonstrate that this cannot be the case.
Section 925 of the IRC Is Not Justified as A “Safe Harbour”
4.243  Given the options allowed by Section 925, it is clear that companies will adopt the formulaic
methods if they result in less US tax being payable than if Section 482 were applied.  But it was also
suggested that companies might use these methods – and risk paying more US tax than would
otherwise be necessary under Section 482 – simply for administrative convenience.
4.244  Apart from the fact that this would mean that  such companies would be failing in their
fiduciary duty to their shareholders, the incorrectness of this statement is demonstrated by the
Article in Tax Notes International referred to above which shows how companies are applying
computer software to obtain maximum benefit from the differences between the methods.
                                                     
119 For the mathematically-minded this is because 1.83% x FTGR equals 23% FTI when profit margin
is 8%. (FTI equals FTGR x profit margin (p). 1.83% x FTGR = 23% x (p x FTGR). Therefore, p = 1.83/23 =
0.0795652173913 = 8% (approx). )
120 See paragraph 3.4 of the Guidelines in Exhibit EC-11.
121 Pages 198 to 202.WT/DS108/R
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4.245  The United States has suggested that its special administrative pricing rules are merely a “safe
harbour,122” as provided for in the OECD Guidelines.
4.246  The OECD Guidelines are critical of “safe harbours.123”  The Guidelines conclude  that “safe
harbours are generally not compatible with the enfo rcement of transfer prices consistent with the
arm’s length principle124” and that: “special statutory derogations for categories of taxpayers in the
determination of transfer pricing are not generally considered advisable, and consequently the use of
safe harbours is not recommended125”.
4.247  The OECD guidelines concede that safe harbours might be an appropriate way to relieve
compliance burdens on small companies.  But this is not the purpose of FSCs.  The administrative
pricing rules in the FSC scheme are not just available to small companies: they are available to all,regardless of size.
Conclusion
4.248  The FSC legislation allows companies to compute their transfer prices ex post facto - a
procedure that is totally at odds with what would ha ppen at arm's length.  At arm's length, parties to
transactions generally agree the terms on which they will deal before the transactions take place.
4.249  The special administrative pricing rules are an essential part of the FSC scheme.  They are
designed to enable taxpayers to maximise the profits accruing in the FSC, and thus the benefits of the
scheme.  They are therefore not really "pricing" me thods at all, but a mechanism for shifting
profits from one company to another.  Pricing decisions at arm's length are not driven by
considerations of this kind, but by economic and commercial realities.
The economic effects of the FSC
Introduction
4.250  When the FSC legislation was originally adopted it was provided (Section 804(a) Tax Reform
Act 1984) that the US Department of the Treasury would produce [periodic] reports on the operationand effect of the legislation, just as had been done for the DISC scheme before it.  In fact only two
exist, that for the period 1 January 1985 to 30 June 1988 (Exhibit EC-4), published in January 1993, at
and that for 1 July 1992 to 30 June 1993, published in November 1997 (Exhibit EC-5).
4.251  Much of the data on the economic effects of the FSC scheme given below is based on this
rather inadequate data.  For more recent data it is necessary to go to unofficial sources and a few ofthese are also enclosed as exhibits.
4.252  One source which has already been mentioned is the entitled A FSCful of Dollars:
Maximizing FSC Benefits through Transaction Level Pricing Article in “Tax Notes International”
pages 197 to 203, 15 July 1996.
4.253  Another source to which the European Communities will refer is an Article from the South
Florida Business Journal of 24 February 1997 contained in Exhibit EC-9.
126
The Economic Importance of the FSC Scheme
                                                     
122 Section IV.E paragraphs 4.94 to 4.123 of the OECD Guidelines in Exhibit EC-11.
123 See esp.  paragraphs 4.103(b), 4.104, 4.105, 4.10 6, 4.107, 4.120, final sentence, 4.121, 4.123 of the
OECD Guidelines in Exhibit EC-11.
124 Paragraph 4.121 of the OECD Guidelines in Exhibit EC-11.
125 See final sentence of paragraph 4.123 of the OECD Guidelines in Exhibit EC-11.
126 Available from the Internet on http://www.amcity.com/southflorida.WT/DS108/R
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4.254  The number of active FSCs increased from 2,613 in 1987 to 3,073 in 1992.127  According to
the Article by David Wallace from the South Florida Business Journal of 24 February 1997, the
number had reached 5000 by 1997.  According to articles in the Economist128 and the Journal of
Commerce129 there are about 6,000 FSCs today.
4.255  According to the Treasury Reports, the Foreign Trading Gross Receipts of FSCs doubled
from US$84,280 million in 1987 to $152,263 million in 1992.  Net Exempt Income increased over the
same period from $2,111 million to $4,508 million.
4.256  The US Treasury has estimated the revenue cost of the FSC programme.  This is estimated by
increasing the taxable income of the US shareholders by the amount of exempt FSC income
attributable to them and using a tax calculator to determine their new US tax liability.  The revenuecost of the FSC programme was estimated to be US$1,380 million in calendar year 1992.  In its 1997
report, the Treasury estimated that, on the assumpti on that FSC exports grew at an annual average of 8
per cent, the revenue cost would increase steadily to $2,080 million in 1997.
130  However, as noted
above, other sources indicate that the total number of FSCs, has increased much more and The
Economist claims that since 1993 the total benefit generated by FSCs has probably tripled  (Article ofMarch 1998).
4.257  Another indication that the importance of the FSC scheme is growing is the fact that it was
expanded to cover computer software in 1997.
131
A breakdown of FSC benefits to different sectors
4.258  Manufactured products account for the vast majority of FSC generated exports.  Classified by
the “gross receipts” of FSCs, all manufactured products accounted for $136,287 million out of a totalof $152 billion in 1992.  Non-manufactured produc ts and services, including agriculture, accounted
for $15,747 million in 1992.
132
4.259  The largest exported product groups were in 1992:
 Gross receipts in $ million
 Manufactured goods:
 
 Non-electrical machinery:  29,758
 Chemicals  29,285
 Electrical machinery  21,121
 Transportation equipment  18,125
 Others  37,998
 Subtotal:  136,287
 
Non-manufactured products and services
 Agricultural products  8,116
 Other non-manufacturing  7,631
 Subtotal  15,747
 Total  152,034
                                                     
127 Based on a comparison of the two US Treasury reports on FSCs.
128 7 March 1998.
129 2 December 1997.
130 See The Operation and Effect of the Foreign Sales Corporation Legislation , Department of the
Treasury, November 1997 in Exhibit EC-5, at p.12-17.  The estimates for future growth are contained in
Table 5.1 on page 17.
131 By Section 1171(a) of Public Law 105-34 amending subsection (a)(2)(B) of Section 927 IRC.
132 See Daniel S.  Holik , Foreign Sales Corporations, 1992, at p.121-128 EC Exhibit EC-12.WT/DS108/R
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Trade effects of FSCs
4.260  The benefits accruing to US exporters through the FSC scheme allow them to price their
goods more cheaply and market them more aggressive ly than would be the case in the absence of the
FSC scheme.  This according to the US Treasury report of 1997 report: “The FSC program
encourages exports by reducing the tax rate on export income” 133(page 10).
4.261  In its 1992 and 1997 reports, the Treasury has estimated the “export stimulus” of the FSC
program.  It depends on three factors:
• how great is the tax saving for exports?
• how responsive is the US export supply to a change in the export price (the elasticity of
the US export supply134)?  and
• how responsive is the foreign demand for US exports to a change in their price (price
elasticity of foreign demand for US exports)?
4.262  Chapter 4 of the report for the period from 1 July 1992 to 30 June 1993, the most recent
available to the European Communities, states that “overall the FSC programme is estimated to have
increased US exports by about US$1.5 billion in 1992”.  This is based on a sophisticated econometric
model that even allows for the fact that the increased exports generated by the FSC scheme increasethe exchange rate of the US dollar and thus tend to reduce exports in those sectors where FSCs cannot
be used.  Even allowing for the increased imports resulting from the same exchange rate effect the
overall effect of the FSC scheme on the US balance of trade in goods was estimated to be
US$0.6 billion.  The effect in each sector is set out in Table 4.1 on page 15 of Exhibit EC-5.  Since
then the use of FSCs has expanded and new sectors such as software have been included so that theoverall benefit to the US balance of trade in goods must now be much larger.  This overall advantage
to US trade in goods is of course the consequence of a large number of beneficial effects at the level
of individual export transactions.
4.263  The estimated overall annual export gain to US industry in 1987 and 1992 amounted to $1.2
billion and $1.5 billion, respectively.  As a rough estimate, the total export stimulus created by FSCs,
since they were created in 1985, may therefore amount to $20 billion.
4.264  According to the US Treasury Report published in 1997, the sectors with the highest export
gain were in 1992:
 US$(million)
• Non-electrical machinery  700
• Electrical machinery  700
• Scientific instruments  170
• Lumber and wood  130
• Chemicals  100
The cost of setting up a FSC
4.265  There are only a few requirements for FSC action outside the United States.  The actual
incorporation and running of an FSC does not normally cost more than US$2,000 per year.135
Moreover, to reduce administrative costs up to 25 US  corporations may jointly set up an FSC.  Most
                                                     
133 Exhibit EC-5 at page 10.
134 Export supply is generally believed to be highly price elastic, because output can be diverted away
from domestic consumption toward export markets.
135 See Article by David Wallace from the South Florida Business Journal of 24 February 1997
contained in Exhibit EC-9 quoting Robert Thornton of Export FSC International Ltd.WT/DS108/R
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FSC exporters do not set up local operations but use FSC service providers.  Most of the FSCs operate
in jurisdictions that impose little or no tax.
A comparison of DISC and FSCs
4.266  It has already been noted above that the FSC scheme was designed to replace the DISC
legislation of 1971 but to be functionally equivalent.  The DISC legislation had been part of a package
of “new economic policy”.  Congress sought to generate additional exports, while keeping the loss of
tax revenues as low as possible.  DISCs were not taxed on their profits; the shareholders paid the tax
on a pro rata basis when DISC income was repatriated to them.  The income was then treated as
foreign source income, entitling the shareholders to a tax credit against their tax liabilities.  Resultingtax could be deferred indefinitely.  This system encouraged exports by lowering the effective tax rate
on export income.
4.267  Available figures show that, as was intend ed by Congress, DISC and FSC programmes
provide roughly for the same amount of tax incentives.  The Treasury’s report on the operation and
the effect of DISCs during the period 1981-1983 estimates the revenue cost of the DISC programmeas US $1.5 and 1.24 billion for 1982 and 1983, respectively.  This is within the same range as the $1.3
billion FSC revenue cost calculated by the Treasury for 1992 (see above).
Legal Arguments
FSC scheme is a subsidy within the meaning of Article 1 of the SCM Agreement
Definition of subsidy
4.268  The notion of subsidy for the purposes of the SCM Agreement is defined in its Article 1.1.
The relevant part for the purposes of the present dispute is as follows:
“1.1 For the purpose of this Agreement, a subsidy shall be deemed to exist if:
(a)(1) there is a financial contribution by a government or any public body
within the territory of a Member (referred to in this Agreement as
"government"), i.e. where:
. . .
(ii) government revenue that is otherwise due is foregone or not collected
(e.g.  fiscal incentives such as tax credits)
136;
. . .
and
(b) a benefit is thereby conferred.”
4.269  The European Communities will be identifyin g and objecting to two subsidies in the FSC
scheme in the following legal analysis.
4.270  The first is the tax exemptions comprised in the FSC scheme.  These are essentially:
• The exclusion of the “foreign trade income” of FSCs from the controlled foreign
corporations provisions of Subpart F of the IRC (Sections 951(e) and 954(d) and (e)
                                                     
136 There is a footnote to sub-paragraph (ii) which provides that certain practices concerning taxes on
goods (i.e.  indirect taxes) shall not be deemed to be a subsidy, but this is not relevant to the present dispute.WT/DS108/R
Page 48
IRC);
• The exemption from US tax which would otherwise be due on the “exempt foreign
trade income” of the FSC (Section 921(a) IRC).
• The fact that the parent of the FSC is accorded a 100 per cent dividends received
deduction (i.e. exemption from US tax) for the dividends received from the FSC from“earnings or profits attributable to foreign trade income” (Section 245(c) IRC in
conjunction with Section 926(a)).
4.271  These exclusions, exemptions and deductions (hereafter referred to as the “tax exemptions”)
complement each other and lead, as they are intended to lead, to less tax being paid than would be the
case if the FSC scheme did not exist (or rather if it did not contain the tax exemptions).
4.272  The tax exemptions by themselves would be of relatively little economic significance if they
were not compounded by the existence of the second of the subsidies which the EuropeanCommunities identifies and objects to.  That is availability for the calculation of the exempt foreign
trade income of FSCs of special administrative pricing rules which derogate from the transfer pricing
rules which would otherwise apply.  These increase the non-taxed profits of FSCs and reduce the
taxed profits of the parent companies and consequently decrease the tax burden on exports effected
under the FSC scheme.
4.273  The European Communities makes this distinction between two aspects of the FSC scheme
because each could exist in the absence of the other and it is important that both be held to be
prohibited export subsidies so that both will have to be withdrawn.
4.274  When these two aspects of the FSC scheme are both being referred to in the remainder this
submission they will be termed the “FSC subsidies”.
4.275  The European Communities will proceed to establish first that each of the FSC subsidies
involves a financial contribution by the US Governme nt within the meaning of Article 1.1(a)(1)(ii) of
the SCM Agreement.  It will then show that these confer a benefit within the meaning of
Article 1.1(b) of the SCM Agreement before turning to examine their export contingency (which also
establishes their specificity).
Financial Contribution by Government
4.276  Both aspects of the FSC scheme identified as subsidies above result in revenue forgone for
the United States within the terms of Article 1.1(a)(ii) of the SCM Agreement.
The FSC tax exemptions
4.277  In order to show that revenue is forgone as a result of the tax exemptions it is necessary to
compare the tax arising on a transaction qualifying under the FSC scheme with that which would arise
if the FSC scheme did not exist or that arising on an equivalent transaction which does not qualify.
There are a number of comparisons which can be made, such as the following:
If the FSC scheme did not exist or if the export transaction through a FSC were not to qualify
under the scheme (for example because it involved the export of goods from another territory than the
United States, or the local content conditions were not satisfied), no part of the FSC’s income from
that transaction would be “exempt foreign trade income” and it would be subject to United States
taxation.  The existence of the FSC scheme, or the applicability thereof to the transactions, will
therefore lead to revenue forgone.
If the FSC were to conduct an import transaction on behalf of its parent or sell the goods of its
parent to a customer in the United States instead of conducting an export transaction, no part of theWT/DS108/R
Page 49
FSC’s income from those transactions would be “exempt foreign trade income” and it would be
subject to United States taxation.  The availability of the FSC scheme for the export transaction would
lead to revenue forgone compared with the tax payable on the equivalent import or domestic
transactions.
If a manufacturer were to sell the goods on the domestic market or to export the goods
directly itself instead of passing though the FSC, no part of the profit would be exempted from tax and
thus the tax paid would be higher.  The use of the FSC therefore leads to revenue forgone.
4.278  There are some cases, as explained in the Testimony of Joseph J. Guttentag in
Exhibit EC-2137, where the tax position of the parent (excess unused foreign tax credits from other
transactions) is such that it may advantageous not to export through the FSC but to export directly.
4.279  The situation where it is advantageous to export directly rather than through an FSC will be
exceptional. But in any event it does not prevent th e FSC tax exemptions from constituting a subsidy
in the majority of cases where they do lead to revenue forgone and are beneficial. Exporters have achoice, which they do not have for non-FSC qualifying transactions such as domestic transactions or
for import transactions.
The Administrative Pricing Rules
4.280  The application of special administrative pricing rules to transactions of FSCs compounds the
revenue forgone resulting from the tax exemptions and also gives rise to an additional financial
contribution from government in the form of revenue forgone compared with the situation whichwould prevail if the normal transfer pricing rules of Section 482 of the IRC had to be applied.
4.281  An FSC has a choice between calculating its profits on the basis of the generally applicable
transfer pricing rules contained in Section 482 of the IRC and the special “administrative pricing
rules” contained in Section 925 of the IRC, if it satisfies the conditions set out in Section 925(c) IRC.
The use of these rules, and in particular the fact they may be used at the option of the taxpayer, ex
post and on a transaction by transaction basis when they give a more favourable result, have as a
consequence lower tax revenues for the US Government than would be the case if these rules did not
exist.  Revenue is therefore forgone.
4.282  The amount of the revenue forgone as a result of the application of the administrative pricing
rules is the difference between the extra tax that would be collected if Section 482 IRC wereapplicable in the same way as for all other trans actions between related companies compared with the
tax that is in fact collected with the special admi nistrative pricing rules in existence.  (Most FSCs use
exclusively the administrative pricing rules).
138
4.283  The US Government has itself calculated the effect of the FSC scheme on US tax revenues.
According to the Treasury Report published in 1 997, “the revenue cost of the FSC programme is
estimated to be $1,380 million for calendar year 1992.”139  It furthermore estimated that it would
increase to over US$2,000 million in 1997.  This estimate is based on the US Government’s normal
methodology and assumes that the profits of the FSCs would be normally taxed in the hands of the
parents.  It therefore corresponds to the revenue which is forgone as a result of the existence of FSCs.
4.284  The above estimate is based on data of five years ago.  In view of the great increase in the
number of FSCs and the increasing sophistication with which they are being exploited to obtain
                                                     
137 See pages 11-12 in Exhibit EC-2.
138 See Testimony of Joseph J. Guttentag in Exhibit EC-2, p. 11.
139 Exhibit EC-5 at p. 16.WT/DS108/R
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exemption from tax for profits from export sales.140  The revenue actually forgone at present is
probably much greater.
A benefit is conferred
4.285  In the present case, the existence of a benefit conferred in the form of a financial advantage to
FSCs and their parents is evident, for both of th e subsidies identified above (the tax exemptions
comprised in the FSC scheme per se and application of the special administrative pricing rules), since
the revenue which the United States is forgoing is equal to the sum of money which does not have to
be paid in taxes by FSCs and their parents.  This  sum of money remains the property of the FSCs and
their parents and benefits them.
4.286  Since FSCs are an artificial tax device, it may be argued that they would not exist in the
absence of the tax exemptions and that this reduces the benefit.  However, the fact that a benefit exists
despite these costs is evident from the fact that FSCs are not obligatory and therefore are only be used
when they do give rise to a benefit.
4.287  The existence of the special administrative pricing rules also give rise to an additional benefit.
The use of these rules will reduce costs since the rules are more certain and involve less discussion
and negotiation with the tax authorities.  There is therefore an additional benefit arising out of the
increased certainty (the so-called “safe harbour” effect).
4.288  The benefit conferred by the FSC subsidies leads to a price advantage for the exported goods
and thus leads to an overall increase in the export of United States goods.
Specificity
4.289  Article 1.2 of the SCM Agreement provides that only subsidies which are specific are subject
to Parts II, III, and V of the SCM Agreement.  Article 2 of the SCM Agreement defines specificity
and Article 2.3 provides that any subsidy falling under Article 3 is deemed to be specific.  The
applicability of Article 3 is examined below.
Conclusion
4.290  If the FSC subsidies fall within Article 3 of the SCM Agreement (which will be shown
below), they constitute subsidies subject to the SCM Agreement within the meaning of Articles 1 and
2 of the SCM Agreement.
The FSC subsidies are contingent in la w upon export performance contrary to
Article 3.1(a) of the SCM Agreement
4.291  In this section, the European Communities will demonstrate that the FSC subsidies (both the
tax exemptions comprised in the FSC scheme per se and that arising from the application of the
administrative pricing rules), are contingent in law upon export performance contrary to Article 3.1(a)of the SCM Agreement.  The European Communities will first demonstrate that the FSC subsidy falls
squarely under Article 3.1(a).  It will then demonstrate that it also falls under item (e) of Annex I to
the SCM Agreement.
Article 3.1(a) of the SCM Agreement
4.292  Article 3.1(a) is entitled “Prohibitions” and provides in relevant part as follows:
                                                     
140 See the Article from “Tax Notes International” entitled “ A FSCful of Dollars: Maximizing FSC
Benefits through Transaction Level Pricing ” in Exhibit EC-8.WT/DS108/R
Page 51
“Except as provided in the Agreement on Agriculture, the following subsidies, within
the meaning of Article 1, shall be prohibited:
(a) subsidies contingent, in law or in fact141, whether solely or as one of several
other conditions, upon export performance, including those illustrated in
Annex I142;”
4.293  Article 3.1 of the SCM Agreement starts with the words “except as provided in the
Agreement on Agriculture”.  It will be demonstrat ed in Section C below that the AA does not provide
any relevant exception for FSCs exporting products falling under that Agreement but that on the
contrary, the FSC scheme violates the provisions of the AA.
4.294  The FSC subsidy which arises from the tax exemptions  comprised in the FSC scheme per se
results from the forgoing of tax revenues which would otherwise accrue on:
• the “exempt foreign trade income” of the FSC as defined in Section 921(a) IRC; and
• the dividends received by the parent from the FSC from “earnings or profits
attributable to foreign trade income” of the FSC within the meaning ofSection 245 (c) IRC i conjunction with Section 926 IRC.
4.295  The FSC subsidy which arises from the application of the administrative pricing rules results
from the increase in the “exempt foreign trade inco me” of the FSC and corresponding reduction in the
direct profit of the parent from the transaction compared with the situation that would prevail if the
normal transfer pricing rules of Section 482 of the IRC were applied to the transaction.
4.296  Both the FSC tax exemptions per se and the increase in the amount of those tax exemptions
arising out of the application of the administrative pricing rules, depend on the existence and amountof “exempt foreign trade income” (the amount of the FSC’s income that does not bear tax).  This can
only be produced by the export of United States goods.  The revenue forgone and the benefit increase
with each export transaction relating to United States goods and do not increase if non-qualifying (e.g.
domestic or import) transactions are conducted.  Neither the tax exemptions nor the advantages
arising from the use of the special administrative pricing rules are available in respect of domestic
transactions.
4.297  “Exempt foreign trade income” as defined in Section 923(a)(1) depends on “foreign trade
income” as defined in Section 923(b) which depends on “foreign trading gross receipts” as defined in
Section 924(a) IRC and these derive from the “gross receipts of any FSC which are from the sale,
exchange, or other disposition of export property” or the “lease or rental of export property for use by
the lessee outside the United States”.
143
4.298  “Export property” is defined in Section 927(a) IRC as being property:
“(A) manufactured, produced, grown, or extracted in the United States by a person
other than a FSC,
                                                     
 141This standard is met when the facts demonstrate that the granting of a subsidy, without having been
made legally contingent upon export performance, is in fact tied to actual or anticipated exportation or exportearnings.  The mere fact that a subsidy is granted to enterprises which export shall not for that reason alone beconsidered to be an export subsidy within the meaning of this provision.
142 Measures referred to in Annex I as not constituting export subsidies shall not be prohibited under this
or any other provision of this Agreement.
143 Receipts from certain services connected with export transactions can also give rise to foreign trading
gross receipts under Section 924 (a), but these are not relevant for this case.WT/DS108/R
Page 52
(B) held primarily for sale, lease, or rental, in the ordinary course of trade or business,
by, or to, a FSC, for direct use, consumption, or disposition outside the United States,
and
(C) not more than 50 per cent of the fair market value of which is attributable to
articles imported into the United States.”
4.299  Consequently, only revenue derived from the export of United States goods qualifies for the
tax exemptions and the use of the special administrative pricing rules.  It is difficult to imagine a
clearer case of de jure export contingency.
Item (e) of Annex I to the SCM Agreement
4.300  Article 3.1(a) of the SCM Agreement expressly provides that the subsidies contingent upon
export performance illustrated in Annex I to the SCM Agreement are included in the prohibition.
4.301  Item (e) of the illustrative list deals with direct tax measures such as the FSC scheme.  It
deems to be a prohibited export subsidy:
“The full or partial exemption remission, or deferral specifically related to exports, of
direct taxes144 or social welfare charges paid or  payable by industrial or commercial
enterprises.145”
4.302  The tax exemptions comprised in the FSC scheme have all the features required by the text of
item (e).  They are:
- exemptions
- specifically related to exports
- of direct taxes- payable by industrial or commercial enterprises.
                                                     
144 For the purpose of this Agreement:
- The term "direct taxes" shall mean taxes on wages,  profits, interests, rents, royalties, and all other
forms of income, and taxes on the ownership of real property;
- The term "import charges" shall mean tariffs, duties, and other fiscal charges not elsewhere
enumerated in this note that are levied on imports;
- The term "indirect taxes" shall mean sales, excise, turnover, value added, franchise, stamp,
transfer, inventory and equipment taxes, border taxes and all taxes other than direct taxes and
import charges;
- "Prior-stage" indirect taxes are those levied on goods or services used directly or indirectly in
making the product;
- "Cumulative" indirect taxes are multi-staged taxes levied where there is no mechanism for
subsequent crediting of the tax if the goods or services subject to tax at one stage of production
are used in a succeeding stage of production;
- "Remission" of taxes includes the refund or rebate of taxes;- "Remission or drawback" includes the full or partial exemption or deferral of import charges.
145 The Members recognize that deferral need not amount to an export subsidy where, for example,
appropriate interest charges are collected.  The Members reaffirm the principle that prices for goods in
transactions between exporting enterprises and foreign buy ers under their or under the same control should for
tax purposes be the prices which would be charged between independent enterprises acting at arm's length.  AnyMember may draw the attention of another Member to administrative or other practices which may contravenethis principle and which result in a significant saving of direct taxes in export transactions.  In suchcircumstances the Members shall normally attempt to resolve their differences using the facilities of existingbilateral tax treaties or other specific international mechanisms, without prejudice to the rights and obligations
of Members under GATT 1994, including the right of consultation created in the preceding sentence.
Paragraph (e) is not intended to limit a Member from taking measures to avoid the double taxation of
foreign-source income earned by its enterprises or the enterprises of another Member.WT/DS108/R
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4.303  As explained above, the FSC scheme exempts part of the FSCs foreign trade income from
United States tax, and exempts the dividends arising out of that income from tax in the hands of the
parent.  The subsidy arising out of the application of the special administrative pricing rules increases
the exemption and is thus in itself also an exemption. In addition the fact that this is to be considered
an exemption (or perhaps a remission) of direct taxes is confirmed by footnote 59 to item (e) whichstates that “the Members reaffirm the principle that prices for goods in transactions between exporting
enterprises and foreign buyers under their or under the same control should for tax purposes be the
prices which would be charged between independent enterprises acting at arm's length.” As explained,
the FSC special administrative pricing rules do not comply with the arms length principle and are a
derogation from it designed to shift profits from export sales into a tax exemption.
4.304  Both the tax exemptions per se and the special administrative pricing rules are “specifically
related to exports” since they are conditional upon exportation of United States goods and limited in
scope to the extent of such exportation.
4.305  The exemptions and the special administrative pricin g rules all relate to direct taxes, that is to
say income tax.
4.306  The taxes involved are those payable by FSCs, which are commercial enterprises exporting
United States goods, and their parents, which are either industrial or commercial enterprises.
4.307  Accordingly, the FSC subsidies also fall within  item (e) of the illustrative list and this
confirms the clear terms of the prohibiti on in Article 3.1(a) of the SCM Agreement.
Conclusion
4.308  The FSC scheme is a clear prohibited subsidy within the meaning of Article 3.1(a) of the
SCM Agreement and item (e) of the Illustrative list in Annex I to the SCM Agreement.
The United States  responds in its First Submission as follows:
Factual Background
4.309  This dispute involves an attempt by the Eu ropean Communities to reopen issues that the
GATT resolved long ago, and to call into question well-established tax principles that guide almost all
WTO Members in exercising their tax sovereignty, including members of the European Communities.
In particular, implicit in the European Communities'  claims is a request that this Panel reject the
fundamental principle that income attributable to foreign economic processes need not be taxed.  Thelast time this issue was raised, the GATT found itself ensnared in a decade-long dispute that impaired
the GATT’s ability to achieve its mission of reducing trade barriers, underscoring that a trade-based
organization is not the most appropriate body to establish fundamental, international norms of
taxation.
4.310  The FSC regime, which was designed to conform to GATT principles, incorporates salient
features of territorial and other common tax systems, including those of European Communities
member States.  If the FSC confers an illegal export subsidy, so too do the tax systems of many
European countries that are based on territoriality or that incorporate territoriality principles.  Indeed,
the European Communities' assertions have a familiar ring, because these same issues were debated in
the GATT in the 1970s and early 1980s in the context of the Tax Legislation Cases .  The reports in
the Tax Legislation Cases  ruled that the US Domestic International Sales Corporation (“DISC”)
provisions and the income tax regimes of France, Belgium and the Netherlands had some attributes of
export subsidies that were impermissible under GATT 1947.  The parties agreed to the adoption of all
four panel reports only after negotiating a set of principles that, in an unusual step, were reflected in a
decision of the GATT Council (the “1981 Council De cision”).  That decision, in effect, permitted
France, Belgium, and the Netherlands to maintain their export-favoring tax systems without basic
change, and provided a clear-cut territoriality test that served as a guideline for the United States toWT/DS108/R
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conform its tax system to GATT subsidy disciplines.  In 1984, in order to achieve a resolution of the
DISC controversy, the US Congress replaced the DISC with the FSC.  Congress carefully designed
the FSC so as to comply with all applicable trade rules.  Now, years after the fact, and in the absence
of any alteration in the applicable rules, the European Communities challenges the FSC, even though
its structure is based on territorial and related principles of taxation that many European Communitiesmembers themselves employ.
4.311  Accordingly, a full understanding of the present dispute requires a detailed review of the US
and European tax systems, as well as the history of the Tax Legislation Cases , because the FSC was
born from the embers of that dispute, and, indeed, was part of the solution to that controversy.
Tax Systems and the GATT and WTO
National Tax Systems Vary in Their Territorial Reach
4.312  The taxation systems of sovereign nations are diverse.  The US tax system is different from
the tax regimes of the European Communities countries, and the tax regimes of the EuropeanCommunities countries differ markedly among themselves.  There are two generally recognized
grounds for any nation to tax income:  jurisdiction over the recipient of the income based on the
residence of the taxpayer, and jurisdiction over the activity that produces the income ( i.e., the source
of the income).
146  Under the residence principle, a country taxes the worldwide income of persons
subject to its jurisdiction (the worldwide system of taxation).  Under the source principle, a country
taxes income earned within its borders (the territorial system of taxation).  Most countries tax under a
mix of both principles.147
4.313  Because sovereign nations apply different tax regimes, one country’s tax on residence income
may be duplicated by another country’s tax on the same income based on source.  Most countries
have developed principles to accommodate these competing claims in order to avoid or mitigate
double taxation.  Countries that apply a territorial system avoid double taxation by exempting ( i.e., not
taxing) income earned outside of the country’s territorial borders (the exemption approach), whetherearned by a foreign subsidiary or a foreign branch of a domestic corporation.  In the case of a foreign
corporation, this is accomplished by exempting the income earned by the foreign corporation and by
exempting the income when transferred to the shareholder as a dividend.  Countries that tax on a
worldwide basis generally mitigate double taxation by allowing a tax credit against the resident
country tax for income taxes paid by the taxpayer to a foreign country on income subject to taxationby that country (the foreign tax credit approach).  In some cases, a combination of exemption and
foreign tax credit methods are used, as applicable, to different categories of income.
The US Tax System
4.314  The US tax system generally operates on a worldwide basis.  The United States taxes all of
the income of US residents, as well as the income  of nonresidents arising within US borders.  The
United States imposes income taxes on, among other taxable persons, all US corporations.  Because
the United States defines the residence of corporations for tax purposes purely on the basis of place of
incorporation, a US corporation is defined as one that is organised under the laws of one of the
50 states within the United States, or the District of Columbia.
148  The US system taxes all income
earned by US corporations, regardless of where that income has been earned or whether it was earned
by a foreign branch office.
                                                     
146  Edward H. Gardner, Taxes on Capital Income: A Survey , in George Kopits, ed., Tax Harmonization
in the European Communities: Policy Issues and Analysis , IMF Occasional Paper No. 94 (Washington, D.C.
1992), p. 52 (copy attached as US Exhibit 5).
147  Id.
148  Section 7701(a)(4) of the IRC (copy attached as US Exhibit 12).WT/DS108/R
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4.315  On the other hand, the United States generally exempts from direct taxation all income of
foreign corporations that has been earned outside the United States.  Foreign corporations are defined
as all corporations that do not fit the criteria of US corporations; i.e., corporations organized outside
the 50 states and the District of Columbia.149  This definition includes corporations organized in US
possessions.
4.316  The exemption of foreign corporations from direct US income tax on their foreign-source
income applies even to foreign subsidiaries of US corporations.  The United States generally taxes
income of such subsidiaries only at the time it is transferred to the US parent company in the form of
dividends.  The period of exemption between the earning of such income by the subsidiary and the
transfer to the US parent company is termed “deferral” under the US tax system.
4.317  Because of the potential for tax avoidance, the United States has adopted a series of “anti-
deferral” regimes that constitute targeted exceptions to the general norm of deferral and that respond
to specific concerns.  One of these regimes is Subpart F of the Internal Revenue Code, which limits
the benefits of deferral for certain types of income earned by certain controlled foreign subsidiaries of
US companies.150
European Tax Systems
4.318  In contrast to the United States, many European countries impose income taxes, at least in
part, on a territorial basis.  To the extent that European governments tax income on a territorial basis,
only income arising from economic activity conducted within the territory of the taxing jurisdiction is
subject to tax.  Under these territorial tax systems, the home country generally does not tax income
from economic activity conducted outside the territory of the taxing jurisdiction, regardless ofwhether such activity is conducted by a domestic or foreign corporation.
151  Such a tax exemption for
income from offshore economic activity can include income derived from the sale of goods exported
from the home country, and, in some circumstances, whether or not any foreign tax is imposed.
4.319  Accordingly, as opposed to a worldwide system, such as that of the United States, many
European tax systems provide more favorable treatment for exporters of goods and services.  This isbecause whenever activities related to an export transaction occur outside of the territory of the taxing
jurisdiction, income from such activities is not taxed under territorial or territorial-type systems.
Neither the GATT Nor the WTO Requires That  Members Adopt a Particular Tax System
4.320  There is no rule of international law that requires nations to conform to a single tax system.  A
country can have a worldwide system, a territorial system, or a system that incorporates elements of
both.  In recognition of principles of tax sovereignty, a country using the worldwide system is free to
incorporate elements of a territorial system (or vice versa ), so that a foreign subsidiary, or particular
kinds of foreign subsidiaries, such as a FSC, are taxed in a manner similar to foreign corporations
under a territorial system (exemption of income plus an exemption for dividends) or are taxed like aforeign branch might be taxed under a territorial system (exemption).
4.321  The WTO never was intended (and is not well equipped) to establish international tax norms,
especially when there is such diversity in accepted tax practices.  The WTO certainly should not
penalize a country using a worldwide system for incorporating elements of a territorial system in
order to obtain comparable tax treatment.  However, that is precisely  what the European Communities
is asking the Panel to do.
The DISC
                                                     
149  Section 7701(a)(4) and (9) of the IRC (copy attached as US Exhibit 12).
150  Section 951 of the IRC.  See Exhibit EC-1.
151 In the case of a foreign corporation, this is accomp lished by exempting income earned by the foreign
corporation and exempting profits from tax when distributed back to the parent corporation as a dividend.WT/DS108/R
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4.322  In 1971, the United States established a system of tax deferral for corporations known as
DISCs and for their shareholders to correct the inherent advantage enjoyed by European exporters, as
compared to US exporters; i.e., the fact that under European territorial systems, income earned
offshore by European exporters was (and continues to be) exempt from taxation.
4.323  A DISC was a domestic  subsidiary of a US company engaged in exporting, and the DISC
regime had very strict qualifying rules requiring that they participate almost exclusively in export
transactions.  The income of a DISC was not taxed directly by the United States, and DISCs were not
required to file tax returns separate from their parent company’s tax returns.  Instead, DISC income
was taxed when it was paid as a dividend to the US parent company.  Each year, the DISC wasdeemed to have paid a portion of its income from export transactions as a dividend to the parent
company, thereby subjecting the parent to taxation on that income.  US income tax on the remainder
of the DISC’s income could be deferred without an interest charge until the income was actually paid
to the parent company (or certain other events occurred).
The Tax Legislation Cases
4.324  In February 1972, the requested GATT 1947 dispute settlement consultations regarding the
DISC, alleging that the DISC constituted an export subsidy under Article XVI of GATT 1947.  The
United States responded by requesting similar consultations with France, Belgium and the
Netherlands, alleging, in effect, that if the DISC was a subsidy, then the income tax laws of those
countries resulted in at least the same tax subsidy to their exporters as the DISC allegedly provided to
US exporters.  The United States noted that these countries followed the territorial principle oftaxation or otherwise did not tax income earned from foreign activities in export sales.  As a result,
the United States argued, those countries did not tax export sales income of foreign branches or
foreign sales subsidiaries of domestic manufacturing firms – a more favourable treatment than DISC,
which merely provided for a deferral of tax.
4.325  The United States and the European Communities requested the establishment of panels
concerning their respective claims, and four panels, each with the same membership, were
established.
152  The panel issued its reports in the four cases on 2 November 1976153, finding that both
the DISC and  the European tax systems had characteristics of an export subsidy.154
4.326  With respect to the European practices, the panel found that basic features of a territorial tax
system may themselves constitute an illegal subsidy, even though "the practices may have been anincidental consequence of . . . taxation principles rather than a specific policy intention [to favor
exports]."
155  The panel found that the "application of the territoriality principle," in the case of
Belgium and France, and the "application of the world-wide principle by the Netherlands, in
conjunction with the qualified exemption in respect of foreign income," in each case:
allowed some part of the export activities belonging to an economic process originating in the
country, to be outside the scope of [the applicable country's] taxes.  In this way [the country]
                                                     
152  In light of the identical membership, the United States will use the singular term “panel.”
153  Tax Legislation - United States Tax Legislation (DISC) , L/4422, BISD 23S/98, Report of the panel
adopted 7-8 December 1981; Tax Legislation - Income Tax Practice Maintained By France , L/4423, BISD
23S/114, Report of the pane l adopted 7-8 December 1981; Tax Legislation - Income  Tax Practice Maintained
By Belgium , L/4424, BISD 23S/127, Report of the panel adopted 7-8 December 1981; Tax Legislation - Income
Tax Practice Maintained By The Netherlands , L/4425, BISD 23S/137, Report of the panel adopted 7-8
December 1981.
154  Specifically, the panel concluded that "the DISC legislation in some cases had effects which were
not in accordance with the United States obligations  under Article XVI:4 [of GATT]."  BISD 23S/98,
paragraph 74.  The panel also noted that "the deferral did not attract the interest component of the tax normally
levied for late or deferred payment and therefore . . . to this extent, the DISC legislation constituted a partial
exemption which was covered by . . . the illustrative list."  Id., at paragraph 71.
155  See, e.g. , BISD 23S/137, paragraph 35.WT/DS108/R
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has foregone revenue from this source and created a possibility of pecuniary benefit to
exports in those cases where income and corporation tax provisions were significantly more
liberal in foreign countries.156
4.327  The panel’s rulings against the European tax practices were based on three propositions:  (1)
that income generated by the economic processes of a foreign branch or subsidiary properly may be
viewed as “originating in” the country in which the parent company engages in export activities; (2)
that foregoing tax revenue on income attributable to these foreign economic processes creates the
possibility of a pecuniary benefit to exports from low tax rates in the foreign country in which those
processes occur; and (3) that a subsidy on exports may arise if this benefit is not also available withrespect to income attributable to domestic activities.  As discussed below, the GATT Council
essentially rejected these propositions.
The 1981 Council Decision
4.328  France, Belgium, and the Netherlands refused to accept the findings against them, essentially
claiming that the GATT rules never had been intended to prohibit particular tax systems or to require
the taxation of foreign source income.157  For its part, the United States refused to accept the DISC
finding unless the Council adopted the panel rulings on the European tax practices.  The parties finally
agreed to the adoption of all four reports subject to an understanding that was reflected in a decision
of the Council and that essentially reversed the rationale of the panel reports.  That decision provided
as follows:
The Council adopts these reports on the understanding that with respect to these cases, and in
general, economic processes (including transactions involving exported goods) located
outside the territorial limits of the exporting c ountry need not be subject to taxation by the
exporting country and should not be regarded as export activities in terms of Article XVI:4 of
the General Agreement.  It is further understood that Article XVI:4 requires that arm’s-lengthpricing be observed, i.e., prices for goods in transactions between exporting enterprises and
foreign buyers under their or the same control should for tax purposes be the prices which
would be charged between independent enterprises acting at arm’s length.  Furthermore,
Article XVI:4 does not prohibit the adoption of measures to avoid double taxation of foreign
income.
158
4.329  Following adoption of the reports, the Chairman of the Council noted that the Council’s
decision did "not mean that the parties adhering to Article XVI:4 are forbidden from taxing the profits
on transactions beyond their borders, it only means that they are not required to do so. "159
4.330  Thus, the 1981 Council Decision set forth three basic legal rules that permitted the exemption
of certain export-related income from tax without running afoul of GATT anti-subsidy rules:
• foreign economic processes need not be taxed by the exporting country;
• arm’s-length pricing should be observed; and
• measures can be adopted to avoid double taxation of foreign income.160
                                                     
156  BISD 23S/114, paragraph 47; BISD 23S/127, paragraph 34; and BISD 23S/137, paragraph 34.
157 These three countries stated their positions in the following memoranda:  GATT Doc.
Nos. C/97/Rev. 1 (21 March 1977) and C/97/Add. 1 (21 July 1977) (France); GATT Doc. Nos. C/98(15 March 1977) and C/98/Add. 1 (21 November 1977) (Belgium); and GATT Doc. No. C/99 (15 March 1977)(the Netherlands).
158  Tax Legislation , BISD 28S/114 (December 7-8, 1981).  The United States agreed to adoption of the
DISC report without conceding that the DISC violated the GATT.
159  Id. (Emphasis added).WT/DS108/R
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4.331  The 1981 Council Decision effectively overruled the panel’s decisions with respect to France,
Belgium, and the Netherlands, and established a clear-cut territorial test for determining whether a
particular income tax measure constitutes an export subsidy; namely, that income attributable to
activities taking place outside the territory of the taxing country need not be taxed, and that a decisionnot to tax such income does not give rise to an export subsidy.  This test permitted France, Belgium
and the Netherlands to retain their export-favoring territorial-type systems, while at the same time
providing the United States with clear rules for how it  might modify its tax laws so as to provide, in a
GATT-consistent manner, the same treatment provided by European governments to their exporters.
The rules contained in the 1981 Council Decision built upon the rules contained in the SubsidiesCode, and those rules were not altered during th e Uruguay Round negotiations that resulted in the
SCM Agreement.
Overview of the FSC
Enactment of the FSC
4.332  Although the initial US view was that the 1981 Council Decision validated the DISC
161, in
order to resolve the DISC dispute, in October 1982, the United States made a commitment to the
GATT Council to propose legislation that would address concerns of other GATT Contracting Parties.
In March 1983, the US Administration approved the general outlines of a proposal to replace the
DISC with a territorial-type system of taxation for US exports designed to comply with GATT
subsidy rules.  As with the DISC, the goal of the FSC legislation was to redress, to some extent, the
imbalance accorded US exporters as the result of differing approaches between the European system
of territorial taxation and the US worldwide system of taxation.
4.333  In 1984, Congress enacted the Deficit Reduction Ac t of 1984, Title VIII of  which replaced the
DISC with the FSC.162  In the accompanying legislative materials, Congress expressed its intention
that the FSC legislation be GATT-consistent:
Under GATT rules, a country need not tax income from economic processes
occurring outside its territory.  Accordingly, Congress believed that certain income
attributable to economic activities occurring outside the United States should be
exempt from US tax in order to afford US exporters treatment comparable to what
exporters customarily obtain under territorial systems of taxation.163
                                                                                                                                                                    
160  The last two rules were drawn virtually verbatim  from Footnote 2 to Item (e) of the Illustrative List
of Export Subsidies annexed to the Tokyo Round Agreement on Interpretation and Application of Articles VI,XVI, and XXIII of the General Agreement on Tariffs and Trade (“Subsidies Code”), which entered into force on1 January 1980.  The Subsidies Code Illustrative List represented the results of further agreements to update the1960 Illustrative List that the panel had relied on in each of the reports in the Tax Legislation Cases .  See BISD
23S/98, paragraph 28; BISD 23S/114, paragraph 50;  BISD 23S/127, paragraph 37; and BISD 23S/137,
paragraph 37.  The three European countries each cited th e Subsidies Code Illustrative List, as well as a mutual
recognition that economic activities taking place outside of the territory of the country of origin need not betaxed by that country, as bases for the inclusion of the principles memorialized in the 1981 Council Decision.See GATT Doc. Nos. C/114 (8 December 1980), C/115 (8 December 1980), and C/116 (8 December 1980).
161  See Staff Comm. on Taxation, 98th Cong., General Explanation of the Revenue Provisions of the
Deficit Reduction Act of 1984 , 1041 (1985) (" General Explanation ") (Exhibit EC-6).
162  Pub. L. No. 98-369,  Sections 801-805, 98 Stat. 985, 985-1003 (1984).  The FSC provisions are
contained in sections 921-927 of the Internal Revenue Code (Exhibit EC-1).
163 General Explanation , at 1042.  Contrary to the European Communities' assertion (First EC
Submission, paragraph 20), the FSC was not designed to be the “functional equivalent” of the DISC, but ratherwas designed to cure the alleged defects in the DISC by instituting an entirely different system that would be
compatible with all applicable GATT standards.  In this regard, US courts have recognized that the FSC regime
is less favorable to companies than was the DISC regime.  See, e.g. , McCoy Enterprises v. Commissioner , 64
T.C.M. (CCH) 1449 (1992) (copy attached as US Exhibit 16).WT/DS108/R
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4.334  Thus, in designing the FSC, Congress was seeking to devise a method by which it could
exempt a portion of the income from foreign economic processes occurring in export transactions.  To
understand and properly analyse the FSC, it is necessary to keep this overriding purpose in mind.
Description of the FSC
4.335  The General Explanation  provides the following useful overview of the FSC provisions:
The Act provides that a portion of the export income of an eligible foreign sales
corporation (FSC) will be exempt from Federal income tax.  It also allows a domestic
corporation a 100-per cent dividends-received deduction for dividends distributedfrom the FSC out of earnings attributable to certain foreign trade income.  Thus, there
is no corporate level tax imposed on a portion of the income from exports.
164
4.336  Thus, a portion of the “foreign trade income” of a FSC is exempted from US tax by treating it
as foreign source income not effectively connected with a US trade or business.165  This treatment
corresponds to the exemption of income attributable to a foreign branch or foreign subsidiary of a
French, Belgian, or Dutch corporation under a territorial-type system.  In addition, shareholders of a
FSC are eligible for a 100 per cent dividends-received deduction from distributions made out of the
earnings and profits attributable to the foreign trade income of a FSC.  This treatment corresponds to
the “participation exemption” typically provided by territorial-type tax systems, such as those of
France, Belgium, and the Netherlands.
4.337  The General Explanation  further explains that an exemption from tax is permitted under
GATT rules:
only if the economic processes which give rise to the income take place outside the
United States.  In light of these rules, the Act provides that a FSC must have a foreign
presence, it must have economic substance, and that activities that relate to its export
income must be performed by the FSC outside the US customs territory.Furthermore, the income of the FSC must be determined according to transfer prices
specified in the Act:  either actual prices for sales between unrelated, independent
parties or, if the sales are between related parties, formula prices which are intended
to comply with GATT's requirement of arm's-length prices.
166
4.338  It is evident that the FSC differs significantly  from the DISC in very fundamental respects
that were intended to conform to the principles articulated in the 1981 Council Decision and, now, the
SCM Agreement.  Unlike a DISC, which is a US corporation, a FSC must be incorporated outside the
US customs territory in a jurisdiction that meets US requirements for exchange of information on tax
matters.167  In contrast to a DISC, a FSC must have a foreign office and maintain a set of permanent
books of account at that office, thereby rendering the FSC equivalent to a foreign branch office or a
permanent establishment.168  Unlike a DISC, which was not a taxable entity, a FSC files a separate tax
                                                     
164  General Explanation , at 1042.  A detailed description of the FSC is set forth in Appendix A to this
submission.
165  Such income is generally exempt from tax under section 882 of the Internal Revenue Code.  See
Exhibit EC-1.
166  General Explanation , at 1042-1043.
167  The following EC countries are a qualified situs for a FSC:  Austria, Belgium, Denmark, Finland,
France, Germany, Ireland, the Netherlands, and Sweden.  Notice 84-15, 1984-2 C.B. 474 (copy attached as USExhibit 6). The Netherlands and Belgium, in particular, have actively recruited FSCs.
168  The General Explanation , page 1044, states that "to satisfy [the requirement of having an office and
books of account outside the United States], Congress in tended that the office cond uct activities comparable to
those of a 'permanent establishment' under income ta x treaty concepts."  “Permanent establishment” is an
international term used to describe a foreign branch office that may be subject to tax in the source (host) countryunder tax treaty principles.  It is not necessary here to discuss the specific, technical requirements for aWT/DS108/R
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return and pays taxes, including estimated taxes, on a substantial portion of its income.169  Moreover,
by statute a FSC is required to be legally and financially responsible for certain crucial economic
processes occurring outside the United States.  Only if a FSC meets these requirements will the FSC
provisions exempt from taxation income attributable to those foreign economic processes, as
permitted by the 1981 Council Decision and the SCM Agreement.  These requirements are discussedin more detail below.
FSCs Are Legitimate, Operating Foreign Corporations
4.339  Congress mandated that a FSC be a foreign corporation organized outside the customs
territory of the United States.170  As noted above, under US tax law, a foreign corporation is any
corporation organized under the laws of a jurisdiction outside the fifty states and the District of
Columbia.  The European Communities assertion that FSCs are shams and not real foreign
corporations is, therefore, factually incorrect.171
4.340  Indeed, in enacting the FSC provisions, Congress added requirements that are more stringent
than those usually imposed in US tax law for recognition of a foreign corporation.  Although the
United States normally does not impose management and control requirements, which are central
concepts for recognizing the legitimacy of separate entities under many tax systems, a FSC is required
by statute to have a board of directors that includes  at least one individual who is not a resident of the
United States.172  In addition, the meetings of a FSC’s board of directors and shareholders must occur
outside the United States.173  Moreover, a FSC’s principal bank account must be maintained in a
qualifying foreign country, and all dividends, legal and accounting fees, salaries of officers, anddirectors fees must be disbursed out of bank accounts held outside the United States.
174
4.341  By statute, a FSC must have attributes comparable to a “permanent establishment” or foreign
branch office.175  All FSCs incur real administrative costs, including – at a minimum – the costs of
corporate registration and accounting, legal, and management fees.176  A FSC must file its own tax
returns and pay its own taxes to the US federa l government and any other applicable taxing
jurisdiction.177  Indeed, a number of US judicial decisions have confirmed the status of FSCs as valid
foreign corporations for taxing purposes.178
                                                                                                                                                                    
permanent establishment, because Congress did not intend that a FSC would have to satisfy all of the
requirements for a permanent establishment.
169  A FSC is required to pay an underpayment penalty with respect to estimated taxes even when the
FSC and its related supplier have made an overpayment of taxes.  Because the FSC and its related supplier aretwo separate taxpayers, there is no netting of estimated tax payments between the two.  In this manner, the
separate status of the FSC is respected.
170  Senate Print No. 98-169, at 636 (“ Senate Print ”) (Copy attached as US Exhibit 11).
171  First EC Submission, paragraphs 35, 39, 42.
172  Section 922(a)(1)(E) of the IRC.
173  Section 924(c)(1) of the IRC.
174  Section 924(c)(3) of the IRC.
175  Senate Print , at 637.
176  The European Communities suggestion that FSCs ar e shams because their initial start-up costs are
relatively low is misleading.  In fact, most corporations cost relatively little to organize.  TheEuropean Communities fails to acknowledge that the costs of actually operating a FSC are substantial.
177  Note that any corporation incor porated in a US possession is generally considered a foreign
corporation under US tax law.  See Section  7701(a)(4) and (9) of the IRC.  In fact, the US Virgin Islands, where
many FSCs are organized, has collected over $68 million in  taxes from FSCs located within its jurisdiction.
Although the US Virgin Islands is a US possession, it is outside the customs territory of the United States and isa taxing jurisdiction separate from the United States, like many possessions and territories of EC member States.
178  From time to time, certain US states have attempted to impose taxes on a FSC’s foreign income by
relying on the theory that FSCs are sham corporations that should be taxed as though they were domestic
operations of their parent companies.  Those theories have been rebuffed by state courts and administrative
agencies that have held FSCs to be valid foreign corpor ations over which those states could not assert their tax
jurisdiction.  See, e.g., SLI International Corporation v. Crystal , 236 Conn. 156 (February 27, 1996) (copyWT/DS108/R
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4.342  Corporate meetings of a FSC must comply with the requirements of the jurisdiction in which
it is located.  If the jurisdiction of incorporation of a FSC mandates that corporate meetings occur
physically in that location, such meetings must take place there.179  The FSC rules requiring
compliance with such mandates are enforced by the United States through regular audits of FSC tax
returns by the US Internal Revenue Service.
A FSC Is Required to Be Responsible for All Distributor Functions and to Perform a
Significant Portion of Them Outside the United States
4.343  A FSC must either itself perform or pay for specific economic processes related to the
relevant export transaction.  By statute, in order to qualify for the partial tax exemption, a FSC thatuses administrative pricing rules must perform, contract, or pay for all of the distribution activities
attributable to the export transaction.
180  These include the solicitation (other than advertising),
negotiation, or making of the contract for the relevant FSC export transaction.  At least one of these
three important activities must be performed outside the United States.  Additionally, the FSC must
take responsibility for all of the following distribution activities:
(a) Advertising and sales promotion;
(b) Processing of customer orders and arranging for delivery;
(c) Transportation of goods involved in the transaction to the customer;(d) Determination and transmittal of final invoice or statement of account, and
receipt of payment; and,
(e) Assumption of credit risk.
181
4.344  In addition, the FSC must incur outside the United States at least 50 per cent of the total direct
cost of the five activities listed above, or 85 per cent of the total direct costs associated with two of the
five activities.182
4.345  Because the purpose of the FSC rules is to attribute to the FSC those activities that take place
outside of US territory, the FSC statute requires that the FSC be responsible for these activities.  The
rules do not require that the FSC perform all of these activities itself through its own employees.
Instead, it is permissible for them to be performed by an agent under contract with the FSC.  The FSC
must pay for these activities, however.  These rules reflect that Congress designed the FSC toreplicate the results of a territorial exemption, and that it did so by requiring the FSC to take economic
responsibility for all foreign economic activity in the transaction, regardless of who performs it.
4.346  Congress designed the FSC to isolate the foreign economic activity taking place outside US
territory, whether the export transaction involves a sale, a lease, or a provision of services.  If a sale is
                                                                                                                                                                    
attached as US Exhibit 13) (holding that a corporation meeting the federal requirements of a FSC has a valid
business and economic purpose and reflects an arm's length relationship from its parent and other subsidiaries);
see also Kimberly-Clark Corporation v. Wisconsin Department of Revenue , 1994 Wisc. Tax LEXIS 13
(Wisconsin Tax Appeals Commission, April 12, 1994) (“ Kimberly-Clark ”) (copy attached as US Exhibit 14).
Also, case law in the United States has held consistently that an entity incorporated for the purposes of obtaining
a tax or other advantage is to be treated as a separate business entity.  For example, in Hospital Corp. of
America v. Commissioner , 81 T.C. 520 (1983) (copy attached as US Exhibit 15), the US Tax Court respected the
Cayman Islands corporation at issue as a separate en tity and allocated income to  it in accordance with the
economic activities performed outside the United States.
179  See, e.g. , Kimberly-Clark ; and Advisory Opinion - Petition No. C880726A , 1989 N.Y. Tax LEXIS
123 (State of New York - Commissioner of Taxation and Finance, January 31, 1989) (copy attached as USExhibit 17).
180  Section 925(c) of the IRC.
181  Section 924(d) and (e) of the IRC.
182  Section 924(d) of the IRC.WT/DS108/R
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involved, the US parent company must produce the product or service that is the subject of the
transactions; FSCs are not permitted to do so.  The US parent company may choose to sell the
qualifying product to the FSC, which will then resell that product to the customer.  Alternatively, the
US parent may also sell directly to the customer, with the FSC acting as a commission agent, never
taking title to the qualifying product.  If a lease or service is involved, then the FSC still must performor pay for the required intermediary functions that are necessary to complete the transaction.  In any
of these cases, the FSC is statutorily required to be legally and financially responsible for the
functions that a distributor would perform, while the US parent retains responsibility for the
producer’s functions.  The FSC’s share of income, based on the functions for which it is responsible,
is calculated using the applicable transfer pricing ru les.  The purpose, again, is to isolate and attribute
to the FSC the income that is fairly attributable to economic activities occurring outside of US
territory.  A portion of that income will be exempted if the FSC has complied with all of the legal
requirements.
4.347  With respect to the functions for which the FSC  is responsible, the FSC statute requires that
income be allocated to FSCs under one of three methods.  One of these methods uses the pricesactually charged between the FSC and the “related supplier” ( i.e., the US parent), subject to the
standard US transfer pricing rules in Section 482 of the Internal Revenue Code.
183  The other two
methods are administrative pricing rules, allocating to the FSC either 1.83 per cent of the qualified
gross receipts from transactions using that method, or 23 per cent of the combined taxable income
(“CTI”) of the FSC and its related supplier attributable to transactions using that method.184  The CTI
allocation method requires a calculation of all costs incurred by both the FSC and its parent that are
related to the transactions involved; those costs are subtracted from the gross receipts to find the total
CTI.  Of that amount, 23 per cent is allocated to the FSC as distributor and 77 per cent to the US
producer.  A FSC may use the administrative pricing rules only for transactions in which it performs
or pays for all of the distributor functions mentioned above.185  The US Congress stated specifically
that these pricing rules “are intended to comply with GATT’s requirements of arm’s length prices”
and “to approximate arm’s length pricing.”186
4.348  Finally, the FSC is designed to prevent double taxation of export income earned outside the
United States by exempting a portion of the FSC’s income from taxation.  Income thus exempted is
not eligible for double taxation relief using the foreign tax credit mechanism.187
4.349  Thus, through this combination of requirements and transfer pricing rules, the FSC emulates
the type of tax treatment received by a foreign sales subsidiary of a manufacturing company in aterritorial-type system.  Like those systems, the FSC exempts from tax income earned outside the
territory of the home country.
188
4.350  Finally, it must be noted that the European Communities grossly exaggerates the size and
effect of the tax reduction provided by the FSC.  In the First EC Submission, paragraph 100, the
European Communities accurately reports from the 1997 US Treasury report (Exhibit EC-5) that theFSC resulted in a revenue reduction of $1,380 million for calendar year 1992.  However, the
European Communities withholds from the Panel data that  put this figure in perspective.  Specifically,
the $1,380 million “expenditure” for all FSCs corresponds to gross receipts for the same time period
of $152,263 million.
189  Putting these figures together in ad valorem  terms, the resulting figure is 0.93
                                                     
183  Exhibit EC-1.
184  Section 925(a) of the IRC.
185  Section 925(c) of the IRC.
186  General Explanation , at 1042-43, 1054.
187  Section 901(h) and Section 906(b)(5) of the IRC.
188  As in a territorial system, the FSC provides shareholders with an exemption for dividends received
by the parent with respect to foreign income.
189  Exhibit EC-5, Table 6-4, p. 23WT/DS108/R
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per cent ad valorem .190  In other words, even assuming for purposes of argument that the FSC is a
subsidy, any “benefit” it provides is less than 1 per cent ad valorem .  Similarly, while the European
Communities accurately cites Treasury’s estimate that the FSC increased US exports by about $1.5
billion in 1992191, the European Communities omits the fact that this estimated increase amounted to a
percentage increase in exports of only 0.3 per cent.192
The FSC Is Not an Export Subsidy
Introduction
4.351  The European Communities makes two basic arguments in support of its claim that the FSC
regime constitutes a prohibited export subsidy in violation of Article 3.1(a) of the SCM Agreement.
First, the European Communities contends that FSC tax exemption itself is a prohibited export
subsidy.  Second, the European Communities alleges that the FSC administrative pricing rules provide
an additional export subsidy because they allegedly decrease the tax burden that otherwise would be
imposed, presumably by allocating too much income to the FSC.  The first is an incorrect proposition
as a matter of law; the second is both legally flawed and wholly unsupported by facts.
4.352  The United States first responds to the European Communities' first argument – that the FSC
partial tax exemption is an export subsidy.  This position is untenable, as a matter of law, because it
ignores the specific provision of the SCM Agreem ent that contains the controlling legal standard
applicable to its claim – Footnote 59 and the GAT T subsidy principles it embodies.  Footnote 59
confirms that income generated from economic activity outside the territory of the taxing authority
need not be taxed, and that a decision not to tax such income is not a prohibited subsidy.  Thisprinciple, which dates back to the GATT’s original ban on export subsidies and which is articulated in
the authoritative 1981 decision of the GATT Council, makes clear that such a tax exemption does not
violate Article 3.1(a).
193  The FSC was expressly designed to exempt income derived from foreign
economic activities.  Because it does so, it is entirely consistent with WTO standards and principles.
4.353  Then the United States addresses the European Communities' second claim – that FSC
administrative pricing rules separately confer a prohibited subsidy by improperly shifting, or
misallocating, income.
4.354  First, as a legal matter, the European Commun ities misconstrues the governing provision of
the SCM Agreement and builds its entire argument on that erroneous premise.  Footnote 59, the
applicable provision of the SCM Agreement, provides that WTO Members may allocate income fromexport transactions in order to distinguish income derived from economic activities outside their
territory from income derived from economic activities within their territory.  Footnote 59 clearly
provides that in making such allocations, Members are free to use administrative or other practices.
Accordingly, Members have considerable discretion in deciding what administrative practices to
apply, so long as the overall allocation of income approximates arm’s length results and does notresult in a “significant saving” of direct taxes in export transactions.
                                                     
190  In fact, assuming arguendo  that the FSC administrative pricing rules confer a subsidy, this figure
overstates the size of the “benefit.”  The 0.93 per cent  figure includes data for FSCs that use the section 482
method of allocating profits, a method that the European Communities has conceded does not constitute a
subsidy.  Thus, any alleged “benefit” conferred by the FSC administrative pricing rules would be some fraction
of 0.93 per cent .
191  First EC Submission, paragraph 106.
192  Exhibit EC-5, p. 14.  The European Communities also omits the following Treasury conclusion:  “In
several industries the FSC benefits were so small relative to the total value of exports that the adverse effect ofthe exchange rate is estimated to exceed the benefit from the FSC program.  For these industries, the FSCprogram has a small adverse  effect on exports.”  Id. (Emphasis added).
193 For these same reasons, the exemption from direct taxes of foreign-source income is not a subsidy at
all.  To the extent that the FSC tax exemption is not a subsidy within the meaning of SCM Agreement Article 1,it does not constitute a prohibited subsidy under Article 3.1(a) or any other provision of the SCM Agreement.WT/DS108/R
Page 64
4.355  The European Communities misstates this standard and, instead, assumes that a prohibited
subsidy exists, by definition, because the FSC does not perform enough activities itself to earn the
income allocated to it under the administrative pricing rules, or because the use of an administrative
pricing rule may, in particular transactions, produce results different from the result that Section 482
might yield in the same transaction.  This ipso facto  argument ignores the fact that the purpose of
footnote 59 is to discipline the allocation of income so as not to overstate income attributable to
foreign economic activities, and thereby confer a subsidy by exempting income generated from
activities occurring within the taxing authority’s territory.  By alleging simply that in particular
transactions administrative rules yield prices that are different from those that would result were those
rules not available, the European Communities misses both the point of footnote 59 and the point ofwhat the FSC provisions, including its administrative pricing rules, are intended to do.
4.356  In fact, the results produced by the FSC – of which the administrative pricing rules are but
one part – do properly allocate to FSCs the income th at is attributable to economic activities occurring
outside United States territory.  When the US Congress designed the FSC, it was explicit in its
intention to implement the 1981 Council Decision which confirmed that GATT Contracting Partiescould exempt from tax the income properly allocable to foreign economic processes.  By doing so,
Congress sought to replicate features of a territorial tax system.  Because the United States system is
residence-based, Congress achieved this result by using a bona fide  foreign entity, the FSC, and by (1)
requiring the FSC to perform or contract and pay fo r all of the distribution activities attributable to
exports, a significant portion of which are required to be performed outside the United States; and (2)
crediting the FSC with the actual foreign economic processes in an export transaction, whether
performed by the FSC directly or through an agent, including a related supplier under contract.
4.357  To ensure that the foreign activities of the FSC s and their related suppliers justify the limited
tax exemption granted by the FSC, the Congress imposed a variety of requirements to operate in
conjunction with the statutory administrative pricing rules.  Specifically, the FSC statute:
- Requires that FSCs be foreign corporate entities;
- Requires that FSCs be managed abroad and engage in prescribed activities
outside of the United States;
- Attributes all distribution and sales activities (which includes all foreign
economic processes) to the FSC (even when performed abroad by the FSC’s
United States parent);
- Limits the percentage of income or profit that may be allocated to the FSC;
and
- Further deems that, for purposes of the FSC tax exemption, only a fraction of
the income attributable to the FSC qualifies for the tax exemption.
4.358  The effect of these provisions, operating together, is to approximate – or even understate –
the income attributable to foreign economic activities.  Moreover, in no event do the FSC rules resultin a “significant saving” of taxes due on income attributable to economic activities occurring within
the United States.
4.359  Thus, the FSC provisions fully comport with the standards set forth in Footnote 59.  In
particular, the effect of the FSC is to exempt income generated by foreign economic activities.  The
result, as intended, replicates the results of a territorial system, and is entirely consistent with thestandards set out in the SCM Agreement.
4.360  The European Communities' arguments do not a ddress whether the FSC exemption relates to
foreign economic activity, and the First European Communities submission offers no factual evidence
whatsoever indicating that it does not.  Instead, the European Communities invokes an erroneous legalWT/DS108/R
Page 65
standard and asserts that, by definition, the FSC does not meet it.  As a result, the European
Communities has failed to make a prima facie  case.  It has fallen even further short of meeting its
burden of showing a “significant saving” of direct taxes within the meaning of footnote 59.
Under Controlling WTO Provisions, a Decision to Exempt Income Attributable to Foreign
Economic Processes from Tax Is Not a Prohibited Export Subsidy
4.361  Implicit in the European Communities' first argument is an extraordinary proposition; namely,
that WTO rules mandate  that Members tax income attributable to foreign economic processes.194  The
relevant provisions of the SCM Agreement, properly interpreted, refute the European Communities'
argument, however, and make clear that the FSC’s  exemption from taxation of certain income from
export transactions is not prohibited per se .  Indeed, if the WTO rules were as the European
Communities claims they are, then the income tax systems of EC members would be in violation of
the SCM Agreement.
Footnote 59 Embodies the Principle That WTO Members Need Not Tax Income
Attributable to Foreign Economic Processes
4.362  Article 3.1(a) of the SCM Agreement provides in relevant part that “the following subsidies,
within the meaning of Article 1, shall be prohibit ed:  (a) subsidies contingent in law or in fact,
whether solely or as one of several other conditions, upon export performance, including those
illustrated in Annex I.”  Annex I (the “Illustrative List of Export Subsidies”), in turn, gives specific
meaning to the provision to which it is attached.  The Illustrative List, which consists of 12
paragraphs, identifies practices that do or do not come within the prohibition of Article 3.1(a).
Footnote 5 to Article 3.1(a) makes clear that practices identified by the Illustrative List as not
constituting an export subsidy are not prohibited under Article 3.1(a).
4.363  Thus, if the Illustrative List treats a measure as an export subsidy, it is prohibited.
Conversely, if the List treats a measure as not being an export subsidy, it is not prohibited.  No further
analysis is needed to divine the meaning of Article 3.1(a) with respect to measures addressed by the
Illustrative List.
4.364  The European Communities has cited paragraph (e) of the Illustrative List in support of its
argument that the FSC is a prohibited export subsidy.  Paragraph (e) states the general rule that  “the
full or partial exemption, remission, or deferral specifically related to exports, of direct taxes” is an
export subsidy.  However, footnote 59 to paragraph (e) qualifies the scope of that paragraph and
                                                     
194  The European Communities defines the tax exemption at issue in this case to include three parts:
 The exclusion of the “foreign trade income” of  FSCs from the controlled foreign corporations
provisions of subpart F of the Internal Revenue Code (Sections 951(e) and 954(d)-(e) of theIRC).
 The exemption from US tax which would otherwise be due on the “exempt foreign trade
income” of the FSC (Section 921(a) of the IRC).
 The fact that the parent of the FSC is accorded a 100 per cent dividends-received deduction
(i.e., exemption from US tax) for the dividends received from the FSC’s “earnings or profits
attributable to foreign trade income.”  (Section 245(c) of the IRC in conjunction with Section
926(a) of the IRC).
First European Communities Submission, paragraph 125.  The United States also includes these three
components (inapplicability of subpart F, exemption of a portion of foreign trade income, and the dividends-received deduction) in its definition of “exemption” as used in this submission.  However, the United Statesdisagrees with the European Communities' characterizatio n of the second component as an exemption from tax
“which would otherwise be due.”  As discussed below, because there is no WTO requirement that the
United States tax income attributable to foreign economic processes, the partial exemption of such income fromtax cannot be considered as the foregoing of revenue which is “otherwise due”.WT/DS108/R
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makes clear that exempting income attributable to foreign economic processes from direct taxation is
not a prohibited export subsidy.195
4.365  Footnote 59, among other things, spells out general rules for allocating income to economic
activities outside the territory of the taxing auth ority.  According to footnote 59, where profits are
allocated between related parties, they must be allocated in accordance with the arm’s lengthprinciple:  “The Members reaffirm the principle that prices for goods in transactions between
exporting enterprises and foreign buyers under their or under the same control should for tax purposes
be the prices which would be charged between independent enterprises acting at arm’s length.”
Footnote 59 further provides that WTO Member s may “draw the attention of another WTO Member
to administrative or other practices which may contravene this principle and which result in asignificant saving of direct taxes in export transactions.”
4.366  The necessary predicate of footnote 59 is that income from foreign economic processes may
be exempted from direct taxes.  Were that not the case, the arm’s length principle would be irrelevant.
The arm’s length principle prevents income from being inappropriately shifted between parties or
functions.  In the context of export transactions, the principle focuses on ensuring that incomeproperly attributable to economic processes within  the taxing jurisdiction is not shifted to another
jurisdiction.  If the SCM Agreement were interpreted as requiring that income attributable to both
foreign and domestic economic processes be taxed by the domestic taxing authority, the shifting of
income between related parties would be irrelevant (because no tax advantage would be gained), and
the relevant portions of the footnote would be rendered devoid of meaning.
196  Therefore, implicit in
footnote 59 is the longstanding principle that income attributable to foreign economic processes need
not be taxed.
The Principle Underlying Footnote 59 Is Well-Established
4.367  The principle underlying footnote 59 – that income attributable to foreign economic processes
need not be taxed – is well-established and reflects the long-held views of GATT Contracting Parties
and WTO Members, particularly European Members.  Not only have Members relied on thisprinciple, but it has been a central element of proposals that various countries have made during the
development and evolution of the Illustrative List.  This history, summarised below, confirms that
WTO Members, like GATT Contracting Parties before them, never intended that a decision to exempt
income attributable to foreign economic processes from taxation should be considered an export
subsidy.
4.368  The original ban against export subsidies was contained in Article XVI:4 of GATT 1947.  As
originally crafted, Article XVI did not address export subsidies.  Because Article XVI was lacking in
this and a number of other important respects, the Contracting Parties decided to renegotiate and
                                                     
195  In this regard, the Appellate Body has stated that, where the issues before a panel implicate two
provisions, the panel should examine the more specific provision first.  European Communities - Regime for the
Importation, Sale and Distribution of Bananas , WT/DS27/AB/R, Report of the Appellate Body adopted 25
September 1997, paragraph 204.  The Appellate Body’s reasoning in this regard derives from the interpretive
principle of generalia specialbus , which holds that “a matter governed by a specific provision, dealing with it as
such, is thereby taken out of the scope of the general provision dealing with the category of subject to which thatmatter belongs, and which otherwise might govern it as part of that category.” Gerald Fitzmaurice, The Law and
Procedure of the International Court of Justice 1951-4:  Treaty Interpretation and Other Treaty Points , 1957
British Y.B. Int’l L. 236 (copy attached as US Exhibit 7).  Accordingly, the United States addresses first item (e)
and footnote 59, the provisions of the SCM Agreement that most specifically address a tax measure such as theFSC.
196  Such an outcome, of course, is impermissible under public international law.  “An interpreter is not
free to adopt a reading that would result in reducing whole clauses or paragraphs of a treaty to redundancy orinutility.”  United States – Standards for Reformulated and Conventional Gasoline , WT/DS2/AB/R, Report of
the Appellate Body adopted 29 April 1996, at 23 (“ Reformulated Gasoline ”); see also  Japan – Taxes on
Alcoholic Beverages , WT/DS8/AB/R, Report of the Appellate Body adopted on 4 October 1996, at 11
(“Alcoholic Beverages ”) (same).WT/DS108/R
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amend the provision.   The current part B of Article XVI, which addresses export subsidies, was added
in 1955 and generally came into effect for those parties accepting its obligations in 1957.197  T h e
revision added a new paragraph 4, which provides that “as from 1 January 1958 or the earliest
practical date thereafter, contracting parties shall cea se to grant either directly or indirectly any form
of subsidy on the export of any product other than a primary product ... .”198
4.369  On 19 November 1960, a number of GATT Contracting Parties agreed to a declaration that
gave effect to Article XVI:4 for the first time.199  Accompanying that declaration was a report of a
working party that included what would become the first Illustrative List of Export Subsidies.200  The
list, which was proposed by France, explained that “these practices generally are to be considered
subsidies in the sense of Article XVI:4 . . .”201  Paragraph (c) of the list – which is the precursor to
paragraph (e) in Annex I to the SCM Agreement – stat ed that “[t]he remission, calculated in relation
to exports, of direct taxes . . . on industrial or commercial enterprises” should be considered to be an
export subsidy.202
4.370  It is clear that paragraph (c) was not intended to prohibit Contracting Parties from exempting
income attributable to foreign economic processes from taxation.  This can be seen from the fact thatall of the European parties to the Tax Legislation Cases  – France, Belgium, and the Netherlands –
agreed to the declaration.
203  Each of the three European governments at the time either had territorial
tax systems or systems that contained features of a territorial system.  Each government considered
sales income from export transactions to be foreign and thus exempt from taxation, and each argued in
the Tax Legislation Cases  that it was simply impossible to believe that GATT Article XVI:4
prohibited the exemption from tax of income attributable to foreign economic processes relating to
exports from their territories.204
4.371  In 1979, Article XVI was further refined by the adoption of the Subsidies Code.205  Article 9
of the Subsidies Code, which banned export subsid ies on non-primary products, referred to an Annex
and stated that “[t]he practices listed in points (a) to (l) in the Annex are illustrative of export
subsidies.”206  Entitled the “Illustrative List of Export Subsidies,” the Annex was a modified version
of the 1960 Illustrative List.207
4.372  Paragraph (e) of the 1979 Illustrative List was a revised version of paragraph (c) of the 1960
list.  Paragraph (e) provided that “the full or partial exemption, remission, or deferral specifically
related to exports, of direct taxes . . .” is an export subsidy, language that is identical to what later
became paragraph (e) in Annex I of the SCM Agreement.
4.373  Paragraph (e) also contained a footnote 2, which had essentially the same language as
footnote 59 of the SCM Agreement.  Footnote 2 stated in pertinent part:
The signatories reaffirm the principle that prices for goods in transactions between
exporting enterprises and foreign buyers under their or the same control should for
tax purposes be the prices which would be charged between independent enterprises
                                                     
197  BISD 3S/222, 224-27 (1955); Protocol Amending the Preamble and Parts II and III of the GATT,
1955  (Agreement No. 33 in App. C), GATT Doc. L/717 (1957).
198  Id.
199  BISD 9S/32.
200  BISD 9S/185.
201  Id., at 187.
202  Id., at 186.
203  BISD 9S/33; see also  J. Jackson, World Trade and the Law of GATT , Section 15.3, page 374, note
24 (1969) (US Exhibit 8).
204  See BISD 23S/114, paragraph 20 (France); BISD 23S/127, paragraph 21 (Belgium); BISD 23S/137,
paragraph 21 (Netherlands).
205  BISD 26S/56.
206  Id., at 68-69.
207  Id., at 80-83.WT/DS108/R
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acting at arm’s length.  Any signatory may draw the attention of another signatory to
administrative or other practices which may contravene this principle and which
result in a significant saving of direct taxes in export transactions.  In such
circumstances the signatories shall normally attempt to resolve their differences using
the facilities of existing bilateral tax treaties or other specific internationalmechanisms, without prejudice to the rights and obligations of signatories under the
General Agreement, including the right of consultation created in the preceding
sentence.
Paragraph (e) is not intended to limit a signatory from taking measures to avoid the
double taxation of foreign source income earned by its enterprises or the enterprisesof another signatory.
4.374  Footnote 2 reflected the then ongoing concerns of the disputing parties regarding the panel’s
conclusions in the Tax Legislation Cases .  On the one hand, footnote 2 recognized the principle that if
income attributable to foreign economic processes were exempted from direct taxation, the attribution
or allocation of such income must be made on the ba sis of the arm’s length principle, a major concern
being raised at the time by the United States.
208  On the other hand, it recognized that countries could
design their tax systems so as to avoid the double taxation of income, a primary feature of the
European territorial systems of taxation then under attack.209  In short, footnote 2 was inserted into the
Subsidies Code to acknowledge and confirm that GATT Contracting Parties were not obligated to tax
income attributable to foreign economic activities and that an exemption of such income from
taxation would not constitute an export subsidy, provided that income was properly allocated between
domestic and foreign activities where related parties were involved in export transactions.
4.375  In 1981, two years after the Subsidies Code wa s adopted, the GATT Council, in adopting the
reports in the Tax Legislation Cases , explicitly articulated and reiterated these principles.  The
Council’s decision states:
The Council adopts these reports on the understanding that with respect to these
cases, and in general, economic processes (including transactions involving exported
goods) located outside the territorial limits of the exporting country need not be
subject to taxation by the exporting country and should not be regarded as export
activities in terms of Article XVI:4 of the General Agreement .210
4.376  The decision also states:
It is further understood that Article XVI:4 requires that arm’s-length pricing be
observed, i.e., prices for goods in transactions between exporting enterprises and
foreign buyers under their or the same control should for tax purposes be the prices
which would be charged between independent enterprises acting at arm’s length.
Furthermore, Article XVI:4 does not proh ibit the adoption of measures to avoid
double taxation of foreign income.211
4.377  The 1981 Council Decision echoed footnote 2 of the Subsidies Code.  It expressly articulated
what was implicit in footnote 2; namely, the general principle that “economic processes (including
transactions involving exported goods) located outside the territorial limits of the exporting country
need not be subject to taxation by the exporting country and should not be regarded as export
                                                     
208  BISD 23S/114, paragraph 26.
209  See, e.g. , BISD 23S/114, paragraph 20 (“the representative of France stated that the territoriality
principle . . . was part of a concept which respected th e fiscal sovereignty of States and which enabled double
taxation to be avoided”).  Of course, the avoidance of  double taxation is also a principle recognized by the US
tax system in, for example, its use of foreign tax credits.
210  BISD 28S/114 (emphasis added).
211  Ibid.WT/DS108/R
Page 69
activities in terms of Article XVI:4 of the General Agreement.”  It also made clear, however, that in
allocating income to foreign economic activities, “arm’s length pricing must be observed,” and it
reiterated that applicable GATT articles “do not prohibit the adoption of measures to avoid double
taxation of foreign source income.”  By unambiguously confirming that the exemption of income
attributable to foreign economic processes from taxation does not constitute a prohibited exportsubsidy, the Council Decision effectively reversed certain findings made by the panel in the Tax
Legislation Cases .
4.378  This history culminates in paragraph (e) and footnote 59 of the SCM Agreement.  By
incorporating the same language that was used in the Subsidies Code, the drafters of the Agreement
brought the history of the GATT’s treatment of the exemption from direct taxation of incomeattributable to foreign economic processes forward into the WTO.
212  The language of footnote 59,
when read in light of a history that dates back to the inception of GATT Article XVI:4, reflects a
consistent understanding among the GATT Contracting Parties and WTO Members that the
exemption from direct taxation of income attributable to foreign economic processes per se  does not
constitute an export subsidy.
The Principle Articulated in the 1981 Council Decision Is Controlling Here
4.379  The 1981 Council Decision not only informs the interpretation of the SCM Agreement and
reflects a long-held GATT principle, it also warrants separate weight in its own right.  As the
Appellate Body has explained, “Article XVI:1 of the WTO Agreement and paragraph 1(b)(iv) of the
language of Annex 1A incorporating the GATT 1994 into the WTO Agreements bring the legal
history and experience under the GATT 1947 into the new realm of the WTO in a way that ensurescontinuity and consistency in a smooth transition from the GATT 1947 system.”
213  Article XVI:1 of
the WTO Agreement states that “[e]xcept as otherwise provided under this Agreement or the
Multilateral Trade Agreements, the WTO shall be guided by the decisions, procedures and customary
practices followed by the CONTRACTING PARTIES to GATT 1947 and the bodies established in
the framework of GATT 1947.”
4.380  The 1981 Council Decision provides the most explicit statement of the principle that income
attributable to foreign economic processes need not be taxed.  Because it contains reasoning that the
GATT Council specifically endorsed, it is akin to an  authoritative interpretation of a WTO agreement
by the Ministerial Conference or General Council which, under Article IX:2 of the WTO Agreement,
“have the exclusive authority to adopt interpretations  of this Agreement and of the Multilateral Trade
Agreements.”214  In light of the fact that the GATT Council made a specific pronouncement of legal
principles, its statement constitutes a “subsequent practice” within the meaning of Article 31(3)(b) of
the Vienna Convention on the Law of Treaties  (“VCLT ”) with respect to GATT Article XVI:4, as
amended by the Subsidies Code.  At minimum, the decision merits more weight than Council
decisions that merely adopt a panel report.215
                                                     
212 With the exception of certain conforming changes and the elimination of certain transitional
provisions, item (e) and footnote 59 of the SCM Agreement are identical to item (e) and footnote 2 of theSubsidies Code.  This is not surprising, because although other items of the Illustrative List were discussed and
modified during the Uruguay Round negotiations, item (e) was not a subject of negotiation.
213  Alcoholic Beverages , at 13.
214  See also Article 3.9 of the DSU, which  provides that “[t]he provisions of this Understanding are
without prejudice to the rights of Members to seek authoritative interpretation of provisions of a coveredagreement through decision-making under the WTO Agreement or a covered agreement which is a PlurilateralTrade Agreement.”
215 The Appellate Body has stated that a decision of the Contracting Parties to adopt a panel report,
without more, does not necessarily reflect that the Cont racting Parties “intended that their decision would
constitute a definitive interpretation of the relevant provisions of GATT 1947,” nor “constitute agreement by the
Contracting Parties on the legal reasoning in that report.”   Alcoholic Beverages , at 12-13.  Nevertheless, a
decision by the Contracting Parties to adopt a report is part “of the GATT acquis ” and it “creates legitimateWT/DS108/R
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4.381  There can be no doubt that the GATT Council intended its decision to have broader
application than the specific cases then before it.  In articulating its decision, the Council stated:  “The
Council adopts these reports on the understanding that with respect to these cases, and in general ,
economic processes (including transactions involving exported goods) located outside the territorial
limits of the exporting country need not be subject to taxation by the exporting country and should notbe regarded as export activities in terms of Article XVI:4 of the General Agreement.”  (Emphasis
added.)  The Council made explicit that it was establishing a principle to be applied not only in the
cases at hand, but also in future cases.
4.382  It is clear that the first European Communities argument – that the FSC tax exemption, in and
of itself, constitutes a prohibited export subsidy – is incorrect.
216  The European Communities'
position is directly contradicted by the controlling standard discussed above.  As noted by the
Chairman of the GATT Council, the principle spelled out in the 1981 Council Decision “does not
mean that the parties adhering to Article XVI:4 are forbidden from taxing profits on transactions
beyond their borders, it only means that they are not required to do so ."217  How or to what extent
WTO Members choose not to impose a tax on such activities is irrelevant.  Members can apply theterritorial principle, limiting their tax jurisdiction at  the water’s edge.  Alternatively, Members using a
worldwide system can adopt exemption, deferral, or credit regimes (or any combination of the three)
to accomplish this same goal.  However it is done, the exemption of some or all of the income
generated from foreign economic activities, through whatever means, is not an export subsidy.
The FSC Administrative Pricing Rules Do Not Constitute an Export Subsidy
4.383  The European Communities' second assertion – that the FSC administrative pricing rules
create an export subsidy in violation of the arm’s length principle established by footnote 59 – is
based upon a fundamental misinterpretation of both the footnote and the FSC regime’s replication of
territorial tax concepts.  As such, the European Communities' second claim is wholly unsupported by
relevant facts.
218
4.384  Footnote 59 is designed to ensure that attributions or allocations of income to foreign
economic activities are appropriate and do not confer a subsidy by over-allocating income so that
income attributable to domestic  economic activities escapes taxation. Under footnote 59,
administrative practices to allocate income must satisfy the arm’s length principle, and must not allow
a “significant saving” of direct taxes.  The FSC rules were intended to, and do, meet this standard by
establishing a territorial exemption for income attributable to distributor functions performed outsidethe United States, whether by the FSC directly or by related manufacturers or third parties under
contract to, and paid by, the FSC.
4.385  The European Communities errs by focusing solely on how administrative pricing rules may
apply in a particular transaction and by insisting on analysing FSCs as separate corporate entities,
rather than as a method for allocating income to foreign economic activities in accordance with thestandard of footnote 59.  By failing to present any evidence relevant to the actual standard contained
                                                                                                                                                                    
expectations among WTO Members, and, therefore, shou ld be taken into account whenever relevant to any
dispute.”  Id.
216  See First European Communities Submission, paragraphs 151, 158.
217  Tax Legislation , BISD 28S/114 (emphasis added).
218 First European Communities Submission, paragraph 158. The European Communities does not
challenge the results of the FSC pricing rules that rely on section 482 of the Internal Revenue Code.
Section 925(a)(3) of the IRC.  Instead, the focus of th e European Communities' critic ism is directed at the
administrative pricing rules as alternatives to section 482.  See First European Communities Submission,
paragraphs 150, 158.  In that regard, however, it should be recognized that a certain percentage of FSCtransactions do not use the administrative pricing rule s, but instead use the standard “non-administrative”
transfer pricing rules.  Although that percentage may be relatively small overall, it is much higher in some
industry sectors than others.  In the aircraft industry, for instance, counting both categories of aircraft sales and
aircraft leases, the 1992 data show that section 482 transfer pricing accounted for some 23 per cent of the totalexempt FSC income earned by US aircraft manufacturers that year.  See Exhibit EC-12, at 128.WT/DS108/R
Page 71
in footnote 59, the European Communities has not made even a prima facie  case for its subsidy
allegation, and, under established principles of WTO dispute settlement, the United States is not
obligated to present a rebuttal.219  The United States nonetheless does so below.
The Arm's Length Standard of Footnote 59 Tests Whether Income Is Properly Allocated to
Foreign Economic Processes
4.386  The European Communities argues that the FSC administrative pricing rules are per se  export
subsidies because they allegedly do not approximate “the normal return on the economic activity of
FSCs,” they derogate from “normal transfer pricing rules of Section 482 IRC,” and they do not
comply with the arm’s length principle, as established by the OECD Guidelines.220  Even if these
assertions were true, none of them establishes that the FSC administrative pricing rules are an export
subsidy because the European Communities relies on the wrong legal standard.  What matters for
purposes of footnote 59 of the SCM Agreement is not whether the FSC administrative pricing rules
might produce determinations of tax liability that are different from what would be determined
through the application of Section 482 or the OECD Guidelines.  Instead, the proper question iswhether the FSC rules properly allocate income between foreign and domestic economic processes.
4.387  In evaluating the European Communities' argument regarding the FSC administrative pricing
rules, several aspects of footnote 59 are important.  First, as discussed above, footnote 59 embodies
the fundamental GATT rule that income derived from foreign economic processes need not be taxed.
Second, it imposes discipline on how that rule is applie d.  Some standard is necessary to ensure that
only income attributable to foreign processes involved in export transactions is exempt from taxation.
Otherwise, by misallocating income that is attributable to domestic activities, a Member could abusethe right conferred by footnote 59.  Thus, in the context of this case, the arm’s length principle of
footnote 59 requires only that the FSC administrative pricing rules properly allocate income in export
transactions.  The purpose of the arm’s length principle in footnote 59 is not, as the European
Communities asserts, to arrive at an actual price in individual export transactions (as would be the
goal, for example, of an analogous determinati on for customs valuation or antidumping purposes).
221
Instead, its purpose is to ensure that income is properly allocated between activities performed in the
United States (which are taxed by the United States) and activities performed outside the country
(which WTO rules permit the United States to exempt from tax).
4.388  Third, footnote 59 expressly allows WTO Members to use administrative pricing methods to
allocate income between domestic and foreign economic processes.  The text states that “any Membermay draw the attention of another Member to administrative or other practices  which may
contravene” the arm’s length principle established in the footnote’s previous sentence.  (Emphasis
added).  The clear implication of this language is that Members may rely on administrative practices
to allocate income, as long as they do not “contravene” the arm’s length principle contained in
footnote 59 and cause a significant saving of direct taxes.
222  Footnote 59 does not further dictate the
form or substance of the practices by which Member s may allocate income.  That determination is left
to individual Members.
4.389  Moreover, footnote 59 makes clear that administrative practices that approximate arm’s
length results on an overall basis are permissible.  Under footnote 59, only an administrative or other
practice that “result[s] in a significant saving of direct taxes in export transactions” can be considered
                                                     
219  Below, the United States discusses burden of proof principles as they apply to this case.
220  First European Communities Submission, paragraphs 67-72, 93, 150, 158.
221  In this regard, based on a computer search of the entire text of the WTO Agreements, footnote 59
appears to be the only provision in any of the WTO agreem ents that uses the term “arm’s length”.  Moreover, it
uses the term in the context of “tax purposes.”
222 Given the express language of footnote 59, which is the applicable standard, the
European Communities' assertion that the FSC administra tive pricing rules are not the type of “safe harbour”
allowed by the OECD Guidelines, even if it were true, is irrelevant.  See First European Communities
Submission, paragraphs 87-91.WT/DS108/R
Page 72
to be a potential export subsidy.  The structure of the third sentence of footnote 59 – the plural form of
the words “taxes” and “transactions”, together with the singular for “saving” – indicates that
allocations of income to foreign economic processe s must comply with the arm’s length principle of
footnote 59 on average or in the aggregate.  If they do, then the objective of imposing the appropriate
level of tax is met.
4.390  Administrative rules or practices are used for reasons of administrative convenience for both
administrators and users of the system.  Administrative rules avoid the burden of challenging or
defending allocations on a transaction-by-transaction basis.  If such practices are used, however, the
resulting overall allocations of income from domestic and foreign economic processes must satisfy the
arm’s length principle and not produce any “significant,” impermissible tax saving.223
4.391  Finally, footnote 59 states that “prices . . . in transactions between exporting enterprises and
foreign buyers . . . should for tax purposes  be the prices which would be charged between
independent enterprises at arm’s length.”  (Emphasis added).  Because parties dealing at arm’s length
can agree on a variety of prices, it is accepted in the tax area that the application of the arm’s length
principle produces a range or zone of prices.224  Prices falling within this range meet the standard of
“arm’s length,” and allocations of income consistent with this range are, for purposes of footnote 59,
at “arm’s length.”
4.392  In its effort to establish that the FSC administrative pricing rules violate the arm’s length
principle of footnote 59, the European Communities  invokes the OECD Guidelines and Section 482
of the Internal Revenue Code.  As a matter of law and treaty interpretation, neither the OECD
Guidelines nor US law governs this dispute.  Nothing in footnote 59, the 1981 Council Decision, or
any other provision of the SCM Agreement provid es that the OECD Guidelines or Section 482
establishes a standard applicable to all WTO Members.  Indeed, were the Panel to declare the OECD
Guidelines as the applicable benchmark for measuring compliance with the arm’s length principle of
footnote 59, it would be imposing OECD norms on the 100-plus WTO Members that have not
acceded to those Guidelines.  Such an action by the Panel would clearly exceed its authority under the
DSU.225
4.393  Moreover, both the Guidelines and Section 482 are concerned with allocating profits between
related entities in individual transactions for tax administration purposes.226  The standard of
                                                     
223 The European Communities contends that the very fact that the FSC administrative pricing rules
reduce transfer pricing compliance costs constitutes an export subsidy.  First European CommunitiesSubmission, paragraph 142.  This surprising and sweeping contention would create disincentives for moreefficient tax administration, because it suggests that steps taken to reduce administrative burdens for both
administrators and taxpayers could constitute a subsid y under the SCM Agreement.  Indeed, individual US
taxpayers who elect to take the “standard deduction” in lieu of the more labour-intensive (but potentially taxsaving) itemized deductions would be surprised to learn that by doing so, they receive a subsidy.
224 The European Communities concedes this point when it refers to the OECD Guidelines and
section 482.  See OECD Guidelines, paragraph 1.45 (“transfer pric ing is not an exact science”).  This concept is
also embodied in the US section 482 rules.  See Treas. Reg. 1.482-1(e)(1), which establishes the standard of an
“arm’s length range” (US Exhibit 9).
225 Cf., European Communities - Measures Affecting Importation of Certain Poultry Products ,
WT/DS69/AB/R, Report of the Appellate Body adopted 23 July 1998, paragraphs 79-81 (Oilseeds Agreementwas not a “covered agreement” and, as such, did not contain the relevant obligations of the EuropeanCommunities under the WTO Agreement).  In this regard, even if the drafters had intended OECD Guidelines to
govern the application of footnote 59, it could not have been the 1995  Guidelines, because those Guidelines did
not yet exist when the WTO Agreement  entered into force on 1 January 1995.
226  See OECD Guidelines, paragraph 1.6 (rules designed to allocate profits, and thereby taxable
income, of the related companies that have entered transactions with one another or together); and Treas.Reg. 1-482-1(b)(1) (US Exhibit 9).  In this regard, the United States notes that the FSC administrative pricingrules are more restrictive than section 482 in an important and unique respect.  The regulations implementing
section 482 contemplate flexibility in allocations based on an evaluation of all relevant facts and circumstances.
By contrast, the FSC administrative pricing rules apply only if threshold foreign economic process requirements
are satisfied.WT/DS108/R
Page 73
footnote 59 has a different purpose – that any administrative practices used by Members when
allocating income between domestic and foreign economic processes not confer a subsidy to exporters
by systematically over-allocating income to foreign economic processes in such a way as to create a
“significant saving” of taxes on income attributable to domestic  economic processes.227
4.394  To prevail on its claim that the FSC administrative pricing rules fail to comply with the arm’s
length principle of footnote 59, the European Communities must demonstrate, at a minimum that:  (1)
the allocations of income between domestic and foreign economic processes that the FSC rules
produce fall outside the range of comparable allo cations between independent enterprises acting at
arm’s length; and (2) such a misallocation results in a significant saving of direct taxes in export
transactions.  Under the controlling WTO principles, this is the standard that must be met, andwhether the FSC meets this standard should be the Panel’s sole inquiry.
4.395  By arguing simply that allocations between related entities in particular transactions may not
coincide with the result that would be reached under Section 482, the European Communities fails to
satisfy its burden as the complaining party to establish a prima facie  case under the applicable legal
standard.  By focusing on a separate company, transactional pricing analysis, the EuropeanCommunities misconstrues entirely the economic objective and import of the FSC regime.  Its failure
to do so is fatal to its claim.
The United States Designed the FSC to Replicate the Territorial Exemption Authorised by
Footnote 59 and Thereby to Conform with the Arm's Length Principle of that Footnote
4.396  The European Communities' failure to establish a prima facie  case regarding the FSC
administrative pricing rules is not surprising.  This  is because the express purpose of the US Congress
                                                     
227  In addition, several of the European Communities' assertions regarding the compliance of several
aspects of the FSC administrative pricing rules with those benchmarks are simply inaccurate.  For example, the
European Communities asserts that the FSC pricing rules must be improper simply because they permit
grouping of transactions and ex post facto  determinations with respect to the pricing method chosen.  See, e.g.,
First European Communities Submission, paragraphs 63, 136.  Indeed, the European Communities states thatUS transfer pricing rules under section 482 would not normally allow any choice of method by a corporation.See First European Communities Submission, paragraph 74.  These assertions reflect a fundamental lack of
understanding of the US transfer pricing rules applicable  for tax purposes.  It is not generally necessary that
transfer prices be fixed for individual transactions at  the time those transactions are executed.  The US tax
regulations issued under section 482 provide that companies may re-compute transfer prices at any time up tothe point when the tax return for the relevant year is filed.  See Treas. Reg. 1.482-1(a)(3) (US Exhibit 9).
Moreover, if a company finds that its original transfer pr ice needs to be adjusted in a way that results in higher
taxable income, it may re-compute that price on an amended tax return at any time before the Internal Revenue
Service contacts it about the price as originally reported.  Id.; Treas. Reg. 1.6662-6(a)(2) (US Exhibit 10).
Furthermore, under the section 482 regulations, companies also may group the results of transactions
for transfer pricing purposes, “evaluating the arm’s-length results by applying the appropriate method to theoverall results for product lines or other groupings.”  Treas. Reg. 1.482-1(f)(2)(iv) (US Exhibit 9).  Thisauthorization to group transactions for transfer pricing pu rposes is similar to the grouping by product line that is
permitted under the FSC transfer pricing rules.  See Section 927(d)(3).
Finally, the OECD Guidelines and US rules address another objection that the European Communities
makes to the FSC administrative pricing rules – that those rules permit companies to choose a transfer pricingmethod when normal practice allegedly would not do so.  See First European Communities Submission,
paragraph 75.  Both the Guidelines and the regulations under section 482 discuss at length various methods thatmay be accepted for the purpose of establishing an acceptable transfer price, and those lists are not exhaustive.
Tax administrators have recognized that, for different industries, different types of businesses, and different
conditions of business, different methods will be most appropriate.  The choice of methods under the FSCtransfer pricing rules reflects this recognition.  More generally, the US rules under section 482 state explicitlythat it is the result, not the method, that matters for transfer pricing purposes; so long as the taxpayer has reachedan arm’s length result, it does not matter how that result was reached.  See Treas. Reg. 1.482-1(f)(2)(v) (US
Exhibit 9).  For purposes of satisfying the arm’s length standard applicable to this dispute, it is also the result
that matters, not the method.  Footnote 59 requires that ta x provisions reach arm’s length results in the aggregate
in order to prevent any significant saving of direct taxes on export transactions.  The FSC administrative pricingrules are completely consistent with this approach.WT/DS108/R
Page 74
in creating the FSC was to allocate income in export transactions so as to exempt income attributable
to foreign, but not domestic, economic activities from tax, in accordance with existing GATT rules.
As the staff of the Joint Committee on Taxation explained,
Under GATT rules, a country need not tax income from economic processes
occurring outside its territory.  Accordingly, Congress believed that certain incomeattributable to economic activities occurring outside the United States should be
exempt from US tax in order to afford Un ited States exporters treatment comparable
to what exporters customarily obtain under territorial systems of taxation.
228
4.397  The Committee staff further stated:
[u]nder the GATT rules, an exemption from tax on export income is permitted only if
the economic processes which give rise to the income take place outside the
United States.   In light of these rules, the Act provides that . . . the income of the FSC
must be determined according to transfer prices specified in the Act . . . [including]
formula prices which are intended to comply with GATT’s requirement of arm’s-
length prices .229
4.398  Thus, the FSC rules, including the administrative pricing rules, were specifically designed to
achieve the type of allocation required by footnote 59.  The FSC rules are the administrative
practice230 through which Congress sought to ensure that only income properly attributable to
economic processes occurring outside the United States is eligible for the exemption from tax
provided by the FSC.
4.399  To implement the objective of exempting from tax that income which is attributable to
foreign economic activities, and thereby provide the same treatment to United States exporters that
exporters receive under territorial systems, Congress fashioned rules that are compatible with the
basic principles and structure of the US tax system.  To replicate the effect of a territorial system
within the US system, Congress, for reasons discus sed below, required the formation of a foreign
corporation, the FSC.  Congress required the FSC to be responsible for all distributor functions,
including all of the foreign economic activities in an applicable export transaction, regardless of
whether or not the FSC actually performs those activities directly or contracts for their performance
through a related supplier or another agent.  Only a portion of the income from those foreign activities
credited to the FSC is exempted from tax; the balance is taxed by the United States as being
attributable to distribution activities occurring with in the United States.  By failing to discuss this
purpose or structure, the First European Communities Submission does not even address whether the
FSC complies with the standard of footnote 59.
The Structure of the FSC Is Dictated by Congress' Decision to Work Within the US Tax
System
4.400  Because the US tax system is a worldwide system, rather than a territorial system, the
United States generally taxes the foreign activities of United States corporations, but exempts from
tax (subject to certain anti-avoidance rules) income from foreign economic processes earned by
foreign corporations, including foreign subsidiaries of United States corporations.  By contrast, under
a tax system with “territorial” features, income from extraterritorial processes associated with exportscan be exempted whether it is earned through the activities of a foreign corporation or the foreign
(“branch”) activities of a domestic corporation.
                                                     
228  General Explanation , at 1042.
229  Id. at 1042-43 (emphasis added).
230 Senate Print , at 649 (FSC administrative pricing rules designed as an administrative convenience to
both tax administrators and taxpayers) (US Exhibit 11).WT/DS108/R
Page 75
4.401  By requiring that the FSC be a foreign corpor ation, Congress, acting within the confines of
traditional US taxation principles, created a means for providing a partial exemption for all
extraterritorial activities associated with export tr ansactions, whether carried out by the FSC itself or
whether attributed to the FSC.  The FSC provisi ons rely on a foreign corporation as the means for
achieving an exemption for foreign economic activities because that is the most appropriate methodfor doing so under the US world-wide taxation system.
4.402  To ensure a significant level of foreign economic activity, a FSC is required to:  (1) be
incorporated outside of the United States; (2) maintain an office with a permanent set of books in a
qualified jurisdiction outside the United States; (3) satisfy certain “foreign presence” criteria that give
it attributes comparable to a branch office or “permanent establishment” of the US parent company;and (4) as a condition of the application of the administrative pricing rules, take legal and financial
responsibility for all of the functions traditionally carried out by a distributor with respect to export
transactions (whether performed by the FSC, the US parent, a third party, or any combination of the
these).  The FSC is then credited with essentially all of the distributor/sales functions in the
transaction performed outside of the United States, whether done by the FSC directly or by anotherparty under contract to the FSC.
231
4.403  The First European Communities Submission does not acknowledge this design.  The
European Communities' argument is focused largely, and erroneously, on the assertion that a FSC
does not directly perform enough economic activity using its own in-house resources to justify the
share of the profits allocated to it under the administ rative pricing rules.  However, the FSC rules were
not designed to force the FSC to perform all of the foreign economic activities itself; rather, they were
designed to attribute to the FSC that income which is derived from foreign economic processes,regardless of the manner in which those processes are performed.  So long as the FSC rules, in the
end, exempt only income attributable to foreign economic processes of export transactions, the
standard of footnote 59 is satisfied and the corporate forms are irrelevant.
4.404  In addition, in its attack on the more lenient rules for “small FSCs,” the European
Communities argues that because a small FSC is exempt from the foreign management and foreigneconomic processes tests, small FSCs should not be entitled to a partial tax exemption.  However, a
small FSC is required to have foreign incorporation, a foreign office, and, in order to use the
administrative pricing rules, must perform (or have performed on its behalf), all eight economic
activities that are essential to the export sales function.
232  Thus, small FSCs do not have to satisfy the
activities described in Sections 924(d) and 924(e) of the Internal Revenue Code.  However, thistreatment is justified as a means of reducing the burdens on small businesses, especially in light of the
fact that small FSCs receive a partial tax exemption with respect to a maximum of $5 million of
foreign trading gross receipts.
233
4.405  Finally, the FSC rules have been vigorously enforced by the US Internal Revenue Service.
Like all other corporations, FSCs are required to submit tax returns and pay taxes, including estimatedtaxes.  FSCs are routinely subjected to audits, adjustments of tax due, and penalties for taxes not paid
when due.  Moreover, in auditing a FSC return, examining agents check carefully to ensure that all
                                                     
231  Looking at the FSC and its US parent company together is fully consistent with a territorial tax
system, which allows an exemption for foreign economic processes carried out through a foreign branch of a
domestic corporation.  Therefore, Congress spoke explicitly of “viewing the FSC and any related supplier as asingle entity which sells to the purchaser.”  Id.
232  Sections 924(d)-(e) and 925(c) of the IRC.
233  The European Communities has conceded that what it calls “safe harbours” might be an appropriate
way to relieve compliance burdens on small companies.  First European Communities Submission,paragraph 91.  In that regard, there are a number of pr ovisions of the Internal Revenue Code that treat small
businesses more favorably with respect to taxation and compliance requirements.  If desired, the United Stateswould be prepared to provide the Panel with a list of these provisions.
In addition, while the European Communities cites the fact that small FSCs account for 48 per cent of
all FSCs, it ignores the fact that their economic impact is  negligible, given that small FSCs account for only 2.3
per cent of all FSC income.WT/DS108/R
Page 76
foreign presence, foreign management, and foreign economic process requirements are complied
with, and that the computation of the partial tax exemption is accurate.  Finally, the FSC rules have
been enforced through court proceedings.234
Congress Limited the Tax Exemption Available Through the FSC
4.406  As an additional safeguard to ensure that the tax exemption received by a FSC extends only to
income attributable to foreign economic activity, as required by footnote 59, Congress chose to
exempt from tax less income than the United States was entitled to exempt under GATT rules.
Although this decision was driven to a large extent by the fiscal policy of preventing a larger revenue
loss, it nevertheless is the case that only a fraction of the income allocated to the FSC under theadministrative pricing rules is eligible for the ta x exemption.  For example, under the CTI method
most commonly used by FSCs, of the 23 per cent of the combined taxable income of the FSC and its
related supplier that may be allocated to the FSC, only 15 per cent of the combined taxable income of
the FSC and its related supplier attributable to foreign trade gross receipts is exempt from federal
income tax (0.23 x 15/23 = 0.15).  This figure is a conservative approximation of the amount offoreign economic activity for which the FSC is responsible.
The European Communities Has Failed to Establish that the Allocations to FSCs Under
the Administrative Pricing Rules Do Not Yield Results Within the Range of the Arm's
Length Results Required by Footnote 59
4.407  The factual and historical record just discussed makes it clear that the US Congress was
attempting specifically to comply with the income  allocation principle that later was set forth in
footnote 59.  The only possible remaining question is whether the FSC rules failed to achieve thatpurpose.
4.408  Notwithstanding the existence of publicly available data that would help answer this question,
the European Communities has failed to offer any evidence on this point, relying instead on
conjecture rather than facts.  Because the European Communities has not presented any evidence, let
alone evidence sufficient to establish a prima facie  case, the United States has no evidentiary showing
to rebut.
4.409  However, the European Communities' allegations could be tested in a variety of ways.  The
points of reference under the FSC rules would be, of course, the allocations allowable under the FSC
administrative pricing rules.  The more commonly us ed of the two administrative pricing alternatives
is the CTI method.  Under this method, 23 per cent of the combined taxable income of the FSC and itsrelated manufacturer-supplier is allocated to the FSC.  Of the 23 per cent of total income, only 15 per
cent (or 15/23) of the total is eligible for the FSC  tax exemption.  Accordingly, the tax exemption
available under the CTI method is 15 per cent of the total combined income of the FSC and its
manufacturer-supplier.  Thus, in assessing whether the result under the CTI method conforms to
footnote 59, the question would be whether, in the case of unrelated manufacturers and distributors,the distributors earn in the range of 15 per cent or more of the combined total income of the
distributors and unrelated manufacturers.
4.410  The other administrative pricing alternative is the gross receipts method, under which 1.83 per
cent of qualified gross receipts is allocated to the FSC.  Here, the question would be whether the gross
receipts of distributors that are unrelated to their manufacturer-suppliers are in the range of the1.83 per cent prescribed by the FSC rules.
4.411  With these points of reference in mind, the European Communities could have attempted to
show that the FSC administrative pricing rules rely on faulty assumptions regarding the profit
attributable to distributors in export transactions.  Because the FSC rules require FSCs to be
                                                     
234 See, e.g. , Naporano v. United States , 834 F. Supp. 694 (D. N.J. 1993) (US Exhibit 18); and Union
Carbide Corp. v. Commissioner of Internal Revenue , 110 T.C. No. 28 (1998) (US Exhibit 19).WT/DS108/R
Page 77
responsible for the distributor functions in export transactions, their function is analogous to the
function of independent distributors.
4.412  The European Communities could have used publicly available Statistics of Income data
published annually by the US Internal Revenue Service to determine the relative profit shares realized
by independent distributors and unrelated manufacturers.  This aggregate, public data then could havebeen used as a basis for comparing empirical perf ormance with the 23 per cent of combined taxable
income that the CTI method allocates to FSCs.  These data would allow such comparisons to be done
on an industry-by-industry basis.
4.413  The European Communities could have performed a similar empirical analysis using publicly
available data derived from corporate financial statements filed annually by US corporations with theUS Securities and Exchange Commission.  These data would support an analysis not only of how
profits split between distributors and unrelated manufacturers, but also of the allocation made under
the FSC gross receipts allocation method.
4.414  Such comparisons with empirical taxpayer and corporate data would be one basis for
evaluating the reasonableness of the FSC administ rative pricing rules, and for determining whether
those rules result in an over-allocation of income to foreign economic processes.
4.415  Because individual taxpayer information is not publicly available, the data on which such
analyses could be made is, of course, aggregate data.  However, aggregate data is an entirely
appropriate basis for assessing the results that the FSC rules seek to achieve.  Not only does
footnote 59 anticipate that Members may employ administrative practices (the reasonableness of
which can be confirmed only by average, or aggregate, data), but also the ultimate test under
footnote 59 – that, in the end, administrative practices for allocating income must not result in a“significant saving of direct taxes in export transactions” – suggests that an aggregate test is
appropriate.
235
4.416  However, notwithstanding the existence of seemingly relevant data, and notwithstanding that
it is the burden of the European Communities, as th e complainant in this case, to make an initial
factual showing that the FSC administrative pricing rules violate the standard set forth in footnote 59,
thus far, the European Communities has failed to offer any evidence that the FSC administrative
pricing rules create tax exemptions for anything ot her than income attributable to economic activity
occurring outside of United States territory.  That standard is the only standard required by the SCM
Agreement.236
4.417  To meet its burden of proof, the European Communities must come forward with evidence
showing that the FSC administra tive pricing rules generally allow income generated from economic
activities occurring in the United States to escape taxation and that this results in a “significant saving
of direct taxes in export transactions.”  The mere assertion that the FSC, as a separate entity, does not
itself perform all of the foreign economic processes involved in an export transaction is not enough.
                                                     
235 Footnote 59 also provides that any Member that  believes that another Member’s administrative or
other practices contravene the arm’s length principle may draw that issue to the attention of the other Member.Because taxpayer information is generally confidentia l, aggregate data would be the logical basis for a
Member’s making such an assertion.  This suggests that the drafters of footnote 59 contemplated the use of
aggregate data on this issue.
236 The European Communities' superficial conclusions about the operation, purpose, and effect of
FSCs may be attributable in part to the secondary literature on which the European Communities' case has reliedso heavily. Written by authors who appear not to have a complete understanding of both the trade and taxorigins of the FSC provisions, some of the articles are marketing efforts that exaggerate the tax reductionsavailable through FSCs.  Others, drawn from the popular press, superficially portray FSCs, along with a host of
other governmental programmes and institutions, in a flamboyant, not an analytical, manner.  That such sources
provide the evidentiary support for the European Communitie s' claims speaks to more than just the burden of
proof.WT/DS108/R
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Even if the FSC Administrative Pricing Rules Were Considered to Contravene the Arm's
Length Principle in Footnote 59, Those Rule s Do Not Result in a Significant Saving of
Direct Taxes in Export Transactions
4.418  The United States has demonstrated that the FSC administrative pricing rules do not
contravene the arm’s length principle of footnote 59.  However, even assuming arguendo  that those
rules did depart from the arm’s length principle, they still would be consistent with footnote 59,
because the rules do not generate a significant saving of direct taxes in export transactions within the
meaning of the footnote.
4.419  Nowhere does the European Communities address footnote 59’s requirement that, in order to
create a prohibited export subsidy, any derogation by administrative or other practices from the arm’s
length principle must create a “significant saving of direct taxes in export transactions.”  This
requirement, which is joined to the arm’s length pr inciple with the conjunctive “and” in the footnote’s
text, is an essential element that the European Communities must prove in order to support its
allegation.
4.420  Because the European Communities failed to addr ess this standard or to provide any evidence
relating to it (other than a general discussion of the aggregate tax reduction reportedly enjoyed by
FSCs), the European Communities has failed to make a prima facie  case with regard to its export
subsidy claims.  Therefore, in the absence of additional evidence, neither the Panel nor the
United States is required to address the issue further.237  Nevertheless, the United States will do so.
4.421  Although no GATT or WTO panel has yet attempted to quantify “significant saving” under
footnote 59 specifically, the text of the SCM Agreement itself provides helpful guidance in construingthat term.  Consistent with the generally accepted principle that subsidies should have distortive trade
effects in order to warrant a remedy under the SCM Agreement, the Agreement has more than one
provision setting a threshold above which subsidies must rise to warrant a remedy.
4.422  One such threshold is the de minimis  standard found in Article 11.9 for purposes of the
countervailing duty remedy.  Under Article 11.9, a Member contemplating countervailing measures
against subsidized imports must find that the amount of the benefit conferred by subsidies are more
than de minimis .  Otherwise, a countervailing duty investigation must be immediately terminated.
4.423  “De minimis ” is a defined term.  Article 11.9 provides that any subsidy shall be considered de
minimis  if it is less than 1 per cent ad valorem .
238  Annex IV to the SCM Agreement prescribes how
ad valorem  subsidy rates are to be calculated for certain subsidy disputes.  The overall value of the
subsidy benefit is expressed as a percentage of the total value of the recipient firm’s sales during the
period in which the subsidy is granted.  This method is used by the United States for purposes of its
own countervailing duty law, and the United States understands that the European Communities also
employs this method for purposes of its countervailing duty law.
4.424  For tax-related subsidies, the calculation rules in Annex IV are explicit.  Specifically,
footnote 64 states that “in the case of tax-related subsidies the value of the product shall be calculated
as to total value of the firm’s sales in the fiscal year in which the tax-related measure was earned.”
Here, too, the United States uses the same met hod under its countervailing duty law, and the
United States believes that the European Communities does also under its countervailing duty law.
Under this method, a subsidy with a value of less than 1 per cent of sales value (effectively a
percentage of gross receipts) would be considered de minimis  for purposes of Article 11.9.
4.425  This definition of de minimis  is, of course, found in the very same agreement that excludes
direct tax subsidies that do not produce a “significant saving” of direct taxes in export transactions.
                                                     
237 See European Communities - Measures Affec ting Meat and Meat Pr oducts (Hormones) ,
WT/DS26/AB/R, Report of the Appellate Body adopted 13 February 1998, at paragraph 98.
238  Articles 27.10 and 27.11 establish higher de minimis  thresholds for developing country Members.WT/DS108/R
Page 79
Principles of construction of international agreements, as articulated in WTO jurisprudence, indicate
that these terms should be construed rationally and harmoniously within the context of the SCM
Agreement.239  The same considerations that led the drafters to make de minimis  subsidies non-
actionable under Part V of the SCM Agreement underlie the requirement that a tax measure result in a
“significant saving of direct taxes in export transactions” in order to constitute a prohibited exportsubsidy.  The plain meaning of the two terms indicates that de minimis  is the lower threshold and that
anything that is de minimis  falls well below “significant.”  It would be anomalous, as well as a
distortion of the language of the SCM Agreement, for the “benefits” of a tax measure to be “ de
minimis ” but at the same time “significant.”
4.426  The most recent report by the Treasury Department to the US Congress on the operation of
the FSC, dated November 1997, aggregates the maximum tax savings that may be attributed to the
FSC.
240  Using the same type of calculation as that set out in Annex IV of the SCM Agreement and
used by the United States and the European Communities for countervailing duty purposes, the report
shows that the aggregate tax savings under the FSC for all products and services in the year covered
by the report was 0.93 per cent ad valorem .  This is below the 1 per cent de minimis  level of
Article 11.9.
4.427  Moreover, this calculation overstates any possible subsidy attributable to the FSC
administrative pricing rules, because the calculation includes all tax savings conferred under the FSC
provisions during the year measured.  Thus, the 0.93 per cent figure includes tax savings available
under the Section 482 allocation method, a method that the European Communities has conceded does
not contravene the arm’s length principle of footnote 59.  Because the exemption from taxation of
income derived from foreign economic processes is permissible as long as the arm’s length principleis observed in allocating income, and because the European Communities has conceded that the
Section 482 method conforms to the arm’s length principle, any potential “subsidy” that might be
conferred through the application of the FSC administrative pricing rules (an amount for which the
European Communities has offered no evidence) would be only a fraction of 0.93 per cent ad
valorem , a figure that is already de minimis .
4.428  In sum, any “benefit” conferred by the FSC administrative pricing rules is indisputably de
minimis  under the rules of the SCM Agreement.  By an even wider margin, those “benefits” do not
result in any “significant saving of direct taxes in export transactions” under footnote 59.  The
European Communities has not presented any evidence otherwise.  Instead, its own evidence (in the
form of Exhibit EC-5) establishes that any “benefit ” conferred by the FSC administrative pricing rules
falls below all of the thresholds set forth in the SCM Agreement.
The FSC Is Not a "Subsidy" Under the SCM Agreement
4.429  In the preceding section, the United States addressed the status of the FSC under the
provisions of the SCM Agreement that most specifically address an income tax measure like the FSC.The United States responded to the European Comm unities' claim that the FSC constitutes an export
subsidy under Article 3.1(a) of the SCM Agreement by discussing the controlling legal standard found
in footnote 59 and the related 1981 Council Decision.  The same legal principles apply, however, to
the question of whether a Member’s decision not to tax income attributable to economic processes
located outside of its territory is a “subsidy” at all, as that term is defined in Article 1 of the SCMAgreement.
                                                     
239  See, e.g. , Reformulated Gasoline , at 16-17 (citing Article 31 of the VCLT  for the proposition that
GATT 1994 articles “should be read in context and in such manner as to give effect to the purposes and objectof the General Agreement . . . [and] the context of [the relevant article] includes the provisions of the test of the
General Agreement . . . .); and Alcoholic Beverages , at 11 (“Provisions of [GATT 1994 and other “covered
agreements”] are to be given their ordinary meaning in their context”).
240  Exhibit EC-5.WT/DS108/R
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4.430  For a measure to be a prohibited or actionable subsidy, it must first come within the definition
of a “subsidy” set forth in Article 1.  With respect to Article 1, the European Communities alleges that
the FSC amounts to “a financial contribution by a government” because, under the FSC, “government
revenue that is otherwise due is foregone or not collected (e.g. fiscal incentives such as tax
credits).”241  What the European Communities fails to do, however, is to explain why potential tax
revenues from income attributable to foreign economic processes are revenues that are “otherwise
due.”
4.431  The conclusive answer to the question that th e European Communities declines to discuss is
provided by the controlling legal principles articulated in footnote 59 and the 1981 Council Decision.
The broad principles expressed in footnote 59 and the 1981 Council Decision necessarily bear onArticle 1, and they must be interpreted in harmony with each other.
242  Indeed, it is clear from the
language of footnote 59 and the 1981 Council Decisi on that the principle they embody must apply to
the interpretation of Article 1.
4.432  As explicitly stated in the 1981 Council Decision, “economic processes (including
transactions involving exported goods) located outside the territorial limits of the exporting countryneed not be subject to taxation by the exporting country  . . . .” (emphasis added).  As explained by the
Chairman of the GATT Council at the time the Decision was adopted, this statement “does not mean
that the parties adhering to Article XVI:4 are forbidden from taxing the profits on transactions beyond
their borders, it only means that they are not required to do so ” (emphasis added).
243
4.433  Thus, where the applicable WTO rules provide that a category of income need not be taxed,
taxes on that income cannot be considered as “otherwise due.”  Any other reading of this provision
would be inconsistent with the ordinary meaning of both footnote 59 and of Article 1.1(a)(1)(ii).
4.434  The circular reasoning upon which the European Communities bases its argument shows
nothing other than that if income that is exempt from tax were not exempt from tax, there would be
additional government revenue.244  While this proposition is not, on its face, incorrect, it does not
address the controlling legal question of whether the hypothetical government revenue was “otherwise
due.”  In this case, WTO principles provide that the United States is not required to tax incomeattributable to foreign economic processes.  The fact that the provision through which the
United States chooses to exercise its right not to  tax such income is often referred to as an
“exemption” does not mean that taxes would be “otherwise due” any more than a decision to adopt a
territorial tax system and “exempt” income arising from activities outside the territory from tax means
that such a decision is an Article 1 “subsidy”.
4.435  Returning to the definition of “subsidy” in Article 1.1 of the SCM Agreement, the FSC does
not cause the US Government to forego revenue that is “otherwise due.”  As a result, the FSC does
not constitute a “financial contribution by a government” and, thus, is not a “subsidy” for purposes of
Article 1.1(a).  Consequently, the FSC cannot be a prohibited export subsidy within the meaning of
Article 3.1(a), because Article 3.1(a) requires that export subsidies must first be “subsidies . . . withinthe meaning of Article 1”.
4.436  That the FSC is not a “subsidy” within the meaning of Article 1 has far-reaching implications
in this case.  Not only does it dispose of the European Communities' Article 3.1(a) claim, it also
forecloses the European Communities' claim that the FSC is a prohibited import substitution subsidy
within the meaning of Article 3.1(b).  Article 3.1(b) requires as a threshold matter that a challengedmeasure be a subsidy under Article 1.  Moreover, it also defeats the European Communities' claim
that the FSC violates the export subsidy provisions of the AA, because those provisions must be
construed in light of the subsidy definitions of Article XVI of GATT 1994 and the SCM Agreement.
                                                     
241  First European Communities Submission, paragraphs 123-130.
242  VCLT , art. 31(1).
243  Tax Legislation , BISD 28S/114.
244  First European Communities Submission, paragraph 132.WT/DS108/R
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Accordingly, this definitional issue under Article 1 of the SCM Agreement is dispositive of all of the
European Communities' claims.
The European Communities Has Failed to Make a Prima Facie Case that the FSC Violates
WTO Rules
4.437  Finally, the United States notes that, as the complaining party, it is the European
Communities, not the United States, that bears the burden of proof in this case.245  As a result, the
European Communities is obligated to establish a prima facie  case with respect to each of the
elements necessary to demonstrate the violations alleged.  Establishing a prima facie  case requires
presenting both sufficient legal arguments and, where factual issues are in dispute, adequatesupporting evidence.  The Appellate Body has made th is clear, stating that a panel should begin “its
analysis of each legal provision by examining whet her the [complaining party] has presented evidence
and legal arguments sufficient to demonstrate that the . . . measures were inconsistent with the
obligations assumed by the [responding party] under each article of the [applicable] agreement
addressed by the Panel.”
246
4.438  To establish a prima facie case, the European Communities must provide a quantum of
evidence sufficient to establish a presumption that the FSC violates a provision of a WTO
agreement.247  In this regard, the Appellate Body has stat ed that “we find it difficult, indeed, to see
how any system of judicial settlement could work if it incorporated the proposition that the mere
assertion of a claim might amount to proof . . . [T]he party who asserts a fact . . . is responsible for
providing proof thereof.”248
4.439  Absent such a showing, the United States, as the responding party, need not rebut the
allegations.  The Appellate Body has explained that “[o]nly after such a prima facie determination has
been made by the Panel may the onus be shifted to  the [responding party] to bring forward evidence
and arguments to disprove the complaining party’s claim.”249
The European Communities Has Failed to Establish a Prima Facie Case that the FSC TaxExemption Is Per se a Prohibited Subsidy Under Article 3.1(a)
4.440  The European Communities first alleges that the tax exemption conferred by the FSC
constitutes a per se  prohibited export subsidy under Article 3.1(a) of the SCM Agreement.  This
argument is a legal, not a factual, argument.
4.441  With respect to this argument, the European Communities has failed to make a prima facie
case principally because, first, it has failed to  invoke the correct legal standard.  The European
Communities has ignored the fact that footnote 59 and the 1981 Council Decision qualify
paragraph (e) of Annex I by providing that the exem ption from tax of income attributable to foreign
economic processes (including income arising out of export transactions) does not constitute an export
subsidy.  Because the FSC does just that, the Euro pean Communities' argument is insufficient on its
face to support the contention that the FSC tax exemption is per se  prohibited by Article 3.1(a).
                                                     
245 The United States arguments reflected in paragraphs  4.437-4.439 apply with respect to all of the
claims of the European Communities.
246  EC – Measures Affecting Meat and Meat Products (Hormones) , WT/DS26/AB/R, WT/DS48/AB/R,
Report of the Appellate Body adopted 16 January 1998, at paragraph 109; see also , United States – Measure
Affecting Imports of Woven Wool Shirts and Blouses from India (Shirts and Blouses),  WT/DS33/AB/R, Report
of the Appellate Body adopted on 25 April 1997, at 16 (“a party claiming a violation of a provision of the WTOAgreement by another Member must assert and prove its claim”); and India – Patent Protection for
Pharmaceutical and Agricultural Chemical Products , WT/DS50/AB/R, Report of the Appellate Body adopted
on 16 January 1998, at 27 (noting that the Panel had “properly requir[ed] the [complaining party] to establish aprima facie  case” before proceeding to the next step of its evaluation of the claim at issue).
247  Shirts and Blouses,  at 13.
248  Id., at 14.
249  Hormones , at paragraph 109; see also , Shirts and Blouses , at 14.WT/DS108/R
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4.442  Furthermore, as a threshold matter, Article 3.1(a) requires that a measure first must be a
subsidy under Article 1.  In this case, the question of whether the FSC is a subsidy turns on whether it
involves the United States foregoing revenue “that is otherwise due.”  The principle underlying
footnote 59, however, indicates that no taxes need be levied on income attributable to foreign
economic processes.  Thus, revenue from such income is not due at all and cannot be said to be“foregone.”  By arguing that government revenue is foregone simply because a tax exemption is
conferred, the European Communities makes a conclusory assertion, not a legal argument tied to the
actual text of the SCM Agreement.
250
4.443  Indeed, in light of the established legal principle that income attributable to foreign economic
processes need not be taxed, and in light of Congress’ clear purpose to take advantage of preciselythat principle, the only export subsidy issue properly before the Panel is whether the FSC, in practice,
exempts more income than this principle allows.  This is the question raised by the second European
Communities allegation.
The European Communities Has Failed to Meet Its Burden of Proof With Respect to Its
Claim that the FSC Administrative Pricing Rules Constitute a Prohibited Subsidy UnderArticle 3.1(a)
4.444  The second major European Communities contention under Article 3.1(a) is that the FSC
administrative pricing rules allegedly contravene the arm’s length principle of footnote 59.  On this
point, the European Communities has failed to make a prima facie case for three reasons.  First, the
European Communities misconstrues the applicable legal standard under Article 3.1(a), and, as a
result, has failed to present any evidence relevant to that standard; namely, whether the FSCadministrative pricing rules allocate income attri butable to foreign economic processes to the FSC in
accordance with the standard of footnote 59.  Second, even under the mistaken theory on which the
European Communities relies, the European Communities has failed to present facts sufficient to
demonstrate that the FSC administrative pricing rules do not approximate arm’s length results.  Third,
the European Communities has failed to provide any evidence that the FSC administrative pricingrules result in a significant saving of direct taxes in export transactions.
The European Communities Has Relied on the Wrong Standard and Provided No Evidence
to Prove Its Claim Under the Right Standard
4.445  The European Communities maintains that the FSC administrative pricing rules contravene
the arm’s length principle of footnote 59 because they may produce results in individual transactions
that would differ from those that would be obtai ned under Section 482.  However, as demonstrated
above, this point is irrelevant.  What matters for purposes of footnote 59 is whether the FSC pricing
rules properly allocate income attributable to fore ign economic processes (or, conversely, whether the
FSC pricing rules improperly allocate income attributable to domestic  economic processes to the
FSC).  On this seminal question, the European Communities has provided no evidence.
4.446  In particular, the European Communities has presented no evidence even suggesting that the
FSC administrative pricing rules have resulted in an exemption for income attributable to domestic
economic processes.  The European Communities has not shown that the overall tax exemption
conferred by the FSC includes any income derived from economic activities occurring within  the
United States.
The European Communities Has Offered No Proof of a "Significant Saving" of Tax
                                                     
250  For the same reasons, the European Communities has failed to make a prima facie  case that the FSC
tax exemption violates Article 3.1(b).  Because the tax exemption does not result in foregone revenue that is
“otherwise due,” it does not constitute a subsidy under Article 1.  In addition, because the tax exemption is notan export subsidy under Annex I, it cannot, pursuant to footnote 5, be prohibited by Article 3.1(b).WT/DS108/R
Page 83
4.447  Finally, even assuming arguendo  that the FSC administrative pricing rules do allow for the
exemption of direct taxes on income attributable to domestic economic processes, the European
Communities has presented no evidence showing that the resulting tax saving from such exemption is
“significant,” as is required under footnote 59.
4.448  In short, the European Communities must prov ide the Panel with evidence showing both that
the FSC administrative pricing rules contravene the arm’s length principle of footnote 59 and that any
such contravention results in a significant saving of taxes.  In the absence of such evidence, the
European Communities' claim regarding the administrative pricing rules must be rejected.251
The European Communities  rebuts the United States' response in its Oral Statement at the First
Meeting of the Panel as follows:
Introduction
4.449  In discussing the more legal questions, the European Communities will follow the order of its
First Written Submission and deal first with the export subsidy and local content subsidies under the
SCM Agreement and then turn to the AA.
4.450  But first, the European Communities would just remind you that its First Written Submission
identified and objected to two subsidies in the FSC scheme.
4.451  The first was the tax exemptions comprised in the FSC scheme. The second was the
availability for the calculation of the foreign trade income of FSCs of special administrative pricing
rules which derogate from the transfer pricing rules which would otherwise apply. Both are
contingent in law on export of United States goods and on the use of United States rather than
imported inputs in the manufacture of those goods.
4.452  The European Communities makes this distinction between two aspects of the FSC scheme
because it is important that both be held to be prohibited subsidies so that both will have to be
withdrawn.
Export Subsidies – SCM Agreement
Introduction
4.453  In its First Written Submission the European Communities demonstrated that the tax
exemptions contained in the FSC scheme and the increased revenue forgone as a result of the
application of its administrative pricing rules constitute prohibited export subsidies by following asystematic approach dictated by the structure of the SCM Agreement.
- It first showed that they resulted in re venue forgone and conferred a benefit within
the meaning of Article 1.1 of the SCM Agreement;
- It then explained that by virtue of Article 2.3 of the SCM Agreement they would be
specific if contrary to Article 3 of the SCM Agreement.
                                                     
251 For the same reasons, the European Communities has failed to make a prima facie  case that the FSC
administrative pricing rules violate Article 3.1(b).  The European Communities' assertion fails for the samereasons discussed in connection with its assertion regarding the FSC tax exem ption:  (1) because the
administrative pricing rules do not result in foregone revenue that is “otherwise due,” those rules do not
constitute a subsidy under Article 1; and (2) because the administrative pricing rules are consistent with
footnote 59, they are not an export subsidy under Annex I, and, thus, under footnote 5 cannot be prohibited byArticle 3.1(b).WT/DS108/R
Page 84
- It then showed that the FSC subsidies were contingent in law upon export
performance contrary to Article 3.1(a) SCM Agreement.
4.454  Although the above is in fact sufficient to s how that the FSC subsidies are prohibited export
subsidies under the SCM Agreement, the European Communities went on to show that this result isconfirmed by Item (e) of the Illustrative List.  It is important to stress that the Illustrative List contains
a certain number of export subsidies which are deemed  to be included in the prohibition in
Article 3.1(a) of the SCM Agreement and of course that it is illustrative.
4.455  Item (e) specifically deals with export subsidies deriving from
“the full or partial exemption remission, or deferral specifically related to exports, of
direct taxes … paid or payable by industrial or commercial enterprises.”
And thus confirms that there is no implicit ex ception from the SCM Agreement for direct taxes.
4.456  Of course it is easy to show that the FSC subsidies come within Item (e) and this the
European Communities did in its First Written Submission.
The US Arguments
4.457  The European Communities will now comment on the United States' arguments.  Instead of
applying the SCM Agreement to the FSC scheme by starting with Article 1 (the definition of a
subsidy) and then applying Article 3.1 (the prohibition on export and local content subsidies) and
Item (e) of the Illustrative List (which deals with exemptions from direct taxes) in the light of its
footnote 59, the United States turns the whole system on its head and starts with footnote 59 which ithas to twist and turn to extract what it would wish to be a "controlling legal standard".
4.458  Fundamental to the United States case is a clever concept which it calls the “controlling legal
standard” or principle.  By this it is not referring to Item (e).  It is not even referring to the footnote to
Item (e).  It is referring to a principle which it wishes to read into the footnote and thus the SCM
Agreement but which does not in reality exist .
4.459  The United States refers to the second sentence of footnote 59 which states that
“The Members reaffirm the principle that prices for goods in transactions between
exporting enterprises and foreign buyers under their or under the same control should
for tax purposes be the prices which would be charged between independent
enterprises acting at arm's length.”
4.460  and claims
252 that:
“The necessary predicate of footnote 59 is that income from foreign economic
processes may be exempted from direct taxes.”
4.461  The United States does not clai m that footnote 59 says this.  Footnote 59 does not mention
“foreign economic processes” and does not exempt anything.  The United States claim is that theprinciple it would wish the Panel to apply underlies footnote 59.
4.462  This is not true. The European Communities will examine in a moment the arguments the
United States makes in support of its claim of an underlying principle or “necessary predicate,” which
rely heavily on a distortion not only of texts but also of negotiating history.  But first it is necessary to
point out that the United States approach to interpretation is incorrect and contrary to the DSU.
                                                     
252 Paragraph 59 of the US First Written Submission.WT/DS108/R
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The Correct Approach to Interpretation
4.463  The United States' claims can already be seen to be misguided from the fact that they derive
from a wrong approach to interpretation.
4.464  Panels are directed by Article 3.2 DSU to interpret the WTO Agreements  “in accordance
with customary rules of interpretation of public international law”. As the Appellate Body has
confirmed on a number of occasions these are codified in Articles 31 and 32 of the 1969 Vienna
Convention on the Law of Treaties.  Article 31.1 provides that
“a treaty shall be interpreted in good faith in accordance with the ordinary meaning to
be given to the terms of the treaty in their context and in the light of its object andpurpose”.
4.465  This means in particular that a treaty interpreter must respect the structure of the treaty and
interpret the words that are there.  He may not start by imagining a “necessary predicate” of a footnote
to an Annex containing an Illustrative List and distort all the rest of the Agreement to fit in with what
he wishes this footnote to mean.  This is turning interpretation on its head.
4.466  In order to justify this approach, the United States makes a lex specialis argument.
253
4.467  The United States refers to the Appellate Body’s advice to Panels in Bananas254 to examine
more specific provisions first, which the United States says derives from the interpretative principle of
generalia specialibus non derogant.
4.468  We can leave to one side the question of whether the Appellate Body was confirming the
applicability of a principle of “lex specialis”  or simply giving panels a lesson in “judicial economy”.
(This principle is not mentioned in the Vienna Convention and its application to the WTO is notwithout difficulty in the light of the general interp retative note to Annex 1A of the WTO.)  For present
purposes it is sufficient to note that we are not concerned here with different agreements or even
provisions – we are examining  a single legal norm .  That is the prohibition of export subsidies in
Article 3.1(a), which expressly  includes  the export subsidies in the Illustrative List, which of course in
turn includes  Item (e) and its footnote. There is no scope here for lex specialis.   The United States is
seeking to persuade the Panel to do the opposite of what Article 31 of the Vienna Convention
requires, that is to interpret footnote 59 out of context .  Its context is first the text of Item (e) which
expressly deems to be an export subsidy “the exemption of direct taxes payable by commercial
enterprises if this is “specifically related to exports”, and second Article 3.1(a) itself which prohibits
subsidies contingent in law or fact on export performance. The applicability of these provisions to theFSC subsidies could hardly be clearer.
4.469  The United States is also asking the Panel to disregard Article 31 of the Vienna Convention
by interpreting not only Article 3.1(a) and Item (e) but also footnote 59 divorced from the ordinary
meaning of the terms used.  The terms of footnote 59 do not refer to “foreign economic processes” as
being exempted from tax.
The other defects in the United States arguments
4.470  Do not imagine that this is the only weakness in the United States argument.  Let us examine
the other arguments the United States makes in s upport of the existence of its “controlling legal
standard”. These are:
                                                     
253 It is perhaps a recognition of its weakness that it is contained only in a footnote (footnote 68 to
paragraph 89 of the US First Written Submission).
254 European Communities - Regime for the Importation, Sale and Distribution of Bananas ,
WT/DS27/AB/R, Report of the Appellate Body adopted 25 September 1997, paragraph 204.WT/DS108/R
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• First that if there were no such principle, the arm’s length principle (which is
mentioned in footnote 59) would be irrelevant.255
• Second that this “controlling legal standard” is well-established in pre-existing GATT
law.  The argument that, in the absence of the "controlling legal standard", the
arm's length principle would be irrelevant
4.471  The reference to arm’s length prices in footnote 59 reads as follows:
 “The Members reaffirm the principle that prices for goods in transactions between
exporting enterprises and foreign buyers under their or under the same control should
for tax purposes be the prices which would be charged between independent
enterprises acting at arm's length.”
4.472  This sentence is not irrelevant – it is stating that one of the ways in which an export subsidy
can be given is by allowing an exporter to sell at an undervalue to a foreign related buyer.  Of coursethis sentence assumes that the foreign related buyer may not be taxed at the same level as the exporter
and this may lead to a lower total tax charge for the income arising from the export transaction.  There
may be all sorts of reasons for this factual circumstance.  The quoted sentence does not say or even
imply that the exporting country has the right to exempt from tax income from an export transaction
which would otherwise bear tax.  If it did, it would be directly contradicting both Item (e) andArticle 3.1(a).
The argument that the "controlling legal standard" is well-established in pre-existing
GATT law
4.473  The second United States argument – that the “controlling legal standard” is well-established
in pre-existing GATT law is based on the Decision of the GATT 1947 Contracting Parties to adopt the
Panel Reports in the Tax Legislation Cases
256 and includes a claim that this is part of the negotiating
history of footnote 59.
4.474  The European Communities has a number of comments to make on these claims.
• First the Understanding in the Tax Legislation cases is irrelevant to the present case
which is based on the SCM Agreement, not Article XVI GATT.
• Second, the Understanding is not part of GATT 1994;
• Third, the Understanding in the Tax Legislation cases does not contain the claimed
“controlling legal standard”.
4.475  It ought not to be necessary to spend much time on GATT history and the Understanding in
the Tax Legislation cases for the simple reason that this is related to Article XVI GATT 1947 and the
present case is based on the SCM Agreement.
4.476  The European Communities does not wish to belitt le the importance of these cases at the time
or the quality of the work performed by the persons involved in the 1970s and 80s, but the world, and
the WTO, have moved on since then.  We now have a detailed SCM Agreement with a specific andstrict prohibition of export subsidies, including t hose deriving from the exemption of direct taxes
                                                     
255 Paragraph 91 of the US First Written Submission.
256 United States - Tax Legislation (DISC) , L/4422, BISD 23S/98; Tax Legislation - Income Tax
Practice Maintained By France , L/4423, BISD 23S/114; Tax Legislation - Income Tax Practice Maintained By
Belgium , L/4424, BISD 23S/127; Tax Legislation - Income Tax Practice Maintained By The Netherlands ,
L/4425, BISD 23S/137. All the reports were adopted on 7-8 December 1981 on the basis of an Understandingpublished in BISD 28S/114.WT/DS108/R
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specifically related to exports – something which did not exist in 1973 when the Tax Legislation cases
were brought. One could also add that there is now a superior system of dispute settlement in
existence.
4.477  The United States further claims that the Understanding in the Tax Legislation cases is part of
the negotiating history of the predecessor to footnote 59, footnote 2 to Item (e) to the Tokyo Roundrevision of the Illustrative List.  This is false.  One reason is that the Understanding was adopted in
December 1981, more than two and a half years after the conclusion of the Tokyo Round SCM
Agreement. The Understanding was proposed after conclusion of the Tokyo Round and was the
subject of political compromise up to the last moment.  Some elements of the Understanding repeat
elements found in the Illustrative List but this is not the case with the reference to “foreign economic
processes” on which the United States relies so heavily.
4.478  Another reason why this contention is incorrect is that, as US President Jimmy Carter stated
in his Memorandum of 4 January 1979 notifying the US Congress that he intended to conclude the
Tokyo Round Agreements (which the European Comm unities annexes to this statement as Exhibit
EC-23), the Tokyo Round the SCM Agreement introduced a “flat prohibition of export subsidies” and“a definition of export subsidy which abolishes the existing dual pricing requirement”.
257
4.479  The Tax Legislation  reports are all based on the thesis that the legislation under review leads
to dual pricing, that is lower prices for exports th an for domestic sales.  Since this requirement has
been abolished and the current rules on export pricing are tighter, the Tax Legislation  reports are no
longer relevant.
4.480  The United States attempts to give current force and relevance to the Understanding by
claiming that it is a decision of the GATT Contracting Parties which is carried over into the WTO byvirtue of Article XVI:1 of the WTO Agreement  and paragraph 1(b)(iv) of the introductory language to
GATT 1994
258, even claiming259 that this even makes the Understanding “subsequent practice” within
the meaning of Article 31(3)(b) of the Vienna Convention on the Law of Treaties .
4.481  The Appellate Body has explained the status of such decisions in Japan – Taxes on Alcoholic
Beverages260 and this entirely contradicts the position of the United States in the present case.  The
Appellate Body sa id the following:
“[W]e do not agree with the Panel's conclusion in paragraph 6.10 of the Panel Report
that "panel reports adopted by the GATT CONTRACTING PARTIES and the WTO
Dispute Settlement Body constitute subsequent practice in a specific case" as the
phrase "subsequent practice" is used in Article 31 of the Vienna Convention .  Further,
we do not agree with the Panel's conclusion in the same paragraph of the Panel
Report that adopted panel reports in themselves constitute "other decisions of the
CONTRACTING PARTIES to GATT 1947" for the purposes of paragraph 1(b)(iv)
of the language of Annex 1A in corporating the GATT 1994 into the WTO
Agreement .”
4.482  The 1981 Decision adopting the Tax Legislation reports may be unusual to the extent that it
qualified those reports but this does not change its legal nature.  Panel reports were always only
proposals to the GATT CONTRACTING PARTIES which was the body which adopted
recommendations for the resolution of disputes  and so the GATT CONTRACTING PARTIES was
                                                     
257 See page 1935 of the document in Exhibit EC-22
258 Paragraph 103 of the US First Written Submission.
259 Paragraph 104 of the US First Written Submission.
260 WT/DS8/AB/R, WT/DS10/AB/R, WT/DS11/AB/R of 4 October 1996 (AB-1996-2) at page 13.WT/DS108/R
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doing no more than fulfilling its role. Therefore the United States is wrong to suggest that the 1981
Decision is “akin to an authoritative statement.”261
4.483  In any event, the Understanding in the Tax Legislation cases does not contain the principle or
“controlling legal standard” claimed by the United States.  The relevant part states that:
 “… economic processes (including transactions involving exported goods) located
outside the territorial limits of the exportin g country need not be subject to taxation
by the exporting country and should not be regarded as export activities in terms of
Article XVI:4 of the General Agreement.”262
4.484  Please note that it says that economic processes (that is all economic processes, not just
export activities) which are outside the territorial limits of the exporting country need not  be subject to
taxation by the exporting country.  It does not say that a GATT Contracting Party may specifically
exempt transactions relating to exported goods even where other economic processes, which may be
considered outside the territorial limits of the exporting country, are subject to tax.
4.485  This is a fundamental weakness of the United States case.  Even if one accepts all the
United States legal construction seeking to make the 1981 Understanding relevant to this case (and theEuropean Communities does not) the Understanding does not say what the United States would wish
it to say.  It never did say what the United States would wish it to say as the European Communities
and seven other countries pointed out when they ob jected to the FSC and held formal consultations
under Article XXII GATT 1947 on 26 March 1985.
263
Conclusion
4.486  The conclusion is clear.  The "controlling legal st andard" that the United States is proposing
does not exist.  It is a figment of the United States imagination designed to defend the indefensible.
The Administrative Pricing Rules
4.487  The United States follows a similar approach to that it employs in respect of the first FSC
subsidy when responding to the European Communities' arguments that the special administrativepricing rules which are available to FSCs also constitute a prohibited export subsidy.  It constructs a
legal standard that it would wish to prevail and then argues that the European Communities has not
proved that these rules infringe the standard.  The United States is wrong on all counts.
4.488  The reason why the special administrative pricing rules give rise to a prohibited export
subsidy is that they result in revenue forgone, confer a benefit, and are only available in respect ofexport sales.  Exporters have a choice that is available to no other taxpayers and in particular not to
importers and domestic transactions. Just as for the first FSC subsidy, one does not need to consult the
Illustrative List to come to this conclusion.
4.489  But, as before, the conclusion is confirmed by the Illustrative List. The Illustrative List
confirms in the sentence of the footnote which I have already quoted twice that one of the ways (notthe only way) an export subsidy can be given is through allowing the use of non-arm’s length pricing.
4.490  The United States again attempts to read into the footnote conditions which are not there and
which it wishes were there. It claims to read this footnote as allowing it to designate a certain category
of economic processes as “foreign” – that is “distributor functions”
264 – and to exempt them from tax
– provided of course that they relate to the export of United States goods.  It candidly admits that the
                                                     
261 Paragraph 104 of the US First Written Submission.
262 BISD 28S/114.
263 See paragraphs 21 and 112 of the European Communities First Written Submission.
264 Paragraph 108 of the US First Written Submission.WT/DS108/R
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administrative pricing rules will not correctly allocate profit between the persons involved (the FSC
and its related supplier) but claims that the two companies should not really be regarded as separate265
and that allocating all “income attributable to distributor functions” to the FSC is just a convenientdevice for taking advantage of a pretended WTO right.
4.491  Of course, footnote 59 says no such thing.  One only needs to look at it to see that it is
referring to arm’s length pricing between related persons not the allocation of income between
“economic processes.”
4.492  The United States position derives from its wishful importation into the SCM Agreement of
the pretended “controlling legal standard” that what a Member arbitrarily deems to be a “foreign
economic process” may be exempted from tax on any condition it pleases, including exportcontingency. The European Communities has refuted this contention above.
4.493  The indefensibility of the United States position is further evident from its admission that the
FSC does not have to carry out these “foreign ec onomic processes” itself, it may subcontract them
back to its related supplier.  According to the Unit ed States they remain “foreign economic processes”
because the FSC is paying for them and is “legally and financially responsible
266” for them.
4.494  The United States position becomes quite worrying, when it states that “Congress chose to
exempt from tax less income than the United States was entitled to exempt under GATT rules267”
4.495  One must assume that according to the United States thesis, a country could legitimately take
the view that the sale of goods to foreigners is 50 per cent or 100 per cent a “foreign economic
process” and devise a scheme whereby the profit is siphoned off to an offshore “foreign sales
corporation” and allowed to be remitted to the parent as a tax free dividend.  The “foreign sales
corporation” would to take “legal and financial responsibility” for the production and export of thegoods, but would of course be entitled to subcontract the production and export back to its parent.
Why should a more determinedly export subsidizing Member than the United States stop at the
modest incentives allowed by the FSC scheme and not completely exempt from tax the income from
the sale of “export property”?
4.496  What is there "foreign" about economic activities relating to the export of United States goods
which are all conducted in the United States?  An FSC can subcontract all its activities back to its
parent and this may make no difference to the amount of tax benefit.
The de minimis arguments
4.497  The United States brings a further argument in defence of the FSC scheme – that is that the
subsidies it provides are de minimis and therefore escape prohibition.
4.498  This is based on the reference in the footnote 59 to a significant saving of direct taxes in
export transactions. The sentence reads:
"Any Member may draw the attention of another Member to administrative or other
practices which may contravene this principle and which result in a significantsaving of direct taxes in export transactions."
4.499  The United States argument is misguided because the sentence only refers to the right to draw
attention to such practices and the word “significant” is simply designed to avoid Members from
invoking individual cases of minor importance.
                                                     
265 Paragraph 109 of the US First Written Submission.
266 See e.g. paragraphs 52 and 126 of the US First Written Submission.
267 Paragraph 130 of the US First Written Submission.WT/DS108/R
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4.500  The prohibition on export subsidies is absolute.  There is no de minimis rule.  The existence of
a de minimis rule in countervailing duty cases is dictated by the different nature of this remedy and in
particular the fact that countervailing duties can only be imposed where there is injury and injury is
not likely where the price effect is less than 1 per cent. Also the de minimis rule in countervailing duty
cases applies only to the imposition of duty on the product of an exporter.  No subsidy scheme  escapes
countervailing duty because it amounts to less than 1 per cent of sales value.
4.501  In any event, the FSC subsidies are significant at US$2 billion per year according to the
United States own estimates.  The success of the scheme demonstrates that it is of interest exporters.
Companies are normally quite keen to take measures that add 1 per cent or so to their profit margins.
This may after all increase their profits by 10 or 20 per cent and this is what matters to companies.
4.502  Even the  ad valorem effect can of course, in some cases, be much more than the 0.93 per cent
claimed by the United States, since this is only an average.
4.503  The FSC scheme is important since it applies throughout the United States economy.  In this
regard, the United States would have you believe that  a 0.3 per cent increase in United States exports
is insignificant.  It is not. It is enormous and in any event much greater than trade effects theUnited States has complained of in the past.
Most FSCs are not foreign
4.504  It is not only because the economic activities of the FSC may be carried out in fact by the
related supplier that they are not foreign.  They would also not be foreign even if carried out by the
FSC where the FSC is established in a United States territory or possession.
4.505  The European Communities pointed out that, according to US Treasury data
268, United States
possessions host 74 per cent of all FSCs.  66 per cent of all FSCs are located in the US Virgin Islands.
4.506  The main location for FSCs is the US Virgin Islands.  This is an organised, unincorporated
territory of the United States, administered by the Office of Territorial and International Affairs in the
US Department of Interior.  It elects a me mber to the US House of Representatives.
4.507  The tax legislation of the US Virgin Islands is contained in the US IRC.  Section 932 of the
IRC provides that the United States will be treated as including the Virgin Islands for purposes of
determining the United States tax liability of United States citizens or residents with Virgin Islands
income.
4.508  According to the Naval Appropriations Act of 12 July 1921, “the income tax laws now in
force in the United States of America and those which may hereafter be enacted shall be held to belikewise in force in the Virgin Islands of the United States.”
4.509  A Virgin Islands tax publication of July 1992 states that “the 1984 Tax Equity and Fiscal
Responsibility Act (…) make the Virgin Islands a highly attractive location for United States
exporters desiring to form FSCs.  United States exporters can earn tax-exempt income by using V.I.
FSCs to perform some sales activities outside the United States that a United States company might
otherwise perform” (emphasis added).
269
4.510  The United States claim that the FSC havens which are United States territories and
possessions are foreign is that they are not part of the United States customs territory.  This is not the
correct test.  Even the 1981 Understanding on which the United States relies so heavily refers to
"transactions involving exported goods . . . located outside the territorial limits of the exportingcountry." That is not the case of the United States territories and possessions. In addition these
                                                     
268 See Table 6.1 on page 20 of the Treasury Report for 1992-1993 in Exhibit EC-5.
269 See Exhibit EC-18.WT/DS108/R
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territories and possessions are not separate WTO Members but come under the responsibility of the
United States. The fact that they are different customs territories is simply a matter of formal
definition.
4.511  WTO Members are not obliged to collect customs duties or to have customs territories at all.
The fact that a part of their territory is deemed outside their customs territories or to be a separatecustoms territory cannot exempt them from WTO obligations.  Otherwise the scope for abuse is
enormous. Parts of ports could be excluded from a customs territory and used to grant export
subsidies.
Burden of Proof
4.512  The United States relies heavily on the allegation that the European Communities has not
proved that the FSC scheme exempts from tax more than it is entitled to.
4.513  The first answer to this objection is that the FSC scheme is not entitled to exempt anything
from tax if this is contingent on export performance or specifically related to export.
4.514  The second answer is that it is proved that th e FSC scheme provides a benefit.  The European
Communities demonstrated by reference to the United States own documents how much revenue
forgone is involved.
4.515  Even accepting arguendo the United States view that the availability of exemptions and
favourable pricing rules is not in itself a benefit and a benefit compared with the situation that would
prevail if what it describes as the “controlling legal standard” applied it can easily be demonstrated
that the FSC scheme provides a benefit by offering taxpayers a choice.
4.516  Most FSCs use exclusively the administrative pricing rules
270, which already demonstrates
how advantageous they are.  But in addition there are two rules and taxpayers can choose the one
which gives the most favourable result transaction by transaction and ex post .  If the special
administrative pricing rules did provide an approximation to arm’s length pricing or even a
“controlling legal standard” then why should there be two rules one of which can give twice the tax
exemption of the other?  If one of these tests gives the right result the other must give the wrongresult.  By giving taxpayers a choice there is clearly revenue forgone.
4.517  In addition, what administrative convenience is involved in giving taxpayers such a choice?
In reality the only purpose of the special administrative pricing rules is to shelter a part of export
profits from United States tax.
Footnote 5
4.518  The United States has referred to footnote 5 to the SCM Agreement to support its argument.
This does not support its position since it only relates to measures which are considered not to be
export subsidies in the Illustrative List.  If it exempted subsidies not expressly prohibited by the
Illustrative List, it would be transforming the Illustrative List into an exhaustive list,  which would be
contrary to the expressed intent.
Conclusion
4.519  The European Communities concludes that the FSC scheme is a clear prohibited subsidy
within the meaning of Article 3.1(a) of the SCM Agreement and Item (e) of the Illustrative list inAnnex I to the SCM Agreement.
The United States  further responds in its Oral Statement at the First Meeting of the Panel as follows:
                                                     
270 See Testimony of Joseph J. Guttentag in Exhibit EC-2, page 11 and discussion above.WT/DS108/R
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4.520  At the outset, perhaps we should clarify what it is we are talking about in this dispute.  What
we have here is a situation where a WTO Member taxes income attributable to domestic economic
processes involving the sale of goods, but does not tax foreign economic activities involving the sale
of goods in export transactions.  The European Communities claims that this type of situation
involves an export subsidy.
4.521  What the United States has described to you is what happens in a typical territorial tax
system.  The FSC was specifically designed to emulate the features of a territorial system.  The
European Communities' position is that it is permissible for European Communities countries with
territorial or territorial-type systems to decline to tax income arising out of foreign economicactivities, but that it is impermissible for WTO Members with a different type of tax system, such as
the United States, to do the same.  However, the WTO rules must apply equally to all.  Thus, if the
FSC constitutes an export subsidy, then so, too, do the tax systems of those WTO Members with
territorial tax systems or tax systems that incorporate this particular feature of a territorial system.  In
other words, if the Panel accepts the European Communities' legal theory, then the tax systems ofmost, perhaps even all, WTO Members – including European Communities member States – will be
transformed overnight into prohibited export subsidies, and there will be an awful lot of activity under
Article 4 of the SCM Agreement.
4.522  However, this should not be the outcome.  As previously noted, the European Communities'
claims should be dismissed for procedural reasons.  However, putting aside procedural issues, the
European Communities' case is fatally flawed on the merits because the European Communities
ignores the controlling legal standard applicable to its claims.  As a result, the European Communitieshas not supplied the Panel with sufficient evidence to meet its burden of presenting a prima facie  case,
and the Panel should reject the European Communities' claims.
The FSC tax  exemption is not an export subsidy
4.523  The first task faced by the Panel in this case is  to identify the controlling legal principle that
serves as the analytical starting point.  The pivotal GATT/WTO principle applicable here is that
Members are not obliged to tax income attributable to foreign economic activity, and declining to tax
such income does not give rise to an export subsidy.
4.524  This is the principle on which the GATT Council (and France, Belgium, the Netherlands, and
the United States) resolved the Tax Legislation Cases  in 1981.  This is the principle on which
Members, including the European Communities member States and the United States, have relied,
and on which they continue to rely.  This is the pr inciple that applies equally to Members today.  And
this is the principle around which the FSC was designed.  If the European Communities contests the
continuing validity of this principle, and if the Panel accepts the European Communities' arguments,
the implications of this case will be far-reaching, indeed.
4.525  Beginning with the FSC tax exemption, which the European Communities claims is a
prohibited export subsidy in and of itself, the Eu ropean Communities fundamentally misconstrues the
relevant standard under the SCM Agreement.  The European Communities does so because it fails to
take into account the controlling provision of the SCM Agreement – footnote 59 in Annex I.
Footnote 59 brings forward into the WTO the pr ior GATT standard regarding tax exemptions for
income attributable to foreign economic activities.  This standard was most clearly articulated in the
1981 Council Decision adopting the Tax Legislation Cases .  Because the European Communities
ignores footnote 59, it fails to recognize that footnote 59 qualifies the general rule contained in
paragraph (e) of the Illustrative List of Export Subsidies regarding direct tax exemptions related to
export transactions.
4.526  More specifically, the European Communities overlooks the threshold question of what types
or sources of income must be taxed.  Clearly, if, under WTO rules, a WTO Member is not obligated toWT/DS108/R
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tax certain categories of income, then the exemption of such income from taxation cannot constitute a
subsidy, let alone an export subsidy.
4.527  Footnote 59 indicates that one type of income that WTO Members are not required to tax is
income derived from economic activities occurring outside their respective territories, even if those
activities relate to export transactions.  Because such income need not be taxed, its exemption fromtaxation does not constitute an export subsidy.
4.528  The reasons for allowing income attributable to foreign economic processes to go untaxed are
not hard to fathom.  This type of treatment of such income is common to most, perhaps all, WTO
Members.  Although they exempt such income from tax through different methods and to varying
degrees, most countries do not tax most income of foreign companies operating abroad.  Somemembers of the European Communities, for example, tax only economic processes occurring within
their borders.  Under these tax systems, even  the income of domestic companies – including
subsidiaries and branches of domestic companies – arising out of activities that they engage in abroad
is not taxed.  The effect of a territorial or territorial-type system is that foreign activities of domestic
companies that are specifically related to export transactions are exempted from taxation, even thoughthe same activities are taxed when conducted within a country’s territory.
4.529  If exempting income arising out of foreign economic activities were deemed to constitute an
export subsidy, then all of these classes of income would have to be taxed, and almost every tax
system in the world would be in violation of WTO ru les.  It is unlikely that the drafters of the SCM
Agreement intended such a result, and footnote 59 is evidence that they did not.
4.530  This reality of the tax systems of WTO Members is reflected in the history that led to the
eventual inclusion of paragraph (e) and footnote 59 in the SCM Agreement.  This history reveals thatthe GATT Contracting Parties and WTO Members never were of the view that nations must tax
income derived from foreign economic processes.  The United States has recounted this history in its
First Submission, and need not repeat it here.  Suffice it to say that paragraph (e) traces its origins to a
proposal made by a nation that has long exempted income attributable to foreign economic processes
from taxation and that never intended that such an exemption would be considered a prohibitedsubsidy.
4.531  This understanding among Contracting Parties regarding the treatment of income attributable
to foreign economic processes is expressed most clearly in the 1981 Council Decision.  The panel in
the Tax Legislation Cases  had just rejected this understanding by declaring that territorial tax systems
and tax systems with territorial features inherently subsidize exports.  The Council essentiallyreversed the panel, and expressly stated what had been understood all along:  “economic processes
(including transactions involving exported goods) located outside the territorial limits of the exporting
country need not be subject to taxation by the exporting country and should not be regarded as export
activities in terms of Article XVI:4 of the General Agreement.”  The lone qualification that the
Council made with respect to ex empting income attributable to foreign economic processes from
taxation is that the allocation of income between related parties must reach a result consistent with the
arm’s length principle.
4.532  The GATT practice regarding the taxation of income attributable to foreign economic
processes was carried over into footnote 59 of the SCM Agreement.  The footnote uses essentially the
same language as the GATT Council in stating that the arm’s length principle applies to relatedparties in export transactions.  The purpose of footnote 59 is manifest from its text – it qualifies the
general rule stated in paragraph (e) by indica ting that income attributable to foreign economic
processes need not be taxed.  If this were not the case, much of footnote 59 would have no meaning,
an unacceptable result under customary rules of treaty interpretation.
4.533  To whatever extent footnote 59, or the SCM Agreement more broadly, can be said to be
unclear on this point, past practice, which forms part of the context, should be dispositive.  The 1981
Council Decision is not merely persuasive, as any decision of the GATT Contracting Parties to adoptWT/DS108/R
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a panel report would be.  Instead, the 1981 Council Decision is tantamount to an authoritative
interpretation of GATT Article XVI:4, which must be read in harmony with the analogous provisions
of the SCM Agreement.  Unlike most decisions to adopt a panel report, which contain no statement of
whether the Contracting Parties agreed or disagreed with the reasoning contained in the report, in its
1981 Decision, the Council made its views known.  Those views should be respected here, because
the fundamental issues before this Panel are essentially the same as those that were before the Council
in 1981 – namely, the extent to which a failure to tax income attributable to foreign economic
processes violates WTO subsidies disciplines.
4.534  If it is correct that Members are not required to tax income arising out of foreign economic
activities – and that principle is indisputably correct – then the European Communities' first exportsubsidy claim (that the FSC tax exemption is prohibited per se ) cannot stand.  Just as territorial tax
systems stop short of taxing foreign economic activity, the United States is free to do the same.  This
is precisely what the FSC is designed to do, as th e explicit statements of the US Congress made clear
when the FSC was enacted.  Thus, the only possible legitimate objection that the European
Communities could have to the FSC is that the FSC allegedly does not grant the WTO-permittedexemption accurately, not that income attributable to foreign economic activity cannot be exempted at
all.  In other words, this is a dispute about the details of implementation, not about principle.
4.535  Because the European Communities has failed to demonstrate – or even provide any evidence
– that the FSC tax exemption covers anything other than income attributable to foreign economic
activities, the European Communities has failed to make a prima facie  case.  The fact that the
European Communities does not acknowledge the principle underlying the 1981 Council Decision
and footnote 59 is not only striking, it is alarming.  As stated previously, if the principle articulated by
the Council in 1981 is no longer valid, then the ta x systems of most WTO Members, including those
of EC member States, will be the subject of future disputes and will be found to be export subsidies.
The FSC tax exemption is not a subsidy
4.536  For the reasons just discussed, the European Communities also is unable to show that the FSC
tax exemption is a subsidy for purposes of Article 1 of the SCM Agreement.  In order for the FSC tax
exemption to constitute a subsidy, it must involve the United States foregoing “revenue that is
otherwise due.”  As previously explained, under WTO rules, WTO Members need not tax income
attributable to foreign economic processes.  Therefore, such income cannot be considered to be “due”
at all.  Because the FSC tax exemption does not involve a “financial contribution,” the FSC is outsidethe scope of Article 1.
The FSC administrative pricing rules do not constitute export subsidies
4.537  The European Communities' second major claim is that the FSC administrative pricing rules
constitute separate export subsidies in and of themselves.  As noted previously, this is an issue ofdetail, of implementation.  It is not an issue of fundamental principle.
4.538  As an aside, the United States must note a certain oddity in the European Communities'
position that the FSC administrative pricing rules can exist separately from the FSC tax exemption,
and that the Panel must make findings with respec t to both the tax exemption and the administrative
pricing rules.  If the European Communities is co rrect that income attributable to foreign economic
processes may not be exempted from tax – and the United States reiterates that the European
Communities is not correct – the administrative pricing rules are irrelevant.  If such income must be
taxed, then it really does not matter, for purposes of WTO subsidy rules, whether 0, 50, or 100 per
cent of the income earned in an export tr ansaction is attributed to those activities.
4.539  However, putting this point aside, the European Communities' attack on the FSC
administrative pricing rules also lacks merit.  Here, too, the main defect in the
European Communities' position is that it relies on an incorrect legal standard.  Instead of arguing thatthe FSC administrative pricing rules improperly allocate income from domestic, as opposed toWT/DS108/R
Page 95
foreign, economic activities – as the European Communities must do to show a violation of
Article 3.1(a) – the European Communities mistak enly asks the Panel to examine whether the
administrative pricing rules achieve results that are different from those that might obtain under
Section 482 of the US Internal Revenue Code.  As explained in the First US Submission, however,
Section 482 does not supply the definition of arm’s length for purposes of the SCM Agreement.Instead, the fundamental question with respect to this European Communities claim is whether or not
the FSC administrative pricing rules generate results that fall within an acceptable range of arm’s
length values for purposes of footnote 59, and, if they do not, whether they result in a significant
saving of direct taxes in export transactions.
4.540  Having ignored the governing legal standard, the European Communities naturally has not
presented any evidence on point.  The European Communities not only has failed to prove that the
FSC administrative pricing rules result in the exemption from tax of income attributable to domestic
economic processes, but also has failed to show that  any resulting tax saving on income attributable to
domestic  economic processes is “significant,” as footnote 59 requires.  Unless and until the European
Communities does so, it has not made a prima facie  case that the FSC administrative pricing rules
constitute an export subsidy.
4.541  The European Communities' misunderstanding of the governing legal standard is matched by
its misunderstanding of how the FSC rules actually operate.  The European Communities would have
the Panel believe that what matters is whether the FSC itself, using its own in-house resources,
performs certain activities in export transactio ns.  The European Communities maintains that some
FSCs do little and that under the FSC rules they re ceive a share of income that is disproportionately
large.  From this, the European Communities concludes that FSCs are “shams,” providing a way forUS exporters to improperly shift a portion of fully-taxable income to partially-exempt FSC income.
4.542  The European Communities simply has it wrong.  What matters about FSCs is not whether
they perform through their own in-house resources su fficient activities by themselves to justify the
allocation of income allocated to them under the administrative pricing rules.  What matters under
footnote 59 is whether income is allocated in such a way as to isolate the income attributable toforeign economic activities – the income which, under WTO rules, need not be taxed.  The FSC rules
make FSCs responsible for all sales and distribution functions in covered export transactions.  This
means that where a FSC has not performed such a function itself through its own in-house resources,
it is required to pay the party who did.  Thus, even  if a FSC were not considered as performing the
foreign economic processes carried out by its agents, it would be appropriate to attribute all sales anddistribution activities to FSCs because these functions are the part of export transactions that typically
occur abroad.
4.543  In this regard, it is important to bear in mind that not all income derived from the sales and
distribution activities attributed to FSCs is ex empt from income.  Instead, the exempted amount
(approximately 15 per cent, or 15/23's of 23 per cent) reflects (somewhat conservatively) the portionof the FSC export transaction that generally occurs outside of the United States.
4.544  The European Communities has provided the Panel with no basis on which it could conclude
that the FSC tax exemption is not justified by economic processes conducted outside of the
United States.  The European Communities has not even asked the question.  Instead, the European
Communities merely asserts that no methodology akin to the FSC administrative pricing rules isacceptable.  However, such an assertion is at odds with the text of footnote 59, which plainly
contemplates that Members may use “administrative and other practices” so long as they do not
contravene the arm’s length principle and do not result in a “significant” saving of direct taxes in
export transactions.  Moreover, the European Communities' assertion that the mere availability of a
choice of methods violates footnote 59 ignores the fact that it is the overall results of a method, rather
than the label attached to a method, that matter.
4.545  The European Communities has to do more than merely point to the methodology underlying
the FSC administrative pricing rules.  It must show that those rules achieve impermissible results.WT/DS108/R
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Notwithstanding the existence of publicly available information that the European Communities could
have examined in an effort to determine whether the FSC rules do achieve impermissible results, the
European Communities has presented no empirical evidence whatsoever.  For that reason alone, its
claim regarding the FSC administrative pricing rules should be rejected.WT/DS108/R
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Observations Regarding the European Communities' Oral Statement
4.546  The United States now would like to comment briefly on some of the points made by the
European Communities in its Oral Statement.  First, regarding the European Communities'
characterisation of the FSC and its relationship to Subpart F of the Internal Revenue Code, Subpart Fis an exception to the normal rule of deferral.  Thus, if one wants to use the term “exception,” the FSC
is an “exception to an “exception.”
4.547  Regarding the European Communities' assertion that FSCs are “shams,” the United States
disagrees, and refers the Panel to our written submission on this point.  Here, I just will reiterate that it
is relatively inexpensive to establish a corporation, such as a FSC, but much more expensive to runone.
4.548  Regarding the European Communities' characterization of the FSC as a functional equivalent
to the DISC, the FSC is quite different from the DISC.  These differences are laid out in detail in our
written submission, principal differences being that FSCs are subject to foreign presence, foreign
management, and foreign economic process requirements to which DISCs were not subject.
4.549  Regarding the European Communities' accusation th at the United States has failed to follow
the treaty interpretation rules of the Vienna Conv ention, the United States believes that it is the
European Communities that has failed to follow thos e rules.  The United States has looked at the
SCM Agreement in light of its text, context, object and purpose, while the European Communities has
looked selectively at certain portions of the text alone.
4.550  With respect to the European Communities' refere nce to President Carter’s notification of the
Tokyo Round agreements, it does not establish anything regarding the status of the 1981 CouncilDecision, because the Council Decision did not referen ce the bi-level pricing issue to which President
Carter’s notification referred.
4.551  With respect to the European Communities' appr oach to footnote 59, it essentially reads it out
of existence.  The drafters must have intended that footnote 59 have some meaning, and the principle
of effectiveness creates a presumption that they did.
4.552  Regarding the European Communities' reference to the fact that FSCs have a choice among
transfer pricing methods, taxpayers have a choice under Section 482.
4.553  Finally, with respect to the European Communities' claim that the United States should have
sought to exempt the FSC from subsidy discipli nes during the Uruguay Round, in the view of the
United States, the FSC did not constitute a subsid y under the rules existing prior to the conclusion of
the Round, and there was no reason for the United States to “pay” to have clarified something that it
already had – namely, rules under which the FSC was not considered to be a subsidy – and that it
continues to have under the current rules.
The European Communities  further rebuts the United States' response in its Second Submission as
follows:
Introduction
4.554  The European Communities argued in its First Written Submission that:
• the tax exemptions contained in the FSC scheme and the increased revenue forgone
as a result of the application of its administrative pricing rules constitute subsidies
subject to the SCM Agreement within the meaning of Article 1 and 2 of the SCM
Agreement; the subsidies are contingent in law upon export performance contrary to
Article 3.1(a) of the SCM Agreement;WT/DS108/R
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• the subsidies are contingent in law upon the use of domestic over imported goods
contrary to Article 3.1(b) of the SCM Agreement; and
• as regards agricultural goods covered by the AA, the subsidies violate Articles 3 and
8 AA read in conjunction with Articles 9.1(d), 10.1 and 10.3 of the AA.
4.555  Although the character of the FSC subsidies as prohibited export subsidies is clear already
from Articles 1, 2 and 3 of the SCM Agreement, the European Communities went on to show that this
result is confirmed by Item (e) of the Illustrative List, which contains a certain number of exportsubsidies which are deemed  to be included in the prohibition in Article 3.1(a) of the SCM Agreement .
4.556  In response, the US First Written Submission attempted to argue that the
European Communities' approach was misguided because it neglected what the United States termed
the “controlling legal standard” or principle, which it believed to be implicit in, or “predicated by”, a
footnote to the Illustrative List.
4.557  At the First Meeting of the Panel  the United St ates also attempted to argue that the dispute
between the European Communities and the United States related to “details of implementation” of its
“controlling legal standard
271” and stressing that the European Communities had to meet its burden of
proof that the “controlling legal standard” was not met.
4.558  The European Communities demonstrated in its Statement to the First Meeting of the Panel
that it was the United States approach which was misguided and indeed that it turned interpretation on
its head, being contrary to the customary rules of interpretation of public international law codified in
Articles 31 and 32 of the 1969 Vienna Convention on the Law of Treaties and thus with Article 3.2
DSU.  It also stressed in response to the US Statemen t to the First Meeting of the Panel that the dispute
was not at all about “details of implementation” but in the first instance about a fundamental difference
of approach to the interpretation of the SCM Agreement.
4.559  The European Communities is of course prepared to develop these arguments if the Panel
considers it necessary but anticipates from the United States reaction at the First Meeting of the Panel
and its written questions addressed to the European Communities, that it will adopt different lines of
argument in its Second Written Submission concen trating more on Article 1 of the SCM Agreement.
In order to assist the Panel, the European Communiti es will make a first response to these alternative
lines of argument and demonstrate that they also cannot justify the FSC subsidies.
4.560  The first argument the United States may make is that the 1981 Understanding on the basis of
which the DISC and Tax Legislation panel reports were adopted lays down in some way overriding
taxation principles that must be followed by WTO Members and that, if followed, prevent any
violation of WTO Agreements arising.  This will be examined below.
4.561  Next the United States may seek to argue that the FSC subsidies do not result in any “revenue
forgone” that is “otherwise due” within the meaning of Article 1.1(a)(1)(ii) of the SCM Agreement.
This will be examined below.
4.562  The European Communities notes that the United States has not attempted to contest the
export contingency of the FSC subsidies272 nor indeed that they are specifically related to exports
within the meaning of Item (e) of the Illustrative List273 and thus the European Communities has
nothing to add for the present to its arguments in its First Written Submission and in its Statement to
the First Meeting of the Panel.
                                                     
271 See e.g. paragraph 16 of the United States Statement to the First Meeting of the Panel.
272 Demonstrated in paragraphs 146 to 154 of the European Communities' First Written Submission.
273 Demonstrated in paragraphs 155 to 132 of the European Communities' First Written Submission.WT/DS108/R
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4.563  One issue to which the United States devoted more arguments is its defence of the FSC
scheme’s special administrative pricing rules where it argues that the European Communities would
need to prove that they lead to a “significant saving of direct taxes in export transactions.”  The
European Communities will be responding further to these arguments below.
The 1981 Understanding
Introduction
4.564  The 1981 Understanding is in the following terms:
“The Council adopts these reports on the understanding that with respect to these
cases, and in general, economic processes (including transactions involving exported
goods) located outside the territorial limits of the exporting country need not be
subject to taxation by the exporting country and should not be regarded as export
activities in terms of Article XVI:4 of the General Agreement.  It is further
understood that Article XVI:4 requires that arm's-length pricing be observed, i.e.,prices for goods in transactions between exporting enterprises and foreign buyers
under their or the same control should for tax purposes be the prices which would be
charged between independent enterprises acting at arm's length.  Furthermore,
Article XVI:4 does not prohibit the adoption of measures to avoid double taxation of
foreign source income.”
“Following the adoption of these reports the Chairman noted that the Council's
decision and understanding does not mean that the parties adhering to Article XVI:4are forbidden from taxing the profits on transactions beyond their borders, it only
means that they are not required to do so.  He noted further that the decision does not
modify the existing GATT rules in Article XVI:4 as they relate to the taxation of
exported goods.  He noted also that this decision does not affect and is not affected by
the Agreement on the Interpretation and Application of Articles VI, XVI and XXIII.Finally, he noted that the adoption of these reports together with the understanding
does not affect the rights and obligations of contracting parties under the General
Agreement”.
274
4.565  The European Communities does not disagree in an y way with the principles set out in the
1981 Understanding as it understands them but considers that it is not applicable to the present dispute
or relevant as “negotiating history” or “subsequent practice.”  The European Communities also most
definitely does not agree with the meaning the United States attempts to give to the Understanding.
The 1981 Understanding is not applicable or relevant to the present dispute
4.566  The 1981 Understanding is not applicable to the present case because it relates to the adoption
of panel reports under a different legal norm to that under consideration in this case.  This case
concerns a violation of Article 3.1(a) of the WTO SCM Agreement whereas the 1981 Understanding
concerned the adoption of panel reports under Article XVI:4 of GATT 1947.
4.567  The DISC and Tax Legislation  cases were based on Article XVI:4 GATT 1947 as it existed in
1973 (the date the panels were established), which is probably very different in legal content from
Article XVI:4 of GATT 1994 and – certainly very  different from Article 3.1(a) of the SCM
Agreement.  As mentioned above, the economic approach taken in those cases was very different
from the more legal analysis called for to establish “financial contribution”, “benefit” and “exportcontingency” as required by the SCM Agreement.
                                                     
274 L/5271, 28S/114.WT/DS108/R
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4.568  If any confirmation of the inapplicability of the 1981 Understanding to the present case were
needed, it can be found in the statement of the Chairman of the GATT Council at the time who
expressly stated  “this decision does not affect and is not affected by the Agreement on the
Interpretation and Application of Articles VI, XVI, and XXIII275” (that is the Tokyo Round SCM
Agreement).  Its inapplicability to the SCM Agreem ent (which of course did not even exist at the
time) can hardly be clearer.
4.569  The 1981 Understanding is also not relevant as part of the negotiating history of the SCM
Agreement and the United States has expressly stated that it is not contending that it is (seeUnited States written question n° 19 to the European Communities reproduced in Annex EC-1).
Rather, the United States is arguing that if the SCM Agreement is ambiguous, resort may be had to
the “history of treatment of tax exemptions for foreign-source income under the GATT” and that this
is appropriate under Article XVI:1 of the WTO Agreement (see United States written question n° 15
to the European Communities reproduced in Annex EC-1).
4.570  The European Communities' response to this is  first of all that Article 3.1(a) is not
ambiguous.  But the United States is also wrong to consider that Article XVI :1 WTO provides a basis
for using elements of GATT history for the interpretation of possibly ambiguous WTO provisions.
Article XVI :1 provides for the WTO to be guided by the decisions, procedures, and customary
practices followed by GATT 1947, only where not otherwise provided.  When it comes to theinterpretation of WTO provisions there is a specific rule in the WTO and that is provided in
Article 3.2 DSU which provides that this should be c onducted in accordance with customary rules of
interpretation of public international law, which th e Appellate Body has confirmed means the rules laid
down in Articles 31 and 32 of the Vienna Convention on the Law of Treaties .
4.571  Therefore, even if the SCM Agreement were ambiguous in any respect, the United States
would have to establish that the 1981 Understanding is part of the negotiating history of the SCM
Agreement (which it admits it is not) or that it is “subsequent practice” within the meaning of
Article 31(3)(b) of the Vienna Convention on the Law of Treaties .  It is this in effect that the
United States is claiming (expressly in paragraph 103 of the United States First Written Submission).
This would, however, at most, make the 1981 Understanding relevant for the interpretation of GATT
1994, not of the SCM Agreement.
4.572  The European Communities contests that the 1981 Understanding constitutes relevant
“subsequent practice” within the meaning of Article 31(3)(b) of the Vienna Convention on the Law of
Treaties .
276  It could at most be “subsequent practice ” for the purposes of Article XVI:4 GATT 1947.
This provision is however no longer in force and Article XVI:4 is legally very different.  It is not
interpreted by the Tokyo Round Agreement or subject to instruments such as the 1960 Declaration
which paid a large role in the DISC and Tax Legislation cases, not least because the parties to GATT
1994 are not the same as the parties to that agreement and declaration.
4.573  The European Communities also disagrees that the 1981 Understanding can be considered a
decision of the GATT Contracting Parties which is carried over into the WTO by virtue of
Article XVI:1 of the WTO Agreement  and paragraph 1(b)(iv) of the introductory language to
GATT 1994.  It refers the Panel to the arguments it made in paragraphs 45 to 52 of its Statement tothe First Meeting of the Panel.
4.574  The 1960 declaration on which the DISC and Tax Legislation reports and the thus the 1981
Understanding are founded is also not a decision within the meaning of paragraph 1(b)(iv) of the
introductory language to GATT 1994 and not part of GATT 1994 and so the Understanding cannot be
considered part of GATT 1994 by this means either.
                                                     
275 Quoted in full above.
276 Paragraph 103 of the United States First Written Submission.WT/DS108/R
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The Understanding relating to the DISC and Tax Legislation cases does not contain the
claimed principle
4.575  In any event, even if the 1981 Decision were a decision to which paragraph 1(b)(iv) of the
introductory language to GATT 1994 referred, this w ould only make it part of GATT 1994, not of the
SCM Agreement.
4.576  A major purpose of the SCM Agreement is to provide clear definition of the term “subsidy”
and a stricter prohibition of export subsidies than under previous law and in particular Article XVI:4
of GATT 1947.  A decision taken in relation to Article XVI:4 of GATT 1947 cannot therefore assist
in the interpretation of the SCM Agreement.
4.577  In any event, the 1981 Understanding relating to the DISC and Tax Legislation cases does not
contain the principle or “controlling legal standard” claimed by the United States.
4.578  The United States is taking the terms of the Understanding out of context and interpreting it in
contradiction to its own expressed belief277 that the WTO or SCM Agreement does not require
Members to adopt a particular tax system or to follow certain tax principles.
4.579  The European Communities is firmly of the vi ew that it was not the purpose of the GATT
1947 and is not the purpose of the WTO or SCM Agreement to generally regulate tax systems or
methodologies; they do not “mandate278” Members to tax income in a certain way nor to give a
“right279” to exempt certain income tax systems and methodologies they wish.  The purpose of the
Article XVI GATT 1947 (and now the SCM Agreement) is to impose disciplines on the granting of
certain subsidies by Members.  These disciplines apply to taxation just as to any other field of
government action.  Conflict between taxatio n and Article XVI GATT 1947 (and now the SCM
Agreement) can be avoided in the same way as conf lict between any other field of government action.
Conflict with the export subsidy provisions  of Article XVI:4 GATT 1947 could be avoided by
ensuring that any subsidy did not “[result] in the sale of [a] product for export at a price lower than the
comparable price charged for the like product to buyers in the domestic market”  (just as conflict with
the SCM Agreement can be avoided by ensuring that rules are neutral in their trade effects, that arenot specific  within the meaning of Article 2 of the SCM Agreement and in particular not contingent
on export performance).
4.580  When the 1981 Understanding states that economic processes located outside the territorial
limits of the exporting country need not  be subject to taxation by the exporting country it is simply
saying that the mere fact that a tax system is territori al is not to be considered an export subsidy.  It is
not of course saying that a GATT Contracting Party may specifically exempt transactions contingent
upon export performance.
4.581  The United States is not only disregarding the ordinary meaning of the words “need not” it is
also erecting the sentence into a rule governing tax practices of GATT Contracting Parties and now
WTO Members along the lines of “States are entitled to tax or not tax foreign economic processes asthey please”.  Not only is that not what it says, it is also not what it could say since it would be
interfering in tax practices beyond what is necessary to avoid the granting of export subsidies.
4.582   This is a fundamental weakness of the United States case.  Even if one accepts all the
United States legal construction seeking to make the 1981 Understanding relevant to this case (and the
European Communities does not) the Understanding does not say what the United States would wishit to say.  It never did say what the United States would wish it to say as the European Communities
                                                     
277 E.g. at paragraphs 27 and 28.
278 See paragraph 86 United States First Written Submission.
279 See paragraph 148 86 United States First Written Submission.WT/DS108/R
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and seven other countries pointed out when they ob jected to the FSC and held formal consultations
under Article XXII GATT 1947 on 26 March 1985.280
Conclusion
4.583  The 1981 Understanding is not applicable or relevant to the present dispute and in any event
does not contain the “controlling legal standard” that the United States claims.
Whether the FSC scheme gives rise to "revenue forgone" which would be "otherwise due"
Introduction
4.584   The United States finally comes to consider Article 1.1 of the SCM Agreement and alleges
that the European Communities fails to explain why potential tax revenues from income attributable
to foreign economic processes are revenues that are “otherwise due.”  Invoking its “controlling legal
standard” it claims that
“In this case, WTO principles provide that the United States is not required to tax
income attributable to foreign economic processes.  The fact that the provision
through which the United States chooses to exercise its right not to tax such income is
often referred to as an “exemption” does not mean that taxes would be “otherwise
due”.” (Emphasis supplied.)
4.585  Similarly in paragraph 8 of its Statement to the First Meeting of the Panel, the United States
summed up its case as follows:
“Clearly, if under WTO rules a WTO Member is not obligated to tax certain
categories of income, then the exemption of such income from taxation cannot
constitute a subsidy, let alone an export subsidy.”
4.586  The United States is in effect treating the 1981 Understanding281 as granting it a “right not to
tax” income it designates as foreign on conditions of its choosing.  The European Communities hasdiscussed this error above and explained that neither the WTO (nor the GATT before it) grant rights
to tax or not to tax - they simply provide that the tax system should not provide subsidies. The
United States also misunderstands or misrepresents the European Communities' position when it
states at paragraph 86 of its First Written Submission that the European Communities is arguing that
the SCM Agreement “mandates” the taxation of certain income.
4.587  The absurdity of the United States reasoning is evident from the fact that nothing in the WTO
“obligates” or requires a Member to tax any income at all and the United States logic would lead to
the conclusion that it could exempt a particular company or industrial sector from tax as it pleases.
Indeed Article 1.1(a)(1)(ii) SCM Agreement and Item (e) could never apply.
4.588   The European Communities stated that the various exemptions provided by the FSC scheme
and the derogation from the application of the normal transfer pricing rules of Section 482 IRC led to
revenue forgone and since they conferred benefits constituted subsidies.  The United States claims
that this is not a sufficient demonstration of the fact the revenue forgone would otherwise be due and
that “shows nothing other than that if income that is exempt from tax were not exempt from tax, there
would be additional government revenue.”
282
                                                     
280 See paragraphs 21 and 112 of the European Communities First Written Submission.
281 The United States also appears to be claiming th at such a right is also granted by footnote 59 to
Item (e) of the Illustrative List in Annex I to the SCM Agreement but this is considered below.
282 See paragraph 153 of the United States First Written Submission.WT/DS108/R
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4.589  The European Communities will therefore now provide a more detailed explanation of why
the FSC scheme gives rise to revenue forgone which would otherwise be due.
Interpretation of Article 1.1(a)(1)(ii) of the SCM Agreement
4.590  It is correct that, in order to establish whet her revenue is forgone which would otherwise be
due it is necessary to compare it with a comparable situation where the revenue is due.  The European
Communities is not arguing that this comparable situation is simply the situation which would prevail
in the absence of the measure complained about.  Its position is that the United States is deviating
from the generally applicable rules and principles prevailing in its system as evidenced by the
treatment it accords to comparable situations.
4.591  What is important is that there must be a deviation from or exemption to the generally applied
rate or basis for collection for there to be a subsidy.  Therefore, the European Communities would not
argue that the decision of a WTO Member to reduce its standard rate of corporate income tax from 40
to 35 per cent is a subsidy, since 35 per cent then becomes the standard rate from which any deviation
or exception is to be measured.  If such a reduction in the basic rate were a subsidy, it could also beargued that the failure of a government to tax at any rate of less than 100 per cent is a subsidy.  In the
same way as the choice of the standard rate is not a subsidy, so also the adoption of a generally
applicable tax rule cannot in itself be a subsidy.
4.592  The European Communities notes that the Unit ed States uses the same interpretation of
Article 1.1(a)(1)(ii) of the SCM Agreement in its countervailing duty practice and countervails as
subsidies deviations from or exemption to the generally applied rate or basis for collection of tax.
283
4.593  The European Communities gave a number of examples of relevant comparisons in its First
Written Submission to demonstrate that the FSC scheme deviated from the general system.  Since the
United States seems to have missed them, the European Communities will recall them:
• If the FSC scheme did not exist or if the export transaction through a FSC were not to
qualify under the scheme (for example because it involved the export of goods fromanother territory than the United States, or the local content conditions were not
satisfied), no part of the FSC’s income from that transaction would be “exemptforeign trade income” and it would be subj ect to US taxation.  The existence of the
FSC scheme, or the applicability thereof to the transactions, will therefore lead to
revenue forgone.
• If the FSC were to conduct an import transaction on behalf of its parent or sell the
goods of its parent to a customer in the United States instead of conducting an export
transaction, no part of the FSC’s income from those transactions would be “exemptforeign trade income” and it would be subject  to US taxation.  The availability of the
FSC scheme for the export transaction would lead to revenue forgone compared with
the tax payable on the equivalent import or domestic transactions.
• If a manufacturer were to sell the goods on the domestic market or to export the
goods directly itself instead of passing though the FSC, no part of the profit would be
exempted from tax and thus the tax paid would be higher. The use of the FSCtherefore leads to revenue forgone.
4.594  The European Communities would add that in the case of the last example, the analysis result
would remain the same even if the manufacturer arranged to solicit, negotiate and conclude the sale
abroad.  The tax paid would still be higher than if an FSC were used and thus revenue is forgone
which would otherwise be due.
                                                     
283 See e.g. CVD on Salmon from Norway, imposed on 4 Dec 1991 - Case no. 403-802.WT/DS108/R
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4.595  As regards the second subsidy, the availability of the special administrative pricing rules, the
European Communities stated and the United States has not contested that these rules are the only
deviation which exists from the generally applicable rules for determining prices for tax purposes
between related companies contained in Section 482 IRC.  An FSC can of course use the Section 482
IRC rules but it has a choice to use the special administrative pricing rules which is available nowhereelse in the United States IRC.
The Amount of Revenue Forgone and Its Calculation
4.596  The European Communities has already pointed out that the United States itself admits in its
periodic reports that the FSC scheme results in revenue cost which it calculates
284 and estimates to be
US$2 billion in 1997.  In case it should be argued that this does not correspond to revenue forgone
within the meaning of Article 1.1(a)(1)(ii) of  the SCM Agreement, the European Communities
attaches as Exhibit EC-25 an extract from the Un ited States contribution to a 1996 OECD Report on
“Tax Expenditures – Recent Experiences”.
4.597  The United States defines “tax expenditure” as “revenue losses attributable to provisions of
the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or
which provide a special credit, a preferential rate of tax, or a deferral of tax liability”285  It explains
that two benchmarks are used for determining tax expenditures: the normal tax baseline and the
reference law baseline. The former would consist of a set of general principles (a “theoretical normal”
tax system) while the latter would be the generally applicable existing law.
4.598  The European Communities does not consider that revenue is necessarily forgone which
would otherwise be due within the meaning of Article 1.1(a)(1)(ii) of the SCM Agreement, if therevenue collected is less than a theoretical level (the “normal tax baseline” in United States
terminology) only if there is revenue forgone compared with the generally applicable law (the
“reference law baseline” in United States terminology). The United States also calls these measures
“special exceptions in the tax law that serve programmatic functions … such as national defence,
agriculture or health care.
286 ”
4.599  The Report explains the criteria  used in identifying a tax expenditure.287  The first is that
“absent that special provision, the tax laws provided general rules to enable a taxpayer to determine
his income tax due and payable”. The second criterion would be that “it is necessary that the special
provision apply to a sufficiently narrow class of transactions or transactors to permit the specification
of a programme objective that could be administered  on the direct spending side of the budget with
appropriate funds”.
4.600  Lastly, the report states that one of the categories that have been labelled as tax expenditures
“would consist of deviations from general rules of the existing tax system that could be measured and
evaluated in a manner comparable to the measurement and evaluation of subsidy and transfer
programmes on the outlay side of the budget”288.
4.601  The FSC tax expenditure is listed on page 112 of the document “exclusion of income of
foreign sales corporations” and the “Revenue forgone” (the Report’s words) in 1995 is  given as
US$1,400 million. It is clear from the report that the method used to measure this revenue forgone
was the “reference law baseline” (cases where the normal tax method are used are indicated with a
footnote 1 sign).
                                                     
284 See paragraphs 100 and 138-139 of the European Communities' First Written Submission.
285 See Chapter I “Background” on page 107 of the document.
286 See Chapter III on page 108 of the document.
287 See Chapter III on page 108 of the document.
288 See last paragraph of Chapter III on page 109 of the document.WT/DS108/R
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4.602  The United States has therefore admitted again in this report that the FSC scheme provides an
exemption to the generally applicable United States tax rules .
The FSC scheme exempts from tax economic processes which are not foreign
4.603  Even if the United States were correct in its view (which the European Communities does not
share) first that the SCM Agreement (or some other provision) gives WTO Members a right not to tax
foreign economic processes and second that it is entitled to make this exemption contingent upon
export, the FSC exemptions can still be demonstrated to be contrary to the SCM Agreement.
4.604  This is because the FSC scheme exempts from tax economic processes which are not foreign.
There are three main reasons for this:  first that FSCs are allowed to be located on (non-metropolitan)United States territory; second that the activities of FSC’s can in reality be subcontracted back to the
United States related supplier with no diminution of the share of the profit accruing to the FSC and
thus partly sheltered from tax and third that the scheme derogates from the normal United States
source rules and deems 15/23 of the FSCs income to be foreign source income where the generally
applicable rules would provide for the income to be largely United States source.
FSCs are allowed to be located on US territory
4.605  The European Communities has already explained
289 that most FSCs are situated in
United States territories such as the US Virgin Islands.  The European Communities does not accept
these as foreign and has put to the United States a number of questions the answers to which will
further demonstrate this.  The European Communities has explained (and the United States has not
contested) that:
• The US Virgin Islands are an organised, unincorporated territory of the United States,
administered by the Office of Territorial and International Affairs in the USDepartment of Interior.  It elects a member to the US House of Representatives.
• The US Virgin Islands are generally subject to the laws of the United States. In
particular to its tax legislation which is contained in the US IRC.  Section 932 of theIRC provides that the United States will be treated as including the Virgin Islands for
purposes of determining the US tax liability of United States citizens or residents withVirgin Islands income.  According to th e US Naval Appropriations Act of 12 July
1921, “the income tax laws now in force in the United States of America and those
which may hereafter be enacted shall be held to be likewise in force in the Virgin
Islands of the United States.”
• The United States has also stated at the First Meeting of the Panel  in answer to a
question from the European Communities that the United States has WTO obligations
in respect of the Virgin Islands.
• The only claim to foreignness that the European Communities believes is made for
the US Virgin Islands is that they constitute a separate customs territory to the rest of
the United States.  According to the last page of Exhibit EC-18 to the
European Communities' First Written Submission (containing an account of the
relevant legal provisions relating to the US Virgin Islands), the customs duties of theUS Virgin Islands are only imposed on goods coming from outside the United States.
4.606  If any rule along the lines of the United States’ “controlling legal standard” does exist which
gives WTO Members a right not to tax foreign economic processes (and such Member is entitled to
make this exemption contingent upon export), then the term “foreign” must have some objective
meaning.  A WTO Member surely cannot deem certain parts of its territory to be places where
                                                     
289 See paragraphs 42-49 of the European Communities' First Written Submission.WT/DS108/R
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companies are entitled to conduct foreign economic processes and be entitled to give them tax
privileges (and make those privileges contingent upon export).  The European Communities submits
that “foreign” can only mean outside a Member’s territorial sovereignty or at least located in a
“separate customs territory possessing full autonomy in  the conduct of its external commercial relations”
within the meaning of Articles XXXI and XXXIII GATT 1994 and on neither of these bases are the USVirgin Islands and the other United States territories and possessions which qualify as FSC locations
“foreign”.  In particular a separate customs territory of a single WTO Member cannot be considered
“foreign” in relation to the rest of the territory of that Member.  Many Members have special customs
zones including parts of their major ports.
4.607  It is only possible to bring dispute settlement proceedings against Members of the WTO, not
against separate customs territories of those Members. Yet WTO Members are bound to respect WTO
obligations in respect of all the territories of other Members for which those Members have accepted
the WTO Agreement.  For example the European Communities is bound by Article II GATT 1994 in
respect of all United States territories.  It cannot have been the intention of the WTO Members when
they concluded the WTO Agreement that an exemption from taxation of companies established in aseparate customs territory of a Member which is not and could not be a separate Member of the WTO
but which enjoys WTO rights, could not be considered a subsidy.
4.608  Indeed the 1981 Understanding on which the United States places so much reliance speaks of
“economic processes … located outside the territorial limits of the exporting country”.  When WTO
Agreements refer to territory, they refer to the whole territory of a Member and when they refer to a
separate  customs territory this is specified.
4.609  Accordingly, any economic processes conducted by FSCs cannot be considered “foreign” by
virtue their location in United States territories and possessions because these territories and
possessions are not foreign in relation to the United States.
FSC activities can be sub-contracted back to the US related supplier
4.610  The European Communities has explained a number of times that an FSC is entitled under the
FSC scheme to subcontract all its activities back to its related supplier and they may therefore be
conducted in the United States almost exactly as if the FSC had not been established.  Because of the
way the special administrative pricing rules operate this may make no difference to the tax benefit
obtained.  The European Communities does not accept that activities that are in fact conducted in the
United States by the related supplier may be considered “foreign” for the purposes of the SCMAgreement, even if this should be relevant.
The FSC scheme derogates from the normal US source rules
4.611  The European Communities explained in its First Written Submission that one of the tax
exemptions accorded by the FSC scheme was exemption from the normal United States source rules.Section 921(a) IRC deems a FSC’s exempt foreign trade income to be “foreign source income which
is not effectively connected with the conduct of a trade or business in the United States.  Where the
special administrative pricing rules are used this is 15/23 of the total foreign trade income as
determined by those rules
290 and where the standard arm’s length rules of Section 482 IRC are used, it
is 30 per cent of the total foreign trade income as determined by those rules291. Section 921(d)
provides that the remainder of such foreign trade income “shall be treated as income effectively
connected with a trade or business conducted through a permanent establishment of such corporation
within the United States.”
4.612  Sections 921(a) and (d) are in effect special formulaic source rules for FSC income.  A certain
fraction is deemed foreign and the rest domestic.
                                                     
290 See Section 923(a)(3) of the IRC in conjunction with Section 291(a)(4) of the IRC.
291 See Section 923(a)(2) of the IRC in conjunction with Section 291(a)(4) of the IRC.WT/DS108/R
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4.613  The generally applicable United States source rules on the other hand represent a highly
developed code of what and how much income is properly considered domestic and how much
foreign source for tax purposes.  For example, income from sales activities carried on through an
agent is not generally considered to be sourced at the residence of the person taking “legal and
financial responsibility” but at the place the performance occurs292. When services are performed
partly within the United States and partly outside of the United States, income must be allocated
accordingly293.
4.614  The special source formulae of the FSC scheme do not represent an effort to determine the
true source of a FSC’s income.  Exactly the same allocation is made for buy/sell and commission
FSCs and whether the FSC carries out its functions itself or subcontracts them all back to its relatedsupplier.  Indeed, as for the special administra tive pricing rules, the same formulae apply however
much (or rather however little) of an FSC’s inco me would be considered foreign source under the
generally applicable rules. The United States admits as much when it says:
“the FSC rules were not designed to force the FSC to perform all of the foreign
economic activities itself; rather, they were designed to attribute to the FSC thatincome which is derived from foreign economic processes, regardless of the manner
in which those processes are performed 
294”
and that the amount exempted is
“a conservative approximation of the amount of foreign economic activity for which
the FSC is responsible295”
4.615  Under normal sourcing rules, the income of a FSC might be considered foreign-sourced,
domestic-sourced or a combination of both.  In the case of a commission FSC, the sourcing of the
FSC’s commission income would turn on the location(s) in which the FSC (acting directly or through
its agents) performed the activities necessary to earn  the commission.  If those activities took place
partly within and partly without the United States, the FSC’s income would be allocated accordingly.
(Again, it is the place where the performance occurs, rather than the tax residence of the person
performing the services, that is determinative.)
4.616  As we have previously discussed, these requirements were designed so that exporters could
satisfy them relatively easily and with as little disruption to their normal business practices as
possible.  Once a FSC satisfies the requirements of Section 924 IRC (and the related requirements of
Section 925(c)IRC), it is eligible to utilise the administrative pricing rules and to have the source of its
income calculated under the purely formulaic approach of Sections 921 and 923 IRC.  In contrast, asdiscussed above, the normal rules for determining the source of income are based to a far greater
degree on an evaluation of the substance and value, as well as the location, of the economic activities
that gave rise to the income.
Conclusion
4.617  The European Communities has shown that even if the United States “controlling legal
standard” were to be accepted (which the European Communities does not) the FSC scheme does not
meet it because in the largest proportion of cases where the FSC is incorporated in a United States
territory or possession, none of the FSCs activities can be considered “foreign” at all.  In other cases
FSCs are entitled to subcontract all their activities back to the related supplier so that they may be
carried out in the United States with out any loss of tax benefit.  Also FSCs benefit from a derogation
                                                     
292 See Section 861(a)(3) of the IRC.
293 See Section 863(b) of the IRC.
294 Paragraph 127 of the United States First Written Submission.
295 Paragraph 130 of the United States First Written Submission.WT/DS108/R
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from the normal source rules so that a much larger part of their income would be foreign source than
would be the case under the generally applicable rules (especially in the case of commission FSCs).
The Special Administrative Pricing Rules
Introduction
4.618  The European Communities identified in its First Written Submission296 the special
administrative pricing rules which are available to FSCs and their parents but to no other US tax
payers as a distinct prohibited export subsidy resulting from an additional financial contribution from
government in the form of revenue forgone compar ed with the situation which would prevail if the
normal transfer pricing rules of Section 482 IRC had to be applied and compounding the revenue
forgone resulting from the FSC exemptions.  These special administrative pricing rules may be used
at the option of the taxpayer, ex post and on a transaction by transaction basis when they give a more
favourable result, have as a consequence lower tax revenues for the US Government than would be
the case if these rules did not exist297.
4.619  The United States professes at paragraph 22 of its First Written Submission to find this
second claim by the European Communities to be an “oddity” since, if the European Communities is
correct about the first FSC subsidy, “then it really does not matter, for the purposes of WTO subsidy
rules, whether 0, 50, or 100 per cent of the income earned in an export transaction is attributed to
those activities”.
4.620  The European Communities had already given the explanation298 but will repeat it.  It is
because each of the FSC subsidies could exist in the absence of the other and it is important that bothbe held to be prohibited export subsidies so th at both will have to be withdrawn.  The European
Communities is seeking to avoid a situation where the United States is able to evade bringing its FSC
scheme into conformity with the WTO by removi ng or modifying the exemptions which FSCs and
their parents enjoy but preserves for them the benefit of the special administrative pricing rules.
4.621  The European Communities will develop the followin g further points in this Section.  First, it
will clarify its position as to the legal basis for its view that the special administrative pricing rules
constitute a prohibited export subsidy.
4.622  Second, it will apply these principles to the FSC scheme and explain why this establishes that
the special administrative pricing rules lead to revenue forgone and are contrary to the SCM
Agreement and that it is not necessary to prove on the basis of statistics or tax returns that they resultin a significant saving of direct taxes.
The principles of the SCM Agreement concerning transfer pricing
4.623  The European Communities was asked by the Panel at its first meeting whether the second
sentence of footnote 59 required the use of arm’s length pricing in all cases and whether it was thesole source of rules on the issue.  The European Communities takes this opportunity to explain more
fully its position on the subject.
4.624  The European Communities first repeats its view (which the United States has stated that it
shares)
299 that it is not the purpose of the SCM Agreement (nor indeed the WTO) to lay down rules
                                                     
296 See esp. paragraphs 127, 135-137, and 142 of the European Communities' First Written Submission.
297 A good explanation of how beneficial the option of using these rules is see the Article from “Tax
Notes International” entitled “A FSCful of Dollars: Maximizing FSC Benefits through Transaction LevelPricing,” submitted as Exhibit EC-8 to the European Communities' First Written Submission.
298 See paragraph 128 of the European Communities' First Written Submission and paragraph 23 of the
European Communities' Oral Statement at the First Meeting of the Panel.
299 E.g. at paragraphs 27 and 28 of the United States First Written Submission.WT/DS108/R
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for the taxation of income by Members, it merely provides that whatever taxation systems or
methodologies are used, they must not give rise subsidies and in particular not export subsidies.  In
particular a footnote to an Illustrative List in an Annex cannot lay down absolute rules for the conduct
of tax policy (that is rules which apply whether or not there is proved to be a subsidy).
4.625  The starting point for a consideration of when transfer pricing rules may give rise to a subsidy
must be Article 1 to the SCM Agreement which defines what a subsidy is for the purposes of the
Agreement and when subsidies are subject to the disciplines of the SCM Agreement (i.e. when they
are specific).
4.626  Article 1.1(a)(1)(ii) of the SCM Agreement deems there to be a financial contribution by
government if “government revenue which is otherwise due is forgone”.  It has also explained that thebaseline against which it needs to be assessed whether revenue is forgone may be considered to be the
generally applicable tax law and that the United States shares the same view and calls this the
“reference law baseline”
300.
4.627  The above explains why the second sentence of footnote 59 states that “prices for goods in
transactions between exporting enterprises and foreign buyers under their or under the same controlshould for tax purposes be the prices which would be charged between independent enterprises acting
at arm's length”.  The use of the word “should” is necessary because the footnote cannot lay down a
tax rule, only indicate when there might be an export subsidy.
4.628  Although WTO Members are in principle free as a matter of WTO law not to provide for the
use of arm’s length pricing between related companies, it is clear that in doing so they run the risk of
granting subsidies.  This is because in considering whether a subsidy exists or not one of the factors to
take into consideration will often be the situation which would prevail under market conditions.  Thatis precisely what arm’s length pricing rules seek to achieve.
4.629  The European Communities returns to comment on the United States arguments on
footnote 59 but now applies the above principle to the special administrative pricing rules of the FSC
scheme.
Application of the above principles to the FSC scheme
4.630  The special administrative pricing rules of the FSC scheme are a derogation from the
generally applicable (or standard) rules of the US tax system applicable to the regulation for tax
purposes of the prices considered to be payable on transactions between related companies which as
the United States concedes are contained in Section 482 IRC
301.  They are only available to FSCs and
their parents and give a more favourable result because there is a free choice between the standard
Section 482 IRC method and the two special administrative pricing rules transaction by transaction
and ex post.   The  enormous benefits this gives are demonstrated by the Article from “Tax Notes
International” entitled “ A FSCful of Dollars: Maximizing FSC Benefits through Transaction Level
Pricing, ” submitted as Exhibit EC-8 to the European  Communities' First Written Submission.  It is
also clear from the text of the FSC legislation itself that the 1.83 per cent gross receipts method can
give twice the tax exemption of the 23 per cent of combined taxable income method.  For a worked
example of how this works the Panel can refer to the Example 3 given on page 198 of the Article “ A
FSCful of Dollars: Maximi zing FSC Benefits through Transaction Level Pricing, ” in Exhibit EC-8.
The special administrative pricing rules constitute a prohibited export subsidy
4.631  Having established that the special administrative pricing rules of the FSC scheme give rise to
a subsidy it is clear that they are a prohibited export subsidy since they are contingent upon export
performance and specifically related to exports as the European Communities has abundantly
                                                     
300 See above and Exhibit EC-25.
301 See paragraph 53 of the United States First Written Submission.WT/DS108/R
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demonstrated in its First Written Submission and Statement to the First Meeting of the Panel. The
European Communities notes that United States has not contested export contingency.
4.632  Footnote 59 confirms the conclusion but this is dealt with below.
Conclusion
4.633  The European Communities has clarified above its position as to why the special
administrative pricing rules constitute a prohibited export subsidy. This is based on Articles 1 and 3 of
the SCM Agreement and confirmed by Item(e) and its footnote.  The European Communities will
now proceed to consider the United States arguments on this issue which rely heavily on a distorted
view of footnote 59 to Item (e) of the Illu strative List in Annex I to the SCM Agreement.
Footnote 59 to Item (e) of the Illustrati ve List in Annex I to the SCM Agreement
Introduction
4.634  The United States defence relies heavily on footnote 59 to Item (e) of the Illustrative List in
Annex I to the SCM Agreement which it claims contains or is “predicated by” a “controlling legal
standard” to the effect that a Member has a right not to tax foreign economic processes and may make
non taxation of these foreign economic processes contingent upon any condition it pleases (or at least
upon export performance).
4.635  The European Communities has already explained that the supposed source of this
“controlling legal standard,” the 1981 Understanding on the basis of which the DISC and Tax
Legislation Reports were adopted, is not applicable or relevant to this dispute and does not contain the
standard claimed.
4.636  There remain however a number of issues arising from footnote 59 on which the European
Communities still wishes to comment.
Item (e) in Context
4.637  It is first of all necessary to recall, lest it be forgotten, that Item (e) of Annex I and its
footnote 59 are not necessary to the European Communities' analysis.  The FSC subsidies are contrary
to Article 3.1(a) of the SCM Agreement without any need to refer to the Illustrative List, except for
confirmation.
4.638  The United States is wrong to argue that:
“Thus, if the Illustrative List treats a measure as an export subsidy, it is prohibited.
Conversely, if the List treats a measure as not being an export subsidy, it is not
prohibited.  No further analysis is needed to divine the meaning of Article 3.1(a) with
respect to measures addressed by the Illustrative List.”
4.639  The first sentence is correct. The second is also in principle correct, not as an a contrario
deduction from the first sentence but as a paraphrasing of footnote 5 to Article 3.1(a) of the SCM
Agreement.  But Item (e) of the Illustrative List does not mention any measure as “not constituting
export subsidies” (the correct wording) and the pretended  deduction in the third sentence is
completely wrong.  First a footnote only explains a provision it does not contradict  it as would be the
result of the United States argument. Second, the footnote is providing guidance as to the meaningand significance of the terms in Item (e) and their relationship to the rest of the SCM Agreement.
Thus to take the first sentence (not in issue in this case) it is simply recalling that if interest is charged
on deferred payments, there will not be a subsidy.  And the last sentence of footnote 59 is simply
recalling the general principle (to which the European Communities subscribes) that it is not the
purpose of the SCM Agreement to specify the tax systems Members may pursue.  The sentence is notWT/DS108/R
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excepting from the Agreement specific and export contingent exceptions to the systems which give
rise to export subsidies.
4.640  The European Communities would also make clear that it is not the purpose of Item (e) or any
other provision of the Illustrative List to specify what  is or is not a subsidy, as the United States seems
to be arguing.  That question is exhaustively regulate by Article 1.1 of the SCM Agreement.  It is onlyproviding guidance about export subsidies.  If it were otherwise the fact that a measure is referred to
as not being an export subsidy would mean that it could not (even if applied specifically  but not
export contingently ) ever be considered a subsidy covered by the Agreement at all.
The Second Sentence of Footnote 59
4.641  As the European Communities has already explained, the second sentence of footnote 59
confirms the European Communities position based on the other provisions of the SCM Agreement
that the export contingent derogation which the FSC scheme contained from its arm’s length pricing
rules can and should be considered an export  subsidy.
4.642  The United States however uses the second sentence of footnote 59 for a number of  purposes.
First it attempts to deduce from the sentence support for its “controlling legal standard” by suggesting
that it is ambiguous and that the 1981 Understanding must be imported into the text to resolve this
ambiguity.  Second it attempts to defend the special administrative pricing rules of its FSC scheme by
arguing that the reference to arm’s length pricing it contains does not mean what it seems.
4.643  The United States claims to read this sentence of the footnote as allowing it to designate a
certain category of economic processes as “foreign” – that is “distributor functions”
302 – and to
exempt them from tax – provided of course that they relate to the export of United States goods.  Itcandidly admits that the administrative pricing rules will not correctly allocate profit between the
persons involved (the FSC and its related supplier) but claims that this is not its purpose and it is not
referring to the kind of rules set out in Section 482 of the IRC or the OECD Guidelines but to the
allocation of income between economic functions. A ccording to the United States the FSC and its
related supplier should not really be regarded as separate
303 and that allocating all “income attributable
to distributor functions” to the FSC is just a convenient device for taking advantage of a pretended
WTO right.
4.644  Of course, footnote 59 says no such thing.  It is plain from its text that it is referring to the
need for prices for goods in export transaction between exporting enterprises and foreign buyers under
their or the same control to be those that woul d be charged between independent persons acting at
arm’s length.  They are not referring to the allocation of income between “ economic processes .”  This
is indeed logical as footnote 59, in setting out the abovementioned principle, correctly assumes that in
a transaction between independent parties each party (in this case the seller) would charge a price
which reflects the processes actually  performed by that party (the reason being that, under normal
trading conditions, it would not be possible to inflate the price by including charges for processes notperformed, or the contrary, i.e. it would be unusual commercial behaviour not to include in the price
charges for processes actually performed)  It is even more alien to normal commercial behaviour to
allow the price to be determined ex post according to alternative formulae so as to maximise the profit
of the purchaser or agent but this is exactly what the FSC scheme does.
4.645  Thus the reason for footnote 59 adopting the "arm's length" rule is to approximate as far as
possible the conditions which would have prevaile d in the absence of the relationship between buyer
and seller. The FSC legislation does nothing of the sort as it creates a fictitious allocation of income
(on the basis of predetermined formulaic criteria) regardless of the processes actually performed by an
FSC. As a result the United States theory of footnote 59 containing an "income allocation rule" could
not be further away from reality.
                                                     
302 Paragraph 108 of the United States First Written Submission.
303 Paragraph 109 of the United States First Written Submission.WT/DS108/R
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4.646  It is also clear that the current United States  interpretation of footnote 59 does not reflect the
original intention but is an ex post attempt to use this text to defend the FSC scheme.  The
United States view was different in 1978 when the text was negotiated.  The European Communities
submits as Exhibit EC-28 a letter from Richard R Rivers General Counsel for the US Office of the
Special Representative for Trade Negotiations to the European Communities Commission indicatingthat the second sentence of footnote 59 was intended to refer precisely to guidelines such as those
subsequently drafted by the OECD and indicating that this could apply at least with respect to
Members of the OECD.
The Third Sentence of Footnote 59 and the de minimis Arguments
4.647  A further argument in defence of the FSC scheme is that the subsidies it provides are de
minimis and therefore escape prohibition.
4.648  This is based on the reference in the third sentence to footnote 59 to a significant saving of
direct taxes in export transactions. The sentence reads:
Any Member may draw the attention of another Member to administrative or other
practices which may contravene this principle and which result in a significant saving
of direct taxes in export transactions.
4.649  The United States argument is misguided because the sentence only refers to the right to draw
attention to such practices and the word “significant” is simply designed to avoid Members from
invoking individual cases of minor importance.
4.650  The prohibition on export subsidies is absolute.  There is no de minimis rule.  The existence of
a de minimis rule in countervailing duty cases is dictated by the different nature of this remedy and in
particular the fact that countervailing duties can only be imposed where there is injury and injury is
not likely where the price effect is less than 1 per cent. Also the de minimis rule in countervailing duty
cases applies only to the imposition of duty on the product of an exporter which may be the
cumulative value of a number of subsidy schemes each individually below 1 per cent.  No subsidy
scheme  escapes countervailing duty because it amounts to less than 1 per cent of sales value.
4.651  In any event, the FSC subsidies are significant at US$2 billion per year according to the
United States own estimates.  The success of the scheme demonstrates that it is of interest to
exporters. As explained above, the real effect is more significant than may appear. Companies are
normally quite keen to take measures that save 15-30 per cent of the tax charge on export transactions.
This will after all increase their net profits by 5 - 10 per cent and this is what matters to companies.
4.652  Even the  ad valorem effect can of course, in some cases, be much more than the 0.93 per cent
claimed by the United States, since this is only an average.
4.653  The FSC scheme is important since it applies throughout the United States economy.  In this
regard, the United States argues that a 0.3 per cent increase in United States exports is insignificant.  It
is not.  The European Communities does not agree.  In 1998 United States goods exports wereUS$683 billion.  0.3 per cent represents about US$2 billion which is very significant and in any event
much greater than trade effects the United States has complained of in the past.
4.654  The United States makes an argument based on the wording of the third sentence which the
European Communities will now rebut.  It argues  that this sentence is only referring to aggregate tax
savings across the whole economy because it refers to “saving” in the singular and “direct taxes” and“export transactions” in the plural. The European Communities regards this argument as specious.
The fact that the words “direct taxes” and “export transactions” are in the plural is explained by the
structure of the sentence and the fact that its subject of the second clause is “practices” in the plural.
The use of the singular form for “saving” simply reflects linguistic usage and does not indicate that
only the average reduction of taxes is relevant.WT/DS108/R
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4.655  Such an interpretation would be contrary to the overall objective of the SCM Agreement
which is to discipline specific subsidies.  As explained in Article 2 of the SCM Agreement specificity
includes in particular the grant of a particular advantage to enterprises or groups of enterprises.
Looking at the aggregate effect on companies overall flies in the face of on of the primary principles
of the SCM Agreement.
Commission FSCs
4.656  Even if the United States interpretation to footnote 59 were accepted (and the European
Communities rejects it), it still would not assist most FSCs since the majority are commission FSCs
which do not buy or sell goods.
Footnote 59 and the DISC and Tax Legislation Cases
4.657  Part of the United States argument that footnote 59 permits the FSC subsidies is in effect
based on the notion that the footnote was designed to resolve the complex tax dispute304 arising out of
the DISC and Tax Legislation cases and thus should now be interpreted in that light so as to permit the
FSC scheme, which as the United States has claimed a number of times305, was specifically designed
by the US Congress to satisfy what it perceived to  be  GATT 1947 requirements.
4.658  The first point that the European Communities would make in response to this argument is,
with all due respect, that US Congress’ view of the requirements of GATT 1947 are not authoritative.
It is clearly stated in the General Explanation in  Exhibit EC-6 that Congress, even in 1985, did not
find the GATT arguments against DISC persuasive or credible306.  In addition, the US Congress was
designing a system to be defended under GATT 1947, not the SCM Agreement and so even if theFSC scheme had been compatible with GATT 1947 (a view the European Communities does not take
but on which the Panel does not need to decide), that would not mean that it does not give rise to
prohibited subsides under the SCM Agreement of the WTO Agreement.
4.659  There have been numerous changes in the legal position since the entry into force of the WTO
Agreement in 1995.
4.660  The Tokyo Round SCM Agreement which existed at the time was an “Agreement on
Interpretation and Application of Articles VI, XVI and XXIII of the General Agreement” whereas the
SCM Agreement is an Agreement separate to GATT 1994 and is, by virtue of the General
Interpretative Note to Annex IA to the WTO to prevail in case of conflict with GATT 1994.  It is
therefore no longer an interpretation of GATT.  Article 32.1 of the SCM Agreement does still refer tothe SCM Agreement interpreting GATT but, it is submitted that this refers principally to
Countervailing Duty Action under Article VI of GATT 1994 and is explained by its genesis (it was
copied from Article 19.1 of the Tokyo Round SCM Ag reement with only the “legal revision” changes
to terminology). This is further reinforced by the fa ct that this provision is identical to Article 18.1 of
the WTO Agreement on Implementation of Article VI of the General Agreement on Tariffs and Trade1994 ("the Anti-dumping Agreement").
4.661  The SCM Agreement is not only independent of the GATT  1994 (which is not invoked by
the European Communities in this case) it also makes fundamental changes in particular to the
treatment of export subsidies.  First, there is now for the first time a definition of the term “subsidy”
(Article 1.1 of the SCM Agreement) and a clear statement that the disciplines of the Agreement onlyapply to specific  subsidies (Article 1.2 of the SCM Agreement) and export subsidies are deemed to be
specific (Article 2.3 of the SCM Agreement).  Also  export subsidies are now defined in general terms
as subsidies which are contingent, in law or in fact, whether solely or as one of several other
conditions, upon export performance (Article 3.1(a)) and the (modified) Illustrative List is included as
                                                     
304 See e.g. paragraphs 2, 16, and 38 of the United States First Written Submission.
305 See e.g. paragraphs 40, 53, 81, and 126 of the United States First Written Submission.
306 See first paragraph on page 1042 of the General Explanation in Exhibit EC-6.WT/DS108/R
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illustrations of what is included in the prohibition.  In general this is a much stricter and complete
definition of export subsidies than existed before.  The combination with the Article 1.1 of the SCM
Agreement however (to be an export subsidy a measure must first be a subsidy) makes it more
rigorous and precise and certain measures which might have been considered to fall under the
prohibition of export subsidies of the Tokyo Round SCM Agreement are no longer prohibited if they
do not result in a financial contribution by government and a benefit to the recipient.
4.662  A further difference with the Tokyo Round SCM Agreement is that the SCM Agreement now
also contains a clear prohibition on local content subsidies in Article 3.1(b) of the SCM Agreement
(also relevant to the present proceeding).
4.663  Finally, there are also some relevant changes to the Illustrative List itself.  The old Illustrative
List annexed to the Tokyo Round SCM Agreement, co ntained two provisions specifically designed to
protect the US DISC/FSC legislation (a comp lete text of Annex I to the Tokyo Round SCM
Agreement is included in Exhibit EC-29).  These are:
• An addition after the sentence on deferral of tax of the following sentence:
“The signatories further recognize that nothing in this text prejudges the
disposition by the CONTRACTING PARTIES  of the specific issues raised in
GATT document L/4422.”
GATT document L/4422 is the document containing the DISC Panel Report.
• An addition after the end of the text corresponding to the present footnote 59 of a
paragraph stating that:
“Where measures incompatible with the provisions of paragraph (e) exist,
and where major practical difficulties stand in the way of the signatory
concerned bringing such measures promptly into conformity with the
Agreement, the signatory concerned shall, without prejudice to the rights of
other signatories under the General Agreement or this Agreement, examine
methods of bringing these measures into conformity within a reasonableperiod of time.”
At the time the Tokyo Round Agreements were adopted, the United States had major difficulties
ending the DISC and this had to wait until after the presidential elections in 1980.
4.664  Of course, the above quoted language from the Tokyo Round SCM Agreement is not part of
the SCM Agreement or the WTO. Indeed its absence also indicates an intention not to continue any
exemption for or tolerance of the DISC/FSC.
4.665  All the above differences between the To kyo Round SCM Agreement and the situation
prevailing under the GATT 1947 (and others mentioned elsewhere
307) on the one hand and the SCM
Agreement on the other hand demonstrate that an alleged compatibility of the FSC scheme with, orintention to comply with, the former agreements is entirely irrelevant in the present situation governed
by the WTO and SCM Agreement.
Conclusion
4.666  The European Communities has shown above that footnote 59 is not necessary for its case but
confirms it. It has also shown that footnote 59 provides no defence for the United States.
                                                     
307 See above.WT/DS108/R
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The European Communities  argues as follows in response to a question from the United States
following the First Meeting of the Panel:
4.667  Many United States questions relate to territorial tax systems and suggest that they have the
same effect as the FSC scheme.  The European Communities has given a description of these schemesin its Second Written Submission to which the Panel is referred.  The European Communities doubts
the relevance of the discussion of the territorial tax systems to the case at hand.  It would simply
repeat here that the FSC scheme does not “emulate” territorial tax systems and that the same SCM
Agreement disciplines apply to territorial tax systems as apply to the FSC scheme.
308
4.668  The European Communities' position is simply that WTO Members are not prevented by the
SCM Agreement from not taxing foreign source income if this is done on a general basis.  What is not
acceptable is to exempt only foreign source income deriving from exports since this is a prohibited
export subsidy. The fact that in territorial systems of taxation, taxes would often be generally higher
to reach an equivalent level of revenue is an inhe rent disadvantage of this system compared to the
foreign tax credit system (worldwide system of taxation).
The United States  further responds in its Second Submission as follows:
The FSC Tax Exemption Is Not a Subsidy Under Article 1 of the SCM Agreement Because
It Does Not Entail the Foregoing of Revenue that Is "Otherwise Due"
4.669  Applying the European Communities' approach and beginning with the general rather than the
specific, Article 1.1(a)(1)(ii) of the SCM Agreement provides that a financial contribution existswhere “government revenue that is otherwise due is foregone.”  The European Communities has
argued that the FSC is a subsidy under Article 1.1(a)(1)(ii) because it results in less tax revenue being
collected wherever it applies.
309  The European Communities has stated that “[i]f the FSC scheme did
not exist or if the export transaction through a FSC were not to qualify under the scheme . . . no part
of the FSC’s income from that transaction would be subject to US taxation.  The existence of the FSC
scheme, or the applicability thereof to the transactions [ sic], will therefore lead to revenue forgone.”310
The European Communities has further stated that the FSC “leads to revenue forgone” because less
taxes accrue with respect to FSC transactions than comparable domestic and import transactions.311  In
advancing this argument, the European Communities in effect is taking the position that any tax
exemption, remission, credit, deduction or reduction constitutes a subsidy for purposes of Article 1.  Ifaccepted, this would mean that in any instance where income escapes taxation – or is taxed at a lower
rate than other income – a subsidy is conferred.
4.670  The European Communities' argument might be corr ect if Article 1.1(a)(1)(ii) stated only that
a subsidy exists where “government revenue . . . is foregone or not collected.”  However, this is not
what that provision says.  The European Communiti es ignores a critical portion of the language of
Article 1.1(a)(1)(ii); namely, the words “that is otherwise due.”  The plain meaning of this language is
that it is not enough for revenue to be foregone.  Instead, the revenue in question must first be
“otherwise due.”
                                                     
308 Paragraphs 4.667-4.668 reflect the European Communities' response to the following question from
the United States: In paragraph 14 of the European Communities' Oral Statement, the European Communitiesstates that “countries which do not tax foreign source income” do “not necessarily provide an advantage”because “such a system results in a lower tax base and such countries will have to impose a tax at higher rates to
achieve the same level of revenue.”  Is the European Communities suggesting that exempting foreign source
income from taxation, including such income that is related to exports, is permissible so long as taxes in generalare increased to offset foregone revenue?
309  First European Communities Submission, paragraph 132.
310 Ibid.
311  Ibid.WT/DS108/R
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4.671  The crucial interpretative question posed by Article 1.1(a)(1)(ii) is what constitutes revenue
that is “otherwise due.”  The European Communities has intimated that revenue is “due” if domestic
law makes it so.312  According to the European Communitie s, “revenue that is otherwise due is
forgone” only where a measure initially makes a gene ral category of income subject to taxation and
then another measure, or a different provision of the same measure, creates an exception.313
4.672  However, the European Communities has not provided the Panel with any interpretative
analysis grounded in the rules of the Vienna Convention on the Law of Treaties  (“VCLT ”) for
concluding that a subsidy exists where foreign-source income is not taxed.  Instead, the European
Communities ignores a detailed interpretative analysis, because it knows that such an analysis will
lead the Panel down a path that the European Communities desperately wants the Panel to avoid.Specifically, the European Communities does not want the Panel to consider the Tax Legislation
Cases , the 1981 Council Decision, or footnote 59 of the SCM Agreement.  Individually and
collectively, these interpretative sources disrupt th e European Communities' simplistic legal analysis,
because they clarify that the exemption from tax of income attributable to foreign economic processes
does not constitute the foregoing of revenue that is “otherwise due.”
The Tax Legislation Cases and the 1981 Council Decision Are Relevant Sources for
Interpreting Article 1.1(a)(1)(ii), Clarifying that the Exemption from Tax of Income
Attributable to Foreign Economic Processes Does Not Constitute the Foregoing of Revenue
that Is "Otherwise Due"
4.673  Although the United States position is that the 1981 Council Decision is dispositive in
interpreting Article 1.1(a)(1)(ii), in order to properly understand the Council Decision, one first mustbe clear on what the panel found in the underlying Tax Legislation Cases .  Because the Council
effectively reversed the panel, the panel’s reports in those cases provide the key to unlocking the
significance of the Council Decision.
4.674  Consider, for example, the case against France.  In the report in that case, the panel concluded
as follows:
The Panel noted that the particular application of the territoriality principle by France
allowed some part of export activities, belonging to an economic process originating
in the country [and then continuing in a foreign country], to be outside the scope of
French taxes.  In this way France has foregone revenue  from this source and created a
possibility of a pecuniary benefit to exports in those cases where income andcorporation tax provisions were significantly more liberal in foreign countries .
314
Note in particular the reference to “foregone revenue.”  Having previously found that “profits
generated by undertakings operated abroad are exempt from French taxation,” the panel was declaring
that the exemption of such profits from tax constituted “foregone revenue.”315
4.675  The panel then found that this practice “constituted a subsidy on exports because the above-
mentioned benefits to exports did not apply to domestic activities for the internal market.”316  From
this the panel then arrived at the following conclusion:
                                                     
312  Ibid.
313 Ibid.
314 Tax Legislation - Income Tax Practice Maintained by France , L/4423, BISD 23S/114, Report of the
Panel adopted 7-8 December 1981, paragraph 47 (emphasis added).  The panel made virtually identical findings
in the cases against Belgium and the Netherlands. Tax Legislation - Income Tax Practice Maintained by
Belgium , L/4424, BISD 23S/127, Report of the Panel adopted 7-8 December 1981,  paragraph 34; and Tax
Legislation - Income Tax Practice Maintained by the Netherlands , L/4425, BISD 23S/137, Report of the Panel
adopted 7-8 December 1981, paragraph 34
315 BISD 23S/114, paragraph 9.WT/DS108/R
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In circumstances where different tax treatment in different countries resulted in a
smaller total tax bill in aggregate being paid on exports than on sales in the home
market, the Panel concluded that there was a partial exemption from direct taxes.  The
Panel further concluded that the practices were covered by one or both items (c) and
(d) of the illustrative list of 1960 (BISD, 9 Suppl. P. 186).317
4.676  The panel’s conclusions are important not because they were followed by the GATT Council,
but because they were rejected.  The Council did not accept the panel’s reasoning.  However, rather
than reject the reports or do nothing, the Council decided to adopt the reports by substituting its own
reasoning that essentially reversed key findings of the panel.  In particular, the 1981 Council Decision
states that economic processes located outside the te rritorial limits of the exporting country need not
be subject to taxation by the exporting country.  Put differently, the Council overturned the panel’s
findings that, by declining to tax income from foreign economic processes incurred as part of export
activities, France, Belgium and the Netherlands had “foregone revenue.”
4.677  The European Communities must argue that the Tax Legislation Cases  are irrelevant because
the rules emerging from those cases are fatal to its position.  The European Communities would preferthat the Panel forget the underlying similarity between what the European Communities is accusing
the United States of doing with the FSC and what the United States accused France, Belgium, and the
Netherlands of doing in the 1970s.  The European Communities also would prefer that the Panel
forget that because they could not countenance the panel’s conclusions in the Tax Legislation Cases ,
France, Belgium, and the Netherlands held up adoption of the reports until the Council reversed the
panel.
318  Finally, the European Communities also would like the Panel to ignore that the 1981
Council Decision sanctified the differential tax treatment of foreign and domestic activities, evenwhen those activities involve export transactions.
4.678  Instead, having enjoyed the protection of the Council Decision since 1981, the European
Communities now wants to deny this to the United States by engaging in a bit of revisionist analysis
that leads the European Communities to the conclusion that the Council Decision is not relevant.  The
European Communities offers three arguments in this regard:  (1) the Tax Legislation Cases  and the
Council Decision involved GATT Article XVI, rather than the SCM Agreement; (2) the Tax
Legislation Cases  involved an allegation of dual pricing; and (3) the Council Decision sanctified the
differential tax treatment of foreign and domestic activities only with respect to pure territorial
systems.  For the reasons set forth below, each of these arguments is incorrect.
Even Though the Tax Legislation Cases and the Council Decision Involved GATT
Article XVI, They Are Highly Relevant for Purposes of Interpreting Article 1.1(a)(1)(ii)
4.679  The European Communities claims that the Tax Legislation  panel reports and the 1981
Council Decision are irrelevant because they involved GATT Article XVI.
319  In so claiming, the
European Communities oversimplifies a complicated issue.  As the Appellate Body has explained,“[t]he relationship between the GATT 1994 and th e other goods agreements in Annex 1A [to the
WTO Agreement] is complex and must be examined on a case-by-case basis.”
320  Thus, while it is true
that the panel reports and the Council Decision involved Article XVI of GATT 1947, that does not
                                                                                                                                                                    
316 BISD 23S/114, paragraph 48.  The panel made an identical statement in the Belgian and Dutch
cases.  BISD 23S/127, paragraph 35; BISD 23S/137, paragraph 35.
317 BISD 23S/114, paragraph 50.  The panel reached the same conclusions in the Belgian and Dutch
cases.  BISD 23S/127, paragraph 37; BISD 23S/137, paragraph 37.
318  The United States readily admits that it, too,  held up adoption of the DISC panel report until the
reports in the three European cases were adopted.  The point here is that the European Communities is
disingenuous when it suggests that the delay in adopting the reports in the Tax Legislation Cases  was solely due
to objections by the United States.
319 EC Oral Statement, paragraphs 45-46.
320 Brazil - Measures Affecting Desiccated Coconut , WT/DS22/AB/R, Report of the Appellate Body,
adopted 20 March 1997, page 13 (“ Desiccated Coconut ”).WT/DS108/R
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render them irrelevant for purposes of interpreting Article 1.1(a)(1)(ii) of the SCM Agreement.
Instead, an examination of the text of the SCM Agreement makes clear that the SCM Agreement and
Article XVI are not to be construed in isolation from each other.
4.680  The relationship between the two is demonstrated by the very first article of the SCM
Agreement.  Article 1.1(a)(2), which deals with the definition of a subsidy, expressly referencesArticle XVI when it refers to “any form of income or price support in the sense of Article XVI of
GATT 1994 ... .”
4.681  Similarly, the notification and surveillance provisions highlight the relationship between
Article XVI and the SCM Agreement.  For example, Article 25.6 of the SCM Agreement provides as
follows:  “Members which consider that there are no measures in their territories requiringnotification under paragraph 1 of Article XVI of GATT 1994 and this Agreement shall so inform the
Secretariat in writing.”  (Emphasis added).  Similarly, Article 25.10, which deals with cross-
notification, provides as follows:  “Any Memb er which considers that any measure of another
Member having the effects of a subsidy has not been notified in accordance with the provisions of
paragraph 1 of Article XVI of GATT 1994 and this Article may bring the matter to the attention of
such other Member.”  (Emphasis added).  Finally, Article 26.1 charges the Subsidies Committee with
examining notifications “submitted under paragraph 1 of Article XVI of GATT 1994 and paragraph 1
of Article 25 of [the SCM] Agr eement ... .”  (Emphasis added).
4.682  Even more to the point, paragraph (l) of Annex I to the SCM Agreement refers to “[a]ny other
charge on the public account constituting an export subsidy in the sense of Article XVI of
GATT 1994 .”  (Emphasis added).  If the drafters of the SCM Agreement had intended to render
Article XVI irrelevant for purposes of the SCM Agreement (which essentially is what the EuropeanCommunities is claiming), they would not have written language that expressly directs one to
Article XVI for purposes of identifying an export subsidy under the SCM Agreement.
4.683  Any doubt on this score is eliminated by Article 32.1 of the SCM Agreement, which provides
as follows:  “No specific action against a subsidy of another Member can be taken except in
accordance with the provisions of GATT 1994, as interpreted by this Agreement .”  (Emphasis added;
footnote omitted).  Thus, the SCM Agreement constitutes an interpretation of GATT 1994, including
Article XVI.  This means that Article XVI and the SCM Agreement cannot be interpreted in isolation
from each other.
4.684  In the one case to date that considered the relationship between the SCM Agreement and the
subsidy provisions of GATT 1994, both the panel and the Appellate Body reached this sameconclusion.  In the Desiccated Coconut  case, which involved Article VI of GATT 1994, the panel
observed as follows:
For example, Article 1.1 of the SCM Agreement contains a definition of “subsidy”
and Article 16.1 of the SCM Agreement contains a definition of “domestic industry”
both of which are “for purposes of this Agreement”.  However, the terms “subsidy”and “domestic industry” are used both in Article VI of GATT 1994 and the SCM
Agreement.  If the term “this Agreement” were interpreted strictu sensu  to mean the
SCM Agreement, then the definitions of these key terms in the SCM Agreement
would be inapplicable to the same terms as used in Article VI of GATT 1994.  Such a
result could not have been intended.
321
4.685  The panel went on to conclude that “the drafters expected that Article VI of GATT 1994 and
the SCM Agreement would operate only in conjunction.”322
                                                     
321 Brazil - Measures Affecting Desiccated Coconut , WT/DS22/R, Report of the Panel, as modified by
the Appellate Body, adopted 20 March 1997, paragraph 234.
322 Ibid., paragraph 285.WT/DS108/R
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4.686  The Appellate Body reached the same conclusion as the panel.  Noting that “[t]he authors of
the new WTO regime intended to put an end to the fragmentation that had characterized the previous
system”323, the Appellate Body concluded that
the negotiators of the SCM Agreement  clearly intended that, under the integrated
WTO Agreement , countervailing duties may only be imposed in accordance with the
provisions of Part V of the SCM Agreement  and Article VI of the GATT 1994, taken
together.  If there is a conflict between the provisions of the SCM Agreement  and
Article VI of the GATT 1994, furthermore, the provisions of the SCM Agreement
would prevail as a result of the general interpretative note to Annex 1A.324
4.687  Although the Desiccated Coconut  case involved the relationship between Article VI and the
SCM Agreement, the reasoning of the panel and the Appellate Body apply equally to the relationship
between Article XVI and the SCM Agreement.  This is especially true given the numerous references
in the SCM Agreement, discussed above, to Article XVI.
4.688  As the Appellate Body has noted, under the gene ral interpretative note to Annex 1A, the SCM
Agreement would prevail in the event of a conflict between one of its provisions and Article XVI.325
However, in the instant case, there is no conflict between Article XVI, as interpreted by the 1981
Council Decision, and Article 1.1(a)(1)(ii).  As noted above, the phrase “government revenue that is
otherwise due is foregone” is not self-defining, and, by its terms, does not conflict with the principle
set forth in the Council Decision.  The Council’s st atement that foreign economic processes “need not
be subject to taxation by the exporting country”326 is just another way of saying that revenue from
such processes is not “otherwise due.”
4.689  Moreover, under public international law “[t]here is a presumption against conflicts in that
parties do not normally intend to incur conflicting obligations.”327  As recognized by a prior panel,
“[t]his presumption is especially relevant in the WTO context since all WTO agreements, including
GATT 1994 which was modified by the Understandings when judged necessary, were negotiated at
the same time, by the same Members and in the same forum.”328  What this means is that, to the extent
possible, Article XVI and the SCM Agreement must be  construed in a manner that avoids a conflict.
In the context of this case, this means that Article 1.1(a)(1)(ii) must be construed in light of the 1981
Council Decision.
4.690  In summary, the text of the SCM Agreement and WTO jurisprudence demonstrate that
Article XVI and the SCM Agreement must be interpreted in a harmonious manner.  Therefore,
notwithstanding the fact that the Tax Legislation  panel reports and the 1981 Council Decision
involved Article XVI, they are highly relevant to an interpretation of Article 1.1(a)(1)(ii) of the SCM
Agreement.
The Fact that the Tax Legislation Cases Involved an Allegation of Dual Pricing Does Not
Render Them or the 1981 Council Decision Irrelevant
4.691  The European Communities also notes that the panel reports in the Tax Legislation Cases
were based on an allegation of dual pricing.  A ccording to the European Communities, because the
                                                     
323 Desiccated Coconut , page 18.
324 Ibid., page 17 (underscoring in original).
325 Ibid., page 13.
326 BISD 28S/114.
327 Encyclopaedia of Public International Law  (North-Holland 1984), page 470.
328  Indonesia - Certain Measures Affecting the Automobile Industry , WT/DS55/R, Report of the Panel
adopted 23 July 1998, paragraph 14.28 (footnote omitted) (“ Indonesia Autos ”).WT/DS108/R
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export subsidy rules of the SCM Agreement do not contain a dual pricing requirement, the panel
reports and the 1981 Council Decision are no longer relevant.329
4.692  Here, the European Communities simply distorts the role of the dual pricing test.  GATT
Article XVI:4 (both the 1947 and the 1994 versions) does not contain a strict prohibition on export
subsidies.  Rather, it only prohibits an export su bsidy “that results in the sale of such product for
export at a price lower than the comparable price charged for the like product to buyers in the
domestic market.”  Thus, two elements have to be proved under Article XVI:4:  (1) that there is an
export subsidy; and (2) that the export subsidy results in dual pricing.  As the European Communities
correctly notes, the dual pricing requirement was abolished in the Tokyo Round Subsidies Code, and
continues to be absent from the SCM Agreement.330
4.693  However, the fact that dual pricing is no longer an element to be proved in advancing a
prohibited export subsidy claim does not render the Tax Legislation  panel reports or the 1981 Council
Decision any less relevant.  The panel in those case s found both elements present – the export subsidy
and the dual pricing.  However, had the dual pricing requirement not existed under Article XVI:4 (that
is, had GATT 1947 been less tolerant of export subsidies), the panel still would have found the sameviolation.  The only difference is that there would have been only one element to prove, not two, and
the panel would have reached the same conclusion s; namely, that by exempting from tax income
attributable to foreign economic processes incurred in export transactions, France, Belgium and the
Netherlands had foregone revenue, engaged in differential taxation of export and domestic sales, and
conferred an export subsidy.
4.694  Moreover, the 1981 Council Decision did not address the dual pricing requirement at all.
Instead, as discussed above, the Council reversed the panel’s conclusions regarding the existence ofan export subsidy.
4.695  Thus, the fact that the Tax Legislation Cases  involved dual pricing allegations does not
undercut the relevance of the panel reports or the Council decision one iota.  Indeed, the fact that the
European Communities would even advance such a tenuous argument speaks volumes about the
merits of the European Communities' case.
331
The 1981 Council Decision Does Not Require an "All-or-Nothing" Approach to the
Taxation of Foreign Economic Processes
4.696  As a final attack on the relevance of the 1981 Council Decision, the European Communities
argues that it requires a Member to exercise an all-or-nothing choice when it comes to income arisingout of foreign economic processes.  A Member must either exempt all income from all foreign
economic processes or tax all income from all foreign economic processes.
332
4.697  The European Communities' all-or-nothing theory is not supported by the text of the Council
Decision, and the European Communities provides no other basis in support of its assertion.  The
European Communities simply makes an unsubstantiated claim that the Council intended that such atax exemption may not be limited to instances where exported goods are involved, but instead must be
all-encompassing.
4.698  The language of the Council Decision, though, states otherwise.  The Council made two
fundamental points that contradict the European Communities' theory.  First, the Decision states that
                                                     
329  EC Oral Statement, paragraph 49.
330  EC Oral Statement, paragraph 48.
331  The European Communities' argument is akin to ar guing that because an actionable subsidy claim
requires a showing of adverse effects, a panel or Appellate Body interpretation of Article 1 of the SCMAgreement made in an actionable subsidy case would be irrelevant to an interpretation of Article 1 in a
prohibited subsidy case.
332  EC Oral Statement, paragraph 54.WT/DS108/R
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“in general, economic processes (including transactions involving exported goods) located outside the
territorial limits of the exporting country need not be subject to taxation by the exporting country.”333
Second, the Decision states that such processes “should not be regarded as export activities in terms ofArticle XVI:4 of the General Agreement.”
334
4.699  With respect to the first point, if countries are under no obligation to tax income derived from
foreign economic processes, then they should be free to exempt all such income or just part of it.
There simply is nothing in the language of the Decision that compels a contrary conclusion.
4.700  As for the second point, if foreign economic processes are not export activities for purposes
of Article XVI:4, then exempting such income from  taxation cannot be considered to be contingent
upon exports, as the European Communities contends.  This is true irrespective of whether all foreign-source income or only foreign-source income related to export transactions is exempted.  Indeed, as
discussed below, EC member States do not themselv es maintain pure territorial systems, and would
not pass the test that the European Communities now expounds.
The 1981 Council Decision Is Authoritative
4.701  The European Communities also takes issue with  the authoritative nature of the Council
Decision.  Citing the Appellate Body decision in the Japan Liquor  case, the European Communities
argues that adopted GATT panel reports constitute nothing more than proposals to the GATT
CONTRACTING PARTIES.
335
4.702  The United States does not dispute the Appellate Body’s rejection of the view that “adopted
panel reports in themselves  constitute ‘other decisions of the CONTRACTING PARTIES to GATT
1947' ....”336  However, the Appellate Body did acknowledge that adopted panel reports cannot be
ignored, stating that
[a]dopted panel reports are an  important part of the GATT acquis .  They are often
considered by subsequent panels.  They create legitimate expectations among WTO
Members, and, therefore, should be taken into account where they are relevant to any
dispute.  However, they are not binding, except with respect to resolving theparticular dispute between the parties to that dispute.
337
4.703  Thus, even though the panel reports in the Tax Legislation Cases  – as opposed to the Council
Decision – are not themselves legally binding in this dispute, the Panel should regard them as having
greater interpretative weight with respect to the i ssues raised in the present dispute than is normally
the case with adopted panel reports.  Both the United States and the European Communities wereparties to the Tax Legislation Cases .  The United States enacted the FSC for the specific purpose of
complying with the findings of th e DISC panel, as interpreted by the Council Decision.  And the tax
measures of France, Belgium and the Netherlands, which the European Communities in the present
dispute goes to great lengths to distinguish from  the FSC with respect to their impact upon exports,
are the same measures – essentially unchanged – that the panel in the Tax Legislation Cases  found to
be export subsidies.
4.704  Having said that, however, the 1981 Council Decision is quite different from the panel reports
discussed by the Appellate Body in Japan Liquor .  In that case, the Appellate Body based its decision
concerning the status of adopted panel reports on the fact that
                                                     
333  BISD 28S/114.
334  Ibid.
335  EC Oral Statement, paragraph 51.
336 Japan - Taxes on Alcoholic Beverages , WT/DS8/AB/R, Report of the Appellate Body adopted
1 November 1996, page 15 (“ Japan Liquor ”) (emphasis added).
337  Japan Liquor , page 13.WT/DS108/R
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a decision to adopt a panel report did not under GATT 1947 constitute agreement by
the CONTRACTING PARTIES on the legal reasoning in that panel report.  The
generally-accepted view under GATT 1947 was that the conclusions and
recommendations in an adopted panel report bound the parties to the dispute in that
particular case, but subsequent panels did not feel legally bound by the details andreasoning of a previous panel report.
338
4.705  The GATT Council, though, went well beyond merely adopting the panel reports in the Tax
Legislation Cases .  First, the Council provided substantive views on the merits of the issues then
under consideration, and, in an action that appears to be unprecedented in the annals of GATT,
adopted the panel reports by changing the conclusions contained in those reports.
4.706  Second, there can be no doubt that the GATT Council intended its decision to have broader
application than the specific cases then before it.  The terms of the Council Decision specifically state
that it applies “with respect to these cases, and in general ... .”  Had the Council been concerned
merely with adopting the panel reports and putting an end to a long-running dispute, with or without
an interpretative gloss applicable to the cases at issue, the words “and in general” would have been
superfluous.  Because it must be assumed that the insertion of these additional words was deliberate,
the logical implication is that the Council inte nded to make a ruling that extended beyond the
measures at issue in the Tax Legislation Cases .  In the view of the United States, the unique nature of
the 1981 Council Decision qualifies it as a “decision” within the meaning of Article XVI:1 of the
WTO Agreement.339
4.707  Moreover, in issuing its decision, the Council was expressing the views of the
CONTRACTING PARTIES under Article XXV of  GATT 1947.  Article XXV:1 states that
“[r]epresentatives of the contracting parties shall meet from time to time for the purpose of giving
effect to those provisions of this Agreement which involve joint action and, generally, with a view to
facilitating the operation and furthering the objectives of this Agreement .”  (Emphasis added).
4.708  The Council was authorized to speak for th e CONTRACTING PARTIES.  The Council was
established to replace the Inter-sessional Committee, which theretofore had been the GATT bodydesignated to handle matters between meetings of the CONTRACTING PARTIES.
340  Unlike its
predecessor, which had limited membership, the Council was “composed of representatives of all
contracting parties willing to accept the responsibility of membership therein.”341  In addition, unlike
its predecessor, which had a limited mandate for action, the Council was given broad powers,
including the power “to deal with such other matters with which the CONTRACTING PARTIES maydeal at their sessions.”
342  In order to protect individual contracting parties from unexpected inter-
sessional action, each contracting party had the right to “suspend the operation of such action by the
Council through the submission of a written appeal to the CONTRACTING PARTIES.”343  Thus, the
Council was authorized to act on behalf of the CONTRACTING PARTIES and, absent objection
                                                     
338  Japan Liquor , page 12.
339  In this regard, the Chairman’s note to the 1981 Council Decision states that the Decision in no way
seeks to amend the GATT or the Tokyo Round Subsidies Code.  BISD 28S/114.  At the first meeting of thePanel, the European Communities cited the Chairman’s note to suggest that the United States was improperlyinvoking the Council Decision to amend or otherwise alter the meaning of the GATT or the Subsidies Code.
Nothing could be further from the truth.  In the view of the United States, the Chairman’s note clarifies that the
Council Decision merely reiterates, in general term s, the existing understanding of the CONTRACTING
PARTIES that Article XVI:4 does not require countries to tax the profits derived from activities taking place
outside of their borders, including transactions involving exported goods.  The panel had upset thisunderstanding, and the Council acted to restore it.
340  BISD 9S/7 (1961), pages 7, 8.  The Intersessional Committee had been established in 1951.  BISD,
Vol. II (1952), page 205.
341  BISD 9S/7, pages 7, 8.
342  Id., pages 8-9.
343  Id., page 9.WT/DS108/R
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from an individual contracting party, the Council’s actions would be binding under GATT
Article XXV as if the CONTRACTING PARTIES had themselves acted.
4.709  The authority conferred upon the Council to interpret GATT 1947 was akin to the powers
currently bestowed on the WTO Ministerial C onference and the General Council, which under
Article IX:2 of the WTO Agreement “have the excl usive authority to adopt interpretations of this
Agreement and of the Multilateral Trade Agreements.”  Just as the Conference and the Council may
issue authoritative interpretations of the WTO agreements, so too was the Council empowered to
interpret GATT 1947.  When the Council, in the Tax Legislation Cases , substituted its reasoning for
that of the panel, the Council was exercising that power.
4.710  As important as the 1981 Council Decision was under GATT 1947, it is even more significant
under GATT 1994.  Article 1(b)(iv) of GATT 1994 st ates that the Agreement consists of GATT 1947
and, among other things, “other decisions of the CONTRACTING PARTIES to GATT 1947.”  Thus,
whereas the Council Decision was an interpretation of GATT 1947, it actually is a part of GATT
1994.  Because GATT 1994 includes not only GATT 1947, but also rectifications, amendments,
protocols, certifications and “other decisions of the CONTRACTING PARTIES,”344 the Appellate
Body has recognized that “[i]n many ways therefore, the provisions of the GATT 1994 differ from the
provisions of the GATT 1947.”345
4.711  In summary, the European Communities confuses the adopted panel reports in the Tax
Legislation Cases  with the Council Decision itself.  While the reports may not be authoritative, the
Council Decision is.346
In the Absence of a Clear Statement to the Contrary in the SCM Agreement, the PanelMust Conclude that the Drafters Intended to  Preserve the Principles Contained in the
Council Decision
4.712  In light of the foregoing, the Panel could ignore the 1981 Council Decision only if there were
some clear indication in the SCM Agreement that the drafters intended a meaning at odds with the
Council Decision.
347  However, no such indication exists.
4.713  Instead, as the European Communities acknowledged at the first meeting of the Panel, neither
the taxation of income from foreign economic processes in general, nor paragraph (e) or footnote 59
in particular, was the subject of negotiation during the Uruguay Round.  Given this, it simply is not
possible to maintain, as does the European Communities, that in negotiating a single undertaking with
respect to subsidies rules that included both Article XVI and the SCM Agreement, the drafters sub
silentio  decided to repeal the Council Decision.348
                                                     
344  See Article XVI:1 of the WTO Agreement and paragraph 1(b)(iv) of Annex 1A incorporating the
GATT 1994 into the WTO Agreement.
345  Desiccated Coconut , page 13.
346 As discussed above, while they are not legally binding, the panel reports are important to
understanding the significance and nature of the Council Decision.
347  In this regard, the European Communities previously has acknowledged that if the drafters of the
SCM Agreement had intended to make fundamental changes to GATT rules affecting subsidies, one would haveexpected the drafters to leave eviden ce of such an intention.  In connection with the relationship between the
SCM Agreement and GATT Article III, the European Communities has made the following argument:  “If, as
claimed by Indonesia, the WTO Agreement had rendered GATT Article III inapplicable to subsidies, one would
expect to find some indication in the SCM Agreement of the drafters’ intention to introduce such a fundamentalchange with respect to the situation existing under GATT 1947.  Yet, the SCM Agreement does not contain theslightest trace of such intention.”  Indonesia Autos , paragraph 5.286.  In the context of the instant case, the SCM
Agreement does not contain the slightest trace of an in tention to discard the principles of the 1981 Council
Decision.
348  In this regard, in the exchanges that took place at the first meeting of the Panel, it became apparent
that with respect to the European Communities argument that the Council Decision should be ignored, theWT/DS108/R
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4.714  In this regard, it is instructive to compare the issue facing this Panel with the issue that the
Appellate Body confronted in the Cotton Underwear  case.349  In that case, the Appellate Body had to
determine whether the Agreement on Textiles and Clothing (“ATC”) permitted the backdating of the
effective date of a restraint measure.  In resolving this issue, the Appellate Body considered a
predecessor agreement, the Multifibre Arrangement (“MFA”), which the Appellate Body consideredto be part of the context of the ATC.  The Appellate Body noted that the MFA expressly allowed
backdating, but that this authority was not carried over into the ATC.  This led the Appellate Body to
the following conclusion:
We believe the disappearance in the ATC of the earlier MFA  express provision for
backdating the operative effect of a restraint measure, strongly reinforces thepresumption that such retroactive application is no longer permissible.  This is the
commonplace inference that is properly drawn from such disappearance.  We are not
entitled to assume that that disappearan ce was merely accidental or an inadvertent
oversight on the part of either harassed negotiators or inattentive draftsmen.  That no
official record may exist of discussions or statements of delegations on this particularpoint is, of course, no basis for making such an assumption.
350
4.715  The same logic applies with respect to the Coun cil Decision, albeit in reverse.  The fact that
nothing in the SCM Agreement references a repudiation of the principles of the Council Decision
raises the presumption that the drafters did not, in fact, intend to repudiate those principles.  Without
such an indication, the Panel is not entitled to assume that in an agreement which repeatedly
references Article XVI, “harassed negotiators or inattentive draftsmen” decided to repudiate one of
the most important decisions concerning  Article XVI in the history of GATT.351
                                                                                                                                                                    
European Communities premises its argument in no small part on a distorted view of the changes wrought by
the Uruguay Round with respect to export subsidy disciplines.  While the United States agrees that the UruguayRound brought about significant improvements in those disciplines, these improvements largely did not involve
matters related to the definition of an export subsidy.  Instead, the major improvements were:  (1) an improved
dispute settlement system; (2) the application of export subsidy disciplines to developing country Members; and(3) the potential application of SCM Agreement export subsidy disciplines to agricultural products.
However, with respect to the definition of an export subsidy, the changes were relatively minor.  The
definition in Article 3.1(a) is largely a restatement of principles that previously could be gleaned from theIllustrative List of the Tokyo Round Subsidies Code.  With respect to the Illustrative List itself:  (1) the word
“provision” was substituted for “delivery” in paragraph (d) and a footnote was added; (2) the “consumed in
production” standard was substituted for the “physical incorporation” standard in paragraphs (h) and (i); and (3)the word “manifestly” was deleted from paragraph (j).  In addition, Annexes II and III, which had beendeveloped as part of the work of the Subsidies Code Co mmittee, were added, modified to take into account the
noted change to paragraphs (h) and (i).
None of these changes, either individually or cumula tively, is indicative of a drafting intent to make a
complete break from prior export subsidy rules or to depart from the general objective of the Uruguay Round
drafters to “bring the legal history and experience under the GATT 1947 into the new realm of the WTO in away that ensures continuity and consistency in a smooth transition from the GATT 1947 system.”  Japan
Liquor , page 13.
349 United States - Restrictions on Imports of Cotton and Man-Made Fibre Underwear ,
WT/DS24/AB/R, Report of the Appellate Body adopted 25 February 1997.
350  Cotton Underwear , page 17.
351  In this regard, at the first meeting of the Panel, the European Communities suggested that if the
United States had wanted to ensure the continuation of the principles set forth in the Council Decision, it was
incumbent on the United States to negotiate language to that effect in the SCM Agreement.  The United Statesdisagrees.
As discussed above, the status quo under the pre-WTO regime was that income attributable to foreign
economic processes (including those incurred in connection with export transactions) did not have to be taxedwithout running afoul of GATT subsidy rules.  This was true whether one looked at the issue from the
perspective of Article XVI or the Subsidies Code.  Because the Subsidies Code was an agreement that
interpreted, inter alia , Article XVI, the Council Decision would have been equally applicable to the provisions
of the Subsidies Code, although a decision by the Subsidies Code Committee might not have been applicableWT/DS108/R
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Footnote 59 Supports an Interpretation of Articl e 1.1(a)(1)(ii) that the Exemption from Tax
of Income Attributable to Foreign Economic Processes Does Not Constitute the Foregoing
of Revenue that Is "Otherwise Due"
4.716  In the preceding sections, the United States demonstrated that the 1981 Council Decision
informs an interpretation of Article 1.1(a)(1)(ii) of the SCM Agreement, and leads to the conclusion
that the exemption from tax of income attributable to foreign economic processes does not constitute
the foregoing of revenue that is “otherwise due” within the meaning of that provision.  This
conclusion is reinforced when one takes into accoun t footnote 59 of the SCM Agreement.  Under the
general rules of Article 31.2 of the VCLT , footnote 59 forms part of the context of
Article 1.1(a)(1)(ii).352  Moreover, it is a particularly important part of the context in light of the fact
that footnote 59 qualifies paragraph (e) of the I llustrative List, which, in turn, constitutes a specific
application of the general principle contained in Article 1.1(a)(1)(ii).353
Footnote 59 Narrows the Scope of Paragraph (e)
4.717  The European Communities and the United States appear to agree that paragraph (e) of the
Illustrative List and footnote 59 are pertinent to this dispute, but part company on the import of
footnote 59.  The European Communities has disputed the United States interpretation of the footnote,
maintaining that the footnote clarifies paragraph (e), and may even expand its coverage.  As the
European Communities asserted at the first meeting of the Panel, the language of footnote 59 “does
not say or even imply that the exporting country has the right to exempt from tax income from an
export transaction which would otherwise bear tax.  If it did, it would be directly contradicting bothItem (e) and Article 3.1(a).”
354
4.718  The European Communities overlooks the fact that the language of footnote 59 explicitly
narrows, rather than expands, the scope of paragraph (e).  The clearest example of this can be seen in
the final sentence of footnote 59, which states:  “Paragraph (e) is not intended to limit a Member from
taking measures to avoid the double taxation of foreign-source income earned by its enterprises or theenterprises of another Member.”  This sentence makes clear that paragraph (e) is not applicable to
measures imposed by Members to avoid double taxation of foreign-source income.  It means that any
such measure does not fall within the Article 3.1(a) prohibition, even if the measure in question
                                                                                                                                                                    
with respect to Article XVI depending upon the nature of the issue and the contracting parties involved.  See,
e.g., United States - Imposition of  Countervailing Duties on Imports of Fresh and Chilled Atlantic Salmon from
Norway ,” SCM/153, Report of the Panel adopted 28 April 1994, paragraph 239 (panel convened under the
Subsidies Code considered an adopted report of Group of Experts established under GATT Article VI forpurposes of interpreting Subsidies Code).
Thus, going into the Uruguay Round, the FSC was protected by the Council Decision under both
Article XVI and the Subsidies Code, and there was no need for the United States to “pay” for protection that italready had and that the text of the new SCM Agreement did not affect.  In light of the texts of the WTO
Agreement and the SCM Agreement, the Council Decision would inform the interpretation of the relevant
provisions of the SCM Agreement, just as it previously had informed the interpretation of Article XVI and therelevant provisions of the Subsidies Code.
Indeed, given that the key principle of the Council Decision at issue here was proposed by EC member
States and endorsed by the European Communities, it would seem to have been incumbent upon the European
Communities to negotiate language in the SCM Agreement expressly terminating that principle if the European
Communities no longer found the principle to be in its interest.
352  Cf., United States - Anti-Dumping Duty on Dynamic Access Memory Semiconductors (DRAMS) of
One Megabit or Above from Korea , WT/DS99/R, Report of the Panel  adopted 19 March 1999, paragraph 6.21
(“[T]he entire text of the AD Agreement may be relevant to a proper interpretation of any particular provision
thereof.”).
353 Again, for the reasons set forth in the First US Submission, a proper analysis of the FSC should
begin with the most specific provision of the SCM Agreement, footnote 59.  However, for the reasons set forthherein, an analysis that begins with general provisions, as advocated by the European Communities, does not
change the outcome that the FSC is not a subsidy.
354  EC Oral Statement, paragraph 42.WT/DS108/R
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otherwise would constitute a “full or partial exemp tion . . . specifically related to exports, of direct
taxes” within the meaning of paragraph (e).
4.719  The qualifying nature of footnote 59 is reinforced by the second sentence, which states “[t]he
Members reaffirm the principle that prices for goods  in transactions between exporting enterprises and
foreign buyers under their or the same control should for tax purposes be the prices which would becharged between independent enterprises acting at arm’s length.”  This language protects against
WTO Members conferring an impermissible tax advantage on domestic-source income by allowing
their exporting enterprises to shift income to tax-ad vantaged, related foreign enterprises.  This could
occur if taxing authorities allowed higher-taxed “exporting enterprises” to undervalue prices in
relation to lower-taxed “foreign buyers.”  Artificially shifting income in this way would result in a taxsavings only if the related foreign company was taxed at a lower rate or not at all.
4.720  The European Communities concedes that “this sentence [in footnote 59 regarding the arm’s
length principle] assumes that the foreign related buyer may not be taxed at the same level as the
exporter and this may lead to a lower total tax charge for the income arising from the export
transaction.”
355  In fact, the sentence is relevant and has meaning only if WTO Members are permitted
to tax foreign-source income to a lesser extent than domestic-source income or to exempt foreign-
source income from tax altogether.  If WTO Members are not free to do so, there would be no need
for the drafters of the SCM Agreement to have included this provision.  In such a circumstance,
paragraph (e) would ban any tax advantage conferred on the income of foreign entities taking part in
export transactions.
4.721  A final indicator that footnote 59 narrows the scope of paragraph (e) is the opening sentence,
which states that “[t]he Members recognize that deferral need not amount to an export subsidy where,for example, appropriate interest charges are collected.”  This sentence makes plain that, in certain
circumstances, a deferral of taxes specifically related to exports would not constitute a prohibited
subsidy.  The sentence gives as an example the situation where an appropriate interest rate is charged,
but indicates more generally that there may be other circumstances where a deferral does not give rise
to an export subsidy.
4.722  In summary, footnote 59 belies the European  Communities' claim that under paragraph (e)
any exemption, remission, or deferral of tax, even when contingent upon exportation, constitutes the
foregoing of revenue that is “otherwise due” within the meaning of Article 1.1(a)(1)(ii).
Footnote 59 Indicates that Foreign-Source Income Need Not Be Taxed
4.723  As demonstrated in the preceding section, footnote 59 narrows the scope of paragraph (e).  In
the context of this dispute, however, the most im portant aspect in which footnote 59 narrows the
scope of paragraph (e) is the second sentence.  As explained above, this sentence is relevant only if
WTO Members are permitted to exempt foreign-source income from tax or tax it at a lesser rate than
domestic-source income.
356
4.724  The second sentence of footnote 59, like the rest of the footnote, forms part of the context for
purposes of interpreting Article 1.1(a)(1)(ii).  The second sentence reinforces the conclusion drawn
from a consideration of the 1981 Council Decision that the exemption from tax of income attributable
to foreign economic processes does not constitute foregone revenue that is “otherwise due.”357
                                                     
355  EC Oral Statement, paragraph 42.
356  Even Japan, a third party that has intervened on the side of the European Communities, agrees that
the purpose of the arm’s length principle in footnote 59 is to allocate “profits between domestic activities andforeign activities ... .”  Submission of Japan, 2 February 1999, paragraph 19.  Of course, as a separate matter,
Japan contests whether the FSC administrative pricing rules perform this allocation properly.
357  Of course, for the same reasons as discussed above in connection with Article 1.1(a)(1)(ii), the 1981
Council Decision also informs the interpretation of footnote 59, thereby reinforcing the conclusion that theWT/DS108/R
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Footnote 59 Reflects the GATT's Historical Treatment of Tax Exemptions for Foreign-
Source Income
4.725  The conclusions set forth above regarding footnote 59 are confirmed by a consideration of the
GATT history that preceded the SCM Agreement.  Most notably, the disciplines in the SCMAgreement concerning export subsidies are not, as claimed by the European Communities, some new
concept that first emerged from the Uruguay Round.  Instead, they derive directly from a more narrow
proscription contained in GATT Article XVI:4.  Like wise, the Illustrative List of Export Subsidies
was first issued in connection with Article XVI:4, and paragraph (e) of the current List traces its
lineage to paragraph (c) of the 1960 List.  Because paragraph (c) was proposed by a country, France,that exempted foreign-source income from taxation so as to confer an advantage on exports of goods
as compared to domestic sales of goods, it is un likely that the exemption of such income from
taxation was intended to be considered an export subsidy under paragraph (c) and Article XVI:4.  To
apply a contrary interpretation now to the current Illustrative List would run counter to Article XVI:1
of the WTO Agreement, which, as interpreted by the Appellate Body, was intended to “ensure[]continuity and consistency in a smooth transition from the GATT 1947 system.”
358
Footnote 59 Is Dispositive With Respect to the Question of Whether the Exemption ofIncome Attributable to Foreign Economic Processes Constitutes a Subsidy
4.726  Thus far, the United States has been discussing footnote 59 as part of the context of
Article 1.1(a)(1)(ii), using the European Communities approach of starting with the general instead of
the specific.  However, the correct approach is to  begin the analysis with footnote 59, the specific
provision of the SCM Agreement which most directly  deals with an income tax exemption.  The FSC
tax exemption does not constitute an export subsidy under footnote 59.  For the reasons set forth
below, footnote 59 is dispositive of this question.
4.727  While the European Communities and the United States both agree that the Illustrative List is
“illustrative,” they disagree on the manner in which the List is illustrative.  The EuropeanCommunities appears to argue that if a particular type of financial contribution is described by a
particular paragraph in the Illustrative List, but cannot be considered as an export subsidy under the
standard contained in the particular paragraph, that financial contribution nonetheless can be found to
be an export subsidy under some other standard.
4.728  In the view of the United States, this is not what the drafters intended when they used the term
“illustrative” to refer to Annex I of the SCM Agreement.  Instead, a more reasonable interpretation is
that the drafters used the term “illustrative” to signify that not all types of financial contributions were
covered by Annex I.  For example, with the exception of export credits, which are dealt with in
paragraph (k) and which relate to the sale of goods, the Illustrative List does not address export-
contingent loans, such as government loans provided solely to exporters for purposes of capacityexpansion.  Similarly, with the exception of export credit-related guarantees, which are dealt with in
paragraph (j), the List does not address loan guarantees to producers that are contingent on export
performance.  Likewise, the List does not address forgiveness of government-held debt which may be
contingent upon export performance.  Finally, the List does not address export-oriented equity
infusions, a practice recently alleged in a pending panel proceeding.
4.729  However, where a particular paragraph of the Illustrative List does address a particular type of
financial contribution, that paragraph sets forth the standard for determining whether the financial
contribution is or is not a subsidy.  Consider, for example, paragraph (j) of the Illustrative List, which
deals with export guarantee and insurance programmes.  Looking just at the standard for premium
rates, premium rates give rise to an export subsidy if they are “inadequate to cover the long-term
operating costs and losses of the programmes.”  Implicit in paragraph (j), however, is the notion that
                                                                                                                                                                    
second sentence of footnote 59 evidences an intent of the drafters to permit Members to refrain from taxing
income attributable to foreign economic processes.
358  Japan Liquor , page 13.WT/DS108/R
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premium rates do not give rise to an export subsidy if they are “adequate” to cover long-term
operating costs and losses.  Thus, on its face, paragraph (j) provides Members with a predictable
standard to use in establishing and administering export guarantee and insurance programmes.
4.730  Under the European Communities' approach to the Illustrative List, however, any
predictability is lost.  Because, under the European Communities' approach, paragraph (j) would onlybe “illustrative,” there are numerous ways in which an export insurance or guarantee programme
could be considered to be an export subsidy even though the premium rates conform to the standard in
paragraph (j).  If premium rates were inadequate to cover short-term  operating costs or losses, a
programme could be considered to be an export subsidy.  If premium rates were inadequate to cover
short- or long-term non-operating  costs, a programme could be considered to be an export subsidy.  If
premium rates were less than what an exporter might pay for comparable coverage in the marketplace,
there could be an export subsidy under a “benefit to recipient” approach.  This would be particularly
true in a situation where a specific export transaction involves an unusually severe risk of non-
payment or currency fluctuation.
4.731  It is extremely unlikely that the drafters of the SCM Agreement went to the trouble of crafting
in the Illustrative List specific and detailed rules fo r particular types of financial contributions, such as
the rules in paragraph (j), with the intent that those rules could be readily ignored in favor of more
general standards found elsewhere in the SCM Agreement.  Instead, a more plausible reading is that
the drafters intended to use the Illustrative List as a vehicle for establishing detailed rules for certain
types of financial contributions, rules that elaborate on the general principles contained in Article 1
but that cannot be ignored in favor of those more general principles.
4.732  This reading of the Illustrative List is supported by footnote 5 of the SCM Agreement, which
specifies that a measure referred to in the Illustrative List as not constituting an export subsidy “shall
not be prohibited under [Article 3.1(a)] or any other provision of this Agreement.”  Footnote 5 would
lose its meaning if, as the European Communities  suggests, an export-related measure could be
regarded as a prohibited export subsidy notw ithstanding the fact that the measure does not constitute
an export subsidy under one of the paragraphs of the Illustrative List.  Because such an outcome isincorrect under public international law
359, a correct interpretation of the Illustrative List is that its
provisions are controlling with respect to the measures addressed therein.
The European Communities' Interpretation of "Otherwise Due" Exalts Form Over
Substance
4.733  As established above, when Article 1.1(a)(1)(ii) is interpreted in light of the 1981 Council
Decision and footnote 59, it becomes apparent that the exemption from taxation of income attributable
to foreign economic processes does not constitute the foregoing of revenue that is “otherwise due.”
However, an additional flaw in the European Commun ities' argument to the contrary is that it exalts
form over substance.360
4.734  The European Communities focuses not on the nature of the tax exemption, but on the
manner in which the exemption is conferred.  A measure is no more or less a subsidy if a government
makes a financial contribution by (1) subsuming a ty pe of income within a general tax principle and
                                                     
359 See, e.g.,  Japan Liquor , page 11.
360 The United States also would note that if the European Communities' theory is accepted, then a
portion of its claim against the FSC must be dismissed.  The European Communities has challenged (1) the
exemption of FSC income from current taxation; and (2) the dividends received deduction for FSC dividends
when they are repatriated.  However, as explained in the First US Submission, paragraph 23, the norm under theUS income tax system is to defer the taxation of income from foreign subsidiaries of US corporations until suchtime as the earnings of the subsidiary are transferred to the US parent in the form of dividends.  While theUnited States may tax the current income of a foreign subsidiary of a US corporation under “anti-deferral”
provisions such as Subpart F of the Internal Revenu e Code, these provisions are exceptions to the norm of
deferral.  See id., paragraph 24.  Therefore, even under the European Communities' theory, the exemption of
FSC income from current taxation would not constitute foregone revenue that is “otherwise due.”WT/DS108/R
Page 129
then formally carving out a subset of that income ; or (2) not subjecting a certain type of income to
taxation in the first place.  Both methods have the same effect – that is, to exempt some income from
taxation and thereby to forego revenue.
4.735  Some European territorial systems, for exam ple, exempt foreign-source income from direct
taxes by relying on method (2) – that is, these systems simply do not extend tax liability to foreign-source income.  However, these systems have the same general effect as the FSC – which relies on
method (1) – in that export transactions are subject to a lower tax burden than domestic
transactions.
361  However, nothing in Article 1.1(a)(1)(ii) indicates that one of these methods of
exempting income from taxation constitutes a subs idy while another is not.  The form of the
exemption should not matter.  What should matter is the nature of the income the exemption shieldsfrom taxation.
4.736  The European Communities' position, if accepted and taken to its logical conclusion, would
require WTO Members to tax all income – irrespective of where it is earned or by whom; otherwise,
their tax systems would inherently constitute subsidies.  However, it defies reason to require  WTO
Members to tax income earned outside their borders by foreign enterprises.  Surely, the EuropeanCommunities would not contend that Japan, for example, confers a subsidy to the extent that it fails to
tax income earned by a Brazilian subsidiary operating in Germany.  Would the European
Communities call Thailand’s failure to tax the income of a French business operating in Canada a
subsidy?  If these practices are not subsidies, and of course they are not, then the United States
likewise does not confer a subsidy when it exempts income earned in Brazil by a FSC incorporated in
the Netherlands.
The FSC Properly Exempts from Taxation Income Derived from Foreign Economic
Processes in Transactions Involving Exported Goods
Contrary to the European Communities' Assertions, the Concept of "Foreign Economic
Processes" Is Not Complicated or Ambiguous and Includes Distribution Activities
4.737  The European Communities attempts to diminish the significance of the 1981 Council
Decision by suggesting that the concept of “foreign economic processes,”
362 as articulated by the
Decision and applied to export transactions, is so vague that any objective attempt by a Member to
distinguish between processes that come within the definition – and therefore, need not be taxed – and
processes that do not come within the definiti on is impossible.  According to the European
Communities, any attempt at classification would be  “arbitrary” and would lead to income being
“exempted from tax on any condition [the Member] pleases ... . “363
4.738  Fortunately,  the task of interpreting the Council Decision is not as daunting as the European
Communities makes it out to be.  Dictionaries provide straightforward definitions of  the words
“economic” and “processes. ”  “Economic” is defi ned as “relating to, or concerned with the
production, distribution, and consumption of commodities.”364  “Process” is defined as  “a particular
method or system of doing something, producing something, or accomplishing a specific result.”365
                                                     
361  The European Communities concedes as much when it states that a country that does not tax
foreign-source income of its companies “will have to impose tax at higher rates to achieve the same level of
revenue.”  EC Oral Statement, paragraph 14.  In other words, domestic-source income will have to be taxed at a
higher rate to compensate for the foregone revenue on foreign-source income incurred as part of an exporttransaction.
362 Of course, the United States uses the phrase “foreign economic processes” as a shorthand expression
for “economic processes (including transactions involving exported goods) located outside the territorial limits
of the export country”, the phrase actually used by the Council.
363  EC Oral Statement, paragraph 62.
364 Webster’s Third New International Dictionary of the English Language Unabridged , G. & C.
Merriam (1961), page 720.
365  Ibid., page 1808.WT/DS108/R
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From these definitions, as well as from common experience, it is evident that manufacturing and
distribution are the two primary processes involved in the production and sale of a good, including a
good sold for export.
4.739  In an export transaction, distribution activities often occur outside the territorial limits of the
exporting country.  Once a good is manufactured, it must be distributed to a customer, and distributionactivities frequently take place close to the market in which the customer is located.  As part of the
distribution process, firms expend considerable cost and time in promoting their products, through
advertising, participation in trade shows, and dem onstrating the product to potential customers.  The
distribution process also involves the preparation and negotiation of sales contracts and associated
legal documentation, arrangement of financing, preparation and transmittal of invoices, receipt ofpayment, and delivery of the product to the customer.
4.740  There is often no direct relationship between the amount of distribution costs incurred and the
value of a sales transaction.  Sometimes a major order may be placed following relatively little
promotional effort by a firm; in other cases an extensive sales campaign may result in minimal or no
sales – the order may go to a competitor.  Many distribution costs represent “fixed overhead” to theseller, regardless of the size of the transaction.
4.741  These distribution costs, particularly those associated with sales promotion, are commonly
located at or near the place of business of the customer or potential customer.  Accordingly, in the
case of sales to domestic customers, distribution activities normally would take place domestically.
Conversely, in the case of exports, many of these activities typically take place outside the country of
manufacture:  either in the country of the potential customer, or in a third country that is more
convenient to the potential customer than the country of manufacture.
4.742  Distribution activities, as described in the preceding paragraphs, clearly are substantial
economic processes that are essential to the sale and delivery of a manufactured good to a customer
and to the resulting receipt of income arising out of such sale and delivery.  To the extent that these
activities are performed outside the territory of the country of manufacture, they are foreign economic
processes.
The "Foreign" Character of an Economic Process Depends on Where It Is Performed
4.743  The European Communities fails to  recognize that for purposes of the principle articulated in
the Council Decision, the “foreign” character of an economic process is determined by where the
process is performed.  If the process is carried out within the territory of a Member, it is a domesticeconomic process.  If it is carried out outside the territory of the Member, it is a foreign economic
process.  If an economic process is carried out outside the territory of the Member by a natural person,
that process is “foreign,” regardless of the nationality or citizenship of that person.  If the economic
process is performed by a corporate entity outside the territory of the Member,  it is irrelevant whether
the corporation is incorporated abroad, or whether its principal place of business is abroad.  Shouldthe corporate entity performing the foreign economic process be affiliated with another legal entity,
the foreign or domestic situs of incorporation or principal place of business of the affiliate is similarly
irrelevant in determining where the economic process is performed.  It is also irrelevant to the
“foreignness” of a process whether the process is carried out by an employee or agent.
4.744  That the European Communities takes issue with such a simple concept is astounding when
one considers that it was France, Belgium, and the Netherlands that proposed the “foreign economic
processes” component of the 1981 Council Decision.  France, for example, proposed that the panel
report concerning its tax practices be adopted along with a statement “to the effect that economic
activities which take place after the export operation, and therefore outside of the country of origin ,
are not taxable by that country and cannot be regarded  as an export activity within the meaning of the
General Agreement.”
366  Belgium and the Netherlands each made similar statements.367  The principle
                                                     
366  GATT Doc. No. C/114 (8 December 1980) (emphasis added).WT/DS108/R
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proposed by these three EC member States, now disavowed by the European Communities, is central
to the resolution of this case.
4.745  The European Communities' position is rendered all the more astounding in light of the fact
that the European Communities expressly endorsed the proposal made by France, Belgium, and the
Netherlands.  The European Communities went on record as “shar[ing] the views expressed by eachof the three member States with respect to adoption of the three Reports with qualifications
concerning the notion of ‘export activities’.”
368  Because three EC member States proposed the
concept of “foreign economic processes” and the European Communities expressly endorsed that
proposal, it is disingenuous for the European Communities to now come before this Panel and claim
that the concept is meaningless and fraught with the potential for abuse.  This is yet another example
of the European Communities attempting to rewrite GATT history.
The FSC Administrative Pricing Rules Do Not Constitute a Subsidy or an Export Subsidy
Introduction
4.746  With respect to its claim that the FSC admini strative pricing rules constitute an export
subsidy, the European Communities fundamentally misconstrues the meaning of the arm’s length
principle of footnote 59 as it applies in this case.   The European Communities cites definitions of
arm’s length from United States law and the OECD, but these definitions have not been incorporated
into the SCM Agreement.  As a result, the Eu ropean Communities has provided the Panel with
essentially no analysis of how to interpret the meaning of arm’s length for present purposes and has
adduced no evidence proving that, whatever the correct standard may be, the United States fails tomeet it.  In short, the European Communities' argument regarding the FSC administrative pricing
rules can be reduced to the European Communiti es' claim that the rules are inconsistent with
standards that simply do not apply in the WTO.
4.747  In contrast, the United States has advanced an interpretation of the arm’s length principle that
gives meaning to its terms and that is consistent with its context and purpose.  The United States hasexplained that, where a tax exemption for foreign-sour ce income is at issue, the arm’s length principle
is designed to guard against improperly shifting higher-taxed domestic-source income to a related
foreign entity that is taxed at a lower rate or not at all.  The United States also has explained that
“administrative or other practices” like the FSC administrative pricing rules are expressly allowed
under the language of footnote 59 and that Article 3.1(a) is not violated by such practices unless a“significant saving” of direct taxes on domestic-source income results.  Because the European
Communities has failed to prove that the FSC administ rative pricing rules result in any saving of taxes
on domestic-source income, let alone a “significant” saving, its claims must be rejected.
The European Communities' Interpretation of Arm's Length Is Incorrect
4.748  The European Communities has argued that the FSC administrative pricing rules constitute
prohibited export subsidies because they violate the arm’s length principle.
369  The European
Communities maintained that this was so because “[t]he administrative pricing rules of the FSC
scheme are a major departure from the principles applied by developed countries to deal with the
problem of transfer pricing between related companies as reflected in the [OECD] Guidelines.”370
The European Communities alleged that the OECD Gu idelines are relevant to the present dispute
because “an international consensus has built up about how to deal with these issues and is set out in
the OECD’s ‘Transfer Pricing Guidelines .’”371  The European Communities further asserted that the
                                                                                                                                                                    
367  GATT Doc. No. C/115 (8 December 1980) (Belgium); GATT Doc. No. C/116 (8 December 1980)
(Netherlands); and GATT Doc. No. C/M/145 (14 January 1981), pages 1-4.
368  GATT Doc. No. C/M/145 (14 January 1981), page 4.
369  First EC Submission, paragraph 158.
370  Ibid., paragraph 68.
371  Ibid., paragraph 67.WT/DS108/R
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FSC administrative pricing rules achieve results different from those that would be obtained under
IRC Section 482.372  The European Communities contends that this alleged derogation from Section
482 proves that the FSC administrative pricing rules violate Article 3.1(a).373
4.749  Once again, the European Communities has misconstrued the governing legal provision
applicable to its claims.  Neither the OECD Guidelines nor Section 482 provides the definition ofarm’s length for purposes of footnote 59.  The OECD  Guidelines and Section 482 may be two of the
leading advancements made regarding arm’s length pr icing, but they have not been incorporated into
the SCM Agreement.
4.750  In many respects, the European Communities' position with regard to Section 482 and the
OECD Guidelines is difficult to understand.  Clearly, the domestic law of a single WTO Member,such as Section 482, cannot be used as the benchmark for determining WTO norms of arm’s length
pricing.
4.751  The OECD Guidelines are equally irrelevant to this dispute.
374  Nowhere does the SCM
Agreement provide that the definition of arm’s length for purposes of footnote 59 may be supplied by
the rules of another organization.  As highly este emed as the OECD Guidelines may be, they cannot
be engrafted upon the SCM Agreement where there is no indication that that was the intention of the
Agreement’s drafters.375  Only a small minority of WTO Members has formally agreed to adhere to
the Guidelines.  The fact that “[a]n international consensus” of developed countries is reflected in the
Guidelines is not a basis on which the rights and obligations of WTO Members may be altered.
Undoubtedly, the majority of WTO Members would be surprised to learn that, in joining the WTO,
they undertook to implement and abide by the OECD Guidelines.
4.752  The United States has argued that the WTO’s lack of specific rules on transfer pricing is the
principal reason why footnote 59 indicates that parties “shall normally” take their transfer pricing-
related grievances to appropriate tax fora.  In particular, the United States has argued that this matter
should be reviewed, at least in the first instan ce, by the OECD, because that body has a well-
established and specific set of rules in place – rules that the WTO lacks – regarding the issues the
European Communities raises.  Having brought its claims to the wrong forum, the EuropeanCommunities now attempts to apply rules that are not within the purview of the WTO.
4.753  The fundamental difference between the approaches of Section 482 and the OECD
Guidelines, on the one hand, and footnote 59, on the other, is the level at which the arm’s length
analysis applies.  Section 482 and the OECD Guidelines  focus at the level of the specific related party
transactions of specific taxpayers, and inquire whether those specific transactions reach arm’s lengthresults.  By contrast, footnote 59 focuses on the aggregate results of “administrative or other
practices,” and inquires whether such practices cause a systematic distortion in the allocation between
domestic and foreign income so as to “result in a significant saving of direct taxes in export
transactions.”
4.754  By taking an aggregate perspective, the US Congress was able to ensure that the FSC
administrative pricing rules overall would not “result in a significant saving of direct taxes in export
transactions.”  At the same time, Congress was able to make available methods that afford
considerable administrative ease to both taxpayers and tax authorities.  Because the administrative
pricing rules are aimed at producing arm’s length results in the aggregate, they can relieve both
                                                     
372  Ibid., paragraph 75.
373  Ibid., paragraph 78.
374  In this regard, the United States reiterates that the European Communities has not explained how
OECD Guidelines that came into existence after  the entry into force of the WTO Agreement could be
considered to have been incor porated into the SCM Agreement.
375  The fact that the second paragraph of item (k) to Annex I incorporates by reference the OECD
Arrangement on Guidelines for Officially Supported Export Credits indicates that the drafters of the SCM
Agreement knew how to incorporate OECD standards when they desired to do so.WT/DS108/R
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taxpayers and tax authorities from delving into the factual complexities attendant to a taxpayer-
specific, transaction-specific transfer pricing analysis.
4.755  In fashioning the FSC administrative pricing rules to meet the footnote 59 standard, Congress
was able to legislate methods that have validity and stability in the aggregate, notwithstanding
variances that may occur in individual cases.  The realities of export business necessitates performingsales and distributional efforts close to the target; i.e., a foreign market.  While the magnitude of these
foreign economic processes may vary in particular cases, the administrative pricing rules were
designed to conservatively limit the FSC tax exemp tion on the order of the aggregate amount of these
foreign economic activities occurring in export transactions.  As discussed below, the empirical data
support the conclusion that the administrative pricing rules generate aggregate results that areconsistent with the arm’s length principle of footnote 59.
4.756  Nevertheless, it is incumbent upon the European Communities as the complaining party to
provide a definition of what arm’s length means and why the FSC administrative pricing rules are
somehow inconsistent with the definition.  Because the European Communities has not done so, the
European Communities has failed to make even a prima facie  case that the FSC administrative pricing
rules violate United States obligations under the SCM Agreement.
A Measure Is Not Inconsistent With the Arm's Length Principle Merely Because It Is
Designed for Administrative Ease
4.757  The European Communities has asserted that the FSC administrative pricing rules violate
Article 3.1(a) of the SCM Agreement, at least in part, because they are designed for administrative
ease.  The European Communities has stated that  the OECD Guidelines frown upon some types of
formulae, but, at the same time, the European Communities has acknowledged that the Guidelines
permit the use of certain other formulae.
376  However, the European Communities has identified no
textual basis in the SCM Agreement that supports its assertion that the SCM Agreement – and
footnote 59 in particular – precludes the use of methods that promote administrative ease and
efficiency.
4.758  The SCM Agreement does not mandate the method by which Members are to perform their
transfer pricing analyses.  Rather, it speaks in terms of results.  Footnote 59 makes clear that the arm’s
length principle is satisfied where, for tax purposes, the “prices” used “for tax purposes” between
related entities are the prices that would be used by independent parties.  The provision never states
how such “prices” are to be determined.  Thus, as long as the end results are correct, the principle is
not contravened.
4.759  Furthermore, the text of footnote 59 contempl ates that Members may use “administrative or
other practices” in calculating transfer prices.  Such practices are permissible according to the
footnote as long as they do not result in a “significant saving of direct taxes in export transactions.”
The clear import of this language is that the administrative convenience afforded by such practicesoutweighs the possibility that exporters might receive an insignificant tax saving from them.
4.760  The European Communities has conceded that there is no one accepted method for transfer
pricing.  The European Communities has stated that “[t]he [OECD] Guidelines acknowledge that the
existence of alternative methods of deriving an arm’s length price may be appropriate . . .”
377  In
addition, the European Communities has stated with respect to Section 482 that “[i]t provides for afull range of techniques to be employed based on the latest understanding of the arm’s length
principle as set out in the OECD’s Guidelines.”
 378
                                                     
376  Ibid., paragraph 72.
377  Ibid., paragraph 71.
378  Ibid., paragraph 73.WT/DS108/R
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4.761  Given the European Communities' concession that a variety of methods may be used in
transfer pricing, the United States respectfully submits that the European Communities must provide
some basis other than pointing to the OECD Guidelines to demonstrate that the methodology
underlying the FSC administrative pricing rules contravene the arm’s length principle of footnote 59.
The European Communities will not be able to do so, however, because footnote 59 does notproscribe the use of any particular method.  Under footnote 59, it is the achievement of arm’s-length
results that matters, not how those results are obtained.
The Strict Purchase Price Analysis Proposed by the European Communities Is Incorrect
4.762  In asserting that the FSC administrative pricing rules contravene the arm’s length principle of
footnote 59, the European Communities apparently has adopted an analysis of FSC transfer pricing
based on the assumption that all FSCs purchase goods from their parent companies and then resell
them.  Thus, the European Communities seeks to establish precise transfer prices like those that might
be used for customs valuation purposes when a product is sold in a cross-border transaction.
Unfortunately, this analysis is deeply flawed for a number of reasons, the most important of which isthat the majority of FSC transactions do not fit within the European Communities' assumption.
4.763  Many FSCs never use a so-called “buy-sell” model in their transactions. In other words, they
do not take title to goods before reselling them to customers.  A large proportion of FSC transactions,
and perhaps a majority of FSC sales, use a “commission” model, in which the FSC acts as a
distribution agent for the related producer and is compensated with a commission rather than making
a profit on its resale of the goods.  The distribution and sales functions for which the FSC takes
responsibility for tax purposes do not differ as be tween the two paradigms, and the transfer pricing
computations are the same in both cases.  Nevertheless, a “commission” FSC does not buy goods
from a supplier, and thus no transfer price for goods actually exists under such circumstances.
4.764  Furthermore, many FSC transactions do not involve sales at all, but instead involve leases or
the provision of services.  In these transactions, neither the FSC nor the related supplier can point to a
purchase price equivalent to the sale price for a commodity.  Leased goods remain the property of theproducer, and the FSC’s role as distributor is to facilitate the leasing transaction.  In the case of
services, no tangible goods may be involved at al l, but the FSC must still perform its intermediary
functions.
4.765  What is at issue in FSC transfer pricing (which is purely for tax purposes) is not the price of
goods at a fixed point in time, but the overall value of a FSC’s functions during the taxable year.  Asthe United States has previously explained, the FSC statute attributes to FSCs, for tax purposes, all
foreign distribution and sales functions in connection with a FSC transaction.  If the FSC did not
perform all of those functions itself, it is obligated under the law to pay for them.  It is this group of
functions for which the FSC is responsible that form s the basis for allocating income to the FSC.  As
demonstrated below, the FSC administrative pricing rules properly allocate income to the FSC based
on the foreign functions attributed to it.
A Tax Measure Is Consistent with the Footnote 59 Arm's Length Principle if It Achieves
Results that Approximate a Range of Arm's Length Values
4.766  The European Communities has conceded that arm’s length pricing under footnote 59
involves a “range” of values and only an “approximation” of prices that independent parties would
charge.  In particular, the European Communities has stated that the arm’s-length principle requires
“prices practised between associated enterprises to be adjusted so as to reflect the prices that would
have been practised between independent enterprises.”
379  According to the European Communities,
these adjustments need only “deliver a sufficiently close approximation to arm’s length in a . . . wide
variety of cases over time.”380  In fact, the European Communities even concedes that the arm’s length
                                                     
379  Ibid., paragraph 69.
380  Ibid., paragraph 80.WT/DS108/R
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principle is satisfied as long as the results of a particular measure are within an accepted “range of
tolerance.”381
4.767  The United States does not disagree with any of the foregoing positions taken by the
European Communities.  In fact, the United States will demonstrate below that the FSC administrative
pricing rules do approximate arm’s length results in a “wide variety of cases over time.”
The European Communities Has Not Shown that the FSC Administrative Pricing Rules
Exempt Domestic-Source Income from Taxation and that They Do So to a "Significant"
Extent
4.768  The European Communities has not provided any substantive analysis of how to determine
whether the results attained by the FSC administrative pricing rules are or are not at arm’s length.
More specifically, the European Communities has not apprised the Panel of how it would determine
what the outer points of the accepted range of arm’s length values would be for a given transaction or
group of transactions.  It seems only fitting that, when one Member of the WTO accuses another
Member of conferring an export subsidy by allegedly allowing its traders to deviate from the arm’slength principle for tax purposes, the complaining Me mber should have the burden of first identifying
the range of arm’s length prices applicable to the dispute and then explaining the extent to which the
results produced by the challenged measure do not fall within that range.
4.769  While the European Communities has not provided the Panel with even a basic analytical
framework to find the FSC administrative pricing rules to be in violation of the SCM Agreement, the
United States has articulated the correct standard to be applied in this dispute.  The United States
respectfully submits that, with regard to the FSC administrative pricing rules, analysis of conformitywith the arm’s length principle of footnote 59 entail s a two-step analysis.  The Panel must first ask if
the administrative pricing rules exempt foreign-source, as opposed to domestic-source, income, from
taxation.  If so, the analysis can stop, for the United States is under no obligation to tax foreign-source
income and the exemption of such income from taxation cannot be regarded as a subsidy, let alone a
prohibited export subsidy.
4.770  However, to the extent that the Panel finds that the FSC administrative pricing rules exempt
domestic-source income from taxation, it must then determine whether the tax savings on domestic-
source income earned in export transactions is “significant.”  This requirement derives directly from
the language of footnote 59, which states that “[a]ny Member may draw the attention of another
Member to administrative or other practices which may contravene this [arm’s length] principle andwhich result in a significant saving of direct taxes.”
4.771  This two-step analysis is necessary in the present dispute because the FSC was designed to
emulate the basic aspects of European territorial tax systems which do not tax foreign-source income.
To the extent that foreign-source income need not be taxed under WTO rules, then any tax saving in
relation to foreign-source income is irrelevant.  In this context, the arm’s length principle guardsagainst WTO Members conferring a subsidy by allowing higher-taxed domestic-source income to be
shifted to a related entity so that it is treated as lower-taxed foreign-source income.  As long as
domestic-source income is not exempted from taxation in this manner, the FSC administrative pricing
rules are not conferring a subsidy or an export subsidy.
4.772  The European Communities has presented the Panel with no evidence that the FSC
administrative pricing rules exempt domestic-source income from taxation or that they result in a
“significant saving” of taxes on domestic-source income.  Absent such proof, the
European Communities' position must be rejected.
Available Data Indicates that, in the Aggregate, the FSC Properly Allocates Foreign-
Source Versus Domestic-Source Income
                                                     
381  Ibid., paragraph 86.WT/DS108/R
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4.773  As previously discussed, the US Congress ad opted a new set of tax provisions that were
designed to conform to the principles articulated in the 1981 Council Decision and to take advantage
of the flexibility that it provided.  In doing so, the Congress was quite explicit in its objective.  It
specifically cited the controlling legal principle of the Council Decision, noting that “[u]nder GATTrules, a country need not tax income from economic processes occurring outside its territory.”
382
Congress similarly stated its objective that “cert ain income attributable to economic activities
occurring outside the United States should be exempt from US tax.”383  Its unambiguous purpose in
exempting such income was “to afford United St ates exporters treatment comparable to what
exporters customarily obtain under territorial systems of taxation.”384
4.774  The vehicle Congress chose to achieve this purpose was the FSC, and the statutory rules that
Congress devised were shaped by two considerations.  The first was to realize the benefit that was
authorized by the Council Decision; namely, to, el iminate or reduce US tax on income from foreign
economic processes.  The second was to assure that, in any event, the revenue cost to the US
Government of the FSC partial tax exemption was no greater than the revenue cost of the DISCprovisions that it replaced.  With those objectives in mind, Congress developed and enacted the FSC
statutory provisions that have been in effect in the United States since 1986.
4.775  Congress chose three different approaches for approximating, through the FSC, the amount of
income attributable to foreign economic processes or activities.  The two that have been challenged in
this case are the CTI method, which attributes 23 per cent of the total profit share to the FSC, and the
gross receipts method, which attributes to FSCs a profit margin of 1.83 per cent of total gross receipts.
These methods, it must be stressed, were not necessarily designed to allocate income based on whatactivities the FSC itself performed; rather, they were designed to approximate the amount of income
fairly attributable to foreign economic activities that occurred in connection with the transaction in
which the FSC participated.
4.776  To implement that objective in the context of the existing US tax system, the Congress
required not only that the FSC be a foreign corporation and perform a specified number of economicactivities outside of the United States, but also that the FSC be legally and financially responsible for
essentially all of the distribution functions of the transaction.  These include marketing, sales,
delivery, and the like.  Accordingly, the FSC must either perform such functions itself with its own
resources or contract with another company to perform them.  The FSC was then required to pay for
these functions.
4.777  In this manner, the Congress sought to attribute to FSCs an amount of income that
approximated the income derived from foreign economic activities.  To assure that these provisions
did not allocate to FSCs more profits than the foreign economic activities warranted, and to assure
that the revenue cost of the FSC did not exceed that of its predecessor the DISC, the Congress
exempted from taxation only a portion of the income allocated to FSCs under the FSC transfer pricingrules.
4.778  The central issue with respect to the FSC admi nistrative pricing rules that the Panel must
address is whether they in fact achieve the purpos e that the US Congress intended or whether, as the
European Communities asserts, they provide a tax benefit that is greater than Congress intended and
what the rules of the SCM Agreement permit.  Stated differently, the question is whether the FSCsystematically over-allocates income to FSCs, ther eby, in effect, reducing US taxes on income from
domestic economic processes.  For the European Communities to support its contention, it must show
that the income attributable to foreign economic processes under the FSC administrative pricing rules
does not, in fact, approximate on an aggregate basis the total amount of foreign economic activity but,
instead, (1) systematically allocates more income to FSCs than would be justified under the arm’s
                                                     
382  Exhibit EC-6, page 1042.
383  Ibid.
384  Ibid.WT/DS108/R
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length principle; and (2) that the aggregate tax sa ving from such a systematic misallocation results in
a significant saving of direct taxes in export transactions.
4.779  The European Communities has offered no factual evidence that would support the
proposition that FSC rules systematically allocate more income to FSCs than the level of foreign
economic activity would justify.  The burden to make such a showing is on the EuropeanCommunities, and the United States is not obliged to prove the contrary in this proceeding.
Nonetheless, the United States notes that to the extent that there is available empirical evidence on
this question, it tends to show that the overall level of foreign economic activities undertaken in
connection with FSC transactions equals or exceeds the amount of foreign activity that would be
required to justify the income allocated to FSCs and the corresponding tax exemption.
4.780  To test this proposition, the United States examined a variety of empirical analyses.  First,
relying on data that is publicly available, the Unit ed States examined income data showing the levels
of profit realized by independent distributors and unrelated manufacturer-suppliers.  Using these data,
the analyses then considered the aggregate amount of profit and determined the relative share of total
profits realized by distributors and the relative share of profits realized by manufacturer-suppliers.These figures were then compared with the relative share of profits attributed to FSCs under the FSC
administrative pricing rules and the relative share of profits left with manufacturer-suppliers.  Because
the baseline data involved unrelated distributors and manufacturer-suppliers, that data reflected, by
definition, an “arm’s length” distribution of profits between distributors and manufacturer-suppliers.
4.781  Five such analyses were undertaken.  Three tested the 23 per cent CTI method, which is used
far more widely by FSCs, and two tested the 1.83 per cent gross receipts rule.  All five analyses
showed that the share of profit that the FSC administrative pricing rules allocate to FSCs – which areresponsible for distributor-like functions – corresponds to the relative share of aggregate profits
realized by independent distributors when dealing with unrelated manufacturer-suppliers.  Although
these analyses address an analogous allocation of income rather than FSCs themselves, they provide a
relevant and informative empirical data point that supports the reasonableness of the income
allocations that the FSC administrative pricing rules achieve.
4.782  These five studies, which are discussed in greater detail in US Exhibit 20, provided as part of
the answer of the United States to European Communities Question #17, are based on two different
sources of data.  The first is the publication of the US Internal Revenue Service that reports aggregate
income by industrial sector.  The second is aggregate data drawn from corporate filings with the US
Securities and Exchange Commission.  In both cases, data from thousands of companies formed partof the total, which fairly reflects the distribution and production sectors subject to US taxation and
regulation.
4.783  The studies on the CTI method analysed the relative profit share of distributors and producers,
using two slightly different approaches in order to confirm that the results would not change
significantly depending on the analytical methodology employed.  The arm’s length ranges variedsomewhat under the three analytical approaches; how ever, all show that the 23 per cent profit share
allocated to FSCs under the CTI method is a conservative measure of a distributor’s return.  The
studies analysing the gross receipts method looked at the overall profit margin of distributors on their
sales.  Both studies found that the 1.83 per cent profit return on gross receipts allowed under the FSC
administrative pricing rules fell within the arm’s length range reflected in empirical data.
4.784  The type of analysis employed in these five instances is the same type of analysis that is
employed to test the acceptability of a transfer pricing figure for US tax purposes.  These empirical
data suggest that the return provided to FSCs under the administrative pricing rules corresponds to the
return realized by independent distributors wh en dealing with unrelated manufacturer-suppliers.
Indeed, the empirical data suggest that the CTI method is conservative in terms of the amount of
income allocated to a FSC.WT/DS108/R
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4.785  The second empirical data point examined by the United States is provided by survey data
designed to show the overall level of foreign activities that major US FSC users undertake in
connection with transactions in which FSCs participate.  To gather this information, questionnaires
were sent to 27 of the largest United States exporters that use FSCs.  The 27 represent a cross-section
of the largest companies in industrial sectors with the highest volume of FSC exports.  The surveyasked for a determination of what percentage of total expenses incurred by each surveyed company
and its FSC were incurred outside the territory of the United States.
4.786  Sixteen of the 27 companies surveyed responded to the survey, which is described in detail in
US Exhibit 21, provided in response to EC Ques tion #22.  The survey results showed the following:
(a) the overall level of foreign activities undertaken in connection with transactions in which FSCsparticipated corresponded to or exceeded the maxi mum level of the tax benefit available to FSCs,
which is approximately 15-16 per cent of the total income of a FSC transaction; and (b) for more than
two-thirds of all of the companies that responde d, the percentage of their economic activities that
occurred outside the United States exceeded the percentage of a FSC’s income that can qualify for a
tax exemption.  For these two-thirds, the tax benefi t allowed under the FSC rules was accordingly less
than would be available if all foreign economic activities were exempt from US tax.
4.787  Accordingly, to the extent that empirical economic data is available, it contradicts the
contention that the European Communities would have to prove in order to meet its burden in this
case.  Indeed, although the available data provide only approximate benchmarks, they tend to suggest
that for most users of the FSC, a full exemption of income from foreign economic processes would
result in greater tax benefits than the FSC currently allows.  In other words, the data confirm that the
FSC administrative pricing rules, as intended by Congress, constitute “administrative or otherpractices” that are consistent with the arm’s length principle of footnote 59.
Even if the FSC Administrative Pricing Rules Were Regarded as Misallocating Some
Domestic-Source Income to FSCs, Any Such Misallocation Does Not Violate the SCM
Agreement Because Any Resulting Tax Saving Is Not "Significant"
4.788  Finally, even if the FSC administrative pricing rules were regarded as misallocating some
domestic-source income to FSCs, those rules would not violate the SCM Agreement.  This is because
footnote 59 requires that any such misallocations result in a “significant saving of direct taxes in
export transactions.”  As demonstrated previously, the most recent data available for the FSC regime
indicates that the total tax exemption amounts to only 0.93 per cent ad valorem , an amount considered
as de minimis  under the SCM Agreement.
385  Moreover, as previously explained, this figure overstates
any possible subsidy resulting from the FSC administrative pricing rules themselves.386
4.789  Although the European Communities grudgingly concedes that the word “significant” in
footnote 59 is “designed to avoid Members from invoking individual cases of minor importance”,387
the European Communities never even tries to explain how a tax saving of less than 0.93 per cent can
be considered as “significant.”388  The European Communities does not even offer a proposed
definition of what “significant” means.
4.790  Instead, the European Communities appears to argue that because the less-than-0.93 per cent
figure is an average, some companies may derive a greater tax savings from income misallocations
than others.389  However, the European Communities offers no support for the proposition that the
                                                     
385  See First US Submission, paragraph 137-147 and Exhibit EC-5.
386  First US Submission, paragraph 146.
387  EC Oral Statement, paragraph 69.
388  To reiterate, any subsidy attributable to a misallocation of income by the FSC administrative pricing
rules would be less than 0.93 per cent ad valorem .  The United States lacks the data to make a precise
calculation, but, in any event, the burden is on the European Communities, as the complainant in this case, to
provide data demonstrating that the FSC administrative pricing rules result in a significant tax saving.
389  EC Oral Statement, paragraph 72.WT/DS108/R
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standard in footnote 59 was intended to apply on an individual company basis.  To the contrary, the
text of footnote 59 appears to contemplate an aggregate approach,390 and it is unlikely that the drafters
intended a standard that could be assessed only on the basis of individual taxpayer data, data that in
many countries is protected from disclosure.  Indeed, it is noteworthy that in the Tax Legislation
Cases , the panel based its conclusions regarding the European tax systems on the fact that “different
tax treatment in different countries resulted in a smaller total tax bill in aggregate  being paid on
exports than on sales in the home market ... .”391
Other Issues
FSCs are Foreign Corporations for Purposes of the SCM Agreement
4.791  Although the European Communities does not appear to contest the fact that FSCs are foreign
corporations for purposes of United States law, it alleges – focusing on the US Virgin Islands – that
FSCs located in territories or possessions of the United States are not “foreign” corporations for
purposes of the SCM Agreement.  Although the European Communities does not contest the fact thatthe territories eligible for FSCs are outside of US customs territory, the European Communities
asserts, without citation to any authority, that “[t]his is not the correct test.”
392
4.792  At the outset, the United States notes that nothing in the FSC statute requires FSCs to be
established in US territories.  Although historically most FSCs have chosen to locate in US territories,
presumably such choices are based on a variety of business considerations, including the tax regime in
place in the host country.  Based on anecdotal evidence of FSC activity since 1992, the period covered
by the most recent Treasury Department report on the FSC, the United States understands that an
increasingly large number of FSCs are incorporated in Barbados, Jamaica, and Bermuda.  If the Panel
were to accept the European Communities' assertion that FSCs located in US territories outside of US
customs territory are not sufficiently “foreign,” that would simply accelerate the trend toward these
countries.
4.793  Moreover, the “evidence” cited by the European Communities is inaccurate and misleading.
The European Communities cites the fact that the US Virgin Islands elects a member to the US House
of Representatives, but fails to note that the member has non-voting status.393  T h e
European Communities' reference to the Naval Appropriations Act in paragraph 78 of the
European Communities Oral Statement ignores the fact, as explained in the United States response to
EC Question #2, that the United States has limited authority over the tax systems of the territories ingeneral, and that those territories are free to reduce the tax liability of FSCs but are not required to do
so.
394  The superficial nature of the European Communities' understanding, though, is best reflected by
its assertion that the Solomon Islands, an independent country and WTO Member, is a territory of the
United States.395
4.794  However, the fundamental problem with the European Communities assertion is that the term
“territory” is generally used throughout GATT to mean “customs territory.”  For example, GATT
Article XXIV:1 refers to the GATT applying on th e basis of customs territories, and Article XXIV:2
contains a definition of what a “customs te rritory” is.  Similarly, GATT Article I:2 (b) permits, as an
exception to the MFN obligation in Article I:1,  “[p]references in force exclusively between two or
more territories which on 1 July 1939, were connected by common sovereignty or relations ofprotection or suzerainty and which are listed in Annexes B, C and D, subject to the conditions set
forth therein ... .”  Annex D, which applies to the United States, lists, inter alia , the “United States of
                                                     
390  See First US Submission, paragraph 134.
391  BISD 23S/114, paragraph 50 (France) (emphasis added).  The panel used the same language to
describe the effects of the Belgian and Dutch tax practices.
392  EC Oral Statement, paragraph 80.
393  EC Oral Statement, paragraph 76.
394  See Attachment A, US Response to EC Question #2.
395  See Attachment A, US response to EC Question #1.WT/DS108/R
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America (customs territory)” and “Dependent territories of the United States of America.”  Thus, as a
matter of GATT and WTO law, as well as United States law, FSCs located in United States
possessions outside of US customs territory constitute foreign corporations for purposes of the SCM
Agreement.
4.795  The European Communities' argument to the cont rary is made all the more puzzling by the
fact that it is at odds with the position taken by the European defendants in the Tax Legislation Cases .
For example, France asserted that “[i]n the GATT sense, it is obvious that export is the sale of a
national product or service to a foreign country, the criterion being the passage of the customs frontier
of the exporting country .”396
4.796  Instead of a legal argument, the European Communities offers a policy argument; namely,
that WTO Members are not obligated to have customs territories, and that if they are allowed to have
them, there will be a tremendous scope for abuse.397  However, the fact is that Members have customs
territories, have had them since the inception of the GATT system, and the abuse cited by the
European Communities does not seem to have occurred.
4.797  Moreover, the European Communities stance on the US territories reflects a profound
ignorance (wilful or not) about the territories and possessions of some European Communities
member States.  For example, in a recent decision, the European Court of Justice (“ECJ”) held that an
individual bringing a boat from the Netherlands Antilles into the Netherlands was liable for VAT
imposed by Dutch authorities, because entry into the Netherlands of goods from the Netherlands
Antilles qualified as entry into the European Communities.398  The European CommunitiesJ’s opinion
does an excellent job of highlighting, in a manner re levant to this dispute, the tension between the
Netherlands Antilles’ status as a part of the Kingdom of the Netherlands and its status as ageographically and juridically separate possession.
The European Communities Has Failed to Meet Its Burden of Proof
4.798  As the complaining party in this dispute,  the European Communities has the burden of
initially presenting the Panel with sufficient facts and legal arguments to raise a presumption that the
United States has violated its obligations under the SCM Agreement and the AA.  The European
Communities has not met its burden on any of its claims.  For the convenience of the Panel, the
United States briefly summarizes below the reasons why this is so.
The European Communities Has Failed to Prove that the FSC Tax Exemption Constitutes
a Subsidy under Article 1
4.799  In order to prevail on its claim that the FSC tax exemption is a prohibited subsidy, the
European Communities must first prove that the FSC is a subsidy within the meaning of Article 1 of
the SCM Agreement.  The European Communities, t hough, has failed to show that the FSC involves
the United States foregoing revenue that is “other wise due.”  The European Communities has failed to
articulate a legal argument as to why income exempted by the FSC is “otherwise due.”  As discussed
above, the United States, like all other WTO Members, is under no obligation to tax such “foreign-
source” income.  This principle derives from prior GATT practice and from footnote 59, both of
which form part of the context of Article 1.  Accordingly, the exemption of foreign-source incomeunder the FSC cannot be said to be revenue that is “due” for purposes of Article 1 and the failure to
tax it is not a subsidy.  The European Communities' me re assertions to the contrary are insufficient to
form a legal basis for its claims.
                                                     
396  GATT Doc. No. C/97 (15 March 1977) (emphasis added).
397  EC Oral Statement, paragraph 81.
398  See US Exhibit 22.WT/DS108/R
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The European Communities Has Failed to Prove that the FSC Tax Exemption Violates
Article 3.1(a)
4.800  Just as the European Communities has misconstrued Article 1, it also has misread
Article 3.1(a) by ignoring the central legal provision applicable to this dispute, footnote 59.Footnote 59 narrows the scope of paragraph (e) of Annex I by providing that the exemption of
foreign-source income from direct taxation does not constitute an export subsidy.  Footnote 5 of the
SCM Agreement provides that, if a measure is referred to in Annex I as not being an export subsidy,
then that measure is immune from all prohibiti ons in the SCM Agreement.  Given that the FSC is
designed to exempt foreign-source income in export transactions, and that such income need not betaxed under footnote 59, the FSC is immune from the prohibition of Article 3.1(a).
4.801  As a result of its failure to apply the corr ect legal standard to its claim, the European
Communities has not provided the Panel with evidence proving that the FSC provides a tax exemption
on export income other than foreign-source income.  In  this context, it is important to recall that the
European Communities has asserted that the only evidence it needs to rely upon in this case is theFSC statute itself.
399  Because the FSC statute does not demonstrate that the FSC exempts anything
other than income attributable to foreign economic processes, the European Communities' failure to
provide any other supporting evidence should prove fatal to its claim under Article 3.1(a).
The European Communities Has Failed to Prove that the FSC Administrative Pricing
Rules Violate Article 3.1(a)
4.802  The European Communities has failed to make a prima facie case with respect to its claim
that the FSC administrative pricing rules violate Article 3.1(a) because it has misconstrued the
applicable legal standard and because it has failed to present the Panel with evidence demonstrating
that those rules contravene the arm’s length principle of footnote 59 by systematically misallocating
domestic-source income to FSCs.  The European Co mmunities has not even identified for the Panel
what the arm’s length principle of footnote 59 cont emplates.  Instead, it simply alleges that whatever
the relevant standard may be, the FSC admini strative pricing rules do not conform to it.
4.803  The European Communities has failed to recogn ize the seminal question pertaining to its
claim regarding the administrative pricing rules, which is whether the FSC pricing rules properly
allocate foreign-source versus domestic-source income in covered export transactions.  On this all-
important question, the European Communities has provided no evidence.  As the United States hasalready pointed out, the European Communities has pr esented no evidence proving that the FSC rules
have resulted in domestic-source income receiving a tax exemption instead of foreign-source income.
The European Communities has not shown that the overall tax exemption conferred by the FSC
includes any income derived from economic activities occurring within  the United States.  Moreover,
the European Communities has still not adduced evidence showing that, to whatever extent the
administrative pricing rules could be said to allow for the exemption of direct taxes on domestic-
source income, the resulting tax savings for domestic-source income is “significant,” a finding that is
required under footnote 59 in order for an “administrative or other practice” dealing with transfer
pricing to be considered a prohibited export subsidy.  The European Communities has not even
proposed a standard for what “significant” means.
4.804  Unless and until the European Communities provides the Panel with evidence showing that
the allocation of foreign-source as opposed to domestic-source income under the administrative
pricing rules is not done on an arm’s-length basis and results in a significant tax saving, the
European Communities' claim regarding the administrative pricing rules must be rejected.
Territorial Tax Systems Provide More Favourable Tax Treatment to Foreign Distribution
Activities than to Domestic Distribution Activities
                                                     
399  European Communities' Response to US Preliminary Objections (25 January 1999), paragraph 13.WT/DS108/R
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4.805  The tax exemption under the FSC rules emulates the exemption under territorial tax
systems.400  In that context, during the course of the first meeting, the Panel requested additional
information on territorial tax systems.  This section responds to the Panel’s question.
The Concept of a "Territorial" Tax System Is Not Precise and Many Income Tax Systems
in Europe Incorporate Some Type of Hybrid System
4.806  At the outset, it should be recognized that while tax systems broadly referred to as
“territorial” are common internationally401, it is difficult to identify a specific income tax system that
is strictly “territorial” in that it exempts all income from foreign economic processes.  Also, it is
difficult to find any two tax systems that exempt exactly the same amount or type of foreign income
or that accomplish the foreign income exemption in exactly the same way.  There are so many
individual variations between statutory schemes involving the exemption of foreign income that it is
difficult to capture all of these variations in summary form.  Just as there is no single model income
tax system internationally, there is no single model territorial tax system. Therefore, the European
Communities cannot be correct in its contention at the first meeting of the Panel that the United States
cannot “pick and choose” elements from diverse territorial systems to be included in its own partial
exemption system.  So long as the system chosen achieves the designated objective of exempting only
income from foreign economic processes, its form and scope is not a matter for disapproval under the
SCM Agreement.
4.807  With respect to European tax systems, in particular, so-called “territorial” tax systems
encompass a broad spectrum.  For example, some European tax systems provide a full or partial
exemption for both foreign branch income (some under domestic law and others by income taxtreaty)
402 and for the foreign income of foreign subsidiaries, subject to certain exceptions.  An
exemption for foreign subsidiary income is accomp lished by permitting deferral of the subsidiary’s
undistributed current income (even income earned in low-tax jurisdictions) and ultimately exempting
the earnings when distributed through a so-called participation exemption.403
The Tax Exemption Available to Income of Foreign Branches and Subsidiaries under
Territorial Tax Systems Effectively Results in a Lower Tax on Income from Foreign
Distribution Activities than on Income from Domestic Distribution Activities
4.808  Various versions of a territorial tax system accomplish a reduction of tax on income from
foreign distribution activities as compared to domestic distribution activities.  The Dutch system isone of three territorial systems whose favoured treatment of foreign-source income was closely
scrutinized by a GATT panel in the 1976 Tax Legislation Cases .  Based on the United States
                                                     
400  See, e.g.,  First US Submission, paragraph 84.
401 Outside of Europe, the following countries would be considered as having “territorial” systems:
Algeria, Benin, Bolivia, Burkina Faso, Burundi, Cameroon, Central African Republic, Congo (Brazzaville),Costa Rica, El Salvador, Eritrea, Ethiopia, Gabon, Guatemala, Ivory Coast, Kuwait, Lebanon, Malawi, Mali,Mauritania, Morocco, Namibia, Nicaragua, Niger, Panama, Paraguay, Senegal, Togo, Tunisia, Uruguay,
Venezuela, Zambia, and Zimbabwe.  Many other countries around the world, such as Pakistan and the Solomon
Islands, have full deferral for the income of foreign branches and subsidiaries and, thus, no taxation until incomeis repatriated to the home office.  When the Tax Legislation Cases  were being considered for adoption, the
French representative “noted that the system of territoriality was applied by some eighty  countries ... .” GATT
Doc. No. C/M/145 (14 January 1981), page 2 (emphasis added).  The Commentary to Article 23 Concerning the
Methods for Elimination of Double Taxation, OECD Model Tax Convention, discusses various methods,
including different types of exemption systems.  See US Exhibit 23.
402  Western European countries that provide for some  type of exemption for certain foreign branch
income, whether by domestic statutory provision or by income tax treaty, include Belgium, France andGermany.
403  The domestic income tax laws of many Western European countries, including Belgium, France, the
Netherlands and Spain, provide for a participation exemption.  In addition, under the Parent-Subsidiary
Directive of the European Union, all EC Member Stat es are required to provide a tax exemption for most
dividends paid by a subsidiary in an EC member state to a parent company in another EC member State.WT/DS108/R
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understanding of Dutch tax law, which has not changed substantially since these cases, the
fundamentals of Dutch treatment of the taxation of  foreign income are as follows.  Companies
resident in the Netherlands are subject to tax on their worldwide income.  The rate is currently 35 per
cent.  In the case of income earned abroad by a Dutc h company, the company is entitled to relief that
has the effect of excluding foreign income from Dutch tax.  In the case of dividends from a foreignsubsidiary, the participation privilege constitutes an exemption from tax for that income.  The effect
of these provisions is to confer a tax exemption on most foreign income, particularly export sales
income attributable to a foreign entity.
4.809  The following example, which compares the in come tax treatment of income from a domestic
sale with the treatment of a sale through a foreign branch or foreign subsidiary, illustrates the effect ofthe Dutch system on the taxation of exports:
(a) Domestic sale.  A Dutch corporation having a profit for the tax year of $200 on a sale
within the Netherlands would pay tax at the regular 35 per cent corporate rate and
therefore would pay a Dutch tax of $70.
(b) Sale through a foreign branch.  Although a Dutch corporation is subject to Dutch tax
on its income from all sources, there is proportional relief given by Dutch law that
has the practical result of exempting foreign-source income received through a
foreign permanent establishment.  The relief applies if the income is subject to tax
(without regard to the rate) in the foreign c ountry in which it is sourced.  There is no
requirement that foreign tax actually be paid.  Thus, the requirement is satisfied even
if the income is exempt from foreign tax because of a tax treaty or a tax holiday.
The relief is the amount which bears the same proportion to the Dutch tax payable on
the total taxable income as the foreign- source income bears to the total taxable
income.  In the case under consideration (that is, a Dutch company with $100 of
domestic income and a foreign branch of that company with $100 of income on the
sale), the total Dutch tax would be $70, and the credit would be $35, computed as
follows:
Foreign income ($100) Dutch tax on
Total income ($200) X total income   = $35 credit
This $35 credit is equal to the Dutch tax that would have been imposed on the foreign
income if it had been earned domestically and therefore constitutes a total exemption
from tax of this income.  In this example the Dutch tax actually paid would be $35,compared to a tax of $70 if the sale had been purely domestic.
(c) Sale to a foreign subsidiary.  Because profits of a foreign subsidiary are not
consolidated with the profits of its Dutch parent, there is no Dutch tax directly on the
subsidiary’s profits.  Moreover, there is not merely deferral of Dutch tax until profitsare repatriated to the Dutch parent in the form of dividends.  Rather, in most cases,
there is exemption from tax for those earnings because the dividends are fully tax
exempt, thereby resulting in remission of Dutch tax on the subsidiary’s profits from
Dutch exports.  Under Dutch law, a Dutch company is exempt from Dutch taxes on
all “benefits” connected with a qualifying shareholding (participation exemption),including cash dividends, dividends in kind, bonus shares, “hidden” profit
distributions and capital gains realized on the disposal of the shareholdings, provided
certain conditions are met, including the minimum shareholding requirement, a
mostly theoretical “subject to tax” requirement, and requirements that would exclude
a mere investment in securities.  The participation exemption is applicable todividends from a domestic company as well as a foreign company.  The difference
between the treatment of domestic and foreign companies is that the domesticWT/DS108/R
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subsidiary is subject to Dutch tax on its profits, whereas the foreign subsidiary would
pay no tax to the Netherlands.  Assuming that goods are manufactured in the
Netherlands by a Dutch company at a cost of $300, that they are sold for $400 to a
foreign subsidiary with respect to which the above tests are met, that the foreign
subsidiary sells the goods to an unrelated purchaser in a third country for $600 andincurs expenses of $100 in connection with the sale; and that $98 (the $100 of profit
less, say, a 2 per cent tax imposed by the foreign country) is distributed to the Dutch
parent corporation free of withholding tax, then the tax imposed by the Netherlands
on the entire transaction would be $35.00 (35 per cent x $100 manufacturing profit),
and the entire profit after Dutch tax on the entire transaction would be reduced by the$2 tax levied by the foreign country, leaving net cash of $163.  The total Dutch and
foreign tax paid would be $37.00.  If the sale had been purely domestic (case (a)
above) the total amount of tax paid would have been $70 (35 per cent on the
manufacturing profit of $100 and 35 per cent on the distribution profit of $100).
4.810  The export-promoting character of territorial tax systems of the Netherlands, Belgium and
France was established in the Tax Legislation Cases . The panel in the Tax Legislation Cases  noted
that the exemption method utilized by the Netherlands amounts to a credit, not for foreign, but for
Dutch tax on foreign income.
404  The Panel also focused on the tax relief for distributions of foreign
subsidiary earnings, the panel apparently not realizing that, while dividends from foreign subsidiaries
qualify for tax relief if they are channelled through a permanent establishment in another country, the
dividends are eligible for relief whether or not channelled through a permanent establishment,provided that the underlying profits are “subject to tax” in the other country.  In responding to the
panel, the Netherlands did not contest the very limited nature of its “subject to tax” requirement, and
recognized that it presents certain inherent dangers with regard to certain tax havens.
405  Nevertheless,
the Netherlands defended it on the basis that “those dangers must not be avoided at the expense of
developing countries.”406
4.811  Nevertheless, the panel found that, because different tax treatment in different countries
resulted in a smaller total tax bill in aggregate being paid on exports than on sales in the home market,
there was a partial exemption from direct taxes and that the practices were prohibited by the
illustrative list of 1960.  The panel concluded that this aggregate differential tax treatment for exports
resulted from the fact that, under the Dutch system, the Netherlands did not levy a tax on profits fromexport sales by foreign branches or subsidiaries when these were subject to tax abroad, irrespective of
whether these tax rights were exercised.
407  Two other European income tax systems, the Belgian408
and French409 systems, each featuring different variations of the territorial principle, were also held to
be covered by the 1960 illustrative list of export subsidies.  Although the 1981 Council Decision in
effect overruled the panel decisions, the factual conclusions of the panel regarding the effect of theterritorial systems in question on exports continue to be correct.
4.812  In addition there are other countries, not a part of the earlier dispute, that present the same
issues because their systems effectively favor exports under a combination of foreign income tax
provisions.  Of particular interest is the income tax system of Spain, under which, as a general rule,
                                                     
404  BISD 23S/137, page 138.
405 Ibid., page 141.
406 Ibid.
407 Ibid., page 145.
408 A foreign branch of a Belgian corporation generally is not taxed on its foreign-source income,
including export income.  Where Belgium has a treaty with the country in which the branch is situated, thetreaty generally provides that foreign branch profits are totally exempt from Belgian tax.  Where earned in anon-treaty country, 75 per cent of the foreign branch income is exempt. A foreign subsidiary of a Belgiancorporation is not taxed on most foreign-source income, including export income, through a combination of atax exemption on undistributed income and a 95 per cent participation exemption on distributions of earnings.
409  Generally, foreign income directly attributable to operations conducted abroad is exempt from tax in
France.  A foreign subsidiary of a French corporation gene rally is not subject to tax on any of its undistributed
income.  On distribution, most foreign subsidiary earnings are eligible for a participation exemption.WT/DS108/R
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resident companies and permanent establishments in Spain are subject to corporate income tax on
their worldwide income.410  Non-resident legal entities without a permanent establishment are, in
general terms, subject to tax only on Spanish-source income resulting from payments made by
resident persons or entities.  A branch in Spain of a non-resident entity, whether engaged in selling or
manufacturing, constitutes a permanent establishment in Spain and is therefore subject to corporatetax on its total net taxable income.  Under Spanish law, relief from double taxation is generally
granted by way of a tax credit method.
4.813  The Spanish tax system cannot be considered purely a worldwide tax system using the foreign
tax credit of alleviating double taxation.  The participation exemption available under Royal Decree-
Law 8/1996 of 7 June (LIS, Art. 30 bis) provides for a tax exemption achieved through granting a100 per cent tax credit, computed as all Spanish corporate income tax attributable to the foreign
dividends paid with regard to the underlying foreign subsidiary profits.  There are limitations,
including that the non-resident company must be subject to a tax “comparable” to the Spanish
corporate income tax with no possibility of being exempt and it may not be a resident in a country or
territory considered to be a tax haven, although it is unclear how this limitation works in practicebecause Spanish law does not define the concept of a comparable tax and a taxpayer that reasonably
interprets the rule is not subject to penalty.  Capital gains realized on the disposal of shares in non-
resident companies are granted relief from double taxation in the same manner as relief is granted for
foreign dividends.  Although generally Spain does not tax the undistributed earnings of foreign
subsidiaries, Spain has controlled foreign corporati on (CFC) legislation that would result in taxation
at the level of the parent company when the CFC is resident in a tax haven (forty-eight tax havens are
identified in Royal Decree 1080/1991 of 5 July 1991, with effect from 25 July 1991).  For tax-havenCFCs, a stricter scheme applies, because it is presumed (although with a right of rebuttal) that:
(a) the corporate tax actually paid on any kind of income by the CFC is less than
26.25 per cent;
411
(b) all income accruing to the CFC is “passive”; and
(c) the annual minimum income derived by the CFC is equal to 15 per cent of the
acquisition cost of the underlying participating interest.412
4.814  Under Spain’s CFC provisions, there is a specific provision favoring services related to
exports.  Under this specific exception from the CFC regime, income is considered “passive,” and
therefore subject to the CFC rules, if it is, inter alia , income from credit, financial and insurance
facilities or services (other than export-linked services)  [italics added for emphasis] supplied directly
or indirectly to Spanish resident individual or corporate related parties if these related parties are
entitled to deduct expenses related to that type of income ( i.e., financial interest, insurance premiums
and service fees).413  Therefore, the Spanish anti-deferral rules provide a specific exception for certain
export-linked foreign subsidiary income from tran sactions between related parties.  Although the
European Communities tries to isolate the FSC provisions as “unique” and different in character from
its own income tax systems, in fact, in its trea tment of foreign-source income from distribution
activities, the partial exemption afforded under the FSC rules is not essentially different from variousEuropean tax systems that the European Communities presumably would defend as being fully
consistent with the relevant EC member States’ obligations under the SCM Agreement.
                                                     
410 See “The Taxation of Companies in Spain,” revised and updated by Stella Raventos Calvo, The
Taxation of Companies in Europe, Guides to European Taxation: Volume II , 1997 International Bureau of
Fiscal Documentation at 1 - 140 (copy of the specific pages referring to particular provisions described areprovided as US Exhibit 24).
411  The regular corporate income tax rate is 35 per cent.
412  Note that these presumptions do not apply when the CFC consolidates its accounts with a Spanish
resident entity.
413  See US Exhibit 24, section 8.4 (Anti-avoidance measures).WT/DS108/R
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Exemption of a Part of a FSC's Income Provides the Same Treatment that Many European
Tax Systems Provide
4.815  Because the United States income tax system overall is a worldwide, rather than a territorial,
system, it generally taxes the foreign branch activities of United States corporations and defers fromtax (subject to certain anti-avoidance rules) the undistributed foreign income earned by foreign
corporations, which is taxed on repatriation.  As compared to the US tax system, European tax
systems provide even a more favourable tax regime for foreign-source income from distribution
activities by imposing very limited anti-avoidance rules that permit greater deferral of undistributed
foreign subsidiary earnings, and providing for a participation exemption.  For qualified export-relateddistribution income, the United States has elected to adopt a system that is partially territorial.  The
difference between the United States and many European systems, which amounts to a difference only
in form, is that the United States has put its rules in a single set of provisions and has maintained
complete transparency in the application of the prov isions.  The mere fact that the partial exemption
for FSCs under the US tax system is more transparen t, as compared with some European tax systems,
should not result in the FSC being treated differently under the SCM Agreement.
The European Communities  further rebuts the United States' response in its Oral Statement at the
Second Meeting of the Panel as follows:
US Exhibits 20 and 21
4.816  The United States has produced some detailed new factual information in its Exhibits 20 and
21.  According to the working procedures they should have been produced in the First Written
Submission.  The European Communities question to which these answers respond were clearly posed
in the European Communities' First Written Submission.  The delay in producing them has prevented
the European Communities from analysing them and responding to them in the detail that it could
have done if they had been produced at the correct time.
4.817  It is however immediately obvious that the ex post facto justification for the FSC formulae is
unconvincing.  The European Communities' reasons for this are more legal than factual but it is
convenient to deal with them here.
Exhibit 20
4.818  Exhibit 20 attempts to show that the administrative pricing rules generate profit allocations to
FSCs that are broadly consistent with ‘arm’s length’ transfer pricing.  The paper purports to conclude
that the 23 per cent CTI and 1.83 per cent gross receipts rules correspond with the share of profit
deriving to independent wholesalers and distributors for different US industries.
4.819  A number of initial objections can be made to the analysis in Exhibit 20. The European
Communities will only mention two:
The paper does not show that administrative pr icing rules generate profit allocations to
FSCs consistent with 'arm's length' transfer pricing
4.820  First a comparison between FSC profit allo cations and allocations between independent
wholesalers and distributors at an aggregate level is not very meaningful. Independent wholesalers
and distributors are remunerated for their activity and the more they do the higher the share in overall
profits. No such correlation between the activit y performed and the profit allocation, however, exists
for FSCs under the administrative pricing rules. The latter prescribe a fixed share of common  profit to
be allocated to FSCs even if the latter’s’ activity has been close to zero.
4.821  Second, there is no basis for supposing that the activities of FSCs correspond to those of
independent wholesalers and distributors in the sample  and the paper makes no attempt to analyse the
differences.  Wholesalers and distributors carry out many functions that FSCs do not.  Indeed theWT/DS108/R
Page 147
activities that qualify for FSC treatment are exhaustively listed in Section 924(a) IRC and do not
include all the activities that are commonly undertaken by independent wholesalers and distributors.
Commission FSCs are more akin to export agents than to distributors.
4.822  The paper therefore tells us nothing about whether the profit allocation for FSCs  under the
administrative pricing rules is similar to those that would result from the application of ‘arm’s length’pricing rules to FSCs .
The analysis ignores the fact that the two ad ministrative pricing rules act as lower bounds
and a safe harbour
4.823  The FSC can choose the most advantageous of the two administrative pricing rules, so that
the profit allocations derived from each act as lower bounds on the profit that can be allocated to the
FSC. Exhibit 20 ignores this lower bound issue when analysing relative profits.  It also ignores that
under Section 482 the IRC can intervene ex post if profits have been allocated excessively to
distributors and wholesalers. This is not the case for FSCs using the administrative pricing rules.
Exhibit 21
4.824  Exhibit 21 uses a survey of FSCs to attempt to determine whether the proportion of FSC
taxable income that is tax-exempt corresponds to the level of FSC functions carried on outside the
United States.
4.825  The survey was sent to 27 companies.  These were the largest companies in each of five
industry sectors that had the largest volume of FSC exports (based on 1992 data).  The survey was
completed by 16 companies, which between them were responsible for circa 9 per cent of total
United States exports in 1994.
4.826  Exhibit 21 does not in fact support this conclusion for a number of reasons of which the
European Communities will only mention three:
Representativeness and size of the sample
4.827  There are over 5000 FSCs.  Even though the respondents are said to account for 9 per cent of
total United States exports, the sample size of 16 is still too small to be representative.
Did the respondents know the purpose of the survey?
4.828  The firms surveyed are not identified but in view of the fact that large United States exporters
are lobbying the US Government to defend the FSC sc heme, it is likely that the respondents knew the
purpose of the survey.  It is therefore doubtful whether they completed the survey objectively.  If a
respondent did not provide accurate answers, this  would be very difficult to identify, as the
respondents were not asked to provide a breakdown of actual costs within each category.
414
4.829  Furthermore, the respondents were able to select the year of the data provided.415 This would
allow respondents some flexibility in choosing the year which provided the ‘right’ results.
The questionnaire sent to the firms is unclear
4.830  The questionnaire used in the survey asks for “Foreign expenses (incurred by both the FSC
and related supplier) included in the CTI.”
                                                     
414 See paragraph 8 of US Exhibit 21.
415 See paragraph 7 of US Exhibit 21.WT/DS108/R
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4.831  It is unclear both whether these expenses include all foreign expenses incurred by the related
supplier (i.e. the US parent) and also what exactly was meant by “foreign”.
4.832  Exhibit 21 claims that the confidential nature of the data had to be protected and it is probable
that the approach taken by different enterprises was variable and unverifiable.
Conclusion on US Exhibits 20 and 21
4.833  Thus, leaving aside the considerable data problems involved in these exhibits even if the
calculations were correct, US Exhibits 20 and 21 do not demonstrate the US objective since. First as
regards Exhibit 20, FSC activities are by no means comparable to those of independent distributors.
The fact that the results of the survey of independent domestic wholesalers and distributors show thattheir profits correspond to some extent to the formulae used in the FSC scheme administrative pricing
rules in fact demonstrates that these provide an over-allocation of profit to FSCs who do not and are
not even able to carry out a similar range of activities.
4.834  It is also important to note that under Section 482, the IRS maintains the possibility to correct
misallocations ex post . This is not the case under the administrative pricing rules which provide for a
fixed allocation of common profit to the FSC irrespective of their actual activities. No ex post
correction mechanism exists if the FSC  activity has been close to zero.
4.835  Coming to US Exhibit 21, results stemming from replies from companies which are the main
beneficiaries of the FSC programme can hardly be convincing. There is no way to verify the accuracy
of the answers provided.
4.836  Both the allocation of a certain percentage of common profits to FSCs and the determination
of the share of FSC profits exempt from tax is arbitrary. They are dictated by two conflicting goals:
• to provide an export incentive by exempting  a certain proportion of common profits
from US income tax
• limit the Treasury’s cost in terms of lost tax revenue.
4.837  The European Communities considers that Exhibits 20 and 21 are both irrelevant for the
purposes of this case and unreliable.  It is however prepared to answer any questions the Panel may
have on them.WT/DS108/R
Page 149
Other Tax Systems
4.838  The United States devotes considerable space to discussing the tax systems of other countries.
The European Communities notes that the only tax measures under review in this proceeding are
those of the United States and declines to enter into a discussion of other tax systems which would beburdensome, inappropriate, time-consuming and beyond the terms of reference of this Panel.  If the
United States has problems with the tax systems of other countries it is free to address them in an
appropriate manner.
4.839  The European Communities offers only one comment on the subject of territoriality which
may help to clarify matters for the Panel.  It is that there is a fundamental difference between a tax
system which specifically exempts only export revenue that it would normally tax and a country that
does not generally tax revenue outside what it defines as its jurisdiction.  In the latter case any
reduction of tax charge on transactions that may result is simply the result of a difference between the
systems, that is an absence of harmonisation.  It is not an objective of the WTO to harmonise tax
systems.  The tax saving in the case of a territorial system is as much a consequence of othercountries’ tax systems as that of the country under consideration.  The FSC subsidies about which the
European Communities is complaining result entirely from the operation of the US tax system.
4.840  Of course, the European Communities is prepared to answer questions that the Panel may
have to the extent that this is possible.
Legal Issues
The 1981 UnderstandingIntroduction
4.841   Turning now to the legal issues we start with the 1981 Understanding.  Not because it is
applicable or relevant (the European Communities' position must be clear to you by now) but becauseit is so fundamental to the case the United States is making.  Indeed this is understandable in view of
the fact that the FSC scheme is so flagrantly export contingent and falls so clearly under Article 3.1(a)
of the SCM Agreement. In an attempt to justif y the FSC the United States is driven to say:
“the 1981 Council Decision sanctified the differential tax treatment of foreign and
domestic activities, even when those activities involve export transactions.”
416
4.842  The dictionary says that “sanctify” means “purify from sin,” so this does make sense on the
basis of the United States interpretation of what the 1981 Understanding allows.  It is also striking to
see the working of the GATT Council  assimilated to those of the Vatican and its like.
The 1981 Understanding is not applicable or relevant to the present dispute
4.843  The European Communities has made clear that it does not disagree with the 1981
Understanding properly understood.  The United States refuses, in these proceedings, to understand
it properly.
4.844  The European Communities has shown two things.  First that the 1981 Understanding is not
applicable to the present case.  Second that it simply does not say what the United States is attemptingto make it say.  The European Communities has already given a lot of reasons for these two points.
417
Today it will take an alternative approach which demonstrates the correctness of many of theEuropean Communities' arguments and puts the matter beyond any doubt.
                                                     
416 See paragraph 26 of the US Second Written Submission.
417 See paragraphs 45 to 56 of the European Communities' Statement to the First Meeting of the Panel
and paragraphs 52 to 71 of the European Communities' Second Written Submission.WT/DS108/R
Page 150
4.845  In order to illustrate the true meaning of th e 1981 Understanding and the true intent of the
parties, the European Communities refers the Pa nel to the framework in which the reports and
understanding were adopted and to the minutes of the GATT Council meeting at which it was
adopted.
4.846  The European Communities would first recall that the GATT procedure which was being
applied was that applicable to dispute settlement between parties not rule making.  When the Tax
Legislation panels were established, the United States had proposed that all four cases be referred to a
“working party … charged with the duty of recomm ending the type of international rules which
contracting parties could adopt to govern their income  tax practices with respect to export sales.  This
would give to all interested cont racting parties an opportunity to e xpress their views and participate in
the formation of such rules, an opportunity that wa s not adequate in Article XXIII:2 proceedings ...”.
This proposal was rejected and a panel established.418
4.847  The dispute settlement rather than rule-making mode of decision making is also clear in
minutes of the Council meetings at which the Reports and Understanding were adopted.  The
European Communities will be quoting from these now and the Panel is invited to turn to ExhibitEC-32.
4.848  On page 5, the matter is wearily introduced by the Chairman who recalls the numerous times
these reports had been on the agendas of Council Meetings and that the principally concerned parties
had been meeting to try to formulate an “understanding,” which had been revised and was now
presented as document C/W/376/Rev.1. The first point to  note then is that the Understanding is a text
drawn up by the United States and European Communities to allow the adoption of the reports in the
Tax Legislation cases.
4.849  The representative of Canada then immediately expresses “the reluctance of some to see the
Council adopt Panel Reports in this fashion, with a text of a proposed understanding which was not
immediately apparent as to its intention and meaning.”  He goes on however to stress the saving grace
of the Understanding that the adoption “would  not diminish rights and obligations under
Article XVI:4.” The representative of the United States then expressly agrees with this statement asdoes the representative of the European Communities.
4.850  It is only after taking note of these statements that the Council adopts the Reports on the
famous Understanding.
4.851  That is what the GATT Council agreed to:  To adopt the reports as qualified by the
Understanding but on the express understanding that  they were not adding to or diminishing rights
under GATT.
4.852  The actual wording of the disclaimer found in the Chairman’s statement on page 7 is even
more to the point.  He said “… the decision does not modify the existing GATT rules in Article XVI:4
as they relate to exported goods.”  He added “this decision does not affect and is not affected by the
Agreement on the Interpretation and Application of Articles VI, XVI and XXIII” (that is the TokyoRound SCM Agreement).
4.853  The United States argues in a footnote (35) to its Second Written Submission that the
statements reflect the belief of the GATT Contracting Parties that the Understanding reflected the
meaning that Article XVI:4 had always had and that is  why they said it did not affect the GATT or the
Tokyo Round SCM Agreement.  That is in the view of the European Communities another way ofmaking the European Communities' point.  The Understanding was not intended to change the
meaning of Article XVI:4 GATT 1947 or to be binding for the future.  It was not therefore a decision
under Article XXV of GATT 1947 (which is nowhere mentioned in the discussions) and it is not a
                                                     
418C/M/89, p. 10.WT/DS108/R
Page 151
decision carried over into GATT 1994 by paragraph 1(b)(iv) of the introductory language to GATT
1994 nor by Article XVI:1 of the WTO Agreement.
4.854  It should also be mentioned that in any event the GATT Council had no authority to interpret
the Tokyo Round SCM Agreement.  And of course if it did not modify the Tokyo Round Agreement
it did not affect the Tokyo Round Illustrative List and can hardly be considered relevant for theinterpretation of the Uruguay Round Illustrative List.
4.855  After the adoption, there was a veritable parade of Contracting Parties seeking reassurance
and expressing their reserves which further demonstrates the correctness of the
European Communities' position on this Understanding.
4.856  The representative of Brazil states (bottom of page 7) that it did not support the
Understanding but did not block consensus so as not to be “an obstacle to solving an old and serious
problem in the GATT.”  He noted (top of page 8) that general interpretations, in GATT practice, were
formulated through different mechanisms”.  This is further confirmation, if any is needed, that it was
not a decision under Article XXV:1 GATT 1947 and was not considered by anyone to be so (the
United States is wrong to pretend that it was at paragraph 55 of its Second Written Submission).Brazil generally reserved its rights.  Australia, Argentina, and Chile did likewise.
4.857  That is clear enough. The European Communities trusts that it has said enough about the
status and relevance of the 1981 Understanding but also refers you to the arguments in its Statement
to the First Meeting of the Panel and Second Written Submission that the 1981 Understanding is not
part of GATT 1994 nor is it relevant “guidance” for the purposes of Article XVI:  1 of the WTO
Agreement.
The Meaning of the 1981 Understanding
4.858  The European Communities has had spent some time on explaining its view of the status and
relevance of the 1981 Understanding because the United States insists on trying to give it an
inappropriate quasi-constitutional character.  But the European Communities has said that it does not
disagree with the 1981 Understanding properly understood and there is also enlightenment on this
score in the Council minutes you have before you.
4.859  If you will please turn to the fourth complete paragraph of page 8 of the minutes you will see
that after all the expressions of reserves which we have just discussed,  the United States tries to have
the last word and put down a marker for its own un ilateral interpretation of the Understanding.  Its
representative states that:
“it was of the view of his government that the rules applicable to cases involving
Article XVI:4 required that the level of taxation to be assessed upon exported
products be at least equal to the level which would apply in the event that a territorial
system of taxation were adopted by the country in question.”
4.860  Sounds familiar does it not?  This is precisely the rationale on which the United States bases
its “controlling legal standard”.  According to the United States, the FSC scheme is allowed because it
“emulates the tax treatment received by the foreign sales subsidiary of a manufacturing company in a
territorial-type system”.
419
4.861  The European Communities (bottom of page 8) and Canada (top of page 9) immediately
distance themselves from this statement.
                                                     
419 See paragraphs 55 and 84 of the US First Writte n Submission and 119 and 177 of the US Second
Written Submission.WT/DS108/R
Page 152
4.862  It is therefore disingenuous indeed for the United States to suggest that the 1981
Understanding represents an agreement between the GATT Contracting Parties on its “controlling
legal standard.”
4.863  The European Communities has already said a lo t about why the United States interpretation
of the 1981 Understanding is wrong.420  This has concentrated on the United States’ error in
considering that a statement that foreign economic processes need not be subject to taxation  means
that there is a right not to tax421 income from such activities on any condition a country chooses.
There are other errors in the United States reasoning about the meaning of the 1981 Understanding.
These permeate its further reasoning on the “controlling legal standard” and the European
Communities deals with them below.
Conclusion
4.864  Thus even if the 1981 Understanding were part of GATT 1994 or relevant guidance under
Article XVI:1 of the WTO Agreement, it is clear not only from the text but also from the above
discussion that the “controlling legal standard” invented by the United States is not part ofGATT 1994 or the WTO.
4.865  The European Communities hopes that this disposes of the 1981 Understanding.
The Relationship Between Article XVI of the GATT and the SCM Agreement
4.866  The United States makes a number of points about the relationship between Article XVI
GATT and the SCM Agreement designed to strengthen its case that the 1981 Understanding should be
read into the SCM Agreement.
4.867  It is true that a number of provisions of th e SCM Agreement refer to Article XVI GATT and
that there is even a reference in Article 32.1 to  Article XVI “as interpreted by this Agreement”.
422
The European Communities is even prepared to accept with the Appellate Body that “the relationship
between the GATT 1994 and the other goods agreements in Annex 1A is complex and must be
examined on a case-by-case basis.”423
4.868  However none of this helps the United States case.  It is clear that the SCM Agreement is
more than an interpretation of Article XVI GATT.  It is better described as a development of
Article XVI and other GATT provisions.  The European Communities has already noted that the title
of the SCM Agreement no longer refers to it as an interpretation of the GATT (the title of the Tokyo
Round SCM Agreement did refer to it being an interpretation).
4.869  The Tokyo Round SCM Agreement was a major advance over Article XVI:4 GATT.  The
European Communities remarked at our last meeting that President Jimmy Carter welcomed it as it
would permit the United States to “limit foreign subsidy practices” and that it introduced a “flat
prohibition of export subsidies” and “a definition of export subsidy which abolishes the existing dual
pricing requirement”.424
4.870  The Uruguay Round SCM Agreement achieved even further progress in combating subsidies
since it introduced a clear definition of subsidies which did not exist before and strengthened the
prohibition on export subsidies.
                                                     
420 See paragraphs 65 to 70 of the European Communities' Second Written Submission.
421 See e.g. paragraph 153 of the US First Written Submission.
422 See European Communities position in paragraph 147 of the European Communities' Second
Written Submission.
423 Brazil - Measures Affecting Desiccated Coconut , WT/DS22/AB/R, adopted 20 March 1997,
page 13.
424 See page 1935 of the document in Exhibit EC-22 to the European Communities Statement to the
First Meeting of the Panel.WT/DS108/R
Page 153
4.871  It is especially the new definition of subsidy which renders Article XVI GATT and the 1981
Understanding redundant for our purposes.  The United States is seeking to import the vague language
of the 1981 Understanding into the clear wording of Article 1 of the SCM Agreement and thus undo
the clarification which was one of that Agreement’s main achievements.  The United States accused
the European Communities of “revisionist analysis” of the 1981 Understanding in its Second WrittenSubmission.  That was wrong and unjust since the record discussed a moment ago shows the
European Communities' interpretation has not changed.  The United States is in fact engaging in a
modern form of Luddism by refusing to accept the progress realised with the Uruguay Round SCM
Agreement and seeking to maintain the comfort of its outdated and unilateral interpretation of subsidy
based on a text that is no longer applicable. (Mr Ludd was the leader of a 19
th century English revolt
against the introduction of machinery – which hi s men went round smashing up – and the consequent
loss of jobs.  Of course as we have learnt from history Luddism appears attractive to those who feel
threatened but in the end it is counterproductive.)
4.872  The United States further seeks to argue that since (according to it) the FSC scheme is
compatible with Article XVI.4 GATT in the light of the 1981 Understanding, it must also becompatible with the SCM Agreement since the Agreements must be construed “not in isolation from
each other”
425 or “in harmony”426.
4.873  The European Communities disagrees for a whole series of reasons, not the least being that it
does not accept that the FSC scheme is compatible with Article XVI:4 GATT 1994 just as it never
accepted that it was compatible with Article XVI:4 GATT 1947.
4.874  The European Communities did not cite Article XVI:4 GATT 1994 in its request for a Panel
as this is superfluous.  The SCM Agreement is a development inter alia of Article XVI:4 and has
more detailed and clearer provisions than Article XVI:4 GATT 1994.  Since the FSC subsidies clearly
fall under Article 3 of the SCM Agreement, there is no need to invoke Article XVI:4 GATT 1994.
4.875  The argument made by the United States that compatibility with Article XVI must entail
compatibility with the SCM Agreem ent, would render the latter redundant and such a result would be
contrary to the principle of effective treaty interpretation.427
4.876  The fact that the SCM Agreement should prevail over Article XVI:4 is also confirmed by the
General Interpretative Note to Annex IA of the WTO Agreement in which both are included.  As is
well known, this provides that in the event of co nflict between a provision of the GATT 1994 and a
provision of another agreement in Annex 1A such as the SCM Agreement, the provision of the latter
shall prevail to the extent of the conflict.
4.877  The United States relies a number of times on the Desiccated Coconut case to argue that its
interpretation of Article XVI:4 (and therefore of the 1981 Understanding) should prevail over the
European Communities' case based on the SCM Agreement.  However in that case it was the SCM
Agreement which prevailed over an argument ba sed only on a GATT provision, the opposite of what
the United States is attempting here.
4.878  The United States also brings up an argument drawn from the Indonesia - Cars  panel428
where Article 3.1(b) of the SCM Agreement was considered not to have rendered the Article III:4
GATT 1994 inapplicable to subsidies. In case there should be any doubt, the European Communities
does not consider that Article XVI:4 is no longer applicable to export subsidies. It merely considers
that the SCM Agreement also applies. It is the United States  which seems to be arguing that
                                                     
425 Paragraph 28 of the US Second Written Submission.
426 Paragraph 151 of the US First Written Submission.
427  See, e.g., Japan - Alcoholic Beverages, page 11.
428  Indonesia - Certain Measures Affecting the Automobile Industry, WT/DS55/R, Report of the Panel
adopted 23 July 1998.WT/DS108/R
Page 154
Article XVI:4 GATT (or rather its view of the 1981 Understanding) renders the SCM Agreement
inapplicable to the FSC subsidies.
4.879  The United States has to engage in circular reasoning to make its case.  On the one hand it
says that “to the extent possible, Article XVI and the SCM Agreement must be construed in a manner
that avoids a conflict.  In the context of this case, this means that Article 1.1(a)(1)(ii) must beconstrued in light of the 1981 Council Decision.
429” On the other hand it seeks to dismiss the
Interpretative Note just referred to because “there is no conflict between Article XVI, as interpreted
by the 1981 Council Decision, and Article 1.1(a)(1)(ii).430”
4.880  For the above reasons, the Panel should dismiss the United States attempts to complicate and
confuse this case by referring to the misty history of Article XVI:4 GATT 1947 and restrict itsanalysis of this case the provisions in its terms of reference – those of the SCM Agreement.
Whether the FSC Scheme Gives Rise to "Revenue Forgone" which Would Be "Otherwise
Due"
Introduction
4.881  This brings us at last to the proper starting point in our analysis is Article 1.1 of the SCM
Agreement and in particular the expression “revenue that is otherwise due is foregone.”
4.882  There is a fundamental difference in this ca se between the European Communities and the
United States as to the basis on which to assess whether revenue is “otherwise due”.
4.883  The European Communities' approach has been to demonstrate that the United States is
deviating from the generally applicable rules in its system as evidenced by the treatment it accords to
a series of comparable situations.  As explained in the European Communities' Second Written
Submission, this is also the approach which the United States takes to what it calls “foreign
subsidies”, that is the subsidies of countries other than the United States.  The European Communities
will return to this matter in a moment.
4.884  The approach that the United States seeks to take in the present case however, is for
“otherwise due” to be assessed on the basis of some notional tax system required or authorised by the
WTO Agreements in some way.
4.885  This is another manifestation of its “controlling legal standard” derived from the 1981
Understanding which the European Communities decisively rejects.
4.886  The United States is therefore arguing that it has a “right not to tax” income it designates as
foreign.  This is rather curious in the light of the statement at paragraph 27 of the US First Written
Submission that:
“There is no rule of international law that requires nations to conform to a single tax
system.  A country can have a worldwide syst em, a territorial system, or a system that
incorporates elements of both.”
And at paragraph 28 that:
“The WTO never was intended (and is not well equipped) to establish international
tax norms..”
                                                     
429 Paragraph 37 of the US Second Written Submission.
430 Paragraph 36 of the US Second Written Submission.WT/DS108/R
Page 155
4.887  Such statements are not repeated in the US Second Written Submission, no doubt because the
United States now realises that it is arguing the opposite.
4.888  The European Communities agrees with both of the above-quoted statements of the
United States from its First Written Submission.  Neither the WTO (nor the GATT before it) grant
rights to tax or not to tax – They simply provide that the tax system should not provide specificsubsidies or discriminate.
4.889  The United States is in fact arguing that revenue is not “otherwise due” if a Member has a
right not to tax it
431 (and does not consider it relevant whether it would normally be taxed under that
Members general rules).  Such a proposition cannot be correct.  Nothing in the WTO requires (or
“obligates”) a Member to tax any income at all.  The United States logic would lead to the conclusionthat it could exempt a particular company or industrial sector from tax as it pleases.  Indeed
Article 1.1(a)(1)(ii) of the SCM Agreement and Item (e) could never apply.  Countries always have
the right not to tax.
4.890  For the European Communities the position is clear.  Once a Member chooses to tax certain
categories of revenue, it must do so in a general manner and if it creates certain kinds of exemptions,for example exempting certain companies or exempting the revenue contingently upon export
performance, it will be granting a subsidy and if this should be specific it will be subject to the
disciplines of the SCM Agreement.
The US Contribution to the 1996 OECD Report on "Tax Expenditures – Recent
Experiences"
4.891  As the European Communities has repeatedly pointed out
432, the United States itself admits in
its periodic Treasury Reports that the FSC scheme results in a revenue cost which it calculates and
estimates to be US$2 billion in 1997.433
4.892  In its Second Written Submission434, the European Communities referred the Panel to a 1996
OECD Report on “ Tax Expenditures - Recent Experiences ” (Exhibit EC-25).
4.893  In that document, the United States defined “tax expenditure” as “revenue losses attributable
to provisions of the Federal tax laws which allow a special  exclusion, exemption, or deduction from
gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax
liability.”435  The United States also calls these measures “special exceptions in the tax law that serve
programmatic functions … such as national defence, agriculture or health care.436”
4.894  The European Communities agrees that this is  the correct approach for assessing whether
“revenue that is otherwise due is foregone”.
4.895  That Report gave the FSC “revenue forgone” (the Report’s words) in 1995 as
US$1,400 million.
The US Practice in Countervailing Duty Cases
                                                     
431 See esp. paragraph 153 of the US Second Written Submission.
432 See paragraphs 100 and 138 to 139 of the European Communities' First Written Submission.
433 See The Operation and Effect of the Foreign Sales Corporation Legislation , Department of the
Treasury, November 1997 in Exhibit EC-5, at p.12-17.  The estimates for future growth are contained inTable 5.1 on page 17.
434 See paragraphs 84 to 90 and Exhibit EC-25 of the European Communities' Second Written
Submission.
435 See Chapter I “Background” on page 107 of the document.
436 See Chapter III on page 108 of the document.WT/DS108/R
Page 156
4.896  The European Communities pointed out in its Second Written Submission437 that the
United States uses the same approach to defining revenue forgone in countervailing duty practice. The
definition of subsidy in Article 1 of the SCM Agreement applies to countervailing duty proceedings as
well as to prohibited subsidies and the United States is obliged to respect it.  Let us consider what the
United States countervailing duty rules say on the subject. (Exhibit EC-33 contains the relevantextracts from the United States countervailing duty rules.)
4.897  Section 351.509 of the United States countervailing duty rules states:
“In the case of a programme that provides for a full or partial exemption or remission
of a direct tax (e.g., an income tax), or a reduction in the base used to calculate a
direct tax, a benefit exists to the extent that the tax paid by a firm as a result of theprogramme is less than the tax the firm would have paid in the absence of the
programme.”
4.898  There is a curious rider that has been added in November 1998 (“ in tempo suspecto ”) at the
end of the commentary which says:
“… in the case of a foreign tax measure that exempts from taxation (either in whole
or in part) income attributable to economic processes (including transactions
involving exported goods) located outside the territorial limits of the exporting
country, the Department would not consider such a measure to be an export subsidy,
provided that the measure complied with other relevant WTO rules.”
4.899  The last few words are interesting “provided that the measure complied with other relevant
WTO rules.”  Thus it appears that at least insofar as foreign subsidies are concerned, the United Statesconsiders that there are other WTO rules which are still applicable to measures falling under the 1981
Understanding, including presumably Article 3.1(a) of the SCM Agreement.  The European
Communities considers the same principle applies to United States subsidies.
4.900  Of course the European Communities does not automatically consider the countervailing duty
practice of the United States to be authoritative, but this particular United States countervailing dutyrule reflects a correct interpretation of the SCM Agreement.
The application of the "revenue that is othe rwise due is forgone" principle to FSCs
4.901  The European Communities has applied just these principles in this case when it
demonstrated by the use of examples that the FSC subsidies gave rise to revenue forgone comparewith comparable situations where the normal United States tax rules applied. The European
Communities notes that the United States has not stated that the comparisons are incorrect in any way
except one point which the European Communities will deal with directly.  It merely insists that it is
entitled to exempt “foreign economic processes” on any condition it pleases.
4.902  The only time that the United States comments on the European Communities' examples
showing that revenue that is otherwise due is forgone was in footnote 56 to its Second Written
Submission where it reasons that if the European Communities' theory is accepted, then a portion of
its claim against the FSC must be dismissed because:
“the norm under the United States income tax system is to defer the taxation of
income from foreign subsidiaries of United States corporations until such time as theearnings of the subsidiary are transferred to the United States parent in the form of
dividends.  While the United States may tax the current income of a foreign
subsidiary of a United States corporation under “anti-deferral” provisions such as
                                                     
437 Paragraph 80 of the European Communities' Second Written Submission.WT/DS108/R
Page 157
Subpart F of the Internal Revenue Code, these provisions are exceptions to the norm
of deferral.  … Therefore, even under the European Communities' theory, the
exemption of FSC income from current taxation would not constitute foregone
revenue that is “otherwise due.”
4.903  This comes down to saying that the European Communities is complaining about an
exception to an exception.  The European Communities does not accept that the Subpart F rules are an
“exception” in the sense this word is being used here (that of exemption); they are part of the
United States system of raising tax revenue – they do not result in the forgoing of revenue.  It is the
FSC scheme which is the exemption since it exempts revenue from this regime of taxation and
therefore revenue is forgone which is otherwise due.
4.904  The  European Communities is prepared to discuss these examples further (and indeed other
examples which it has available) if the Panel considers that the appropriate comparisons have not been
made.
Conclusion
4.905  This discussion of the meaning of the phrase “revenue that is otherwise due is foregone” has
taken some time but is important as it forms the basis of any correct analysis of the FSC scheme.
Revenue is forgone which would be otherwise due when it would normally be taxed under that
Members general or standard tax rules.  Once this test is accepted, it is clear that both the FSC tax
exemptions and the special administrative pricing rules result in revenue forgone which would be
otherwise due.  The United States has not argued that there is no revenue forgone compared with the
application of its normal rules, just that the test is its “controlling legal standard”.
The Substance over Form Debate
4.906  The United States has often responded to the European Communities' correct and methodical
approach to the interpretation of the SCM Agreement and its application to this case by accusing it of
“exalting form over substance.”438
4.907  This is a remarkable accusation to make in defence of the FSC scheme which operates
precisely by seeking to hide the substance of export subsidisation behind the form of complex tax
arrangements.
4.908  The European Communities would like to make clear that it is complaining about the
substance of the FSC subsidies, not the form.  Also, it is asking the Panel to condemn the substancenot the form.
4.909  The European Communities can easily reject the United States accusation that its approach,
taken to its logical conclusion, would condemn “Thailand’s failure to tax the income of a French
business operating in Canada as a subsidy.”
439  As the European Communities has explained a
moment ago, there is revenue forgone which would be otherwise due when a country makes a specificexemption  or derogation to its generally applicable tax rules.
4.910  It is of course necessary for the purposes of a proper analysis to start by looking at the
detailed rules and thus the form of FSC scheme
440.  But the European Communities hopes that it has
made clear that the exemptions, derogations and special rules give rise to a substantive exemption
when it shows, as it reminded you a moment ago, how  FSC transactions are less taxed than equivalent
transactions – whether export, import or domestic.
                                                     
438 See e.g. paragraphs 81 to 84 of the US Second Written Submission.
439 Paragraph 84 of the US Second Written Submission.
440 The European Communities set out the nature of the exemptions at paragraph 65 of its First Written
Submission and paragraph 9 of its Statement to the First Meeting of the Panel.WT/DS108/R
Page 158
4.911  Let us pursue the substance over form approach and see what the substance of the
United States claims really is.
4.912  In answer to the European Communities question 13:
“Is it true that, with respect to the same transaction, a FSC which carries out all the
activities required by Section 925(c) by itself may receive the same amount of taxbenefit as an FSC which subcontracts back all its activities to its parent company?”
The United States replied:
“whether the FSC carries out foreign economic activities itself or subcontracts them
to another party, such as its parent, does not matter under the applicable legalstandard.”
4.913  In its Response to the European Communities question 8
441, the United States states:
“Its [the FSC scheme’s] purpose is to provide a suitable mechanism for isolating and
collecting the income attributable to such processes.”
4.914  It then explains that because of the nature of the US tax system,
“This objective was accomplished by requiring that the FSC be legally and
financially responsible for such activities , but allowing the United States parent to
conduct many of the activities on its behalf.”
4.915  Effectively the United States is saying that
• foreign economic processes are always “foreign”  even if carried out by domestic
parties; this is why the parent companies of FSCs are allowed to actually carry themout on behalf of FSCs;
• the only reason such processes cannot be carried out directly  by United States
producers is that such an explicit exemption would have clashed with the principles
of the United States residence-based system of taxation. There was a need,
therefore, for a foreign  corporation – the FSC – to be formed to create a mechanism
for collecting all of the transaction-related activities of the United States parent and
the FSC that occur outside  the United States.
442
4.916  In other words, the United States position is that there is no need from a WTO point of view
for a special vehicle abroad and FSCs could in principle be established on the mainland territory of
the United States and the US Congress could exempt from tax whatever proportion of their income it
considered was “foreign”.  Indeed why should not the US Congress (or another WTO Member
without a clash of the kind the United States apparently would have with its tax system) not grant the
tax exemption for a portion of the export profits directly to the exporters ? After all, substance shouldprevail over form and so why should a Member oblige exporters to have foreign subsidiaries.  (This
no doubt explains why following the 1981 Council Decision, the United States made a declaration in
April 1982 that the DISC was not a subsidy.)
4.917  That is the logical consequence of the United States approach, a direct tax exemption for part
of the profits of exporters because part can be considered “foreign”.  If one is not convinced by thearguments about the US tax system, an alternative explanation for the need to set up FSCs in FSC
havens, is of course that the subsidy is less apparent.
                                                     
441 Paragraph 27 of the US answers.
442 Paragraph 27 of the US answers.WT/DS108/R
Page 159
4.918  The European Communities also recalls in this connection that its question number 8 was
designed to explore exactly how much income could be exempted by the FSC scheme.  In the last
sentence of this question the European Communities asked:
“Could a scheme which allowed an offshore subsidiary which had legal and financial
responsibility for all aspects of the manufacture, sale and delivery of a product bedevised and be compatible with the WTO, which would allow an exemption from
income tax of the profits of those activities (which could be deemed a foreign
economic process)?”
To which the United States replied that according to it:
“A “scheme” as posited by the European Communities in the last sentence of this
question could very well be compatible with applicable WTO principles, if the
exemption covered income derived from economic processes that take place outside
of the territory of the relevant taxing jurisdiction.  However, such a structure is not
the only “scheme” that would comply with applicable WTO principles.”
4.919  What better demonstration can there be that the United States interpretation of footnote 59 is
wrong.
Export Contingency
4.920  The United States did not contest the export contingency of the FSC subsidies in its First
Written Submission or its Statement to the First Meeting of the Panel. There is some indirect
consideration of this issue in the Second Written Submission of the United States, which the EuropeanCommunities will now address.
4.921  This occurs when the United States seeks to respond to the European Communities' point that
the 1981 Understanding refers to economic processes in general including those related to export
activities when saying that they need not be subject to taxation by the exporting country. (And that it
does not say  that a GATT Contracting Party may specifically exempt transactions relating to exported
goods even where other economic processes, which may be considered outside the territorial limits of
the exporting country, are subject to tax
443.)
4.922  The United States misrepresents the European Communities' argument as an “all-or-nothing”
approach i.e. .
“A Member must either exempt all income from all foreign economic processes or
tax all income from all foreign economic processes.”444
4.923  Of course, as an aside, this was not the European Communities' argument and the European
Communities trusts that the Panel will, in this case as all others, refer to the arguments the European
Communities has actually made and not the United States misrepresentations of them.  But what
interests us at the moment is not the misrepresentation but the United States reply since this is the
only argument it makes on export contingency.
4.924  The United States argues that:
‘First, the Decision states that “in general, economic processes (including transactions
involving exported goods) located outside the territorial limits of the exporting
country need not be subject to taxation by the exporting country.” Second, the
                                                     
443 The European Communities argument is at paragraph 54 of its Statement to the First Meeting of the
Panel.
444 See paragraph 44 of the US Second Written Submission.WT/DS108/R
Page 160
Decision states that such processes “should not be regarded as export activities in
terms of Article XVI:4 of the General Agreement.”'
With respect to the first point, if countries are under no obligation to tax income derived from foreign
economic processes, then they should be free to exempt all such income or just part of it.  There
simply is nothing in the language of the Decision that compels a contrary conclusion.As for the second point, if foreign economic processes are not export activities for purposes of
Article XVI:4, then exempting such income from taxation cannot be considered to be contingent upon
exports, as the European Communities contends.  This is true irrespective of whether all foreign-
source income or only foreign-source income related to export transactions is exempted.’445
4.925  The first point is a complete non sequitur .  It simply does not follow from the fact that
countries are under no obligation to tax income derived from foreign economic processes, that theyshould be free to exempt just part of it on any condition they please.
4.926  The second point is clever false logic.  One may consider that “foreign economic processes”
(in the correctly understood sense of the 1981 Understanding) are not export activities for the
purposes of Article XVI:4” but it does not follow that exempting from taxation income from “foreign
economic processes” cannot be considered to be contingent upon exports.  The statement A iscontingent on B means that A is dependent upon or is conditional on B.  For our purposes A is a
subsidy and B is export performance.  The subsidy in this case is the exemption from tax of certain
income which the United States claims to arise from foreign economic processes.  The condition for
obtaining the subsidy is exporting United States “export property” as defined in Section 927(a) IRC.
Even if it were to be the case that the FSC subsidies in this case (A) derive from a tax exemption of
foreign economic processes which are not in themselves “export activities”, it is nonetheless clear that
this advantage is contingent upon something that obviously is an export activity: the exporting ofUnited States “export property” as defined in Section 927(a) IRC.  The exportation of export
property” is, the European Communities submits, an “export performance” (B in the definition of
contingency just given).
4.927  Of course, this reasoning which the European Communities has just presented is designed to
demonstrate the United States’ false logic and assumes for this purpose the United States propositions.Even on the basis of these propositions it is still export contingent. To be clear, the European
Communities still maintains its position that many of the economic activities which are attributed to
FSCs are not “foreign economic processes” at all.
4.928  The only other time that the United States mentions export contingency is where it says that
“In summary, footnote 59 belies the European Communities' claim that under
paragraph (e) any exemption, remission, or deferral of tax, even when contingent
upon exportation, constitutes the foregoing of revenue that is “otherwise due” within
the meaning of Article 1.1(a)(1)(ii).”
4.929  Here the United States is saying that footnote 59 excuses the FSC subsidies even when
contingent upon exports. It does not and this is a matter which we will now consider.
Footnote 59 to Item (e) of the Illustrati ve List in Annex I to the SCM Agreement
Introduction
4.930  The United States relies heavily on footnote 59 to Item (e) of the Illustrative List in Annex I
to the SCM Agreement which it claims contains or is “predicated by” a “controlling legal standard” to
the effect that a Member has a right not to tax foreign economic processes and may make non taxation
of these foreign economic processes contingent upon any condition it pleases including export
performance.  The European Communities will th erefore spend some time going over the various
                                                     
445 See paragraph s 46 to 48 of the US Second Written Submission.WT/DS108/R
Page 161
elements of footnote 59 in order to leave the Panel in no doubt that it does not help the United States
case.
The Nature of the Illustrative List
4.931  To put matters in context it is necessary to first recall the European Communities' position on
the nature of the Illustrative List.
4.932  The European Communities has always insisted that the Illustrative List is illustrative  – that is
it contains a certain number of subsidies which are deemed  to be included in the prohibition of export
subsidies in Article 3.1(a).  Footnote 5 excludes from the prohibitions of the SCM Agreement any
subsidy which is referred to in the list as not constituting an export subsidy.  This footnote does not
however mean that the Illustrative List in Annex I can be applied a contrario so that a measure which
does not fall within the terms of one of the Items of Annex I is not an export subsidy (or even is not a
subsidy) and escapes the disciplines of the Agreement, including the general prohibition in
Article 3.1(a).  To benefit from footnote 5, it is necessary that there be a clear statement in Annex I
that a measure does not constitute an export subsidy.  There is one clear example of such an
exemption and that is the second paragraph of Item (k) which exempts certain export credit practices
which comply with the OECD Understanding.
4.933  If it were otherwise, the Illustrative List would be an exhaustive list and all sorts of measures
could be argued to escape the prohibition.  For example, Item (a) prohibits:
“The provision by governments of direct subsidies to a firm or an industry contingent
upon export performance.”
4.934  An a contrario approach to the Illustrative List would mean that indirect subsidies to a firm
or an industry contingent upon export performance escaped Item (a) and therefore prohibition by
Article 3 !
4.935  The United States endeavours to make footnote 59 exhaustive of the disciplines applying to
the FSC and would wish that if it could justify the FSC scheme under footnote 59 it would not need to
be concerned with the clear incompatibility with Article 3.1.  It argues as follows446:
The term “illustrative” signifies simply that not all types of financial contributions are
covered by Annex I;
Where a particular paragraph of the Illustrative List does address a particular type of
financial contribution, that paragraph sets forth the standard for determining whether
the financial contribution is or is not a subsidy;
4.936  The United States interpretation makes the word “illustrative” lose its meaning and become a
nullity.  Article 3.1(a) already contains a general prohibition and the word “including” before the
reference to the list.  One does not therefore need the word “illustrative” to make clear that measures
of a kind not described in the list may be covered by Article 3.1(a).  The United States interpretation
is reducing the word “illustrative” to inutility and would be contrary to the principle of effective treatyinterpretation
447.
4.937  The United States goes on to argue:
                                                     
446 Paragraphs 76 to 77 of the US Second Written Submission.
447  See, e.g., Japan - Alcoholic Beverages, page 11.WT/DS108/R
Page 162
The European Communities' approach to the Illustrative List would reduce
predictability.  Even if  the terms of the item are complied with, a measure may still
be a prohibited export subsidy;448
4.938  Of course the United States approach increases predictability.  The narrower a prohibition, the
more predictable it is.  The more exhaustive a list, the more predictable it will be.  Apart fromfootnote 5 (to which we will come in a moment), the European Communities sees no indication that
the reference to the Illustrative List was designed generally to increase predictability about what does
not fall under Article 3.1 – only to make clear that the listed measures do.  On the contrary the general
terms of the prohibition in Article 3.1 and the word “including” indicate a desire to establish a general
principle, not detailed rules.
4.939  The United States then resorts to a presumed drafting history by arguing that it is
“extremely unlikely that the drafters of the SCM Agreement went to the trouble of
crafting in the Illustrative List specific and detailed rules for particular types of
financial contributions … with the intent that those rules could be readily ignored in
favor of more general standards found elsewhere in the SCM Agreement”
;449
4.940  The European Communities disagrees with the United  States views of the intent of the drafters
of the SCM Agreement.  As the United States has pointed out itself (in the context of a different
argument), the Illustrative List in Annex I was taken over with very few changes from previous
agreements were originally contained in a 1960 Working Party Report and approved in a Declaration.
That working party made the following statement:
“The Working Party agreed that this list should not be considered exhaustive or to
limit in any way the generality of the provisions of paragraph 4 of Article XVI.”450
4.941  That seems clear enough.  In taking over the Tokyo Round development of this list with
hardly any changes into the WTO SCM Agreement, WTO Members surely had the same intention not“to limit in any way the generality” of Article 3.1(a) of the SCM Agreement and the language they
used reflected this.
4.942  Finally, the United States argues that footnote 5 would lose its meaning if an export-related
measure could be regarded as a prohibited export subsidy notwithstanding the fact that the measure
does not constitute an export subsidy under one of the paragraphs of the Illustrative List.
451
4.943  Footnote 5 does not lose its meaning under the European Communities' approach.  It
derogates from Article 3.1 but only where Annex I states that a measure does not constitute an export
subsidy.  The European Communities has given one clear example and that should suffice.  Panels
should not interpret provisions they do not need to interpret.452
4.944  Finally in this connection, the European Communities must add that as an exception to a
general prohibition footnote 5 is to be construed restrictively and the burden of proving that a measure
benefits from it would lie with the United States in this case.
Item (e)
                                                     
448 See paragraph 78 of US Second Written Submission.
449 See paragraph 79 of US Second Written Submission.
450 BISD 9S/187, immediately following the list.
451 See paragraph 80 of US Second Written Submission.
452 See Appellate Body in United States - Measure Affecting Imports of Woven Wool Shirts and Blouses
from India , (WT/DS33/AB/R of 25 April 1997) “… we do not consider that Article 3.2 of the DSU  is meant to
encourage either panels or the Appellate Body to "make law" by clarifying existing provisions of the WTO
Agreement  outside the context of resolving a particular dispute”.WT/DS108/R
Page 163
4.945  Thus the European Communities' position is that the FSC subsidies are contrary to
Article 3.1(a) of the SCM Agreement without any need to refer to the Illustrative List.  However it is
not at all afraid of the Illustrative List, nor its footnote 59 since these simply confirm the conclusion.
4.946  It is perhaps useful to look at Item (e) again. After hearing all this argument from the
United States there is a danger of forgetting how clearly it prohibits the FSC subsidies.  It brings
under the prohibition:
“The full or partial exemption remission, or deferral specifically related to exports, of
direct taxes or social welfare charges pa id or payable by industrial or commercial
enterprises.”
4.947  It is worth dwelling on Item (e) an instant since a footnote is only supposed to explain a
provision not contradict  it – as the United States seeks to do.  The European Communities examined
each element of Item (e) in its First Written Submission453 and having not seen any response from the
United States presumes that it is accepted that they apply on their face to the FSC scheme.
The First and Last Sentences of Footnote 59 to Item (e)
4.948  It is important for the United States case to establish that footnote 59 does not explain Item (e)
but “explicitly narrows”454 its scope.  For this reason it briefly mentions the last and first sentences of
footnote 59 (in that order).  The last sentence states that:
“Paragraph (e) is not intended to limit a Member from taking measures to avoid the
double taxation of foreign-source income earned by its enterprises or the enterprises
of another Member.”
4.949  This last sentence of footnote 59 may well guide the interpretation of Item (e) in a manner
that is narrower than an alternative interpretation that might prevail in its absence.
4.950  The United States also mentions the first sentence of  footnote 59 which states that:
“Members recognize that deferral need not amount to an export subsidy where, for
example, appropriate interest charges are collected.”
4.951  Again this is arguably narrowing the scope of Item (e).  (Not contradicting, narrowing.)
4.952  However, the United States is not relying on either of these sentences to defend the FSC
scheme and nor could it for a number of reasons.  For example, the FSC scheme is not designed to
reduce double taxation and there is no deferral of tax or interest charge in the FSC scheme.
4.953  The fact that the first and last sentences of  footnote 59 might narrow Item (e) (a matter the
Panel does not need to decide) does not show that the other sentences do so.  The European
Communities will now show that the sentences on which the United States is relying do not narrow
Item (e).
The Second Sentence of Footnote 59 to Item (e)
4.954  The United States relies on the second and third sentences of footnote 59 (and the fourth
sentence as regards its preliminary objection).
4.955  The second sentence states:
                                                     
453 Paragraphs 157 to 162 of the European Communities' First Written Submission.
454 Paragraph 66 of the US Second Written Submission.WT/DS108/R
Page 164
“The Members reaffirm the principle that prices for goods in transactions between
exporting enterprises and foreign buyers under their or under the same control should
for tax purposes be the prices which would be charged between independent
enterprises acting at arm's length.”
4.956  For the European Communities, the second sentence of footnote 59 merely confirms the
European Communities position based on the other provisions of the SCM Agreement that the export
contingent derogation which the FSC scheme contained from its arm’s length pricing rules can and
should be considered an export subsidy.
4.957  The United States claims that this sentence “reinforces” the “qualifying nature of
footnote 59”.  The European Communities considers that the explanation the United States gives of itsmeaning does not reflect any “narrowing” of Item (e). On the contrary.
4.958  The United States considers that the second sentence:
“protects against WTO Members conferring an impermissible tax advantage on
domestic-source income by allowing their exporting enterprises to shift income to
tax-advantaged, related foreign enterprises.  This could occur if taxing authoritiesallowed higher-taxed “exporting enterprises” to undervalue prices in relation to
lower-taxed “foreign buyers.”  Artificially shifting income in this way would result in
a tax savings only if the related foreign company was taxed at a lower rate or not at
all.”
455
4.959  The European Communities for once does not disagree.  Actually this is describing exactly
what the administrative pricing rules of the FSC scheme do.
4.960  The United States seeks to achieve its desired “controlling legal standard” by reasoning that
“In fact, the sentence is relevant and has meaning only if WTO Members are
permitted to tax foreign-source income to a lesser extent than domestic-source
income or to exempt foreign-source income from tax altogether.  If WTO Members
are not free to do so, there would be no need for the drafters of the SCM Agreement
to have included this provision. In such a circumstance, paragraph (e) would ban anytax advantage conferred on the income of foreign entities taking part in export
transactions .”
456
4.961  This is another example of false logic.
4.962  This piece of reasoning confuses very different concepts.  Foreign source income  and income
from export transactions  are different notions and may not be used interchangeably as the
United States does here and in many other parts of its submission.  It may be that income from export
transactions will in many cases be foreign source income.  In other cases however it will be domestic
source income.  It may also be that a part of an entity’s foreign source income is derived from export
activities.  There are however many other sources of foreign source income (e.g. foreign
manufacturing).  The two concepts simply do not have the same content.
4.963  It does not follow from the fact that foreign source income may be treated differently than
domestic source income that income from export activities may be baptised in all cases foreign source
and exempted from taxation.  That is effectively what the United States is doing by assimilating
income from export transactions with foreign source income.  If this were so the door would be wide
open for tax-based export subsidies as the European Communities demonstrated with its question 8discussed a moment ago.
                                                     
455 Paragraph 67 of the US Second Written Submission.
456 Paragraph 68 of the US Second Written Submission.WT/DS108/R
Page 165
4.964  The real explanation for the second sentence of footnote 59 is that there are a multiplicity of
taxing jurisdictions around the world and some tax rates are lower than others.  Indeed that is the main
reason why transfer pricing rules exist and the United States in particular has such a well developed
set of them.  That is also why this sentence was considered necessary.  It is not a declaration that
Members are free not to tax foreign source income.  It goes without saying that WTO Members maydo this, just as they are free not to tax any income at all, provided that they do not grant exemptions
which give rise to export subsidies.
4.965  The truth is that the second sentence of footnote 59 widens the prohibition of Item (e) by
making clear that the authorisation of non-arm’s length pricing rules may be considered an export
subsidy.
4.966  The United States candidly admits that the special administrative pricing rules of the FSC
scheme will not correctly allocate profit between the persons involved (the FSC and its related
supplier) but claims that this is not its purpose and it is not referring to the kind of rules set out in
Section 482 IRC or the OECD Guidelines but to the allocation of income between economic
functions.  According to the United States the FSC and its related supplier should not really beregarded as separate
457 and that allocating all “income attributable to distributor functions” to the FSC
is just a convenient device for taking advantage of a pretended WTO right.
4.967  However, it is plain from the text of the second sentence of footnote 59 that it is referring to
the need for prices for goods in export transactio ns between exporting enterprises and foreign buyers
under their or the same control to be those that would be charged between independent persons acting
at arm’s length .  It is nowhere referring to the allocation of income between “ economic processes .”  It
refers to allocating income between persons.
4.968  Thus the reason for footnote 59 adopting the “arm's length” rule is to approximate as far as
possible the conditions which would have prevailed in the absence of the privileged relationship
between buyer and seller. As discussed above, however, the United States calls on the Panel not to
regard the FSC and its related supplier as separate. In fact, the only thing the FSC legislation does is
to create a fictitious allocation of income (on the basis of predetermined formulaic criteria) regardlessof the processes actually performed by a FSC. It is therefore incompatible with the second sentence of
footnote 59 and therefore a prohibited export subsidy under Item (e) and Article 3.1(a).
The Third Sentence of Footnote 59 and the de minimis Arguments
4.969  We come now to the third sentence of footnote 59.  The United States does not mention this
as narrowing Item (e) but rather tries to erect it into a burden of proof hurdle for the European
Communities requiring the European Communities to prove that the FSC subsidies give rise to a
“significant” saving of tax.
4.970  The European Communities has already set out its view of the third sentence to footnote 59 at
length in its Second Written Submission and will be brief today. The third sentence only refers to theright to draw attention to such practices and the word “significant” is simply designed to avoid
Members from invoking individual cases of minor importance.
4.971  The prohibition on export subsidies is absolute.  There is no de minimis rule.
4.972  In any event, the FSC subsidies are significant at US$2 billion per year and the relevant effect
of the FSC scheme for companies is that they save 15-30 per cent of the tax charge on exporttransactions.
458
Conclusion
                                                     
457 Paragraph 109 of the US First Written Submission.
458 See paragraphs 36 and 138 of the European Communities' Second Written Submission.WT/DS108/R
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4.973  The European Communities has shown above that the United States is entirely wrong to argue
that footnote 59 narrows the terms of Item (e) in  any manner relevant to the FSC scheme.  On the
contrary it simply confirms the correctness of the European Communities' categorisation of the FSC
special administrative pricing rules as a prohibited export subsidy.
4.974  The European Communities would add that when the third sentence of footnote 59 refers to
administrative and other practices it is not referring to laws but to de facto subsidisation, notably
through administrative practices. It is not providing a derogation for non-conforming legislative
measures. The addition of the word “administrative” to  describe the special pricing rules is a cosmetic
device seeking to take advantage of the Tokyo Round SCM Agreement.
The United States  further responds in its Oral Statement at the Second Meeting of the Panel as
follows:
4.975  In particular, we would like to use this opportunity to summarize for the Panel the numerous
deficiencies in the European Communities' case that preclude a decision in theEuropean Communities' favour.  The European Communities' failings are both procedural and
substantive.  Perhaps most troubling, the European Communities has attempted to skate by on an
overly simplistic theory of the case.  The European Communities, in effect, has done nothing more
than point out what is plain for all to see – namely, that the FSC is a tax exemption which pertains to
exports.  According to the European Communities, all such measures are necessarily prohibited export
subsidies – irrespective of any exceptions or limita tions built into the SCM Agreement or the AA.  By
asking the Panel to declare a measure to be a subsidy simply because the measure is specific, theEuropean Communities is asking the Panel to overlook the language and structure of these
agreements.  In addition, the European Communities is asking the Panel to ignore the unique history
that led to the enactment of the FSC.
4.976  Notwithstanding the many assertions made and questions raised thus far in this dispute, there
are three principal issues confronting this Panel:
(1) a threshold question of whether this case is ripe for decision on the merits or whether,
instead, it should be dismissed or deferred;
(2) whether the SCM Agreement and the AA incorporate or are otherwise consistent with
the fundamental principle that countries are free not to tax income generated fromeconomic processes outside of their territories without running afoul of WTO subsidy
disciplines; and
(3) if so, whether the WTO prohibits the use of rules of administrative convenience in
allocating income attributable to foreign economic processes and whether theEuropean Communities has met its burden of proving that the FSC administrative
pricing rules contravene the arm’s length principle of footnote 59 and result in a
“significant” saving of taxes on income earned from activities taking place within the
territory of the United States.
Dismiss or Defer?
4.977  With respect to the first question, the only point the United States will make here is that this
case involves complicated tax provisions that are, in turn, tied to structural considerations that
underlie the US tax system.  Any decision in this case is likely to have far-reaching repercussions, not
only for the US tax system but also for the tax systems of most, if not all, WTO Members.  These
features of this case make the satisfaction of procedural and evidentiary requirements even moreimportant than they otherwise might be in a typical WTO case.WT/DS108/R
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4.978  The significance of clearly defining and joining the issues, and of presenting well-
documented, pertinent evidence, is further underscored by footnote 59 of the SCM Agreement.  That
unique provision specifically admonishes Members that disputes involving technical tax issues of
transfer pricing should first be taken up in bilatera l channels or a multilateral forum that is specialized
in dealing with such issues.  Not only should such  a requirement be enforced in this case, but its
existence also highlights the importance of having factual and legal issues carefully articulated, well
developed, and supported by relevant, credible evidence.
4.979  The European Communities, though, chose to sidestep this route.  Instead, the European
Communities has attempted to incorporate the rules of one such tax forum – the OECD – into these
proceedings.  Ironically, the letter cited by the European Communities purportedly to demonstratewhy it is appropriate to look to the OECD Guide lines in this case – a 1979 letter from the General
Counsel of the Office of the US Trade Representative – actually belies this contention.  See Exhibit
EC-28.  This letter, which was sent during the pendency of the Tokyo Round negotiations, identifies
the difficulties associated with fashioning rules to address non-arm’s-length practices that could
amount to export subsidies.  The letter notes the need for detailed rules in this area and suggests thatthe Illustrative List of Export Subsidies should be amended to include an interpretative note stating
that the OECD Guidelines may be used to interpret paragraph (e).  Of course, no such note was ever
incorporated into the Illustrative List.  Unlike Article 3 of the Agreement on the Application of
Sanitary and Phytosanitary Measures, Article 2 of the Agreement on Technical Barriers to Trade, or
even item (k) of the Illustrative List of Export Subsidies, item (e) and footnote 59 do not incorporate
by reference external international standards, but instead require Members to resort to international
mechanisms that deal with transfer pricing matters before invoking WTO dispute settlement.
4.980  Nonetheless, the European Communities has attempted to rely upon the OECD Guidelines
because it has been utterly incapable of defining the arm’s-length principle for purposes of the SCM
Agreement without resort to extrinsic rules.  Regr ettably, instead of following the sound procedures
the drafters of the SCM Agreement established and raising its claims in a forum dedicated to
resolving such issues, the European Communities has attempted to take a short cut that ill-serves theWTO and does little to provide the Panel with a sound basis for resolving this dispute.
4.981  For these reasons, and for the reasons set forth in prior United States submissions, the first
issue for this Panel to decide is whether this case is positioned to allow for an informed decision on
the merits or whether, as the United States has urged, the explicit direction provided in footnote 59 for
precisely this type of case should be followed.
The Tax Exemption Issue
4.982  If the Panel decides not to dismiss or defer this case in its entirety, the first and most
important issue that the Panel must address is the ta x exemption issue.  More specifically, the issue is
whether WTO subsidy rules leave Members free to tax, or not to tax, income generated fromeconomic activities, including transactions involving exported goods, that occur outside of their
territories.  (For ease of reference, we identify  such income throughout this statement as “foreign-
source income.”)  If the Panel reaches any part of the merits of this case, it must resolve this
fundamental issue.
4.983  Therefore, the United States believes that the first priority among the substantive issues
before this Panel is whether the principle on which the United States and other WTO Members have
relied since 1981 remains valid.  The resolution of this issue necessarily affects the analysis and
resolution of the remaining issues in this dispute.
Article 1 of the SCM Agreement Incorporates  the Principle that Foreign-Source Income
Need Not Be Taxed
4.984  The European Communities, of course, argues that the Panel should begin its analysis with
the general provisions of Article 1.  In the view of the United States, the result when ones starts withWT/DS108/R
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Article 1 is the same as when one starts with item (e) of the Illustrative List and footnote 59 – the
exemption from tax of foreign-source income is not, in itself, a subsidy or an export subsidy.  As the
United States demonstrated in its second submission, when Article 1.1(a)(1)(ii) is interpreted in light
of the 1981 Council Decision and footnote 59, it is clear that such an exemption does not constitute
the foregoing of revenue that is “otherwise due.”
4.985  With respect to the status of the Council Decision, the European Communities has sought to
muddy the waters on this issue, so let me restate for the Panel the United States position.  The
principal United States position is that the 1981 Council Decision is a “decision” within the meaning
of paragraph 1(b)(iv) of the introductory language to GATT 1994.  As such, the Council Decision,
which interprets Article XVI:4 of GATT 1947, is part of GATT 1994.  GATT Article XVI:4, in turn,constitutes part of the context of Article 1 of the SCM Agreement, as demonstrated by the text of the
SCM Agreement itself and Appellate Body jurisprudence.
4.986  The European Communities  contests that the 1981 Council Decision is a decision within the
meaning of paragraph 1(b)(iv), and refers the Panel to paragraphs 45-52 of the
European Communities' oral statement at the first meeting of the Panel.  However, insofar asparagraph 1(b)(iv) is concerned, that portion of the oral statement simply recites the now well-known
statement by the Appellate Body in the Japan Liquor  case that adopted panel reports in themselves  do
not constitute “decisions” for purposes of paragraph 1(b)(iv).
4.987  The United States has responded to this argument, but it bears repeating that the United States
is not asserting that it is the panel reports in the Tax Legislation Cases  that constitute “decisions”
under paragraph 1(b)(iv).  If that were the case, then the FSC would be an export subsidy, because
those reports found that the exemption of foreign-source income from tax constituted an exportsubsidy and that is what the FSC does.  Instead, it is the Council Decision , which reversed the panel
and which adopted a principle different from that relied on by the panel, that falls under
paragraph 1(b)(iv) and, thus, has become part of GATT 1994.
4.988  The European Communities also argues that, even if the Council Decision does fall under
paragraph 1(b)(iv), it is of no relevance to this case.  According to the European Communities:  “Adecision taken in relation to Article XVI:4 of GATT 1947 cannot therefore assist in the interpretation
of the [SCM Agreement].”  Here, the European Communities is simply wrong.  The text of the SCM
Agreement and Appellate Body jurisprudence support the proposition that GATT Article XVI
constitutes part of the context of the SCM Agreement, and, as such, must be taken into account when
interpreting the SCM Agreement.  In addition, as recognized by the panel in the Indonesia Autos  case,
established principles of public international law require a panel, to the extent possible, to interpret
GATT 1994 and another Multilateral Agreement in a manner that avoids, rather than creates, a
conflict between the two.  Here, the European Communities is asking the Panel to create a conflict
between GATT Article XVI and the SCM Agreement by ignoring the Council Decision,
notwithstanding the fact that it is possible – indeed, desirable – to arrive at a harmoniousinterpretation of the two agreements.
4.989  Turning from the status of the Council Decision to its contents, the European Communities
continues to maintain that what the Council meant to say was that only exporting countries with
territorial tax systems  need not subject foreign-source income to taxation without running afoul of
GATT subsidies rules.  Of course, the Council Decision does not contain any such limitation, and theEuropean Communities has yet to explain exactly how the text of the Council Decision supports its
interpretation.
4.990  The European Communities tries to muddy the waters even more by suggesting that the
United States arguments are somehow inconsistent with the United States position that neither the
WTO nor the SCM Agreement requires Members to adopt a particular tax system.  To the contrary,
the United States position in this case is thoroughly consistent.  To reiterate, the United States view is
that neither the WTO, nor the GATT before it, requires the maintenance of a particular tax system.  Inlight of this, it is impossible to conclude that the GATT Council in 1981 or the Uruguay RoundWT/DS108/R
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negotiators in the 1990's contemplated rules under which only some countries with a particular type of
tax system could exempt foreign-source income from tax and thereby favor exports over domestic
sales.
4.991  The European Communities also has attempted to  diminish the significance of the Council
Decision by asserting that the concept of  “foreign economic processes” is too vague to constitute aworkable standard.  As demonstrated by the United States in its second submission, the concept is not
difficult to grasp – the “foreign” character of an economic process is determined principally by where
the process is performed.  Moreover, because it was EC member States, backed by the European
Communities itself, that proposed the concept in 1981, this particular argument of the European
Communities has no credibility whatsoever.
4.992  The European Communities also argues that the United States interpretation of
Article 1.1(a)(1)(ii) is inconsistent with the interp retation taken by the United States under its own
countervailing duty law.  The European Communities cites a single countervailing duty determination
from 1991, but does not attach the determination as an exhibit or explain what this determination
allegedly says.
4.993  However, the countervailing duty regulations of the US Department of Commerce
demonstrate that there is no inconsistency in the United States position.  Attached as US Exhibit 25
are relevant pages from Commerce’s Notice of Final Rule containing the agency’s substantive
countervailing duty regulations.  Commerce’s regulation on direct tax measures is contained in
Section 351.509 (page 65,411), and this regulation is explained in the preamble to the regulations.  In
the preamble, on page 65,376, Commerce states that it would not consider a foreign tax measure that
meets the criteria of the Council Decision to be an export subsidy.
4.994  Yet another new European Communities argument relates to the tax expenditure list
published by the US Department of the Treasury.  In identifying the tax expenditure list as an
authoritative source for the designation of FSC exempt income as “revenue foregone,” the European
Communities reflects its ignorance of the purpose of that list, as well as its inability to articulate a
standard that would be broadly applicable for purposes of the SCM Agreement.
4.995  Under United States law and practice, the term “tax expenditure” has a somewhat arbitrary
definition.  Tax expenditures are defined by the Congressional Budget Act of 1974 (Public Law 93-
344) as “revenue losses attributable to provisions of Federal tax laws which allow a special exclusion,
exemption, or deduction from gross income or which provide a special credit, a preferential rate of
tax, or a deferral of liability.”  The Act also requires that a list of tax expenditures be included in thebudget of the US Government.
4.996  However, the Act does not specify the baseline tax law against which special provisions or
preferential tax rates can be compared.  Therefore, identifying actual tax expenditures is a matter of
judgment, and there is no theoretically correct baseline for measuring tax expenditures.   For example,
the Congressional Joint Committee on Taxation and the Executive Branch use different baselines and,therefore, sometimes disagree on whether or not a particular provision of the tax law is a tax
expenditure.  The Joint Committee uses a “normal” tax structure for the baseline.  The normal tax
structure is a comprehensive tax on income, where income is defined as the sum of consumption,
taxes and the changes in net wealth in a given period of time.  Beginning in 1983, the Executive
Branch has used the “reference law” for the baseline.  Reference law is a set of generally applicable,statutory income tax rules for measuring taxable income.
4.997  There are a number of differences between the two baselines, however.  For example, under
the Congressional normal tax baseline, tax expenditures arise because not all corporate income is
taxed at the top corporate tax rate, because capital gains can be taxed at a rate lower than ordinary
income, because capital equipment placed in service before January 1, 1997 can benefit from
accelerated depreciation rules, and because the US tax on income of controlled corporations generally
can be deferred until the income is repatriated to the United States.  However, none of theseWT/DS108/R
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provisions is a tax expenditure under the Executive Branch’s reference law baseline.  Therefore, there
is no national standard listing of tax expenditures.
4.998  Moreover, neither the Congressional nor the Treasury concept is designed to isolate measures
representing “revenue foregone” within the meaning of the SCM Agreement.  The Treasury listing
includes such broadly based items as tax deductions for charitable donations and credits for child care.The breadth of the tax expenditure list demonstrates that it cannot be considered as a list of trade
subsidies.
4.999  Indeed, if the United States were to institute a full exemption system covering all foreign-
source income, the cost of that exemption would quite likely be on Congress’ and/or Treasury’s list of
tax expenditures.  However, based on the European Communities' arguments in this case, that itemwould probably not draw an European Communities challenge as “revenue foregone.”
4.1000  In addition, exemptions and credits for foreig n income show up on some EC member State
expenditure lists.  For example, in the OECD document entitled “Tax Expenditures:  Recent
Experiences” (OECD 1996), of which the European Communities provided only a few pages as an
exhibit, Belgium admitted that exempting foreig n-source income might be a tax expenditure.  See US
Exhibit 26, p. 34.
4.1001  A review of the OECD document in its entirety  strengthens the point that tax expenditure lists
are not a reliable basis for identifying “revenue foregone” under the SCM Agreement.  A key point
made early in the OECD report is that “countries’ practices in presenting tax expenditure accounts
very substantially.”  US Exhibit 26, p. 9.  Another key point made in the report is that, even taking
into account the various country definitions of a “tax expenditure,” “classifying statutory fiscal
provisions as either part of the norm or an exception is difficult.”  US Exhibit 26, p. 10.
4.1002  More fundamental, however, is the fact that th e SCM Agreement, when interpreted in light of
the Council Decision, provides that countries may, but need not, tax foreign-source income.  In light
of that, the fact that a country chooses to identify the consequences of exercising this WTO-
permissible choice in the form of a “tax expenditure” does not transform the exercise of that choice
into a prohibited subsidy.
4.1003  In summary, the European Communities simply is wrong when it contends that the 1981
Council Decision has no relevance to this case and that Article 1 of the SCM Agreement does not
incorporate the principle that Members are free to refrain from taxing foreign-source income without
running afoul of WTO subsidy rules.  It simply cannot be correct to hold now that the central premise
of the Council Decision was vacated by the SC M Agreement without any statement in the text
indicating that this was a purposeful design on the part of the drafters.
Article 3.1(a) of the SCM Agreement Also Incorporates the Principle that Foreign-Source
Income Need Not Be Taxed
4.1004  Thus far we have been talking about Article 1 of the SCM Agreement and the fact that the
FSC tax exemption does not constitute the foregoing of revenue that is “otherwise due.” However, the
United States continues to believe that the proper way to approach this issue is by beginning with the
provisions of the SCM Agreement that most specifically deal with an income tax measure such as the
FSC – Article 3.1(a), item (e) of the Illustrative List and footnote 59.  As explained by the
United States in its prior submissions, item (e) interprets the general provisions of Article 1 andArticle 3.1(a), and footnote 59 further qualifies the coverage of item (e).
4.1005  The arm’s length pricing language of footnote 59 would be largely bereft of meaning if the
Panel were to conclude that the SCM Agreement requires foreign-source income to be taxed to the
same extent as domestic-source income.  Under such an interpretation, the use of non-arm’s length
pricing between related parties would not result in any tax savings, because all income would be
taxed, regardless of whether more or less was allocated to the foreign entity.  Thus, the arm’s lengthWT/DS108/R
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pricing language of footnote 59 is relevant only if WTO Members may treat the foreign portion of
income derived from export transactions differently or more favorably than domestic-source income
from the same transactions.  This result is confirmed when the 1981 Council Decision is taken into
account, the Council Decision also forming part of the context of Article 3.1(a), item (e) and
footnote 59.
4.1006  The arguments in the European Communities' second submission regarding footnote 59 lack
merit.  First, the European Communities states, at paragraph 127, that a footnote can “explain” a
provision but cannot “contradict” it.  The European Communities offers no citation for this
proposition, and the United States is not even sure what the European Communities means.  In the
view of the United States, regardless of the verb one uses, footnote 59 affects the meaning of item (e).In this regard, the United States also notes that there are other instances in the SCM Agreement where
footnotes qualify the meaning of the text.  An obvi ous example is footnote 5, which, as discussed in
prior United States submissions, provides that a measure cannot constitute a prohibited subsidy under
Article 3.1(b) if the measure is referred to in the Illustrative List as not constituting an export subsidy.
Clearly, footnote 5 modifies the scope of Article 3.1(b).
4.1007  Another example is footnote 15, which appears to  provide that the rebuttable presumption of
serious prejudice for subsidies in excess of 5 per cent ad valorem  does not apply in the case of civil
aircraft, notwithstanding the text of Article 6.1(a).  Is the European Communities seriously contending
that Article 6.1(a) applies to civil aircraft because footnote 15 cannot, in the European Communities'
words, “contradict” Article 6.1(a)?  If so, my authorities will be extremely  interested to learn of this
change in the European Communitie s' interpretation of the SCM Agreement and the fact that the
European Communities now believes that the rebuttable presumption in Article 6.1(a) applies toAirbus subsidies.
4.1008  The European Communities also cites the Rivers letter in connection with footnote 59.  The
United States is grateful to the European Communities for having submitted this particular exhibit,
because it clarifies several things.  First, in explaining the need for an arm’s length principle in
item (e), Mr. Rivers states that “enterprises may employ pricing practices which result in theattribution of excessive amounts of income to entities taxable in low or no-tax ‘haven’ jurisdictions.
This shields income from export-related activity from taxation as effectively as does an exemption
system.”  In so stating, Mr. Rivers was acknowledging that income shifted “offshore” in this manner
could properly be exempted from tax without running afoul of GATT export subsidy rules, and that
the only method of dealing with this – short of declaring that foreign-source income had to be taxed –was to establish an arm’s length principle that would regulate the manner in which income could be
treated as foreign-source income.
4.1009  Another interesting aspect of the letter is that, as previously noted, Mr. Rivers proposed an
interpretative note that would have provided a basis fo r interpreting item (e) of the Illustrative List in
light of whatever transfer pricing guidelines emanated from the OECD, at least in the case of OECDmembers. Again, such an interpretative note was not adopted, indicating that the drafters rejected the
notion that OECD rules would govern for purposes of the arm’s length principle in what is now
footnote 59.
4.1010  The European Communities also attempts to minimize the significance of footnote 59 by
citing the deletion in the footnote of two transitional references to the DISC contained in apredecessor provision, footnote 2 of the Tokyo Round Subsidies Code.  Although the European
Communities previously has acknowledged that item (e) was not the subject of negotiations during
the Uruguay Round, the European Communities claims, at paragraph 51 of its second submission, that
the deletion of these transitional provisions “indicates an intention not to continue any exemption for
or tolerance of the DISC/FSC.”  This statement is a non sequitur .  The referenced transitional
provisions were eliminated because the DISC dispute had been resolved and the DISC itself had been
eliminated.  In particular, the deleted paragraph in footnote 2 referring to “measures incompatiblewith the provisions of paragraph (e)” could not ha ve been referring to the “DISC/FSC”, as claimed byWT/DS108/R
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the European Communities, because the FSC did not even exist when the paragraph was drafted and
entered into force.
4.1011  Finally, the European Communities continues to main tain that the Illustrative List does not set
forth standards for determining what is and is not an export subsidy.  In the view of the United States,
the Illustrative List, in conjunction with footnote 5 and the “including” language of Article 3.1(a),evidences an intent on the part of the drafters to provide guidance as to how Members could structure
assistance programmes in an acceptable manner without running afoul of WTO subsidy rules.  Rather
than repeat our arguments, the United States simply refers the Panel to paragraphs 74-80 of the
Second US Submission.
Summary
4.1012  In summary, the United States believes that whether one starts with the specific provisions of
Article 3.1(a), item (e) and footnote 59, or the general provisions of Article 1, the conclusion is the
same – Members may exempt foreign-source income from tax without running afoul of the subsidy
prohibitions of the SCM Agreement.  Therefore, the FSC tax exemption in itself is not a subsidy or an
export subsidy.  Once the Panel reaches this conclusion, the Panel must proceed to resolve issues that
all deal with questions of implementation; namely, whether the FSC system properly exempts foreign-
source income from tax.
"Foreign" Economic Processes
4.1013  The first implementation issue the Panel must address is whether the economic activities that
the FSC exempts from tax are foreign, as opposed to domestic.  In its second submission, theEuropean Communities has made three arguments.
4.1014  First, the European Communities argues that FSCs located in certain US territories are not
“foreign,” even though those territories are not part of the metropolitan United States, are outside of
US customs territory, and are outside of the US tax system.  According to the European Communities,
“the term ‘foreign’ must have some objective meaning.”
459  The United States already has responded
to this particular argument, and notes here only that “territory” is widely used throughout the GATT
to mean “customs territory,” and that “customs territory” was the precise concept advocated by the
European defendants in the Tax Legislation Cases  when they proposed what became the 1981 Council
Decision.  The United States cannot understand, nor has the European Communities explained, how
this concept has lost its “objectivity” since the time when its member States first proposed it.
4.1015  A ruling against the United States on this particular issue would invalidate the FSC system
only to the extent that FSCs are located in US territories.  However, because numerous FSCs are not
located in US territories, this would not relieve th e Panel from its duty to consider the other issues
raised by the parties.
4.1016  A second European Communities argument is that because a FSC can subcontract activities to
its related domestic supplier, this means that those activities are conducted in the United States.  Here,
there seems to be agreement between the European Communities and the United States that the
“foreignness” of an activity is determined by where the activity is performed.  However, the European
Communities asserts, without any evidentiary support, that the fact that activities can be subcontracted
means that those activities are performed in the Un ited States.  This is another European Communities
non sequitur .  The mere fact that a FSC may subcontract an activity to its parent – or to an
independent agent, for that matter – does not mean that the activity is performed in the United States.
4.1017  In this regard, US Question #29 asked the European Communities to identify the precise
portions of the First EC Submission and of any submissions made by the European Communities
during the first meeting of the Panel that cont ain evidence supporting the European Communities'
                                                     
459 Second EC Submission, paragraph 94.WT/DS108/R
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assertion that the economic processes attributed to a FSC take place in the United States.  The
United States invites the Panel to look closely at the European Communities' answer to this question.
In the view of the United States, this answer amounts to an admission by the European Communities
that it has submitted no evidence to the Panel that supports its assertion that the FSC system actually
exempts from tax income derived from economic processes occurring in the United States.  This is asubject to which we will return when we discuss the FSC administrative pricing rules.
4.1018  A third argument that the European Commun ities makes for the first time in its second
submission is that the FSC rules allegedly depart from the normal rules of the United States with
respect to the determination of what constitutes “foreign-source income.”  In particular, the European
Communities points to Section 921(a) of the US Internal Revenue Code, which designates all FSCexempt foreign trade income as foreign-source not-effectively connected income.
4.1019  The European Communities' argument has no force.  The United States does have rules for
determining foreign-source income in appropriate co ntexts.  However, one of these contexts – the
application of the foreign tax credit – is irrelevant because FSC exempt foreign trade income is not
eligible for double taxation relief under the foreign tax credit provisions.  A FSC is eligible for doubletaxation relief only through the partial exemption itself, which is equivalent to the double taxation
relief available under a territorial tax system.
4.1020  Moreover, the statutory treatment of FSC exempt income as “foreign-source not-effectively
connected income” is consistent with the treatment of certain other foreign sales under United States
sourcing rules.  For example, a foreign company’s income from a transaction consisting of a sale to a
foreign customer and attributed to a United States office will be treated as foreign-source if a foreign
office materially participated in the sale.
4.1021  Because of the principles applicable to foreign sales by nonresidents, it could be argued that
absent Section 921(a), all income from FSC export tran sactions (at least in the case of a buy-sell FSC)
would qualify for treatment as foreign-source, not-ef fectively connected income.  It was the intention
of Congress that the income exempted under the FSC system correlate to the anticipated level of
foreign activity.  Therefore, Congress limited the exemption by treating only 15/23 (65 per cent) ofthe income as exempt, which was done by providing that only exempt foreign trade income is foreign-
source income and not-effectively connected income under Section 921(d) of the Internal Revenue
Code.  Most other FSC income is treated as non-exempt, US-source income that is effectively
connected with a United States business under Section 921(d).
The FSC Administrative Pricing Rules
4.1022  Having established that the economic processes that the FSC seeks to exempt are foreign, the
next set of implementation issues relate to whether the FSC administrative pricing rules properly
allocate income between domestic and foreign economic processes in accordance with the standard
set forth in footnote 59.
Significant Saving of Direct Taxes in Export Transactions
4.1023  The Panel could simplify its task greatly by addressing first an issue that appears last in the
relevant text of footnote 59 – namely, the issue of whether the FSC administrative pricing rules result
in a significant saving of direct taxes in export transactions.  Even assuming for purposes of argumentthat the European Communities is correct with respect to all of its other contentions concerning the
FSC administrative pricing rules, under the plain text of footnote 59, those rules do not give rise to an
export subsidy unless they misallocate domestic-source income in a manner that gives rise to a
significant tax saving in export transactions.
4.1024  As the United States previously has explained, the total tax saving generated by the FSC
system is 0.93 per cent ad valorem .  Because a portion of this tax saving reflects the exemption from
tax of foreign-source income – income that properly may be exempted under the SCM Agreement –WT/DS108/R
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the tax saving attributable to the exemption of dome stic-source income, if any, must be some smaller
figure.  While the European Communities does not appe ar to take issue with the fact that the tax
saving attributable to the exemption of domestic-source income is smaller than 0.93 per cent, it has
not provided the Panel with any evidence as to wh at the relevant figure is, notwithstanding the fact
that as the complainant in this case, the Eu ropean Communities bears the burden of proof.
4.1025  Thus, the only empirical evidence before the Panel that is relevant to this issue is the 0.93 per
cent figure itself and US Exhibit 21.  In the view of the United States, the 0.93 per cent figure alone
represents a tax saving that is not “significant” within the meaning of footnote 59, because this is less
than the 1 per cent de minimis  standard used in the SCM Agreement for countervailing duty purposes.
In this regard, the United States is not, as claimed by the European Communities, arguing that there isa general de minimis  standard applicable to all potential export subsidies.  Instead, the United States is
arguing:  (1) in the case of income tax measures, the text of footnote 59 provides for a “significant tax
saving” test insofar as transfer pricing is concerned; and (2) a tax saving that is de minimis  for
countervailing duty purposes cannot be considered as “s ignificant.”  Again, it is important to keep in
mind that the tax saving, if any, attributable to the FSC administrative pricing rules is less than 0.93per cent.
4.1026  With respect to US Exhibit 21, the information contained therein does not permit an estimated
calculation of any improper tax saving attributable to the FSC administrative pricing rules.  However,
US Exhibit 21 does show that for the firms surveyed there was, in the aggregate, more foreign
economic activity than required to justify the roughly 15 per cent tax exemption provided by the FSC.
This suggests that even if some domestic-source in come is included in exempt FSC income under the
FSC administrative pricing rules, the amount of an y tax saving is likely to be minuscule in the
aggregate, and by no stretch of the imagination can be considered “significant.”
Administrative or Other Practices
4.1027  Should the Panel choose to deal with the FSC ad ministrative pricing rules in a different order,
then the first issue the Panel has to resolve is whether the SCM Agreement precludes a Member fromusing administrative rules of convenience, such as the FSC administrative pricing rules, at all.
4.1028  In the view of the United States, footnote 59 expressly contemplates that Members may use
“administrative or other practices.”  Even if these practices contravene the arm’s length principle, they
are acceptable if they do not result in a “significant saving of direct taxes in export transactions.”
Thus, footnote 59 contemplates that Members may rely on income allocation practices designed toapproximate arm’s length results in the aggregate.
Arm's Length Results
4.1029  Assuming that administrative rules of convenience, such as the FSC administrative pricing
rules, are permitted by the SCM Agreement,  the Panel must determine whether the FSC
administrative pricing rules generate results that, in the aggregate, are consistent with the arm’s length
principle of footnote 59.  This issue brings us back to the first defect in the European Communities'
case.  By raising its arm’s length claims about th e FSC administrative pricing rules before this Panel
rather than before an international body with more fully developed rules on transfer pricing, the
European Communities has been compelled to resort to  extrinsic texts in order to meet its burden of
proof.  Specifically, the European Communities has argued that the FSC administrative pricing rules
violate the arm’s length principle of footnote 59 because they are purportedly inconsistent with the
OECD Guidelines and Section 482 of the US Intern al Revenue Code.  However, nothing in the SCM
Agreement suggests that these standards are applicable or even relevant.
4.1030  The European Communities has failed to provide a proper interpretation of arm’s length as
that term is used in footnote 59.  In fact, the European Communities has been unable to articulate
what the arm’s length principle of footnote 59 means, the range of values it considers to be within thatprinciple, and what range of values would not be within that principle.  It would seem elementary thatWT/DS108/R
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the European Communities should be obligated to first identify the bounds of the arm’s length
principle before it can be said to have met its burden of proving that the FSC administrative pricing
rules somehow achieve results that fall outside of it.
4.1031  Other than pointing to the OECD Guidelines and Section 482, the European Communities
only argues that the FSC rules violate the arm’s length principle because they result in more incomebeing allocated to FSCs than their own direct activities would justify.  According to the European
Communities, unless FSCs themselves perform economic functions commensurate with their share of
income from covered export transactions, the administrative pricing rules necessarily violate the
arm’s-length principle.
4.1032  The European Communities' entity-to-entity comp arison might have force in other contexts,
but not with regard to the FSC.  FSCs are specif ically designed to conform to the 1981 Council
Decision.  The purpose of the FSC statute is to create a mechanism for properly segregating the
foreign aspect of export transactions, primarily the sales and distribution functions, from the domestic
aspect, which is largely manufacturing.
4.1033  The administrative pricing rules allow a limited exemption to income that is attributable to
foreign activities.  Because the FSC is obligated to take responsibility and pay for the distributor
functions, it does not matter whether the FSC, its related supplier, or a third-party performs them.  If a
FSC uses administrative pricing rules, it must always  be the party that contracts for the services in
question to be performed.  Under this system, the FSC  is properly credited with activities that occur
outside the United States, and the tax exemption conferred under the rules corresponds to income
derived from these activities.
4.1034  The FSC rules are consistent with footnote 59.  They afford taxpayers and the taxing authority
with alternatives to Section 482 that are more fl exible and less burdensome, but nonetheless correlate
to the income that may properly be attributed to the distribution and sales function in qualified export
transactions.  So long as the FSC rules, in the a ggregate, exempt the proportion of income in export
transactions that is attributable to foreign economic processes – and do not permit a tax savings for
domestic-source income that is "significant" – they cannot be said to create a prohibited exportsubsidy.
4.1035  For its part, the European Communities has not supplied the Panel with any evidence
demonstrating that the administrative pricing rules allow for a tax saving – let alone a “significant”
tax saving – on domestic-source income earned in export transactions.  Instead, the European
Communities has argued that the FSC does not properly provide a tax exemption for foreign-sourceincome because (a) FSCs may contract out their sales and distribution functions to their related
United States suppliers and (b) FSCs may be incorporated in the Virgin Islands.  For reasons that we
previously have explained, neither of these arguments has merit.
4.1036  While the European Communities has failed to adduce evidence demonstrating that the FSC
results in any tax savings on domestic-source income, the United States has supplied the Panel withempirical data in US Exhibits 20 and 21, which demonstrate that the FSC administrative pricing rules
reach an overall result consistent with the arm’s length principle and the principle that countries need
not tax income earned outside their territorial borders.  Specifically, the economic studies discussed in
Exhibit 20 show that the FSC administrative pricing rules reflect an appropriate allocation of income
between the FSC, which performs or pays for all sales and distribution activities, and the parentcompany, which is responsible for production activities.  The survey discussed in Exhibit 21 shows
that a cross-section of the largest United States exporting companies that use the FSC are exempted
on a percentage of income that correlates overall with the level of economic activities involved in
their FSC transactions which occur outside United States territory.
4.1037  As its legislative history clearly indicates, the FSC was designed by Congress specifically to
comply with the principles of the 1981 Council Decisi on.  Because neither the FSC in general, nor the
FSC administrative pricing rules in particular, were designed to favor specific industries or products,WT/DS108/R
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the pricing rules could not be tailored to reflect the manner in which specific products might be sold
or specific industries might operate.  On the other hand, any rule applied to all FSCs but modelled on
the operations of a specific industry or product would have been inequitable and inflexible to an
unacceptable degree.
4.1038  Consequently, Congress provided choices in I. R.C. Sections 924(d) and (e) that permit each
FSC to adapt the tests for foreign economic proce sses to their own particular industry or market
conditions.  The requirements of Sections 924(d) and (e) ensure that FSCs must perform at least some
key sales and distribution functions outside the United States.  The survey results in Exhibit 21 show
that the level of foreign economic activity actua lly involved in the FSC transactions of major
exporters correlates favorably with the exemption level for FSC income.  Thus, the FSC rules appear
to be successful in carrying out Congress’s intent ion of applying the criteria articulated in the 1981
Council Decision.
4.1039  In summary, the FSC administrative pricing rules constitute acceptable “administrative or
other practices” that do not contravene the arm’s length principle and that do not result in a significant
saving of direct taxes in export transactions.
European Tax Systems
4.1040  The United States feels compelled to comment on the discussion in the
European Communities second submission of the tax system of its member States.  As the Panel
knows, the United States contends that the results of the FSC tax exemption do not differ
substantively from the treatment accorded exports under the tax systems of various EC member
States.  Apparently recognizing the force of this point, the European Communities spent aconsiderable amount of time in its second submission, especially in its Annex 2, attempting to deny
the pro-export bias of the tax systems of its own member States.
4.1041  To reiterate, the United States position is that  territorial exemption systems operate to favor
export sales because they permit sales activities to be moved outside the home country and thereby
benefit from lower tax rates in another jurisdiction.  To demonstrate this point, let us consider thefollowing hypothetical.  Company C is taxed by its home country, Country C, at the full rate on
commissions related to domestic sales of products manufactured and sold in the home country.
However, Company C is not taxed at all by Country Z – or is taxed at a lower rate – on its
commissions relating to sales of the same types of products made to foreign customers through a
branch of Company C operating in Country Z, “For eign Branch C.”  Assume the same commission of
100 for distribution functions incurred in both domestic and export transactions.
4.1042  Now let us consider what would happen under several European tax systems.  If Country C is
considered to be the Netherlands, the tax on the commission with respect to domestic sales conducted
through a domestic branch would be 35, the commission being taxed at the full Dutch rate of 35 per
cent.  However, suppose that Country Z is the Netherlands Antilles and distribution activities areconducted through Foreign Branch C.  Because the Netherlands Antilles has an income tax on
commissions of 3 per cent, the Netherlands would not tax the commission based on its formalistic
“subject to tax” test.  The net result is that the tax on the commission incurred in the export
transaction is only 3.  As compared to the tax on the domestic transaction of 35, the result is an
increased net income to Company C in the export transaction of 32.
4.1043  Turning to France, the example becomes slightly more complicated.  In the case of a domestic
transaction, the commission of 100 would be taxed at the full French tax rate of 40 per cent, resulting
in a tax of 40.  In the case of distribution activities conducted through Foreign Branch C, the outcome
depends on whether Country Z is a country with which France has a tax treaty.  Assuming that
Country Z is not a treaty country, the 100 commission earned by Foreign Branch C is not taxed by
France if Country Z’s tax rate is such that the commission earned in Country Z is subject to tax by
Country Z at two-thirds of the French corporate tax rate; i.e., at 26.66 per cent.  Assuming thatWT/DS108/R
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Country Z is Panama, which has a tax rate of 30 per cent, the commission of 100 on distribution
activities is not taxed by France.
4.1044  Assuming that Country Z is a treaty country, there is no French income tax on the
commission of 100 earned by Foreign Branch C.  Assume also that Country Z is Ireland, which has a
tax rate of 10 per cent.
4.1045  Under the French tax system, the net increase in income to Company C from using Foreign
Branch C is as follows.  For export sales conducted through Country Z/Panama, the increase is 10 (a
Panama tax of 30 on the export transaction as compared to a French tax of 40 on the domestic
transaction).  For export sales conducted through Country Z/Ireland, the tax saving is 30 (an Irish tax
of 10 on the export transaction as compared to a French tax of 40 on the domestic transaction).
4.1046  Turning to Belgium, again the analysis depends on whether the export transaction goes
through a treaty or a non-treaty country.  Because Belgium has a tax rate of 40.17 per cent, the tax on
the commission of 100 in a domestic transaction woul d be 40.17.  Assuming that Country Z is not a
treaty country, the 100 commission earned by Foreign Branch C is taxed by Belgium at 25 per cent of
the normal rate ( i.e., 10.04 per cent), provided that the commission is “subject to tax” in Country Z.
Assuming that Country Z is Barbados, which has a tax rate of 2.5 per cent on an external company
with an International Business Company licence, the combined Belgium/Barbados tax on Foreign
Branch C’s commission of 100 is 12.54 per cent.
4.1047  In the case of a treaty country, Belgium imposes no income tax.  Assuming again that
Country Z is Ireland, the tax on Foreign Branch C’s commission would be 10.
4.1048  Thus, under the Belgian tax system, the net increase in income to Company C from using
Foreign Branch C is as follows.  For export sales conducted through Country Z/Barbados, the increaseis 27.63 (a combined Belgium/Barbados tax of 12.54 on the export transaction as compared to a
Belgian tax of 40.17 on the domestic transaction).  For export sales conducted through
Country Z/Ireland, the tax saving is 30.17 (an Irish tax of 10 on the export transaction as compared to
a Belgian tax of 40.17 on the domestic transaction).
4.1049  Finally, let us consider Germany.  Because Germany has a tax rate of 40 per cent, a tax of 40
would be imposed on the commission of 100 earned in a domestic transaction.  However, Germany
imposes no income tax on distribution activities conducted through a foreign branch in a treaty
country.  Thus, assuming again that Country Z is Ireland, the tax on the commission of 100 earned by
Foreign Branch C would be 10.  For export sales conducted through Country Z/Ireland, the tax saving
is 30 (an Irish tax of 10 on the export transaction as compared to a German tax of 40 on the domestictransaction).
4.1050  Thus, notwithstanding the European Communities' protestations to the contrary, the territorial
or territorial-type tax systems of its member States provide a tax savings for distribution activities
conducted through a foreign branch, a tax savings that is not available under the United States
worldwide tax system.
4.1051  More generally, the European Communities notes that the tax systems of the United States
and the European Communities member States share common objectives; namely, raising revenue,
avoiding double taxation, and preventing tax avoidance.  While the United States agrees that virtually
all national tax systems are designed to achieve these and other objectives in one form or another, this
fact is irrelevant to the key issue in this case; namely, that the tax systems of many EC member Statesexempt foreign-source income in export transactions from tax, or tax it at a lower rate, and that the
FSC merely attempts to emulate this treatment.
4.1052  The European Communities rejects “the United  States suggestion that any of its Member
States exempts income from tax havens, such as Barbados and the US Virgin Islands.”  Of course,
anyone with any knowledge of European tax systems knows that this statement is inaccurate.  InWT/DS108/R
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several EC member States, it is possible to obtain a tax exemption from various tax havens, including
Barbados.  For example, Germany specifically includes Barbados on a list of developing countries
from which certain dividend income is eligible for a exemption from German tax.  US Exhibit 27.
Also regarding Barbados, foreign branch profits of Dutch and Belgian companies would be eligible
for an exemption (in the case of the Netherlands) and a significantly reduced tax rate (in the case ofBelgium).  The above examples only scratch the surface of the possibilities known to tax authorities
and tax planners internationally for reducing European corporate taxes through tax haven transactions.
4.1053  The European Communities refuses to even conced e a proven fact – That there are countries
that do not tax foreign-source income of companies.  European Communities countries that partially
exempt foreign-source income include Belgium, Fr ance, the Netherlands, and Germany (by treaty).
An even greater number of European Communities countries have participation exemptions under
which income of foreign subsidiaries is repatriated to domestic parent companies tax-free.  Contrary
to what the European Communities asserts in its Annex 2, the United States believes that,
notwithstanding anti-abuse rules, EC member States with participation exemptions generally permit
the tax-free repatriation of foreign subsidiary sales income (even, in some cases, where the income istaxed abroad at a lower rate or not actually taxed at all).
4.1054  The European Communities contends that an exemption from tax for foreign-source income
does not necessarily provide any advantage to European Communities exporters.  Here, the European
Communities implies that providing a foreign tax cred it is the equivalent of providing an exemption.
However, the two approaches are not equivalent.  A foreign tax credit reduces home country tax by
the amount of the creditable foreign tax.  An exemption, on the other hand, eliminates home country
tax on exempt income, often without regard to the extent of foreign tax imposed on the income.  Asthe rate of tax may differ in the foreign jurisdiction, an exemption system is not simply aimed at
eliminating double taxation, and the US foreign tax credit provisions do not achieve the effect of an
exemption system.
4.1055  Finally, the European Communities appears to admit that an exemption system produces more
favorable results for foreign-source income than for domestic-source income, and that this may lead tothe imposition of higher taxes on domestic-source income.  However, this appears to be merely a
roundabout way of saying that export transactions are treated more favorably than domestic
transactions in an exemption system, a proposition with which the United States wholeheartedly
agrees.
4.1056  In summary, the statement by the European Communities that the tax systems of its member
States ensure that income is subject to tax at a le vel similar to that applicable in the member State
concerned simply is incorrect as a general proposition.
The European Communities  argues as follows in response to questions from the Panel following the
Second Meeting of the Panel:
4.1057  The European Communities has always understood the phrase “revenue that is otherwise due
is forgone” as meaning that there is only a financial contribution and therefore a subsidy where an
exemption or exclusion from taxation is not based on neutral and objective criteria, i.e. the exemption
or exclusion is special or programmatic.
460  As the European Communities has explained, this
corresponds to the practice of both the European Communities and the United States in countervailingduty cases.
461,462
                                                     
460 See paragraphs 72-83 of  the European Communities´s Second Written Submission and 78-93 of the
European Communities´s Oral Statement to the Second Meeting of the Panel. The European Communities notedthat the terms “special” and “programmatic” are those used  by the US in its contribution to the OECD Report on
Tax Expenditures in Exhibit EC-25.
461 See paragraph 80 of  the European Communities´s Second Written Submission and 91-93 of the
European Communities´s Oral Statement to the Second Meeting of the Panel referring to Exhibit EC-33.WT/DS108/R
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4.1058  The United States' contribution to the OECD Report on Tax Expenditures provides criteria for
determining where there is “revenue that is ot herwise due is forgone” and therefore a financial
contribution arising out of a tax measure463, which the European Communities is willing to adopt for
the purpose of further explaining to the Panel its approach. The first is that “ absent that special
provision, the tax laws provided general rules to enable a taxpayer to determine his income tax due
and payable”. The second criterion would be that “ it is necessary that the special provision apply to a
sufficiently narrow class of transactions or transactors to permit the specification of a programme
objective that could be administered on the direct spending side of the budget with appropriate
funds” . Lastly, the report states that one of the categories that have been labelled as tax expenditures
“would consist of deviations from general rules of the existing tax system that could be measured and
evaluated in a manner comparable to the measurement and evaluation of subsidy and transfer
programmes on the outlay side of the budget”.464
4.1059  The exemption from taxation of income arising out of economic activities occurring abroad
(known in the tax field as “foreign source income”) is not revenue forgone which is otherwise due and
therefore a financial contribution under this test.  It is a category of income which is defined in broad,neutral and objective terms and is applicable to all types of foreign source income and does not serve
any special programmatic function.  If the 1981 Understanding is considered relevant in this case, it
constitutes clear confirmation of the fact that the exemption or exclusion from taxation of income
from economic activities occurring abroad is not a measure by which “revenue that is otherwise due is
forgone”.
4.1060  The partial exemption from tax of income arising out of export activities with no equivalent
exemption for similar income deriving from domestic transactions or for income deriving fromequivalent foreign transactions on the other hand wo uld come within the scope of “revenue that is
otherwise due is forgone” and therefore a financial contribution under this test since it is a narrow
“special or programmatic” exemption.  Also, for the reasons that the European Communities has
developed at length in its submissions
465, it is not covered by any reasonable interpretation of the 1981
Understanding.
4.1061  The narrow, special and programmatic nature of the FSC scheme is clear from its terms and
its design.  It is expressly limited to income deriving from the export of United States “export
property” and designed to promote exports.  It is even expressly described by the United States as a
“tax incentive for United States exporters,” for example, in the title to the Department of Commerce
document in Exhibit EC-3.466
                                                                                                                                                                    
462 Paragraphs 4.1057-4.1064 reflect the European Communities' response to the following question
from the Panel: The European Communities has stated, in its response to question 5 from the United States, that"the European Communities' position is simply that WTO Members are not prevented by the SCM Agreementfrom not taxing foreign source income if this is done on a general basis."  In explaining its view of "revenue . . .
otherwise due", the European Communities has further stated (paragraph 78 to its rebuttal) that "[w]hat is
important is that there must be a deviation from or exemption to the generally applied rate or basis for collection
for there to be a subsidy." (emphasis in original)  Is it the view of the European Communities that the exemptionof all foreign source income from taxation would not represent the foregoing of "revenue . . . otherwise due"within the meaning of Article 1.1(a)(1)(ii) of the SCM Agreement?  Please explain in detail the legal basis for
your view.
463 See Chapter III on page 108 of the document.
464 See last paragraph of Chapter III on page 109 of the document.
465 See paragraphs 53-55 of the European Communities´s Oral Statement to the First Meeting of the
Panel, 65-70 of the European Communities´s 2nd Submission and 55-60 of the European Communities´s OralStatement to the Second Meeting of the Panel. The te rms “special” and “programmatic” are those used by the
US in its contribution to the OECD Report on Tax Expenditures in Exhibit EC-25.
466 The US describes the FSC scheme as a “programme” throughout the Treasury Reports in Exhibits
EC-4 and EC-5.WT/DS108/R
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4.1062  Other interpretations of the phrase “revenue that is otherwise due is forgone” can be
developed, but the European Communities finds the one it proposes and the United States and the
European Communities use in their countervailing duty practice to be the most reasonable one.
4.1063  First, the phrase could be interpreted as covering any revenue forgone compared with what
would have been collected in the absence of the measure which is being complained against.  Thiswould be a more formalistic interpretation of Ar ticle 1.1 of the SCM Agreement which would simply
rely on the measure under consideration being identified as an exemption or derogation from the rest
of the legislation.  An argument in favour of this interpretation would be that the more limited test
which the European Communities is proposing involves a consideration of the nature of the
exemption and may be considered to be importing a notion similar to that of specificity in Article 2 ofthe SCM Agreement into Article 1 of the SCM Agreem ent.  This approach would clearly lead to the
FSC as well as many other tax measures being considered subsidies for the purpose of Article 1 of the
SCM Agreement.  Bona fide  tax measures (e.g. lower tax rates for SMEs) would, however, escape the
disciplines of the SCM Agreement because they would not be “specific” within the meaning of
Article 2 of the SCM Agreement.  The FSC scheme would not escape because it is clearly contingent
upon export performance and local content, and therefore specific by virtue of Article 2.3 of the SCM
Agreement. The European Communities has not propo sed this possible interpretation of the phrase
“revenue that is otherwise due is forgone” since it considers that substance should prevail over form
in the interpretation of the SCM Agreement and the more purposive and less formalistic approach
proposed above is therefore more appropriate.
4.1064  Second, there is the interpretation of the United States which brings some extraneous notion
of what Members have the right to tax or not to tax into the phrase “otherwise due”.  TheUnited States argues that revenue is not “otherwise due” if a Member has a right not to tax it under
some rule of the WTO (and does not consider it relevant whether it would normally be taxed under
that Member’s general rules).  As the European Communities has explained most recently in
paragraphs 84 to 85 of its Statement to the Second Meeting of the Panel, such a proposition cannot be
correct.  WTO Members have the right not to tax any income at all and the United States logic wouldlead to the conclusion that it could exempt a particular company or industrial sector from tax as it
pleases.  Indeed Article 1.1(a)(1)(ii) of the SCM Agreement and Item (e) could never apply.
4.1065  In conclusion, the European Communities submits that from all the above proposals, the one
which better corresponds to the true meaning and purpose of Article 1.1(a)(1)(ii) is the approach
given at the beginning of this response.
4.1066  The European Communities would first note that for the necessary assumption for this
question is not just that the 1981 Understanding is relevant to the ASCM but that it is in particular
relevant to Article 1 and the definition of a subsidy.  The US has argued that it is relevant for the
interpretation of footnote 59 to Item (e) in the Illustrative List to Article 3.1 and this does not of
course make it relevant for Article 1.
467
4.1067  However, making the assumption for the purposes of answering the question, the
European Communities would observe that the phrase “ should not be regarded as export activities in
terms of Article XVI:4 of the General Agreement ” is simply recalling that foreign activities and export
activities are different notions and should not be confused.  The purpose of this phrase in the 1981
Understanding is to clarify that countries (applying a territorial tax system) which choose to exempt
                                                     
467 Paragraphs 4.1066-4.1067 reflect the European Communities' response to the following question
from the Panel: The 1981 GATT Council decision states that, "in general, economic processes (includingtransactions involving exported goods) located outside the territorial limits of the exporting country need not besubject to taxation by the exporting country and should not be regarded as export activities in terms of
Article XVI:4 of the General Agreement ."  Assuming – without prejudice to the parties' views on this issue – that
the 1981 understanding is relevant to interpretation of the SCM Agreement, please comment on the significance,
if any, of the highlighted language in terms of the concept of revenue "otherwise due” in Article 1 of the SCMAgreement.WT/DS108/R
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income from foreign economic activities, do not pr ovide an exemption for export activities which
would be prohibited under Article XVI:4 of the GATT, because foreign activities and export activities
are two separate notions, contrary to what the United States implies. An exemption for foreign source
income is not prohibited because it is not specific to export activities. Moreover export activities are
not necessarily foreign. Although these two positi ons derive directly from the 1981 Understanding
and abide with the spirit of the WTO regarding subs idies, the United States is trying to extract from
the 1981 Decision exactly the opposite; namely that an exemption specific to export activities is not
prohibited, and that export activities are always foreign, even when FSCs perform virtually no foreign
activities.
4.1068  The European Communities position as was stated at the second Panel meeting is that
subsidies should abide with the requirements of Article 3.1(a) and (b) ASCM so as not to be
prohibited under the ASCM. Tax exemptions give rise to prohibited subsidies only when they are
contingent in law  or in fact , whether solely or as one of a number of other factors (cumulative or
alternative), on exports or local content. Differentiation among types of income (such as dividends,
royalties, interest etc.) is acceptable as long as it is not contingent on export performance or localcontent. The European Communities cannot speculate on what would the US tax system look like if
all, or some, of the above changes were introduced.  It notes, however, that the FSC scheme could not
simply be made available to entities, such as these described in the question, or this would be
meaningless, considering that the entire FSC scheme is built around the notion of “export
property”.
468
4.1069  The European Communities has explained its general position on the meaning of “otherwise
due".  For the purposes of determining whether there is revenue forgone “otherwise due”, the baselineis not what countries allegedly have the right to do under WTO rules but what they have chosen to
do.
469
4.1070  In case the Panel is interested in a more detailed explanation of how “revenue that is
otherwise due is forgone” arises under the FSC scheme, the European Communities  will now
illustrate its position by explaining further the de tails of the FSC exemptions and derogations. For this
purpose,  the European Communities will analyse which rules would be applicable in the absence of
the FSC470 scheme for the same type of activities. Two comparable situations will be examined:
(a) A United States corporation which handles its own export sales directly.
(b) A foreign corporation (which is not a FSC) organised in a typical FSC location,
which handles its United States parent’s export sales.
4.1071  For situation (a) things are relatively easy. The United States company will be taxed on its
worldwide income including all income from expor t sales at the currently applicable United States
corporate tax rate.  Part of its export sales income will be characterised as domestic and part foreignsource income.  This will not change, however, the way this income will be taxed. Thus there will be
no exemption or deduction for foreign source income at tributable to export sales.  Therefore, for a
given export transaction carried by the United States company directly there will be a 15 per cent or
higher increase in its taxable income compared to the same transaction carried out through a FSC.
                                                     
468 Paragraph 4.1068 reflects the European Communities' response to the following question from the
Panel: Given the European Communities' view on the lack of consistency of the FSC with Article 3.1(a) of the
SCM Agreement, would this view be modified if the FSC were also available to entities: (a) involved in
importation of goods into the United States; (b) operati ng overseas in economic activities other than exportation
from or importation into the United States; (c) both.
469 Paragraphs 4.1069-4.1082 reflect the European Communities' response to the following question
from the Panel: Please provide further explanation rega rding your view of the criteria to be applied in
determining whether revenue foregone is "otherwise due" within the meaning of Article 1.1(a)(1)(ii) of the SCM
Agreement.
470 The analysis may be done either on the basis of a FSC not benefiting form the special exemptions,
absent the special FSC rules; or on the basis of a non-FSC entity performing FSC-type activities.WT/DS108/R
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4.1072  Under situation (b), a “foreign export corporation”471 (which is not a FSC) is involved.  For
this situation the analysis will be made on the basis of the standard rules which would be applicable
absent the special exemptions of the FSC scheme as defined in the European Communities'  Statement
to the Second Meeting of the Panel paragraph 9. Each exemption and the special administrative
pricing rules will be analysed separately.
4.1073  First, the special formulaic source rules.  Absent the formulaic source rules of IRC
Sections 921 and 923(a), the IRC standard source ru les of Sections 861 et seq. would apply, which
have been structured to determine the source of income based on factual evidence and which cover all
types of income, including export income.
4.1074  In the case of a foreign export corporation conducting its business in the way that FSCs are
entitled to do and employing its parent company to carry out the export sale,
Sections 864(c)(4)(B)(iii)472 and 865(e)(2) would apply.  These provide that:
Section 864(c)(4)(B)(iii):
“Income, gain, or loss from sources without the United States shall be treated as
effectively connected with the conduct of a trade or business within the United States
by a nonresident alien individual or a foreign corporation if such person has an office
or other fixed place of business within the United States to which such income, gain,
or loss is attributable and such income, gain, or loss—
…
(iii)  is derived from the sale or exchange (outside the United States) through such
office or other fixed place of business of personal property described inSection 1221(1), except that this clause shall not apply if the property is sold or
exchanged for use, consumption, or disposition outside the United States and an
office or other fixed place of business of the taxpayer in a foreign country
participated materially in such sale.”
Section 865(e)(2):
“(A) IN GENERAL.- Notwithstanding any other provisions of this part, if a
nonresident maintains an office or other fixed place of business in the United States,
income from any sale of personal property (including inventory property) attributable
to such office or other fixed place of business shall be sourced in the United States.The preceding sentence shall not apply for purposes of Section 971 (defining export
trade corporation).
(B) EXCEPTION.- Subparagraph (A) shall not apply to any sale of inventory
property which is sold for use, disposition, or consumption outside the United States
if an office or other fixed place of business of the taxpayer in a foreign countrymaterially participated in the sale.”
4.1075  The premises of the parent corporation will be “an office or other fixed place of business
within the United States” (the FSC parent definitely qualifies as such under Section 864(c)(5) IRC)
and the foreign export corporation has no material  participation in such a sale (because assuming
                                                     
471 For the purposes of this analysis a “foreign export corporation” is defined as a subsidiary of a US
manufacturing company incorporated in a typical FSC low-tax or no-tax jurisdiction, which handles its USparent’s export sales performing the same type of activities as a FSC. In other words, it is defined as a FSC
which does not qualify for the special exemptions and the special pricing rules.
472 Text contained in Exhibit EC-1 and referred to at paragraph 65 of the European Communities' First
Written Submission.WT/DS108/R
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financial and legal responsibility can hardly be considered a material participation).Therefore, under
Section 864(c)(4)(B)(iii) IRC, the sale income woul d be considered as effectively connected with a
United States trade or business, and under Section 865(e)(2) the sale income would be considered
sourced in the United States Under both circumstances, however all FSC income would be taxed in
the United States.  The FSC scheme has need of sp ecial source rules to function since otherwise all
the income would be subject to tax in the United States.
4.1076  Consequently, although the usual United States position may be that the source of income
from an activity depends on where the activity is performed, the European Communities notes that the
generally applicable United States rule in these cases (i.e. which would be applicable if not for the
special FSC exception) is that whenever a foreign company derives income from any sale of inventoryproperty outside the United States through an office or a fixed place of business without that foreign
company materially participating in the transaction, this income is taxed in the United States and that
irrespective of where the activities of the office or a fixed place of business are performed.
4.1077  Second, the exception from the Subpart F rules.
473  The foreign export corporation in this
comparison would fall within the “controlled foreign corporation” definition of Section 957(a) IRC,and its earnings will constitute “foreign base company sales income” as defined in Section 954(d)
IRC, which will have to be included in the taxable in come of the United States parent corporation as a
constructive dividend under Section 951(a) IRC.  This means that the benefit of being taxed at zero or
near zero levels in its country of incorporation will be lost because the same income will be taxed at
current United States tax rates in the hands of the parent of the foreign export corporation.  If the
special exception from the Subpart F rules of Secti ons 951(e) and 954(d) and (e) did not exist, the
FSC would receive the same treatment.
4.1078  Third, the 100 per cent deduction for dividends received from Foreign Trade Income under
IRC Section 245(c).  Under standard US tax rules there is no exemption allowed for dividends
received from foreign source income of foreign subsidiaries. The United States parent may only
receive a tax credit for foreign taxes paid abroad as a relief from double taxation. In the case of the
foreign export corporation, however, there would be no (or almost no) foreign taxes to credit since itwould be incorporated in a tax haven as most FSCs are.
4.1079  Fourth, the special pricing rules. The standard rules of Section 482 would apply to the foreign
export corporation, which provide for an allocation of profits based on activities actually performed
by the related entities. The determination of profits under Section 482 is always subject to re-
allocation by the tax authorities and there are no safe harbours. Furthermore separate mechanismsapply for different types of industries and there are no catch-all rules such as the so-called
“administrative pricing rules”. Thus a foreign export corporation that subcontracts all its activities
back to its parent would only receive a transfer price equal to the parent’s costs of performing these
activities. Under the special pricing rules of Sections 925(a)(1) and (2), however, the FSC that
subcontracts all its activities back to its parent receives a transfer price equal to the parent’s costs ofperforming these activities plus an amount which will allow the FSC to derive income equal to the
23 per cent of the combined taxable income, or 1.83 per cent of the foreign trading gross receipts.
                                                     
473 In footnote 56 of its second written submission, the US alleges that the Subpart F anti-deferral rules,
are an exception to the general US system of deferral,  and therefore since the FSC scheme provides for an
exception to this exception the FSC follows the general rule. This argument however is erroneous because the
US anti-deferral regimes have a wide scope of applicatio n and may not be considered as an exception in the FSC
field of activities. In fact one of the major targets of the controlled foreign corporations provisions of Subpart Frules was the tax savings that could be realised under pr ior law by handling international trade activities through
a foreign corporation incorporated in a tax haven country.  As the European Communities stated in paragraph 96of its Statement to the Second Meeting of the Panel, th e Subpart F rules are not an “exception” in the sense of
exemption; they are part of the US system of raising tax revenue – they do not result in the forgoing of revenue.
It is the FSC scheme which is the exemption since it exempts revenue from this regime of taxation and thereforerevenue is forgone which is otherwise due.WT/DS108/R
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4.1080  Under the different methods prescribed by regulations under Section 482, the most
appropriate for a foreign export corporation would be the resale price method described in Treas.
Reg. 1.482-3(c).  The resale price method is used in situations “involving the purchase and resale of
tangible property in which the reseller [ i.e., the foreign export corporation] has not added substantial
value to the tangible goods by physically altering the goods before resale.”. Under the resale pricemethod, the proper, arm’s-length transfer price between the related supplier and the foreign export
corporation would be calculated by starting with the price actually charged by the foreign export
corporation to its unrelated overseas customers and then subtracting an “appropriate gross profit.”.
The “appropriate gross profit” must be determined by reference to completely uncontrolled
transactions – i.e., transactions in which the reseller purchases the goods involved from an unrelated
party and then resells them to another unrelated party.  The uncontrolled transaction must be as
comparable as possible to the controlled transaction, and the regulations direct that the factors to be
considered in determining comparability include the “functions performed” by the reseller and the
“risks borne” by the reseller.
474  Given that the “functions performed” and the “risks borne” by a
foreign export corporation are typically relatively minor, one would generally expect that the“appropriate gross profit” allowable for the foreign export corporation under normal arm’s-length
pricing rules would be relatively small.  Again, these considerations play no role in the administrative
pricing rules under Section 925 IRC.
4.1081  Although it is not easy to determine to what extent the outcome of the special pricing rules
varies from the outcome of the Section 482 rules, as this is different in every individual transaction, it
is obvious that the special pricing rules produce transfer prices which are different from these under
Section 482, since they are an optional and are used by most FSCs.  If the Section 482 rule gave amore favourable result in any case, the FSC could use it.
4.1082  In conclusion, it is clear from the above analysis that the existence of the FSC scheme leads to
the foregoing of “revenue … otherwise due”, since absent the FSC rules, more tax would be payable
for the same activities.
4.1083  The European Communities has explained that the “administrative” pricing rules constitute a
separate prohibited subsidy under the SCM Agreement.  The “administrative” pricing rules constitute
a specific part of the FSC scheme separate from the other exemptions.  Even if all the other special
exemptions available to FSCs were abolished, the special pricing rules alone would provide a benefit
for US exports.  They would give rise to an inde pendent violation of the SCM Agreement.  First they
constitute a subsidy since they confer a benefit by allocating to the FSC more income than may beattributable to the FSC minimal activities and particip ation in the transaction.  Even assuming that all
the FSC tax exemptions were abolished, this could still give rise to revenue forgone since the
combined income of the FSC and its parent could still benefit from lower effective taxation than
under the general US transfer pricing rules contained in Section 482 IRC (as explained above).  Thus
government revenue is foregone that would otherwise be due.  In addition this subsidy is prohibitedunder Article 3 since it is contingent on export performance and the use of domestic over imported
goods. Furthermore, the special pricing rules violate the arm’s length pricing requirement of
footnote 59, although this does not necessarily need to be proved since the pricing rules violate
Articles 3 and 1 even without the invocation of footnote 59.
475
4.1084  One of the basic arguments the United States is making in the attempt to justify the FSC
scheme under the SCM Agreement is that exempt foreign trade income is attributable to foreign
activities or processes and therefore may not be taxed under the 1981 Understanding.476  T h e
                                                     
474 See Treas. Reg. 1.482-3(c).
475 Paragraph 4.1083 reflects the European Communities' response to the following question from the
Panel: Is the European Communities arguing that the special administrative pricing rules have a separate legalexistence such that, even in the absence of the exemptions, they would be capable of giving rise to an
independent violation of the SCM Agreement?
476 See i.e. paragraphs 12, 43-51, and 64-66 of the US  Oral Statement to the Second Meeting of the
Panel.WT/DS108/R
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United States is likely to argue that these activities (or processes) whether performed by the FSC, or
its related supplier, or an independent agent rega rdless of their residence, are foreign because they
have to take place (partly) outside the United States.477,478
4.1085  The European Communities submits that the FSCs’ (or their subcontractors’) activities are not
foreign and that following the Regulations prescr ibed by the IRS these foreign economic processes
tests are easily circumvented by FSCs by simply maintaining a mailbox and a bank account in the
FSC’s location of incorporation.
4.1086  Under IRC Section 924(d)(1)(A), the foreign sales activities test  is satisfied if:
“such corporation [the FSC] (or any person acting under a contract with such
corporation) has participated outside the Un ited States in the solicitation (other than
advertising), the negotiation, or the making of the contract relating to such
transaction”
4.1087  As a general rule the location of any activity is determined by the place where the activity is
initiated by the FSC and not by the location of any person transmitting instructions to the FSC.479  The
“solicitation” and “negotiation” outside the United States requirements are satisfied by acommunication by mail if the mail is deposited in a mailbox outside the United States.
480  T h e
“making of a contract” outside the United States requirement is satisfied if a written confirmation
confirming the acceptance of an order, or confirming variable contract terms or specifying additional
contract, is also sent through a mailbox outside the United States.481  Once the FSC has participated
outside the United States in an activity that constitutes one of the three foreign sales activities as
described above, any prior or subsequent activity of the FSC will be disregarded.482  The regulations
explicitly provide that the disclosure of the identity of a FSC as a separate entity in the performance ofthe foreign sales activities is not required.
483  All three forms of sales activities may be performed by
the FSC or any other person under contract on behalf of the FSC.484
Under IRC Section 924(d)(1)(B) the foreign costs test  is satisfied if:
“the foreign direct costs incurred by the FSC attributable to the transaction equal or
exceed 50 per cent of the total direct costs attributable to the transaction.”
Under IRC Section  924(e):
“The activities referred to in subsection (d) are-
(1) advertising and sales promotion,
(2) the processing of customer orders and the arranging for delivery of the export
property,
                                                     
477 See US first written submission, paragraph 50-51;
478 Paragraphs 4.1084-4.1094 reflect the European Communities' comment on the following question to
the United States from the Panel: Let us assume that a FSC sub-contracts all foreign distribution and sales
functions in connection with FSC transactions to its parent company and pays for them.  In such circumstances,
would the income generated by such transactions be considered foreign source income or domestic sourceincome for fiscal purposes?  In what proportion?
479 Reg.1.924(d)-1(a).
480 Reg.1.924(d)-1(c)(2) and (3).
481 Reg.1.924(d)-1(c)(4).
482 Reg.1.924(d)-1(c)(1).
483 Reg.1.924(d)-1(a).
484 Reg.1.924(d)-1(a).WT/DS108/R
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(3) transportation from the time of acquisition by the FSC (or, in the case of a
commission relationship, from the beginning of such relationship for such
transaction) to the delivery to the customer,
(4) the determination and transmittal of final invoice or statement of account and the
receipt of payment, and
(5) the assumption of credit risk.485
4.1088  Again the disclosure of the identity of the FSC as a separate entity is not required in the
performance of this test, and also these activities may be performed by the FSC or any other person
under contract on behalf of the FSC.486
4.1089  With respect to the advertising and sales prom otion costs requirement, generally, the location
of advertising is the place to which the advertis ing is transmitted (even if initiated within the
United States.487  Thus the advertising costs requirement may be fulfilled by taking out an
advertisement in a foreign trade journal which includes all the export products marketed by it.
Although the foreign direct costs allocated to each export transaction will be minimal, this fact will
not prevent the FSC from meeting this test.488
4.1090  With respect to the processing of customer orders and arranging for delivery costs, this
requirement may be satisfied by assuming the costs of communicating (telephone, telegram, or mail)
from an office outside the United States the delivery or other details of the customer’s orders to the
related supplier, or carrier, or customer.489  Thus this requirement is fulfilled by simply having the
FSC send a letter or make a telephone call, even when the related supplier, or carrier, or customer has
independent knowledge of the order and requirements for delivery, and the communication is
redundant.490
4.1091  With respect to the transportation costs, this requirement is satisfied by considering the FSC
or its related supplier responsible for the property if it has title, bears the risk of loss, or insures the
property during shipment. Once again the FSC may fulfil this requirement by simply holding the title
over the goods and bearing the risk of loss, which may easily be arranged by its parent, without
performing any foreign activity.491
4.1092  With respect to the determination and transmittal of final invoice or statement of account
costs, this requirement may be satisfied if the FSC undertakes the assembly of a final invoice or
statement of account and the forwarding of that document to the customer from a location outside the
United States.492  “Assembly” is defined as folding of documents (where applicable), filling
envelopes, and addressing envelopes. “Forwarding” is defined as mailing or delivery.493  Seldom have
US tax principles been so clearly defined: fold it, stuff it, mail it, and the foreign cost requirement is
fulfilled. With respect to the receipt of payment, the only thing the FSC has to do is receive a payment
from the customer or the related supplier, in a foreign bank account (not even the principal bank
account) equal to at least 1.83 per cent of the gross receipts associated with the transaction.494
                                                     
485 Under IRC sec.925(c) a FSC must perform all of the activities described in section 924(e), in order
to qualify for the use of the special pricing rules.
486 Reg.1.924(d)-1(a).
487 Reg.1.924(e)-1(a)(1)(iii)(A).
488 Reg.1.924(e)-1(a)(1)(i) and (v).
489 Reg.1.924(e)-1(b)(iv).
490 Reg.1.924(e)-1(b)(1) and (2).
491 Reg.1.924(e)-1(c)(1) and (4).
492 Reg.1.924(e)-1(d)(1)(i)(A) and (iii).
493 Reg.1.924(e)-1(d)(1)(i)(D).
494 Reg.1.924(e)-1(d)(2)(i), (ii) and (iii).WT/DS108/R
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4.1093  With respect to the assumption of credit risk costs, this requirement is met if the FSC bears
the economic risk of non-payment with respect to a transaction.495  This cost is by definition foreign
since the “location of the activity of assumption of credit risk is the location of the customer or
obligor whose payment is at risk”496, and the FSC does not need to do anything abroad to satisfy it.
4.1094  It is therefore clear that the above mentioned tests which, the United States alleges
demonstrate the foreignness of the FSC activities, are easily fulfilled, or better circumvented, through
a number of regulations that the European Communities has indicated in its First Written Submission
as constituting part of the FSC scheme. In fact FSCs may satisfy the foreign economic processes
requirements by maintaining a mailbox, through which mail is sent and received, and a bank account,
where money is deposited and paid out in the FSC location of incorporation. The amount of activitiesa FSC, or a person operating under contract on behalf  of the FSC, has to perform is minimal and when
it comes down to foreign activities are almost zero. As demonstrated by these regulations the only
thing most FSCs have to do is send and receive letters and manage a bank account. Therefore the
allegation that the FSC tax exemption is permissible because FSCs have substantial foreign economic
activities is totally absurd. The amount of tax exemption, provided through the formulaic source andpricing rules, that FSCs receive in no way corresponds to their minimal foreign activities.
The United States  argues as follows in response to ques tions from the Panel following the Second
Meeting of the Panel:
4.1095  The Panel’s question reveals the flaws underlying the European Communities' arguments
with respect to Article 1 of the SCM Agreement.  In order to cast the FSC as a subsidy while at the
same time excluding its own territorial tax systems from the scope of that term, the EuropeanCommunities has cobbled together a theory that contorts Article 1.1(a)(1)(ii) almost beyond
recognition.  The problem for the European Communities is that it can achieve the result it seeks only
by interjecting concepts into that provision which simply are not there.  Moreover, while the European
Communities has asserted that its interpretation of Article 1.1(a)(1)(ii) is simple and straightforward,
it has been unable to respond to the most basic questions concerning that interpretation.  At bothmeetings of the Panel, whenever the Panel or the United States attempted to probe the implications of
the European Communities' interpretation, the European Communities begged off by claiming that the
questions were not easy to answer.  However, if the European Communities' interpretation is as
simple and straightforward as the European Communities claims it to be, why does the European
Communities have such difficulty in answering basic questions about that interpretation?
497
4.1096  As the Panel noted in its question, the European Communities first claims that exempting
foreign-source income from taxation does not constitute a subsidy provided that it is done “on a
general basis.”  However, the concept of general or specific application of a measure is simply not a
part of Article 1.  Not only does the language of Article 1.1(a)(1)(ii) make no reference to the breadth
of application of a measure, but Article 1.2 makes clear that “[a] subsidy as defined in paragraph 1 issubject to parts II, III or V of the Agreement” only “if such a subsidy is specific in accordance with
the provisions of Article 2.”  Article 1.2 makes clear that the question of general or specific
application of a measure is reached under Article 2 only following an initial determination that a
measure is a subsidy under Article 1.
                                                     
495 Reg.1.924(e)-1(e)(1).
496 Reg.1.924(e)-1(e)(3).
497 Paragraphs 4.1095-4.1099 reflect the United States' comment on the following question to the
European Communities from the Panel: The European Communities has stated, in its response to question 5
from the United States, that "the European Communities' position is simply that WTO Members are notprevented by the SCM Agreement from not taxing foreign source income if this is done on a general basis."  Inexplaining its view of "revenue . . . otherwise due", the European Communities has further stated (paragraph 78to its rebuttal) that "[w]hat is important is that there must be a deviation from or exemption to the generally
applied rate or basis for collection for there to be a subsidy." (emphasis in original)  Is it the view of the
European Communities that the exemption of all foreign source income from taxation would not represent the
foregoing of "revenue . . . otherwise due" within the meaning of Article 1.1(a)(1)(ii) of the SCM Agreement?Please explain in detail the legal basis for your view.WT/DS108/R
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4.1097  Alternatively, in contending that tax exempti ons for foreign-source income are not subsidies
only if they are provided “on a general basis,” th e European Communities appears to be arguing that
such a practice is a subsidy only if it is limited to exports.  If so, then the European Communities is
confusing Article 1 with Article 3.  The existence of an export contingency is relevant only where a
measure is a subsidy.  If a measure is not a subsidy, it is immaterial whether or not it is contingent onexports.
4.1098  More importantly, the mere existence of an exception to otherwise applicable tax provisions
cannot, in and of itself, establish the existence of a subsidy where foreign-source income is at issue.
The European Communities' argument might have some merit in other contexts, but not here.
Whether foreign-source income is exempted because a tax system does not extend to it, or because aprovision directly states that it is not subject to taxation, the economic result is the same.
4.1099  These considerable deficiencies in the European Communities' position are attributable to the
fact that the European Communities is, in effect, asking the Panel to reduce Article 1.1(a)(1)(ii) to
nothing more than a rule instructing WTO Memb ers on how to draft tax exemptions for foreign-
source income so as not to have them labelled a subsidy.  If the European Communities has its way, a
Member would confer a “subsidy” if it exempted foreign-source income from taxation through an
overt measure, but the very same practice would not be a subsidy if it were achieved indirectly or by
omission.  Such an outcome would fly in the face of the WTO’s many rules and principles promoting
transparency in laws affecting international trade.  Proper interpretation under public international law
surely precludes reaching such an absurd result.  With respect to the meaning of the GATT Council’s
decision, the Council made two important points.  First, GATT Article XVI:4 does not oblige
countries to tax foreign-source income (including income derived from an export transaction), and thefailure to tax such income is not a subsidy or otherwise problematic under GATT subsidies
disciplines.  This derives from the language of the Council’s decision, which states that “in general,
economic processes (including transactions involving exported goods) located outside the territorial
limits of the exporting country need not be taxed.”  In so stating, the Council rejected the finding of
the panel in the Tax Legislation Cases  that a decision not to tax foreign-source income constituted the
foregoing of revenue.
498
4.1100  The second important point is that for purposes of Article XVI:4, foreign economic processes,
including those related to export transactions, are not export activities in the sense of that Article and
a decision not to tax income derived from them does not constitute an export subsidy.  This follows
from the portion of the decision which states that “economic processes (including transactionsinvolving exported goods) located outside the territo rial limits of the exporting country need not be
subject to taxation by the exporting country and should not be regarded as export activities in terms of
Article XVI:4 of the General Agreement.”
4.1101  It is easy to see the connection between the first point and Article 1 of the SCM Agreement.
In declaring that income derived from foreign economic processes need not be taxed, the GATTCouncil made plain that a decision not to tax such income is entirely appropriate and that no
consequences under international trade rules should flow from a country’s decision not to do so.
Likewise, the connection between the second point an d Article 3 of the SCM Agreement is clear.  If
foreign economic processes are not export activities, then no export contingency can be said to exist.
                                                     
498 Paragraphs 4.1099-4.1102 reflect the United States' comment on the following question from the
Panel: The 1981 GATT Council decision states that, “in general, economic processes (including transactionsinvolving exported goods) located outside the territorial limits of the exporting country need not be subject totaxation by the exporting country and should not be regarded as export activities in terms of Article XVI:4 of the
General Agreement.”  Assuming – without prejudice to the parties’ views on this issue – that the 1981
understanding is relevant to the interpretation of the SCM Agreement, please comment on the significance, ifany, of the highlighted language in terms of the concept of revenue “otherwise due” in Article 1 of the SCMAgreement .WT/DS108/R
Page 189
4.1102  At the same time, the second point is also relevant to the “otherwise due” language of
Article 1.  In deeming foreign economic processes not to be export activities, the GATT Council was
saying that foreign economic processes connected to export transactions are wholly foreign and,
accordingly, tax exemptions for income derived from them are entirely outside the scope of the GATT
subsidy disciplines.  In so providing, the GATT Council was drawing a distinct, bright line at the
borders of taxing nations.  Insofar as subsidies rules are concerned, the Council took the position that
an exporting country’s obligation to tax export income in the same manner as income from domestic
sales stops at the country’s border.  Where income is attributable to economic activities occurring
outside a taxing country’s borders, such income is unrelated to that country in the eyes of the GATT
(and, now, the WTO), and a decision not to tax such income cannot be said to be a financialcontribution from that country under SCM Agreement Article 1.
4.1103  In the context of an obligation arising out of an international agreement, one obvious criterion
is whether there has ever been a decision or ruling under the same or a related agreement that a
particular tax practice constituted foregoing revenue that was "otherwise due."  If so, that would be an
appropriate criterion in determining the meaning of those terms.  In this instance, of course, preciselythat has occurred.  In 1981, the GATT Council essentially decided that the failure to tax foreign-
source income did not constitute the foregoing of revenue, and the Council’s decision forms part of
the context for interpreting Article 1.1(a)(1)(ii).  As discussed in the response to Question 3, that
decision answered the point now at issue on two, equally dispositive grounds.  Moreover, as discussed
in the response to Oral Question 15, that decision is part of GATT 1994.
499
4.1104  Another criterion would be the desirability of avoiding results that exalt form over substance.
As discussed above in connection with Question 2, outcomes should not differ depending uponwhether a Member chooses (a) to exempt a category of income from tax, or (b) not to tax the income
in the first place.
4.1105  Yet another criterion to consider is the need to have clear rules so that Members are in a
position to know what is and what is not permitted by the SCM Agreement.  The need for clear rules
is particularly important where, as in this case, trade rules interact with the complex realm ofinternational taxation.  In the absence of clear rule s, it becomes extremely difficult in this context to
determine when revenue foregone is “otherwise due.”
4.1106  The 1981 Decision provides just such a clear rule.  The Council’s declaration that foreign
source income need not be taxed was tantamount to declaring that tax on foreign source income is not
“otherwise due.”  The desirability of such a clear rule is demonstrated by a few examples thatillustrate the arbitrary results achieved when one relies on domestic law as a basis for determining
when foreign source income is “otherwise due”.
4.1107  Example One:  This example illustrates the difficulty of distinguishing a “baseline” rule from
an “exception” under exemption systems.
As discussed in paragraphs 180 and 181 of the Second US Submission, under the
Dutch income tax system, for resident companies, both Dutch-source income and
income derived from sources outside the Netherlands are subject to taxation.  In other
words, corporate income tax is levied on worldwide income.  However, in the case of
income earned abroad by a Dutch company, a company fulfilling the requirements
under Dutch tax law is entitled to relief that has the effect of exempting foreignincome from Dutch tax.
As described in footnote 116 of the Second US Submission, under the French income
tax system, which is based on the principle of territoriality, the income tax law
                                                     
499 Paragraphs 4.1103-4.1114 reflect the United States' response to the following question from the
Panel: Please provide further explanation regarding your view of the criteria to be applied in determiningwhether revenue foregone is "otherwise due" within the meaning of Article 1.1(a)(1)(ii) of the SCM Agreement.WT/DS108/R
Page 190
generally is not applicable beyond French territorial limits.  There are, however,
exceptions, such as tax consolidation and special but temporary foreign investment
tax incentives.  In addition, as discussed in Example Two, below, there also is an
exception providing for the taxation of certain “low-taxed income”.
4.1108  When viewed together, the Dutch and French systems are similar in that both provide certain
exemptions for foreign-source income.  However, if the tax laws of each system are viewed in
isolation, the Dutch system might be considered as resulting in the foregoing of revenue that is
otherwise due, because the exemption for foreign-source income might be viewed as an exception
from the basic principle of worldwide taxation of Dutch companies.  The French system, on the other
hand, might not be considered as resulting in the fo regoing of revenue that is otherwise due, because
an exemption might be viewed as the basic rule, wi th the taxation of foreign-source income being the
exception.
4.1109  Example Two:  This example indicates the difficulty of distinguishing the “baseline rule”
from the “exception” under a tax system with an ti-abuse rules and exceptions to these rules.
As described in Example One, above, as a general rule, profits earned in foreign
branches and foreign subsidiaries are not taxed by France.  However, this exemption
is subject to a limitation.  Under this limitation, France imposes its full corporate
income tax on the income of a foreign branch or foreign subsidiary where the income
is earned in a jurisdiction that imposes a tax of less than 2/3 of the French tax.  See
Second US Oral Statement, paragraph 73.  This low-taxed income limitation is also
subject to exceptions, including, for example, where the low-taxed income is exempt
under an income tax treaty.
4.1110  In attempting to distinguish between the baseline and the deviation in Example Two, one
possible approach is to consider the French general exemption as the baseline rule and the low-taxed-
income exception as a deviation from the baseline rule.  Viewed in that light, any exception that
would exempt low-taxed income would simply repres ent an application of the fundamental rule – the
exemption from tax of foreign-source income – and w ould not constitute the foregoing of revenue that
is “otherwise due.”
4.1111  Under a different approach, however, the fundamental rule could be viewed as the rule under
which low-taxed foreign-source income is taxed by France.  Under this approach, any exception that
would exempt low-taxed foreign-source income could be viewed as the foregoing of revenue that is
“otherwise due.”  However, it appears completely ar bitrary to consider the taxation of certain low-tax
income as part of the baseline and then not to consider any exceptions under that provision as also
part of the baseline.
4.1112  Example Three:  This example illustrates the arbitrariness of arriving at different results
depending on the manner in which anti-abuse rules are formulated.
The income tax systems of Denmark and the United States operate under the same
general rule that the domestic taxation of the foreign income of foreign subsidiaries is
deferred until the income is repatriated to domestic shareholders in the form of
dividends.  Denmark has a controlled foreign corporation (CFC) regime that requires
the current taxation of only low-taxed passive income of foreign subsidiaries.500  The
United States has a broader CFC regime, which requires the current taxation of low-taxed passive income, but also the current taxation of certain active foreign income,
subject to various exceptions.  However, the US CFC regime also has some
limitations.
                                                     
500 Studies in Taxation of Foreign Source Income:  Controlled Foreign Company Legislation ,
Organisation for Economic Co-operation and Development (OECD 1996), p. 55.WT/DS108/R
Page 191
4.1113  The effect of the United States limiting provisions is to make the scope of its CFC regime
narrower, but not as narrow as Denmark’s CFC regime.  Because the norm of both countries is
deferral, it would be arbitrary to declare the United States anti-deferral CFC regime to be the
United States baseline while at the same time declaring Denmark’s baseline to be deferral simply
because the United States “exception” – its CFC regime – is not as narrow as Denmark’s.
4.1114  In this regard, the European Communities has emphasised that the United States rules for
FSCs are part of the Administration’s tax expenditure list.501  However, the fact that a provision
regarding the non-taxation of foreign-source income is listed in a country’s tax expenditure list is not
dispositive of whether there is foregone revenue that is “otherwise due.”  First, for all the reasons set
forth in the Oral Statement of the United States at the Second Meeting of the Panel, a country’s taxexpenditure list is not determinative for purposes of the SCM Agreement, regardless of whether a
country uses “reference” law, “normal” law, or both.  Second, if the rule under the SCM Agreement
were that a country’s tax expenditure list is determinative, a country could easily manipulate the rule
by simply redefining its expenditure list.  In addition, there would be no consistency from country to
country in the absence of a single definition of tax expenditure applied by all authorities in alljurisdictions.  For the sake of fairness and consistency, a clear, transparent test is needed under the
SCM Agreement.  The core principle of the 1981 Decision that “foreign source income need not be
taxed” translates into a clear test that “tax on foreign source income is not otherwise due” within the
meaning of Article 1.1(a)(1)(ii).
4.1115  Footnote 59 is directly relevant to the FSC administrative pricing rules, which were designed
specifically to comply with fundamental principles of both US tax law and GATT law, as articulated
in the 1981 Council Decision and in what is now footnote 59.  The language of footnote 59 must beread in context.  It narrows the scope of item (e) of  the Illustrative List by implicitly recognizing that a
Member may exempt foreign-source income from tax.
502
4.1116  As a factual matter, export transactions normally involve a domestic seller and a foreign
buyer.  Where those entities are not related, the arm’s length principle would ordinarily be observed
simply as a result of market forces.  Where those entities are related, footnote 59 reaffirms that thearm’s length principle applies to transactions between those entities, as well. The second sentence of
footnote 59 rests on the assumption that the income of a foreign entity need not be taxed to the same
extent as income earned by a domestic exporter.  Otherwise, in the context of item (e), it would not
matter whether exporting companies observed arm’s le ngth pricing in their dealings with related
foreign buyers, because deviations from the arm’s length principle would not result in any saving oftaxes.  All of the income, regardless of how it might be allocated between the domestic exporter and
the related foreign buyer, would have to be taxed.
4.1117  Because a country need not tax foreign-source in come, an excessively low transfer price from
the domestic seller to the foreign related buyer could result in an improper reduction of taxes.  The
seller would be subject to tax on a lesser amount of profit than should properly be attributed to itsdomestic activities.  The foreign related buyer would earn too much profit on its foreign activities in
reselling the goods, and all of that profit could be exempt from taxation by the home country.
4.1118  Under the third sentence of footnote 59, if this deviation from the arm’s length principle were
too great, it could lead to a significant saving of taxes and result in WTO Members’ bringing that
deviation to the home country’s attention in a proper forum.  When read together, it is apparent thatthe second and third sentences of footnote 59 are intended to ensure that taxes on income from
domestic activities are not improperly exempted to a significant degree due to the manipulation of
                                                     
501  See the Second EC Submission, paragraph 84 - 90.
502 Paragraphs 4.1115-4.1122 reflect the United States' response to the following question from the
Panel: The second sentence of footnote 59 appears to address the issue of arm's length pricing between entities .
The United States has explained that FSC special admini strative pricing rules are intended to allocate profit
arising from foreign and domestic economic activities .  In light of this fact, please explain why footnote 59 is
relevant to the FSC's special administrative pricing rules.WT/DS108/R
Page 192
transfer prices on sales of goods between related entities so as to shift profits from an entity in the
home country (which would be taxable) to an enti ty in a foreign country (which could be exempt).
4.1119  Although the language of the second sentence of footnote 59 is specifically directed to a
situation similar to that of  buy-sell FSCs, where there are sales of export goods among affiliated
entities, the concerns raised in the preceding paragraph apply equally to commission transactions, inwhich a foreign entity engages in commercial activiti es but does not actually take title to exported
goods.  The improper allocation of fees in this situation could also lead to the exemption of income
derived from domestic economic processes.  To avoid such a loophole, footnote 59 must be
interpreted as permitting an analogous allocation of income between domestic and foreign economic
processes for related party transactions involving the payment of a commission, such as in the case of
a commission FSC.
4.1120  The FSC transfer pricing rules in I.R.C. Section 925(a) are written in much the same terms
and with much the same purpose as footnote 59.  Because a FSC must be a foreign entity, and because
some of its income is exempted from US taxation, th e transfer pricing rules must properly allocate the
income from FSC transactions between FSCs and their related entities.  Section 925(a) provides rules
for the allocation of income to FSCs by reference to the transfer price of eligible property in sales
from the related entities to the FSCs.
4.1121  The link between footnote 59, the administrative pricing rules in Section 925(a), and the
allocation of profits to foreign economic activities is that FSCs are allocated a portion of the profits
from FSC transactions that correlates to the income attributable to foreign distribution and sales
activities.  The European Communities claims that this allocation is improper because footnote 59
allegedly requires an analysis based on the activities performed by the FSC with its own personnel.However, the text of footnote 59 does not call for such an approach.  To the contrary, it is not
inconsistent with the arm’s length principle of footno te 59 to allocate income attributable to foreign
distribution and sales activities to FSCs, because FSCs are required to perform, or pay for, all of those
activities if they use the administrative pricing ru les.  Indeed, US Exhibit 20 demonstrates that the
allocation of profits to FSCs falls within appropriate arm’s length ranges for entities performing, orpaying for, distribution and sales activities.
4.1122  In sales to customers outside the United States, such activities are foreign because they will of
necessity occur predominantly outside the United States.  Thus, the allocation of profits to FSCs under
Section 925(a) reflects primarily an allocation between income attributable to foreign and to domestic
activities.  By imposing income tax directly on a substantial percentage of FSC income, theUnited States ensures that the portion of income exempted from tax will not deviate significantly from
the portion of income attributable to foreign economic activities undertaken in connection with FSC
sales.  US Exhibit 21 provides some empirical evidence of the correlation between foreign economic
activities and the amount exempted.  No significant saving of direct taxes on domestic economic
activities has occurred, and the principles of footnote 59 have been respected.  The EuropeanCommunities has not shown otherwise.
4.1123  The European Communities must speak for itself on this question, because the United States
believes that the FSC as presently constituted is in full compliance with the SCM Agreement.
503
4.1124  However, the United States notes that the Panel’s question identifies a fundamental defect in
the European Communities' arguments concerning Article 3.1(a).  The European Communities assertsthat what is relevant in the present dispute is how the United States taxes the three categories of
foreign-source income referred to above.  Assuming for purposes of argument that the
                                                     
503 Paragraphs 4.1123-4.1124 reflect the United States' comment on the following question to the
European Communities from the Panel: Given the European Communities' view on the lack of consistency of
the FSC with Article 3.1(a) of the SCM Agreement, would this view be modified if the FSC were also available
to entities: (a) involved in importation of goods into  the United States; (b) operating overseas in economic
activities other than exportation from or importation into the United States; (c) both.WT/DS108/R
Page 193
European Communities assertion is correct, then the European Communities' case must fail because
the US tax system does, in fact, exempt these categories of foreign-source income from tax .  It should
not matter whether the United States creates the exemption in one all-inclusive provision or in
multiple, separate provisions, and the fact that US tax laws may appear different from, or more
complex than, the laws of  territorial tax systems is beside the point.
4.1125  To the extent that the term “foreign distribution and sales activities” in Question 7 refers to
distribution and sales activities conducted outside the territory of the United States, all income
attributable to those activities would be income attributable to foreign economic processes.  It would
make no difference whether the activities were conducted by the FSC directly, by the parent company
under a sub-contract from the FSC, or by an independent third party under a sub-contract from theFSC, because the geographical location of the activities would still be outside the United States.  For
example, a sale of goods of substantial value to foreign customers will generally require sales
representatives to meet with those customers at the customers’ home (i.e., foreign) offices.  Such
meetings will be foreign sales activities, whether the sales representatives are employed by a FSC, its
US parent, or an independent third party.
504
4.1126  The fact that activities are performed by the related supplier on behalf of the FSC and paid for
by the FSC does not transmute foreign economic processes into domestic economic processes.  For
example, if a FSC contracts the negotiation function to its related supplier and the related supplier
uses employees of a controlled foreign corporation or an independent agent to perform these activities
abroad, does this make the activity a domestic economic process as the European Communities
contends?  The mere association of a domestic entity with a foreign economic process does not
change that process into a domestic one.  
4.1127  In its submissions, the United States has generally used the term ‘foreign-source income” as a
shorthand expression for the longer formulation used by the GATT Council in its 1981 Decision.
“Foreign-source income” also has a specific technical meaning in US tax law, as reflected in
Section 921(a) with respect to the character of FSC exempt foreign trade income.  In the foreign
corporation context, the meaning of the term relate s normally to whether a foreign corporation will be
subject to US tax.  In this regard, the US tax treatment of sales by foreign corporations of inventory
property for use, disposition or consumption outside the United States (as required for FSC treatment)
is ordinarily more generous than the treatmen t accorded to FSCs.  Under fundamental US tax
principles, income from sales by foreign corpor ations to foreign customers normally would be
considered foreign-source income and would be exempt from taxation by the United States.
4.1128  Indeed, except for FSCs, foreign corporations are virtually never subject to US taxation
directly on their foreign-source income.  Under I.R.C. Sections 864 and 865(e)(2)(B), even if an
office of the foreign corporation in the United Stat es takes an active role in such a sale, the income
would not be taxed by the United States, so long as a foreign office has also participated materially in
the sales activities.  Thus, if a French corporation used a branch office, or the office of a subsidiary, inNew York to assist in selling goods to customers in Latin America, and the head office in France also
participated materially in the sales activities, the United States would exempt that French corporation
from taxation on those sales – even though some of the activity giving rise to the profits from the sales
clearly occurred in the United States.
4.1129  Because the European Communities has confused matters with its belated and superficial
discussion of sourcing rules, the United States offers
 the following brief analysis of the manner in
which the general source rules under US income tax law would apply to the income of a foreign
corporation, such as a FSC.  Depending upon whether one is considering a commission FSC or a buy-
                                                     
504 Paragraphs 4.1125-4.1130 reflect the United States' response to the following question from the
Panel: Let us assume that a FSC sub-contracts all foreign distribution and sales functions in connection with
FSC transactions to its parent company and pays for th em.  In such circumstances, would the income generated
by such transactions be considered foreign source income or domestic source income for fiscal purposes?  Inwhat proportion?WT/DS108/R
Page 194
sell FSC, FSCs earn either commission income (income from services) or sales income.  Regarding
income from services, the general US source rules would source that income where the services are
performed.  In the case of sales income, where the sale is for use, disposition or consumption abroad,
and a foreign office materially participates in the sale, the general source rules would source the
income as foreign.  In this regard, US Exhibit 21 provides evidence that, on an aggregate basis, theFSC income that is exempted from tax arises out of foreign activity, thereby corroborating that the
partial exemption for qualifying FSC income is consistent with the results that would be obtained
under the general source rules for foreign corporations.
4.1130  The statutory requirements that FSCs perform certain foreign economic processes are
generally designed to ensure that FSCs participate materially in every sale for which they may earn
exempt foreign trade income, even when much of the sales activity has been conducted through sub-
contract by the US parent company (in effect, a US office of the FSC).  Thus, the treatment of FSC
income from foreign distribution and sales activities is fundamentally consistent with US rules for
sourcing income of this kind.  The FSC treatment is less generous than the general rule because the
United States designed the FSC to comply with  the requirements articulated in the 1981 Council
Decision.  By imposing income tax directly on a substantial percentage of FSC income – as opposed
to exempting all FSC income – the United States has ensured that the portion of income exempted
from tax will not deviate significantly from the portion of income attributable to foreign economic
activities undertaken in connection with FSC sales.  US Exhibit 21 provides empirical evidence of the
correlation between foreign economic activities and the amount exempted.
4.1131  For its part, the United States cannot see how the FSC administrative pricing rules can be
capable of giving rise to an independent violation of the SCM Agreement “in the absence of theexemptions.”  The existence of the FSC tax exemption is a necessary predicate to the application of
the administrative pricing rules.  If the exemption did not exist, the pricing rules would be superfluous
and have no effect.  Indeed, the United States believes that the European Communities has advanced
this peculiar position in order to obfuscate the fact that a necessary predicate of the arm’s length
principle in footnote 59 is that foreign-source income may properly be exempted from tax withoutrunning afoul of the export subsidy prohibition in the SCM Agreement.
505
4.1132  The United States has explained that there is only one way that the FSC administrative pricing
rules could be deemed to be inconsistent with Article 3.1(a) of the SCM Agreement.  This would be
the case only if the European Communities could demonstrate that, by contravening the arm’s length
principle of footnote 59, the rules exempt domestic -source income from taxation and do so to a
“significant” extent.  The European Communities, of course, has not supplied the Panel with any
evidence to this effect because it has failed to recogn ize the controlling legal principle applicable to its
Article 3.1(a) claims.  In contrast, the United States has supplied the Panel with evidence, in particular
US Exhibits 20 and 21, which indicates that the FSC administrative pricing rules are consistent with
the results in transactions between independent ma nufacturers and distributors, that the rules properly
exempt foreign-source income earned in FSC transactions overall, and that if any saving of taxes on
domestic-source income does occur, such saving is not “significant.”
4.1133  Thus, as a purely theoretical matter, the FSC administrative pricing rules could give rise to an
“independent violation” only in the event that th e Panel concludes that (a) the FSC tax exemption is
permissible (because foreign-source income need not be taxed), and (b) the administrative pricing
rules nonetheless result in domestic-source income escaping taxation to a “significant” extent.
Because the European Communities has not met its burden of proof on these critical points, the Panel
should reject the European Communities' claims regarding the administrative pricing rules.
                                                     
505 Paragraphs 4.1131-4.1133 reflect the United States' comment on the following question to the
European Communities from the Panel: Is the European Communities arguing that the special administrative
pricing rules have a separate legal existence such that, even in the absence of the exemptions, they would becapable of giving rise to an independent violation of the SCM Agreement?WT/DS108/R
Page 195
4.1134  At the outset, the United States notes that the phrase “range of tolerance” was used by the
European Communities, not the United States.  The United States referred to the “arm’s length
range.”  First US Submission, paragraph 115, note 97.  The European Communities has admitted that
adjustments to related party transfer prices need only “deliver a sufficiently close approximation to
arm’s length in a . . . wide variety of cases over time.”506  The European Communities even conceded
that the arm’s length principle is satisfied as long as the results of a particular measure are within an
accepted “range of tolerance.”507,508
4.1135  The United States would admit that in individual cases the results under the FSC
administrative pricing rules may differ from the results that would obtain under Section 482 of the
Internal Revenue Code.  However, footnote 59 does not require a Member to do the type of  full-blown functional analysis that might be required under Section 482.  As stated in the Second US
Submission, particularly in paragraphs 102-103, the FSC administrative pricing rules embody
methods that have validity and stability in the aggregate, notwithstanding variances that may occur in
individual cases.  The administrative pricing rules do this in a manner that affords administrative ease
to both taxpayers and tax administrators.  As previously explained to the Panel, given the need tomaintain the confidentiality of taxpayer information under the laws of most countries, including the
laws of the United States, assessing the consistency of a Member’s transfer pricing practices in the
aggregate is the most appropriate approach under footnote 59, and is likely the approach that the
drafters contemplated.
4.1136  In this regard, the question raised in this dispute is whether the results generated by the FSC
administrative pricing rules depart from the arm’s length principle of footnote 59.  To reiterate, the
European Communities has yet to identify for the Panel what the arm’s length principle of footnote 59contemplates, and its arguments on this issue present a constantly moving target.
509  Instead, the
European Communities merely alleges that whatever the standard in footnote 59 may be, the FSC
administrative pricing rules fail to meet it.  In th e view of the United States, it is incumbent upon the
European Communities, as the complainant, to identify what the relevant standard is under footnote
59 and then provide evidence demonstrating that th e FSC administrative pricing rules fail to generate
results within the “range of tolerance” established by that standard.  Until the European Communities
has done so, it has failed to satisfy its burden of proof, and it does not fall to the United States to
demonstrate why the FSC administrative pricing rules conform to an as-yet-to-be-defined standard.
4.1137  Regarding the second part of the Panel’s question, the United States believes that the
appropriate question to ask is whether the FSC administrative pricing rules, in the aggregate,systematically misallocate domestic-source income to FSCs.  The only empirical evidence the Panel
has in this case are US Exhibits 20 and 21.  US Exhibit 20, which is based on public data that was
freely available to the European Communities, dem onstrates that the FSC allocation percentages are
well within the range of the profit breakdowns be tween manufacturers and independent distributors.
As for US Exhibit 21, it suggests that, in the aggregate, the allocation of income between related USparents and FSCs  appropriately reflects the amount of foreign economic activity performed by FSCs
or for which FSCs are responsible.
4.1138  At the outset, the United States should make clear that it does not view footnote 59 as an
“exception” to item (e).  Instead, it is part of item  (e), just as the European Communities presumably
views footnote 15 of the SCM Agreement as part of Article 6.1(a).  The United States also does notdisagree with the proposition that footnote 59 explains the scope of item (e).  Instead, the
                                                     
506  First EC Submission, paragraph 80, quoted at  Second US Submission, paragraph 114.
507  Ibid., paragraph 86, quoted at  Second US Submission, paragraph 114.
508 Paragraphs 4.1134-4.1137 reflect the United States' comment on the following question from the
Panel: The United States believes that the FSC administrative pricing rules in the aggregate are within the“range of tolerance.”  Would the United States admit that, in individual cases, the FSC administrative pricingrules may depart from an arm’s length result?  What is the tolerable range or “range of tolerance” ?
509  For example, the European Communities seems to have abandoned its initial assertion that the
OECD Guidelines should provide the standard for footnote 59.WT/DS108/R
Page 196
United States disagreement with the European Communities relates to the manner in which footnote
59 explains that scope.510
4.1139  Having said that, the United States sees nothing in footnote 59 that would shift the burden of
proof from the European Communities to the United States, and at the second meeting of the Panel,
the European Communities appeared to share this view.  As a general matter, the Appellate Body hasmade clear that the complainant bears the burden of presenting a prima facie  case of a violation.  See,
e.g., United States – Measure Affecting Imports of Woven Wool Shirts and Blouses from India  (“Wool
Shirts ”), WT/DS33/AB/R, Report of the Appellate Body adopted 25 April 1997, p. 16.  The
assignment of this burden is not avoided by  describing a provision as an “exception.”  EC - Measures
Affecting Meat and Meat Products  (“EC Hormones ”), WT/DS26/AB/R, WT/D S48/AB/R, Report of
the Appellate Body adopted 16 January 1998, paragraph 104.  The assignment of the burden of proof
may shift where a defending Member invokes a provision that is in the nature of an affirmative
defense, such as GATT Article XX.  Wool Shirts , p. 16.  However, footnote 59 lacks the
characteristics of an affirmative defense.
4.1140  Insofar as the interpretation of the meaning of footnote 59 is concerned, even if the footnote
were characterized as an “exception,” this would not warrant a different method of treaty
interpretation.  This point was made clear by the Appellate Body in the European Communities
Hormones  case, paragraph 104, in which the Appellate Body stated as follows:
[M]erely characterizing a treaty provision as an "exception" does not by itself justify
a "stricter" or "narrower" interpretation of that provision than would be warranted by
examination of the ordinary meaning of the actual treaty words, viewed in context
and in the light of the treaty's object and purpose, or, in other words, by applying thenormal rules of treaty interpretation.
4.1141  As previously explained in the First US Submission, paragraph 113, and the Second US
Submission, paragraph 136-138, footnote 59 calls for the use of an aggregate approach.  The
European Communities has dismissed the US analysis by essentially asserting that it is wrong to focuson the choice of words used by the drafters of the SCM Agreement, a rather remarkable proposition in
light of Article 31 of the Vienna Convention on the Law of Treaties .
511
4.1142  An additional textual justification for an aggregate approach is the use of the phrase
“administrative or other practices ” in footnote 59.  (emphasis added).  Under footnote 59, it is the
practice that must contravene the arm’s length principle and result in a significant saving of direct
taxes in export transactions.  “Practice” is defined as follows:
1a The habitual doing or carrying on of something; usual or customary action or
performance; action as opp. to profession, theory, knowledge, etc.  b.  A custom; a
habit; a habitual action.  c.  Law An established method of legal procedure.
As can be seen from this definition, a “practice” in volves more than an isolated act, but instead
connotes actions that are taken repeatedly.  As such, any evaluation of a practice calls for an aggregate
                                                     
510 Paragraphs 4.1138-4.1140 reflect the United States' comment on the following question from the
Panel: The United States says that footnote 59 of the Subsidies Agreement narrows the scope of item (e) of the
Illustrative List.  The European Communities says that footnote 59 explains the scope of item (e).  What would
be the logical implication of the interpretation of footnote 59 with respect to the burden of proof if footnote 59 ischaracterized as an “exception” to item (e)?  In othe r words, who bears the burden of proof that the FSC
administrative pricing rules do or do not satisfy the requirements of footnote 59?  Also, how would thecharacterization of footnote 59 affect the interpretation of that footnote?
511 Paragraphs 4.1141-4.1147 reflect the United States' comment on the following question from the
Panel: Regarding the concept of “aggregate”, what base should one use for assessing what is or is not a
“significant” tax saving?  Put differently, how does one measure a “significant” tax saving?  At the aggregatelevel?  At the company level?WT/DS108/R
Page 197
assessment.  This conclusion is reinforced by the use in footnote 59 of the plural form “transactions”
rather than the singular form “transaction.”
4.1143  Moreover, while the European Communities has conceded that nothing in the SCM
Agreement precludes the use of simplified met hods for applying the arm’s length principle512,
interpreting footnote 59 as requiring the use of a transaction-specific approach would have the effect
of prohibiting the use of rules of administrative convenience with respect to transfer pricing.  This is
because rules of administrative convenience, by their very nature, are less precise than more rigorous,
less administratively convenient rules, and inevitably will generate results in individual cases that may
differ from the results obtained under more precise rules.  Thus, the reasonableness of rules ofconvenience can be fairly assessed only on the basis of the results generated in the aggregate.
4.1144  Finally, the United States would like to take this opportunity to comment on the
European Communities' assertion that the third sentence of footnote 59 does not apply to the FSC
administrative pricing rules because those rules are statutory rather than non-statutory.  This assertion
is not supported by the text of the third sentence, it would generate absurd results if accepted, and it iscontradicted by the European Communities' own evidence (Exhibit EC-28) regarding the purpose of
footnote 59.
4.1145  With respect to the text, the third sentence refers to “administrative or other  practices”.  A
practice reflected in a statute easily can be categorized as an “other” practice.  To hold otherwise
would lead to the absurd result that a practice could be deemed permissible under footnote 59 if it
were articulated in non-statutory form, but the very same practice would be prohibited if it were
articulated in statutory form.
4.1146  Moreover, the “Rivers Letter”, which the European Communities has offered as a relevant
source for purposes of interpreting footnote 59, advocated GATT regulation of both “statutory law”
and “administrative practices” relating to transfer pricing.  Exhibit EC-28, page 2.  In light of this
objective, it is more reasonable to conclude that the ultimate language used – “other practices” – was
intended to embrace transfer pricing methods embodied in statutory form.
4.1147  The United States has suggested a useful way to measure whether or not the FSC provides a
“significant saving” of direct taxes within the meaning of footnote 59.  See First US Submission,
paragraphs 137 - 147.  In summary, the FSC overall provides an ad valorem  benefit of under 1 per
cent, and any saving accorded by the FSC administrative pricing rules is even less.  Whatever the
quantum for “significance” may be, a tax measure that provides only de minimis  benefits under the
rules of the SCM Agreement cannot be considered as conferring a significant tax saving.
4.1148  Whether evaluated at the aggregate or at the company level, it is possible, and indeed required
by footnote 59, for these matters to be dealt with under tax treaties or other appropriate mechanisms.
The issues raised by the European Communities are the types of issues that competent tax authorities
and the OECD are equipped to address.  See US Request for Preliminary Findings.
513
4.1149  The FSC administrative pricing rules do not require a traditional resource-intensive and
company- and transaction-specific transfer pricing evaluation.  Nevertheless, the US Internal Revenue
Service enforces all of the legal requirements  with respect to FSC qualifications and income
allocations, and corrects misallocations ex post , by litigation if necessary.  See US Exhibits 18 and 19.
Because a FSC is required to perform or pay for activities for which it is being allocated a portion of
                                                     
512  See Second EC Submission, Annex EC-1, page 17 (answer to US Question #39).
513 Paragraph 4.1148 reflects the United States' comment on the following question from the Panel: If
you take the view that matters could be evaluated at th e company level, would it be possible to deal with that
under tax treaties or other appropriate mechanisms?WT/DS108/R
Page 198
the profit under the administrative pricing rules, the level of allocation is designed to, and normally
will, fall within the range of values that are considered to be arm’s length.  See US Exhibit 20.514
4.1150  With respect to the first two questions, th e 1981 Council Decision resolves the issue of
payment to an agent by establishing a rule under which the income generated from a process may be
exempted from tax if that process took place outside the territorial limits of the exporting country.Thus, in the context of this case, if a FSC pays an agent to perform a process (whether the agent is
related to, or independent from, the FSC), the income generated from that process may be exempted
from tax if the process is performed outside of the United States.  For example, a sales meeting at the
premises of a foreign customer is a foreign process, regardless of whether the sales representatives are
employed directly by a FSC, are employees of the US parent for which the FSC reimburses the parent,
or are independent agents retained by the FSC.
515
4.1151  With respect to the term “processes”, one definition of “process” is as follows:
4. A thing that goes on or is carried on; a continuous series of actions, events, or
changes; a course of action, a procedure; esp. a continuous and regular action or
succession of actions occurring or performed in a definitive manner; a systematicseries of actions or operations directed to some end, as in manufacturing, printing,
photography, etc.  The New Shorter Oxford English Dictionary  (1993).
In the view of the United States, the functions performed by a FSC –  “distribution” and “sales” – fall
within this definition of “process.”  See also Second US Submission, paragraph 86, which discusses
the definition of “economic” and “process”.
4.1152  With respect to “activity”, one definition of th is term is as follows:  “4. An active force or
operation; an occupation, a pursuit.  b.  In pl.  Things that a person, animal or group chooses to do.”
The New Shorter Oxford English Dictionary  (1993).  Thus, while they may not be synonyms, there
certainly is an overlap in the definitions of “process” and “activity”.  In the view of the United States,
sales and distribution – the things that a FSC does – can be described both as “processes” and“activities”.
4.1153  With respect to “location”, this refers to where the “process” or “activity” is performed.  A
“process” or “activity” is “foreign” if it is performed outside the territory of the exporting country.
The United States refers the Panel to the Second US Submission, paragraph 91-93, wherein the
United States addressed this point.  Here, the United States simply will reiterate that its positionregarding the “foreignness” of an economic process is exactly the same position as advocated by the
European Communities and its member States at the time of the 1981 Council Decision.
                                                     
514 Paragraph 4.1149 reflects the United States' comment on the following question from the Panel: In
its Oral Statement at the Second Meeting of the Panel, 16 March 1999, at paragraph 31, the
European Communities states as follows:
It is also important to note that under Sec tion 482, the IRS maintains the possibility to correct
misallocations ex post.  This is not the case under the administrative pricing rules which
provide for a fixed allocation of common profit to the FSC irrespective of their actualactivities.  No ex post correction mechanism exists if the FSC activity has been close to zero.
What are the views of the United States concerning this statement?  Is the assessment by IRS auditors
qualitative or quantitative regarding the amount of activity of a FSC?
515 Paragraphs 4.1150-4.1153 reflect the United States' comment on the following question from the
Panel: Does the 1981 Council Decision resolve the issue of payment to an agent?  Please reconcile the US
answer with the reference to “processes located outsid e the territorial limits?  What are “processes”?  Are
“processes” the same as “activities”?  What is meant by “location”?  Does this refer to where something isperformed or where it occurs?WT/DS108/R
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4.1154  Under the plain meaning of the 1981 Council Decision, the relevant question is where the
activity is performed, not who performs it.  This is the standard that the European Communities and
its member States proposed to the Council and that the Council adopted.  See Second US Submission,
paragraph 91-93.516
4.1155  In the view of the United States, when one cuts through all of the smoke generated by the
European Communities, it is apparent that the European Communities' complaint is that the FSC
system allegedly has the potential to exempt domestic-source income from tax.  This can be seen from
the European Communities' answer to US Question #29 posed at the first meeting of the Panel.
Question #29 read as follows:
In paragraph 65 of the European Communities' Oral Statement, and on many
occasions during the European Communities' extemporaneous remarks at the Panel
meeting, the European Communities asserted that the economic processes attributed
to the FSC take place in the United States.  Please identify the precise portions of the
First EC Submission and of any submissions made by the European Communities
during the first meeting of the Panel that contain evidence supporting this assertion.517
4.1156  The European Communities answer was as follows:
The European Communities merely stated that the FSC scheme allows  the economic
processes which an FSC is supposed to perform to be subcontracted back to the
related supplier and therefore to take place in the United States and that FSC
legislation allows a standard formulaic tax exemption regardless of the amount of
work actually performed by an FSC .518
4.1157  In the view of the United States, the only reasonable interpretation of this answer is that the
European Communities' complaint is based on the allegation that the FSC system “allows” the
exemption of domestic-source income, not that the FSC system actually exempts such income.
Certainly, the European Communities' answer to US Question #29 demonstrates that theEuropean Communities has presented no evidence that the FSC system actually exempts any
domestic-source income from tax.
4.1158  In view of the plain text of footnote 59, the “potential” to exempt from tax domestic-source
income is insufficient to constitute a violation.  Footnote 59 requires that a practice, such as the FSC
administrative pricing rules, “ result in  a significant saving of direct taxes in export transactions.”
(Emphasis added).  Assuming, as the United States does, that foreign-source income may properly be
exempted from tax, the quoted language means that the European Communities must do something
more than allege that the exemption of domestic-source income is possible.  Instead, it must
demonstrate that such an exemption actually happens and that the frequency and amount of such
exemption are sufficiently large to constitute a significant saving of direct taxes in exporttransactions.
519
4.1159  The United States submits that these are excellent questions that the European Communities
has yet to adequately answer.  With respect to the first question, the United States simply notes that at
the time of the 1981 Council Decision, the position of the European Communities and its member                                                     
516 Paragraph 4.1154 reflects the United States' comment on the following question from the Panel:
How can the United States defend under the plain meaning of the 1981 Council Decision the fact that a FSC is
financially responsible for an activity performed by an agent or parent?  How can that be an economic process
located abroad?
517 Paragraphs 4.1155-4.1157 reflect the United States' comment on the following question from the
Panel: Is the European Communities complaining that the FSC system exempts from tax domestic-sourceincome or that it has the potential to do so?
518  Second EC Submission, Annex EC-1, page 14 (emphasis in original).
519 Paragraph 4.1158 reflects the United States' comment on the following question from the Panel: If
there merely is a potential to exempt from tax domestic-source income, is that enough to constitute a violation?WT/DS108/R
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States was that export activities ceased at the customs border of the exporting country.  See Second
US Submission, paragraph 143-144.  With respect to the second question, under the principle
articulated in the 1981 Council Decision, the cited activities would not constitute export activities.
Nothing in the SCM Agreement requires a different conclusion.520
4.1160  The United States refers the Panel to its answer to Oral Question #6 of the Panel, above.  In
the view of the United States, foreign economic processes, within the meaning of the 1981 Council
Decision, include all economic processes that take place abroad, including manufacturing.521
4.1161  The Panel asked a number of questions concerning the method by which the 1981 Council
Decision was adopted and whether it qualifies as a “decision” under paragraph 1(b)(iv) of  the
incorporation clause of GATT 1994.  In particular, the Panel inquired as to the nature of the debate inthe Council meeting of 7-8 December 1981, recorded as C/M/154, which the European Communities
tabled as Exhibit EC-32 and referred to in paragraphs 36-59 of its Second Oral Statement of 16 March
1999.
522
4.1162  The Council Decision adopted the reports of the four Tax Legislation  Cases , together with the
understanding “that with respect to these cases, and in general,” foreign economic processes“(including transactions involving exported goods)”  “need not be subject to taxation  by the exporting
country and should not be regarded as export activities in terms of Article XVI:4 of the General
Agreement ... .”  Following the adoption of the repo rts, the Council Chairman then stated that “the
Council’s decision and understanding” does not require parties adhering to Article XVI:4 to tax “the
profits on transactions beyond their borders,” and stated that the decision does not modify the existing
GATT rules in Article XVI, nor does it affect the Tokyo Round Subsidies Code or rights and
obligations under the General Agreement.
4.1163  The European Communities argues in paragraph 48 of its Second Oral Statement that the
Council Decision cannot constitute joint action under Article XXV of GATT 1947, and, hence, is not
a “decision” under Article XVI:1 of  the Marrakesh Agreement, nor an “other decision” under
paragraph 1(b)(iv) of GATT 1994, because it does not change the meaning of GATT Article XVI:4.
However, a “decision” is not limited to actions that “change” the meaning of a provision.  An actionthat clarifies or restates the meaning of a provision equally qualifies as a decision.  As stated in the
Second US Submission, paragraph 54, note 35, the Council Decision merely reiterated, in general
terms, the existing understanding of the CONTRACTING PARTIES that Article XVI:4 does not
require countries to tax the profits derived from activities taking place outside their borders, including
transactions  involving exported goods.  This restatement by the Council constituted joint action bythe CONTRACTING PARTIES under Article XXV:1, because the Council was empowered to act on
behalf of the CONTRACTING PARTIES.  See Second US Submission, paragraph 55-56.
4.1164  Moreover, the Council Decision was, in fa ct, adopted by the CONTRACTING PARTIES
themselves.  In GATT Doc. No. L/5414 (12 November 1982) ( Council of Representatives: Report on
Work since the Thirty-Seventh Session ), the Council reported to the Thirty-Eighth Session of the
CONTRACTING PARTIES on matters considered since the Thirty-Seventh Session.  The report
included 33 subjects, the Tax Legislation Cases  constituting subject number 15(e).  The first page of
the report stated as follows:  “Adoption of th is report, which summarizes the action taken by the
Council, will constitute approval by the CONTRACTING PARTIES of that action.”
                                                     
520 Paragraph 4.1159 reflects the United States' comment on the following question from the Panel:
Why would economic activities going beyond exports ever be considered as export subsidies?  Would exportactivities include income earned by a foreign subsidiary selling in a foreign market or manufacturing abroad?
521 Paragraph 4.1160 reflects the United States' comment on the following question from the Panel: Do
foreign economic processes include all forei gn economic processes, including manufacturing?
522 Paragraphs 4.1161-4.1182 reflect the United States' comment on the following question from the
Panel: Explain the relevance of the 1981 Council Decision to this dispute.WT/DS108/R
Page 201
4.1165  With two exceptions, the Thirty-Eighth Session of the CONTRACTING PARTIES then
proceeded to adopt the Council Report.  GATT Doc. No. SR.38/1 (15 December 1982), page 10.  The
exceptions involved subject 1(a) (Progress report s of the Preparatory Committee on preparations for
the Ministerial meeting) and subject 13 (trade restrictions affecting Argentina applied for non-
economic reasons).  Id.  Thus, while the CONTRACTING PARTIES were free to reject the 1981
Council Decision, they chose instead to affirmatively adopt it.
4.1166  The Panel inquired as to the significance of the intervention by the Brazilian delegate to the
Council meeting to the effect that the Decision was cryptic and that he would prefer to separate the
adoption of panel reports and general interpretations.  Despite any reservations the Brazilian delegate
may have had following the adoption of the Council  Decision, it is clear that the Council Decision
constituted a general interpretation of GATT 1947, and was recognized as such by the participants at
the Council meeting.  Its status as a general interpretation is reinforced by the subsequent intervention
of the delegate from Chile, who stated that, “[h]e shared the concern expressed by the Brazilian
delegation, and considered that it would have been  more appropriate to adopt an understanding with a
judicial approach rather than a legislative one, as the present case seemed to be. ” (Emphasis added).
To use the European Communities' terminology, the Chilean delegate correctly perceived the Council
as engaging in a “rulemaking” activity.
4.1167  The subsequent colloquy between the United States, the European Communities and Canada,
cited at paragraphs 54-57 of the European Communities' Second Oral Statement referred solely to the
interpretation the United States made at that time as to the consistency of the DISC with the Council
Decision and, as such,  is irrelevant to divining the overall meaning of the Council Decision in the
context of the present dispute or to its status as a general statement extending beyond the four cases atissue.
4.1168  However, discussions by the GATT Council concerning the DISC subsequent to the adoption
of the Council Decision indicate that the Council members considered the Decision to be a substantive
“decision” by the Council, and not merely the routine adoption of a panel report.  The
European Communities and other Contracting Parties considered the Decision normative and, rightlyor wrongly, criticized the DISC legislation for not being consistent with it.
4.1169  For example, at the 29-30 June 1982 meeting of the Council, the European Communities
representative stated:
We have examined these contentions [by the United States].  In our view the
United States continues to argue as if the DISC system was no different in form fromthe other practices examined by the panel.  In fact they are substantially different; and
the impact of the December decision will vary, depending on the relevance of its
content to the different practices concerned.  One important difference is that the
Panel report on DISC does not mention  the taxation of “export activities” outside the
United States whereas this is crucial in the other cases examined.
The Community submits that the essential qualification adopted by the Council last
December - relating to export activities outside the territory of the exporting country -
has no significance when applied to the DISC case.  Its clear intent was to establishthat the activities of foreign located  branches or subsidiaries or other foreign located
establishments in connection with the export of goods were not within the terms of
Article XVI:4.
The DISC system does not, according to our information, apply to export activities
outside the territory of the United State [ sic].  Unless the United States contests this, it
is clear that the effect of the December decisions is to remove the basis upon which
certain European tax practices were found by the panels to be, in some cases, not in
accordance with Article XVI:4 - and it was for this reason that the EEC and memberWT/DS108/R
Page 202
States had proposed the formula; it does not in any way modify the essential basis for
the Panel’s finding in relation to the DISC.
To conclude on this point:  the Panel report on DISC is not based on an incorrect
judicial basis.  It is based on the provisions of Article XVI:4 - which we are all agreed
have not been modified.  The legal interpretation of last December  has not vitiated
the Panel’s approach, since it applies to a situation which does not occur in the DISC
case.  Consequently it is our view that DISC is the only practice which remains
inconsistent with GATT.  (C/M/159, pages 6-7, reprinted in full as C/W/391, pages 2-
3; underscoring in original; italics added).
4.1170  In a similar vein, the representative of Australia  stated that:
The adoption of the Panel Report had in no way qualified the findings of the [DISC]
Panel, the December 1981 qualification having been limited to clarifying the position
in regard to the taxation of goods arising from economic processes located andincorporated outside the territorial limits of the exporting country.  C/M/159, page 11.
4.1171  In addition, at the 21 July 1982 meeting of the Council, C/M/160, the European Communities
tabled a resolution,  reprinted as C/W/392, that contained a specific reference to the Council Decision:
Recalling that [the DISC] Panel Report had been adopted in December 1981, together
with a decision  on the tax treatment of certain export activities in relation to
Article XVI:4 (L/5271) ... .  (Emphasis added).
4.1172  These references, which are only a small sampling of the statements made following the
December 1981 Council meeting, make clear that members of the Council, including the
European Communities, considered the 1981 Council Decision to be an authoritative interpretation
concerning the taxation of foreign economic processes.
4.1173  That the Council Decision as a whole constituted joint action under Article XXV:1 is
supported by the Analytical Index to the GATT:  Guide to GATT Law and Practice (1995), Volume 2
at 875-876, footnote 13, where, in a discussion of examples of joint action under Article XXV, the
following reference appears:  “ E.g., Council adoption of four Panel Reports on tax legislation subject
to the understanding in L/5271 (28S/114).”  Because the 1981 Council Decision also adopted the four
panel reports, the Council Decision also constituted a decision under Article XXIII.
523
4.1174  Part of the European Communities attack on the 1981 Council Decision appears to be based
on the notion that the GATT 1994 incorporation clause was intended only to incorporate “big”, for
lack of a better word, decisions made under GATT 1947.  At the second meeting of the Panel, the
European Communities suggested that because paragraphs 1(b)(i) through (iii) refer to protocols
relating to tariff concessions, protocols of accession, and waivers, a “decision” must be of similarmagnitude in order to fall under paragraph 1(b)(iv).
4.1175  This contention is simply wrong.  The obligations of Contracting Parties under GATT 1947
consisted not only of the obligations created by the text of GATT 1947 itself, but also of obligations
based on forty-seven years of decisions, protocols and other legal instruments which formed a legally-
enforceable regime.  In the view of the United States, the Uruguay Round negotiators did not intend todiscard this acquis , and the European Communities has offered no evidence that they did.  To the
                                                     
523  Even if that portion of the Council Decision dealing with the adoption of the four Tax Legislation
Cases  were considered to be solely a decision pursua nt to Article XXIII of GATT 1947, the remaining portion
of the Council Decision, which re-affirmed a general rule that income derived from foreign economic processes
need not be taxed by the exporting country and that foreign economic processes should not be regarded as
export activities under Article XVI:4, would constitute joint action by the CONTRACTING PARTIES pursuantto Article XXV:1.WT/DS108/R
Page 203
contrary, paragraph 1(b)(iv) and Article XVI:1 of the WTO Agreement demonstrate that the
negotiators sought continuity between the old regi me and the new, using the general interpretative
note in Annex 1A to resolve any conflicts between the two regimes.  Indeed, because of time
limitations, the negotiators gave up the attempt to revise the text of the GATT to reflect this acquis ,
and chose to rely instead on the incorporation clause.
4.1176  It would take a book to document all of the different decisions and legal instruments that
would be affected if the GATT 1947 acquis  were discarded, as the European Communities suggests.
The United States offers only a few examples here.  On 29 January 1980, the GATT Council adopted
Guidelines for Decisions Under Article II:6(a) of the General Agreement , L/4938, BISD 27S/28,
dealing with the adjustment of specific duties in li ght of exchange rate changes.  Is this decision no
longer valid because it is not, for example, of the same magnitude as a protocol of accession?
Members with specific duty regimes no doubt would be surprised to learn that, in the
European Communities' view, they no longer can rely on these guidelines.
4.1177  On 26 November 1986, the CONTRACTI NG PARTIES approved a report on Procedures for
Future Appointment of the Director-General , L/6099, BISD 33S/55, that resulted in an approved
statement regarding appointment procedures.  It is the understanding of the United States that many
Members, including the United States, take the position that these procedures apply to the pending
selection of the next Director-General of the WTO.  Are these Members wrong to rely on this
statement because it is not of the same magnitude as a decision on a waiver?
4.1178  Unless the Panel is prepared to relegate these and myriad other decisions and legal
instruments to what the European Communities has called the “misty history” of GATT 1947, then it
must accept that the 1981 Council Decision has been incorporated into GATT 1994.
4.1179  At bottom, the European Communities' arguments concerning the status of the 1981 Council
Decision amount to the mere assertion that the Council Decision does not fall under
paragraph 1(b)(iv) because it was generated at the end of a process that began under the dispute
settlement provisions of GATT Article XXIII.  However, whether the process began as part of a
dispute settlement panel or a working party has no bearing on the nature of the Council’s action at theend of the process.  If the Council had merely been acting in an adjudicative mode, it could have
refrained from adopting the panel reports in the Tax Legislation Cases .  Alternatively, it could have
adopted one or more reports, such as the DISC re port, and refrained from adopting others.  Instead,
however, it issued a decision that, by its express terms, was not limited to the cases before it, but that
was intended to apply “in general”, as was understood by the GATT membership at the time,including the European Communities.
4.1180  Although the United States is firmly of the vi ew that the Council Decision is carried over to
GATT 1994, by virtue of Article 1(b)(iv), and to the WTO generally by Article XVI:1 of the
Marrakesh Agreement, should the Panel decide otherwise, the United States calls to the attention of
the Panel the statement of the Appellate Body in Japan - Alcoholic Beverages at 14, with respect to
adopted GATT 1947 panel reports.  The Appellate Body stated that while such reports are not legally
binding on future panels they “are an important part of the GATT acquis.   They are often considered
by subsequent panels.  They create legitimate expectations among WTO Members, and, therefore
should be taken into account where they are relevant to any dispute.”
4.1181  In the present dispute, the above considerations would be even more important with respect to
the Council Decision than would  a normal adopted panel report.  The Council Decision interpreted
GATT Article XVI:4 both generally, and in a dispute between the same parties arising from
legislation that was the predecessor of the legislation that is at issue in the present dispute. Moreover,
as stated throughout the US presentations, the United States relied heavily upon the Council Decision
in crafting the FSC in a manner that was intended to eliminate the criticisms aimed at the DISC.
Finally, the Council Decision constitutes the only clear guidance available to the Panel as to how the
exemption from tax of foreign-source income should be treated for purposes of WTO subsidy rules.WT/DS108/R
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4.1182  Thus, even if the Council Decision were found not to be legally incorporated into the WTO
and GATT 1994, the United States considers that the reasoning expressed in the Council Decision
should be considered as highly authoritative in interpreting Articles 1 and 3 of the SCM Agreement
and item (e) and footnote 59 of the Illustrative List of Export Subsidies.
4.1183  In the view of the United States, there is no conflict between GATT Article XVI:4, as
interpreted by the Council Decision, and the SCM Agreement.  The Council interpreted Article XVI:4
as meaning that the exemption from tax of economic processes (including transactions involving
exported goods) located outside the territorial limits of the exporting country need not be subject to
taxation by the exporting country and should not be regarded as export activities.  In so doing, the
Council essentially reversed the finding of the panel in the Tax Legislation Cases  that the failure to
tax foreign-source income earned as part of an export transaction constituted the foregoing of revenue
by the countries in question.524
4.1184  There is no conflict between the principle ar ticulated by the Council and the SCM Agreement.
Inherent in footnote 59 is the notion that foreign-source income earned as part of an export transaction
need not be taxed without violating the export subsidy prohibition in the SCM Agreement.  See First
US Submission, paragraph 89-91.  Similarly, the language in Article 1.1(a)(1)(ii) regarding foregone
revenue that is “otherwise due” is not self-defining and does not on its face conflict with the principle
articulated by the Council.  Put differently, the principle that “foreign-source income need not be
taxed” can be restated as the principle that tax on foreign-source income is not “otherwise due.”
4.1185  As previously explained by the United States, the text of the SCM Agreement demonstrates
that Article XVI constitutes part of the context of the SCM Agreement.  Therefore, decisions
interpreting Article XVI, such as the 1981 Council Decision, are relevant to an interpretation of theSCM Agreement.  See, e.g.,  Second US Submission, paragraph 28-32.  This conclusion is reinforced
by the panel and Appellate Body decisions in the Desiccated Coconut  case, which support the
proposition that the subsidy provisions of the GATT and the SCM Agreement should not be
interpreted in isolation from each other.  Id., paragraph 33-35.
525  In addition, because there is a
presumption in public international law against the existence of conflicts, the Panel must, to the extentpossible, interpret Article XVI and the SCM Agreement so as to avoid a conflict.  See Second US
Submission, paragraph 37.
                                                     
524 Paragraphs 4.1183-4.1185 reflect the United States' comment on the following question from the
Panel: Is there any conflict between the 1981 Council Decision and the SCM Agreement?
525  In this regard, in its Second Oral Statement, paragraph 72, the European Communities misstates the
US argument regarding the relevance of the Council Decision and the relevance of the decisions in the
Desiccated Coconut  case.  As a review of the US submissions in this dispute make clear, the United States is not
arguing that Article XVI:4, as interpreted by the Council Decision, prevails over the SCM Agreement.  Instead,the United States is arguing that Article XVI:4, as interpreted, constitutes part of the context for interpretingambiguous language in the SCM Agreement.
In the same paragraph, the European Communities also misconstrues the holding of the panel and the
Appellate Body in the Desiccated Coconut  case.  Neither the panel nor the Appellate Body ruled that the SCM
Agreement “prevailed” over GATT Article VI.  Instead, both bodies found that Article VI could not be applied
independently of the SCM Agreement.  Indeed, the Appellate Body, after duly noting that the SCM Agreementwould prevail in the event of a conflict with Article VI, stated as follows:
This does not mean, however, that the other goods agreements in Annex 1A, such as the SCM
Agreement , supersede the GATT 1994.  As the Panel has said:
. . .  The question for consideration is not whether the SCM Agreement supersedes Article VI
of GATT 1994.  Rather, it is whether Article VI creates rules which are separate and distinctfrom those of the SCM Agreement, and which can be applied without reference to thatAgreement, or whether Article VI of GATT 1994 and the SCM Agreement represent an
inseparable package of rights and disciplines  that must be considered in conjunction.
Brazil - Measures Affecting Desiccated Coconut , WT/DS22/AB/R, Report of the Appellate Body
adopted 20 March 1997, pa ge 15 (footnote omitted).WT/DS108/R
Page 205
4.1186  Perhaps more than any of the other questions posed by the Panel and the parties in this case,
this question goes to the heart of the matter, because it highlights the “form over substance” nature of
the European Communities arguments.526
4.1187  Although the SCM Agreement lacks a preamble or any other statement of its objectives, it is
possible to glean those objectives, particularly with respect to the export subsidy prohibition, from thepractices described in the Illustrative List.  Item (c) refers to internal transport and freight charges on
export shipments on terms more favorable than for domestic shipments.  Item (d) refers to the
provision of products or services for use in the production of exported goods on terms or conditions
more favorable than for use in the production of goods for domestic consumption.  Item (f) refers to
the allowance of special deductions directly related to exports or export performance over and abovethose granted in respect to production for domestic consumption.  Items (g) and (h) both deal
generally with indirect tax breaks that give favorable treatment to exported goods as opposed to goods
sold for domestic consumption.
4.1188  Based on these examples, it seems fair to say that the objective of the export subsidy
prohibition in the SCM Agreement is to prevent the artificial stimulation of exports – one that isunrelated to economic efficiency and comparative advantage – by precluding the preferential
treatment of goods sold for export as compared to goods sold for domestic consumption.  This raises
the question of how that objective should be achieved in the context of the taxation of foreign-source
income.
4.1189  Although the discussion of tax regimes that has taken place in this dispute is by no means
exhaustive, we have seen that under the regimes of many countries, exports of goods are treated more
favorably than domestic sales of goods for income tax purposes.  The United States has described howthe tax regimes of the Netherlands, France, Belgium, and Germany allow a firm to pay less tax on an
export transaction than it would on a comparable domestic transaction.  Second US Oral Statement,
paragraph 70-80.  The ability to reduce taxes in this way is something that is known to every
European tax planner.  In a similar manner, the FSC regime results in a lower tax on export
transactions as compared to comparable domestic transactions.
4.1190  If one were starting from scratch and if one considered the objectives of the SCM Agreement
in isolation from anything else, one perhaps might conclude that each of these regimes should be
declared to be an export subsidy because each allows income from export sales to bear less of a tax
than income from comparable domestic transactions.  Moreover, the European tax regimes (or similar
regimes of other WTO Members, for that matter) could not be excused on the grounds that other typesof foreign-source income may not be taxed, because the SCM Agreement is not concerned with, for
example, how Members tax income from import transactions, passive income from overseas
investments, or income earned from manufacturing abroad.  As indicated above, the SCM Agreement
focuses on the favorable treatment of export sales, as compared to domestic sales, of goods.  The tax
benefits accorded to exports under the European tax regimes are contingent upon export performancewithin the meaning of Article 3.1(a) and item (e) because a producer of goods must export in order to
obtain the tax benefits.  In many cases, the export contingency is implicit in the way the various tax
systems operate.  For example, in transactions involving the distribution of goods, tax exemptions
(whether by statute or treaty) under various European tax systems effectively apply only to income
related to distribution activities carried out abroad through foreign branches or subsidiaries and not to
income from distribution through domestic activities.
                                                     
526 Paragraphs 4.1186-4.1196 reflect the United States' comment on the following question from the
Panel: The United States takes the view that any foreign-source income does not have to be taxed.  TheEuropean Communities, in answering US Question #22, says that it is impermissible for the FSC system to
exempt foreign-source income based upon the fact of exportation.  Which view is more consistent with the basic
objective of the SCM Agreement, particularly with resp ect to the prohibition concerning export subsidies?  Put
differently, if one were writing a new SCM Agreement, how would foreign-source income be treated?WT/DS108/R
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4.1191  However, this purist approach founders on the fact that most, if not all, countries tax foreign-
source income differently than they do domestic-source income.  More specifically, while the
methods differ among countries, most, if not all countries, tax foreign-source income less extensively
than they do domestic-source income, and in some cases they may not tax foreign-source income at
all.  For example, some countries, including seve ral in Europe, exempt some or all foreign branch
income of domestic  companies.  An overwhelming number of countries, including the United States,
generally defer the taxation of undistributed foreign income of foreign subsidiaries.  Furthermore, the
deferral of income tax over time may amount to a tax exemption, and some countries, including
several in Europe, combine the deferral of tax on undistributed earnings with a specific exemption for
foreign subsidiary earnings when distributed as dividends.
4.1192  Thus, a purist approach to export subsidies runs into an inevitable structural conflict arising at
the intersection of tax regimes and subsidy rules; name ly, that the purist approach would result in the
classification of most – perhaps even all – tax regimes in the world as prohibited export subsidies.
Needless to say, this is not the sort of result that is likely to be reflected in the legal rules of a
multilateral organization as large as the WTO.
4.1193  The history of the Tax Legislation Cases  is informative in this regard.  The panel in those
cases found that the European tax regimes in question constituted export subsidies because exports
were taxed less heavily than comparable domestic transactions.  See Second US Submission,
paragraph 23-24.  From the standpoint of economics and the objectives that currently are reflected in
the SCM Agreement, the panel’s conclusions were not unsound or irrational.  However, if the panel’s
findings had been allowed to stand, countries would have faced the unacceptable choice of either (a)
reconfiguring their tax regimes so as to tax fore ign-source and domestic-source income identically; or
(b) accept the consequence of having their tax regimes declared to be export subsidies.  Faced with
this structural conflict between tax regimes and subsidy rules, the GATT membership overturned the
panel’s findings.  Rejecting a purist approach, the Council interpreted GATT Article XVI:4 as
allowing countries to exempt foreign-source income from tax, even if this allowed exports to bear a
lower tax burden than comparable domestic transactions.527
4.1194  What all of this means in the context of this ca se is that, from the standpoint of the objectives
of the export subsidy prohibition in the SCM Agreement, the FSC is no more or no less objectionable
than the tax regimes of other Members that result in export transactions bearing a lower tax burden
than comparable domestic transactions.  While a purist approach might warrant declaring the FSC and
these other regimes to be export subsidies, the C ouncil decided to reject such an approach in 1981,
and there is no indication in the SCM Agreement that the Uruguay Round negotiators chose to revisit
or alter that decision.
4.1195  The difference between the United States and the European Communities is that,
notwithstanding the absence of any intent on the part of the negotiators to repeal the 1981 Council
Decision, the European Communities is using this dispute as a vehicle for doing so.  However, if theEuropean Communities indeed wished to rewrite history, it should have sought to do so through
negotiations.  Instead, it chose not even to pursue the issue in that venue.
4.1196  Finally, given the fact that we are talking about the objectives of the SCM Agreement, the
United States submits that another objective is symmetry of obligations.  Although, as noted, the SCM
Agreement lacks a preamble or statement of objectives, the preamble to the Marrakesh Agreement
Establishing the World Trade Organization  refers to “ reciprocal and mutually advantageous
arrangements directed to the substantial reduction of tariffs and other barriers to trade and to the
                                                     
527  This reluctance of the Council to meddle in international tax policy is echoed in Article XIV(d) of
the General Agreement on Trade in Services (GATS), which provides a set of exceptions to the GATS nationaltreatment requirement with respect to measures “aimed at ensuring the equitable or effective imposition or
collection of direct taxes in respect of services or se rvice suppliers of other Members.”  (Footnote omitted).
Although Article XIV(d) relates to national treatment, it nonetheless is indicative of a healthy caution on thepart of the negotiators against embroiling the WTO in transnational tax issues.WT/DS108/R
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elimination of discriminatory treatment in internatio nal trade relations ... .”  (Emphasis added).  Thus,
whatever principles the Panel ultimately chooses to rely on in fulfilling the task assigned to it, those
principles must not result in the treatment of some Members more favorably than others based upon
whether the Member has a worldwide or territorial tax system.  The exemption from tax of foreign-
source income earned in export transactions must either be a subsidy in all cases or a subsidy in none.
4.1197  The phrase “whether solely or as one of several other conditions” suggests that if the Panel
concludes that the exemption of foreign-source income constitutes revenue foregone that is
“otherwise due,” then the tax regimes of many, if not all Members – including European Members –
will be transformed into export subsidies.  As discussed above, territorial or territorial-type systems
allow for foreign-source income earned in export transactions to bear less of a tax burden thandomestic-source income earned in comparable domestic transactions.  The fact that these tax systems
may tax other types of foreign-source income more favorably than comparable domestic-source
income is irrelevant to an export subsidy analysis, because the SCM Agreement does not require that
the export contingency be the “sole” contingency.
528
4.1198  To the best of US knowledge, the author ities responsible for administering the US
countervailing duty law have never knowingly found a tax measure that exempts foreign-source
income from tax, such as the FSC, to be countervailable.529  As explained in paragraph 23 of the
Second United States Oral Statement, and as dem onstrated in US Exhibit 25, the US Department of
Commerce recently has clarified that a measure that exempts foreign-source income from tax would
not constitute an export subsidy for purposes of the US countervailing duty law.  The reference in US
Exhibit 25 to “other relevant WTO rules” was meant to refer to the arm’s length principle of footnote
59 and the 1981 Council Decision.530
4.1199  The European Communities has claimed that the language in the Commerce regulations
referring to foreign-source income was added solely for purposes of this dispute.  This is partially
true.  Until the European Communities initiated this dispute, it never had been seriously contemplated
that the exemption of foreign-source income from tax – provided that the allocation of income did not
contravene the arm’s length pricing principle of footnote 59 and the Council Decision – wasobjectionable.  The European Communities having raised the issue, it became important for the
Commerce Department to clarify its position on the matter.
4.1200  The United States does not believe that the phrase has any special meaning.
531  However, the
United States notes that this phrase was construed by the panel in the Desiccated Coconut  case.
Although the United States quoted the relevant portion of the panel report in paragraph 33 of theSecond US Submission, for the convenience of the Panel, the United States will reproduce the quote
here.  The panel stated as follows:
For example, Article 1.1 of the SCM Agreement contains a definition of “subsidy”
and Article 16.1 of the SCM Agreement contains a definition of “domestic industry”
both of which are “for purposes of this Agreement”.  However, the terms “subsidy”and “domestic industry” are used both in Article VI of GATT 1994 and the SCM
Agreement.  If the term “this Agreement” were interpreted strictu sensu  to mean the
                                                     
528 Paragraph 4.1197 reflects the United States' comment on the following question from the Panel:
What does the word “solely” refer to in Articles 3.1(a) and 3.1(b) of the SCM Agreement with respect to thecoverage of economic activities?
529  The United States says “knowingly” because it is possible that in the near 100-year history of the
US countervailing duty law, the responsible authorities may have countervailed a tax measure based on amisunderstanding as to the type of income exempted from tax by the measure.
530 Paragraphs 4.1198-4.1199 reflect the United States' comment on the following question from the
Panel: Has the United States or the European Communities investigated a measure like the FSC under domesticcountervailing duty procedures?
531 Paragraphs 4.1200-4.1201 reflect the United States' comment on the following question from the
Panel: In Article 1.1 of the SCM Agreement, does the phrase “For purposes of this Agreement” have any specialmeaning?WT/DS108/R
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SCM Agreement, then the definitions of these key terms in the SCM Agreement
would be inapplicable to the same terms as used in Article VI of GATT 1994.  Such a
result could not have been intended.532
4.1201  Thus, the panel rejected the notion that the phrase “For purposes of this Agreement” should
be used as a basis for interpreting Article VI and the SCM Agreement in isolation from each other.
For the reasons articulated by the Desiccated Coconut  panel and the Appellate Body, this Panel
should seek a harmonious interpretation of Article XVI and the SCM Agreement.
C. WHETHER FSC MEASURES ARE SUBSIDIES CONTINGENT UPON USE OF DOMESTIC OVER
IMPORTED GOODS WITHIN THE MEANING OF ARTICLE 3.1( B) OF THE SCM AGREEMENT
The European Communities  argues in its First Submission as follows:
4.1202  As explained, both the tax exemptions and the availability of the special administrative
pricing rules under the FSC scheme are limited to income from the export of products “not more than
50 per cent of the fair market value of which is attributable to articles imported into the United States”(see the definition of “export property” in Section 927(a) of the IRC).
4.1203  In order to qualify for the benefit of the FSC  scheme and therefore the FSC subsidies (both
the tax exemptions and the availability of the special administrative pricing rules), the manufacturer
must ensure that “not more than 50 per cent of the fair market value of which is attributable to articles
imported into the United States” and must therefore give preference to United States over imported
goods when producing the “export property.”
4.1204  FSC subsidies are therefore both contingent in law upon the use of domestic over imported
goods and contrary to Article 3.1(b) of the SCM Agreement.
The United States  responds in its First Submission as follows:
4.1205  The European Communities argues that the FSC violates Article 3.1(b) of the SCM
Agreement because the FSC tax exemption applies to income from export transactions involving
products “not more than 50 per cent of the fair market value of which is attributable to articles
imported into the United States.”
533  The European Communities' legal conclusion regarding this
particular claim is incorrect for several reasons.  Moreover, this is an issue that this Panel need not
reach.
4.1206  First, the FSC cannot be a prohibited subsidy under Article 3 because it is not a “subsidy” as
that term is defined in Article 1.  Second, Article 3 expressly provides that any measure that Annex I
provides is not an export subsidy cannot be prohibited under any other provision of the SCM
Agreement.  As established above, the FSC is not an export subsidy under Annex I.
4.1207  However, before addressing these points in more detail, it is important to note that the
European Communities' assertion that under the FSC rules a manufacturer “must . . . give preferenceto United States over imported goods” reflects a misunderstanding of the nature and the effect of the
50 per cent provision.
534  First, the 50 per cent requirement applies to the overall value  of the exported
product, not to the domestic versus foreign content of its component parts.  In particular, the statutory
definition of “export property” provides that “not more than 50 per cent of the fair market value ” of
the property can be attributable to “articles imported into the United States.”535  The fair market value
                                                     
532  Brazil - Measures Affecting Desiccated Coconut , WT/DS22/R, Report of the Panel, as modified by
the Appellate Body, adopted 20 March 1997, paragraph 234.
533  Section 927(a)(1)(C) of the IRC.
534  First EC Submission, paragraph 165.
535  Section 927(a)(1)(C) of the IRC (emphasis added).WT/DS108/R
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is, in turn, defined to be the appraised value of the goods as determined under applicable customs laws
and procedures.
4.1208  Therefore, compliance with the 50 per cent requirement takes into account not just the value
of “goods” used in producing the finished product, but also every element of value that has
contributed to the total market value of the exported product.  Thus, value added throughmanufacturing, assembling, converting, finishing, or  otherwise producing the finished product are all
included in the calculation.  When a significant portion of the value of a finished product is
attributable to its intellectual property content, to manufacturing or assembling, or to other non-
tangible elements of the product, the “goods” used in manufacturing, whatever their origin, may
account for a relatively small proportion of its total value.
4.1209  The practical implications of this rule, properly understood, bear directly on the
European Communities' allegations on this point.  One implication is that under the 50 per cent rule, a
United States exporter may qualify for FSC benefits even if more than 50 per cent of the “goods” used
in producing the exported product are imported goods.  The reason, of course, is that the value of the
non-goods elements of the product, particularly when combined with any US-origin goods, easilymeets the 50 per cent of value requirement.  Indeed, it is quite possible for a product manufactured or
assembled in the United States entirely from imported goods  to meet the 50 per cent test of the FSC.
4.1210  Second, the practical effect of the 50 per cent rule is further diminished by the principle of
origin applicable to components incorporated into products exported from the United States.  When,
for example, a US exporter sources a component from a United States supplier, that component
normally is deemed to be a US-origin good for purposes of the 50 per cent of total value rule.
However, the goods from which that component was manufactured may have been primarily, or evenentirely, imported goods.  In such circumstances, there is no preference for domestic over imported
goods because the finished component typically is deemed to be a US-origin good.  This same process
obviously can occur not only at the level of components, but also at the level of sub-components, sub-
sub-components, etc.
4.1211  Third, it also must be recognized that for important exporting industries, the 50 per cent
requirement has little or no practical effect.  For example, in the agricultural sector that the European
Communities targets in this case, the notion of incorporating imported goods into export products is
impractical and artificial.  Thus, for the agricultural sector, the 50 per cent requirement is largely
inapplicable.  Likewise, for other industries, such as the chemicals and software industries, the notion
of incorporating imported “goods” into products to be exported is commercially impractical.
4.1212  For all of these reasons, the European Communities' characterisation of the 50 per cent
requirement is inaccurate and misleading.  Nevertheless, as noted above, the Panel does not even have
to reach the question of whether these requirements render the FSC tax exemption “contingent . . .
upon the use of domestic over imported goods” within the meaning of Article 3.1(b).
4.1213  Article 3.1(b) states in relevant part that “[e]xcept as provided in the Agreement on
Agriculture, the following subsidies, within the m eaning of Article 1, shall be prohibited:  . . .
subsidies contingent, whether solely or as one of several other conditions, upon the use of domestic
over imported goods.”  However, Article 3.1(a), th e export subsidy provision, includes a footnote 5
which states that “Measures referred to in Annex I as not constituting export subsidies shall not be
prohibited under this or any other provision of this Agreement.”
4.1214  Accordingly, for a measure to constitute a prohibited subsidy under Article 3, there are four
elements to be satisfied, the first two of which are:
• It must be a “subsidy” within the meaning of Article 1;
• It must not be a measure that under Annex I does not constitute an export subsidy.WT/DS108/R
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4.1215  The United States has demonstrated above that the FSC is not a subsidy under Article 1 of the
SCM Agreement.  Because the SCM Agreement and the 1981 Council Decision provide that a
Member need not tax income attributable to foreign economic processes, such income does not
constitute “revenue that is otherwise due” within the meaning of Article 1.1(a)(1)(ii) of the SCM
Agreement.  Accordingly, the FSC is not a “subsidy” as that term is defined in Article 1.  BecauseArticle 3.1 prohibits measures only if they are “subsidies . . . within the meaning of Article 1,” the
FSC cannot be violative of Article 3.1(b).
4.1216  An additional reason why the Panel need not reach the question of whether Article 3.1(b)
even applies to the FSC is that the European Communities' claim is precluded by footnote 5 of the
SCM Agreement.  Footnote 5 states that “[m]easures referred to in Annex I as not constituting export
subsidies shall not be prohibited under this [Article 3.1(a)]
536 or any other provision of this
Agreement ” (emphasis added).  According to footnote 5, no prohibition contained anywhere in the
SCM Agreement is applicable to measures that are referenced in Annex I as not constituting an export
subsidy.  As explained above, Annex I, the Illustra tive List of Export Subsidies, identifies certain
types of measures as being export subsidies and other types of measures as not being export subsidies.
4.1217  A measure does not have to be explicitly listed or identified with particularity in Annex I as
not constituting an export subsidy in order to be within the immunity from prohibition conferred by
footnote 5.  Rather, a measure need only be “referred to” in the Annex.  According to Webster’s Third
New International Dictionary (1976), to “refer” means “to think of, regard, or classify under a
subsuming principle or with a general group.”  Thus, to the extent that a measure can be classified in a
general group of measures that, under the standard contained in Annex I, do not constitute export
subsidies, it is not subject to any prohibition contained in the SCM Agreement.
4.1218  The FSC meets this standard.  As discussed in detail above, footnote 59 and the 1981 Council
Decision establish a “subsuming principle” or “general group” that is relevant to the FSC; that is,
measures that exempt income attributable to foreign economic processes are not export subsidies if
they are based on administrative or other practices that do not contravene the arm’s length principle
or, if they do contravene such principle, do not result in a significant saving of direct taxes in exporttransactions.  The FSC does not implicate either of these conditions, and thus does not give rise to an
export subsidy.
4.1219  Therefore, because the FSC is not an export subsidy pursuant to Annex 1, and because
footnote 5 of the SCM Agreement renders the FSC  immune from all other prohibitions in the SCM
Agreement, it cannot be prohibited under Article 3.1(b).
The European Communities  rebuts the United States' response in its Oral Statement at the First
Meeting of the Panel as follows:
4.1220  The European Communities explained in its First Written Submission that the violation of
Article 3.1(b) follows from the fact that the FSC ta x exemptions and the availability of the special
administrative pricing rules under the FSC scheme are limited to income from the export of products
“not more than 50 per cent of the fair market value of which is attributable to articles imported into
the United States” (See the definition of “export property” in Section 927(a) IRC).
4.1221  In order to qualify for the benefit of the FSC  scheme and therefore the FSC subsidies (both
the tax exemptions and the availability of the special administrative pricing rules), the manufacturermust ensure that “not more than 50 per cent of the fair market value of which is attributable to articles
imported into the United States” and must therefore give preference to United States over imported
goods when producing the “export property.”
4.1222  The FSC subsidies are therefore both contingent in law upon the use of domestic over
imported goods and contrary to Article 3.1(b) of the SCM Agreement.
                                                     
536  Footnote 5 is attached to Article 3.1(a).  Thus, the term “this . . . provision” refers to Article 3.1(a).WT/DS108/R
Page 211
4.1223  Apart from arguing that there is no subsidy, the only defence the United States can bring up is
that in some cases the actual United States content may be less than 50 per cent since individual
components may be made up of some non-US parts.  Article 3.1.(b). indicates that the subsidy must
be "contingent" upon the use of domestic over imported parts; it does not qualify the prohibition on
the basis of actual usage i.e. that if 100 per cent imported parts were used in a particular product, forthat particular export the subsidy would not be prohibited. The fact that a producer has to take into
account the 50 per cent test in order to meet the conditions for the subsidy forces him to make
decisions on the sourcing of parts which would not have been made in the absence of the provision.
Furthermore, there is no de minimis  rule for the application of the prohibition on local content
subsidies either.
The United States  further responds in its Oral Statement at the First Meeting of the Panel as follows:
4.1224  Furthermore, the fact that the FSC is not a subsidy at all means that it cannot be an import-
substitution subsidy.  By the terms of Article 3.1(b), a measure does not constitute an import-
substitution subsidy unless it is first a subsidy.
4.1225  In addition, because footnote 59 provides that tax exemptions for income attributable to
foreign economic processes, such as the FSC, do not constitute prohibited export subsidies, the FSC
cannot be prohibited under Article 3.1(b).  Footnote 5 of the SCM Agreement states that any measure
referred to in Annex I as not being an export subs idy is not prohibited by any provision of the SCM
Agreement.  Footnote 5, when read in conjunction with footnote 59, renders the FSC exempt from any
prohibition under Article 3.1(b).
The United States  further responds in its Second Submission as follows:
4.1226  With respect to the European Communities' allegation that the FSC tax exemption and the
FSC administrative pricing rules violate Article 3.1(b) of the SCM Agreement, at the first meeting of
the Panel, the European Communities conceded that a measure can violate Article 3.1(b) only if it is a
subsidy.  As established above and in the First US Submission, because the FSC does not involve theforegoing of revenue that is “otherwise due” with in the meaning of Article 1.1(a)(1)(ii), the FSC
cannot violate Article 3.1(b).
4.1227  In addition, because the FSC does not, pursuant to footnote 59, constitute an export subsidy
under Annex I, the FSC is not prohibited under Article 3.1(b) by virtue of footnote 5 of the SCM
Agreement.  In the section of its Oral Statement dealing with Article 3.1(b), the EuropeanCommunities does not address footnote 5 and appears to concede that if a measure is not referred to as
constituting an export subsidy under Annex I, footnote 5 precludes the measure being treated as a
prohibited subsidy under Article 3.1(b).
537
4.1228  The European Communities, however, did mention footnote 5 in connection with its
arguments concerning the FSC as an alleged export subsidy, stating that footnote 5 “only relates tomeasures which are considered not to be export subsidies in the Illustrative List.  If it exempted
subsidies not expressly prohibited by the Illustrative List, it would be transforming the Illustrative List
into an exhaustive list , which would be contrary to the expressed intent.”
538
4.1229  The United States must confess that it finds the above-quoted statement difficult to follow.
What the European Communities seems  to be saying is that even if the FSC does not constitute an
export subsidy under the criteria of item (e) and footnote 59 of the Illustrative List, it can still be
found to be an export subsidy under some other set of criteria.  The United States has addressed this
argument above, and simply will reiterate here that:  (1) the European Communities' approach to the
status of the Illustrative List would render footnote 5 a nullity; and (2) the United States approach to
                                                     
537  EC Oral Statement, paragraphs 90-93.
538  EC Oral Statement, paragraph 88 (emphasis in original).WT/DS108/R
Page 212
the status of the Illustrative List gives meaning to footnote 5 without transforming the List into an
exhaustive list.
4.1230  Finally, in its discussion of the FSC 50 per cent fair market value requirement, the European
Communities carefully tiptoes around the fact that the FSC statute does not require  the use of
domestic over imported goods.  The European Communities states that “[t]he fact that a producer hasto take into account the 50 per cent test in order to meet the conditions for the subsidy forces him to
make decisions on the sourcing of parts which would not have been made in the absence of the
provision.”
539
4.1231  Aside from the fact that the European Communities' assertion about what a producer is
“forced” to do is unsupported by any evidence, it is questionable whether, in the absence of arequirement that domestic goods be used in favor of imported goods, the effect alleged by the
European Communities constitutes the sort of “contingency” required by Article 3.1(b).  If it does,
then the United States submits that the favorable tax treatment accorded by territorial tax systems to
export transactions, as opposed to domestic transactions, equally constitutes a “contingency” for
purposes of Article 3.1(a).  Because a producer subject to a territorial tax system can pay less taxes ifit exports than if it sells domestically, this forces the producer to make decisions which would not
have been made if export and domestic transactions bore the same tax burden.
4.1232  As is the case with its claims under Article 3.1(a), the European Communities' inability to
demonstrate that the FSC is a subsidy under Article 1 means that it cannot be a prohibited subsidy
under Article 3.1(b).  In addition, under footnote 5, the FSC is immune from all prohibitions in the
SCM Agreement because under footnote 59 a measure such as the FSC is referred to as not being an
export subsidy.  Finally, the European Communities has failed to demonstrate that the FSC taxexemption is contingent upon the use of domestic over imported goods.
The European Communities  further rebuts the United States' response in its Oral Statement at the
Second Meeting of the Panel as follows:
4.1233  The United States pays little attention to the violation of Article 3.1(b) of the SCM
Agreement.  The United States repeats that there is no violation of Article 3.1(b) if there is no subsidy
and if it benefits from footnote 5.  These matters have already been dealt with.
4.1234  The other argument the United States makes
540 is to question whether the local content effect
constitutes the sort of “contingency” required by Arti cle 3.1(b) and that any effect it has is comparable
to that resulting from territorial tax systems because, and I quote:
“a producer subject to a territorial tax system can pay less taxes if it exports than if it
sells domestically, this forces the producer to make decisions which would not have
been made if export and domestic transactions bore the same tax burden.”
4.1235  The United States argument is difficult to follow. As the European Communities explained in
its First Written Submission, FSC benefits only apply to the export of “export property” which isdefined in Section 927(a) IRC  to be property “not more than 50 per cent of the fair market value of
which is attributable to articles imported into the United States.”  The United States is doubting
whether this is “contingency” for the purposes of Article 3.1(b) because there are some cases in which
                                                     
539 EC Oral Statement, paragraph 93.  In the same paragraph, the European Communities distorts the
First US Submission when it states that “the only defence the US can bring up is that in some cases the actualUS content may be less than 50 per cent since individual components may be made up of some non-US parts.”What the United States said was that because the 50 per cent requirement is based on the “value” of the finishedproduct, that product could consist of 100 per cent imported “goods” and still qualify for the FSC tax
exemption.  Rather than reiterate here what the United States actually said, the United States refers the Panel to
the First US Submission, paragraphs 156-163.
540 Paragraph 151 of the US Second Written Submission.WT/DS108/R
Page 213
the value added by assembly or manufacture in the United States will already amount to 50 per cent
so that the condition is not a constraint.
4.1236  The European Communities considers that where a law sets a restriction on the use of
imported materials (as Section 927(a) clearly does) that is a local content contingency and it is
irrelevant if in a certain number of cases the restriction has no effect in practice. There is at least localcontent contingency in all those cases where the non-component or raw material value of the exported
goods is less than 50 per cent since it will not then be possible to use 100 per cent imported
components or raw materials.
4.1237  The comparison with the effect of territorial tax systems is entirely misconceived and the
United States has not identified any legal requirement in such systems relating to the use of domesticproducts or restricting the use of imported products.
D. 
WHETHER FSC MEASURES ARE IN VIOLATION OF THE AA
The European Communities  argues in its First Submission as follows:
Introduction
4.1238  Article 3.1 of the SCM Agreement applies “except as provided in the Agreement on
Agriculture”.  It is therefore necessary to examine whether the AA allows the provision of FSC
subsidies to agricultural products.  It will be demonstrated below that it does not and that the FSC
scheme also violates Articles 3 and 8 of the AA r ead in conjunction with its Articles 9.1(d), 10.1, and
10.3 of the AA.  The European Communities will present two lines of argument; the first based on the
assumption that FSC subsidies fall under Article 9.1 of the AA (specifically Article 9.1(d)) and thesecond on the assumption that they do not.
4.1239  The European Communities will first discuss the provisions of the AA relevant to both
arguments and present the data for the agricultural products to be used as examples.
The Relevant Common Provisions of the AA
4.1240  Article 1(e) of the AA defines “Export subsidies” as:
“subsidies contingent upon export performance, including the export subsidies listed
in Article 9 of this Agreement”.
4.1241  Article 3 of the AA provides, insofar as relevant for export subsidies, that:
“1. The … export subsidy commitments in Part IV of each Member's Schedule
constitute commitments limiting subsidization ...
. . .
3. Subject to the provisions of paragraphs 2(b) and 4 of Article 9, a Member
shall not provide export subsidies listed in paragraph 1 of Article 9 in respect of the
agricultural products or groups of products specified in Section II of Part IV of itsSchedule in excess of the budgetary outlay and quantity commitment levels specified
therein and shall not provide such subsidies in respect of any agricultural product not
specified in that Section of its Schedule. ”
(Emphasis added.)
4.1242  Article 8 of the AA provides that:WT/DS108/R
Page 214
“Each Member undertakes not to provide export subsidies otherwise than in
conformity with this Agreement and with  the commitments as specified in that
Member's Schedule.”
4.1243  Accordingly, export subsidies are not allowed under the AA for agricultural products in
excess of the budgetary outlay and quantity commitment  levels specified in the relevant Schedule and
are not allowed at all for agricultural products not listed in the Schedule.
4.1244  Subsidies which are not allowed under the AA may of course be prohibited under the SCM
Agreement. It has been shown above that the FSC subsidies are so prohibited.
4.1245  The AA recognises in Article 10.1 of the AA that there may be some export subsidies that
may not be covered by Article 9.1 of the AA. It states that:
“Export subsidies not listed in paragraph 1 of Article 9 shall not be applied in a
manner which results in, or which threatens to lead to, circumvention of export
subsidy commitments;  nor shall non-commercial  transactions be used to circumvent
such commitments.”
4.1246  Apart from the non-commercial transactions (i.e. development aid) mentioned in Article 10.1,
there is the case of export credits referred to in Article 10.2 of the AA.
4.1247  In view of the difficulty for Members to identi fy which export transactions are subsidised and
which are not, Article 10.3 of the AA reverses the burden of proof and provides that:
“Any Member which claims that any quantity exported in excess of a reduction
commitment level is not subsidized must establish that no export subsidy, whether
listed in Article 9 or not, has been granted in respect of the quantity of exports in
question.”
US Exports of Agricultural Products Benefiting from FSC Subsidies
4.1248  The European Communities has provided in Exhibit EC-16 data on United States exports and
European Communities imports of United States wheat, maize, soya beans and cotton for the period
1995 to 1997.  These show exports of all these products to the European Communities.  For maize,soya beans, and cotton, the United States has included no reduction commitments in its Schedule and
so no export subsidies are allowed.  For wheat, United States notifications to the Committee on
Agriculture show that the quantities of product exported with subsidies were below the commitments.
4.1249  There is nothing in the FSC legislation or elsewhere in United States legislation, which
prevents exports of maize, soya beans and cotton from benefiting from the FSC subsidies.
4.1250  The latest figures provided by the United States for FSCs relate to 1992.  Table 1 to Exhibit
EC-12 shows 27 FSCs active in the export of “grains and soybeans” and 9 for cotton with gross
receipts of US$4.4 and 1.7 million respectively.  This demonstrates that FSCs can be and are used for
the export of these products.  Indeed the FSC legislation contains specific rules designed to facilitate
the application of the scheme to agricultural cooperatives (Sections 923(a)(4) and 925(f) of the IRC).
4.1251  Sections 923(a)(4) of the IRC provides that in  the case of a FSC owned by a cooperative, the
exempt foreign trade income of the FSC is 100 per ce nt of its foreign trade income (instead of 65 per
cent as is normally the case – see Section II.C.8 above).
4.1252  Since the use of FSCs is expanding throughout the United States economy with the use of
computer software to maximise the benefits, it is clear that the exports of wheat, maize, soya beans,and cotton for the period 1995 to 1997 mentioned above have benefited to some extent from the FSC
subsidies.WT/DS108/R
Page 215
4.1253  The European Communities will now explain how the FSC subsidies, whether falling under
Article 9.1 of the AA or not, must be considered contrary to the AA..
FSC Subsidies Fall under Article 9.1(d) of the AA
4.1254  Article 9:1 (d) of the AA requires to be scheduled and to be reduced:
“the provision of subsidies to reduce costs of marketing exports of agricultural
products (other than widely available export promotion and advisory services)
including handling, upgrading and other processing costs, and the costs of
international transport and freight.”
4.1255  It may be considered that the FSC scheme falls within this category.  By reducing the tax
liability arising out of foreign sales, the FSC sche me is reducing the costs of marketing exports.  The
exception for “widely available export promotion and advisory services” does not apply since the FSC
scheme is not a “service” but a tax exemption.
4.1256  Of the four agricultural products being considered, maize, soya beans, and cotton for the
period 1995 to 1997 could not be exported with export subsidies at all.  Therefore the application ofthe FSC scheme to them was contrary to the AA.
4.1257  Wheat on the other hand may attract export subsidies under the AA.  However, as indicated in
the table in Exhibit EC-16, a quantity of up to 20.2 Mio tonnes could in 1995 be exported under the
commitment.  The United States has notified that only 560 000 tonnes  received such subsidies in
1995.  In total, the United States exported 32.4 Mio tonnes of wheat in 1995 which means that 31.8
Mio tonnes  were claimed to be exported without export subsidies.
4.1258  The United States does not take into account subsidies provided to agricultural products under
the FSC scheme for the purpose of compliance with its commitments under the AA.
4.1259  According to Article 10.3 of the AA, it is for the United States to prove that all the maize,
soybeans and cotton, and all the wheat in excess of its reduction commitments were exported without
the benefit of FSC subsidies.  If it does not do so, it must be deemed to have violated Articles 8 and
3.3 of the AA.
FSC Subsidies Do Not Fall under Article 9.1(d) of the AA
4.1260  Even if the FSC scheme subsidy does not fall under Article 9.1(d), this does not prevent it
from being contrary to Article 8 of the AA which applies to all export subsidies to agricultural
products, whether or not described in Article 9.1 of the AA.
4.1261  The export subsidy commitments in the case of th e United States for maize, soya beans, and
cotton are zero.
4.1262  Therefore, pursuant to Article 10.3 of the AA, it is for the United States to prove that all the
maize, soya beans and cotton and all the wheat in excess of its reduction commitments was exported
without the benefit of FSC subsidies. If it does not do so, it must be deemed to have violatedArticles 8 and 3.3 of the AA as well as Article 3 of the SCM Agreement in respect of these subsidies.
Conclusion
4.1263  Subject to the United States demonstrating that none of its exports of cotton, maize, or soya
beans benefit from the FSC subsidies and that none of its exports of wheat in excess of its reductioncommitments do so, it must be held to have violated Articles 3.3 and 8 of the AA.
The United States  responds in its First Submission as follows:WT/DS108/R
Page 216
4.1264  The FSC does not violate United States obligations under the AA for the simple reason that,
as demonstrated below, the FSC is not an export subsidy for purposes of that Agreement.
The Export Subsidy Provisions of the AA Must Be Interpreted in Light of Article XVI of
GATT 1994 and the SCM Agreement
4.1265  As an initial starting point, one must determine what an “export subsidy” is for purposes of
the AA.  In this regard, the European Communities has cited two provisions, Article 1(e) and
Article 9.1(d) of that Agreement.  Article 1(e) is a general definition that provides as follows:
“‘export subsidies’ refers to subsidies contingent upon export performance, including the exportsubsidies listed in Article 9 of this Agreement.”  Article 9.1(d) is more specific, providing as follows:
1. The following export subsidies are subject to reduction commitments under
this Agreement:
. . .
(d) the provision of subsidies to reduce the costs of marketing exports of
agricultural products (other than widely available export promotion and advisory
services) including handling, upgrading and other processing costs, and the costs of
international transport and freight.
As is obvious from the text, neither of these provisions defines the term “subsidy”.  Moreover, no
other provision of the AA provides such a definition
.
4.1266  Accordingly, as an initial threshold question, the Panel must interpret the term “subsidy” as it
is used in the AA.  The United States submits that in accomplishing this task, the VCLT  and
Article 21.1 of the AA require the Panel to consider, as part of the context of the treaty provisions in
question, relevant provisions of other WTO agreements.541  In this regard, provisions that clearly are
relevant are Article XVI of GATT 1994 and Arti cles 1 and 3.1(a) and Annex I of the SCM
Agreement.  Indeed, paragraph (c)(ii) of Article 13 of the AA (the so-called “peace clause”) expressly
recognises the linkage between the AA and these provisions.542
4.1267  As an additional aid to interpretation, the Appellate Body also has emphasised Article XVI:1
of the WTO Agreement , which provides as follows:
Except as otherwise provided under this Agreement or the Multilateral Trade
Agreements, the WTO shall be guided by the decisions, procedures and customary
practices followed by the CONTRACTING PARTIES to GATT 1947 and the bodiesestablished in the framework of GATT 1947.
543
Thus, for example, decisions made and reports issued under Article XVI of GATT 1947 and theSubsidies Code also are relevant to the interpreta tion of the term “export subsidy” as used in the AA.
4.1268  Finally, paragraph 1(b)(iv) of GATT 1994 provides that GATT 1994 shall consist of “other
decisions of the CONTRACTING PARTIES to GATT 1947 ... .”
4.1269  Taking these interpretative resources into account, it is obvious that the FSC is not an export
subsidy for purposes of the AA.
                                                     
541 Article 21.1 provides as follows:  “The provisions of GATT 1994 and of other Multilateral Trade
Agreements in Annex 1A to the WTO Agreement shall apply subject to the provisions of this Agreement.
542 Article 13(c)(ii) provides that during the implementation period, export subsidies in conformity with
Part V of the AA shall be exempt from actions based, inter alia , on Article XVI of GATT 1994 or Article 3 of
the SCM Agreement.
543  Brazil - Measures Affecting Desiccated Coconut , WT/DS22/AB/R, Report of the Appellate Body
adopted 20 March 1997, at 14.WT/DS108/R
Page 217
Given the Absence of any Contrary Indicati on in the AA, Because the FSC Does Not
Constitute a Subsidy for the Purposes of the SCM Agreement or Article XVI of
GATT 1994, It Does Not Constitute an Export Sub sidy Within the Meaning of Article 1(e)
of the AA
4.1270  As demonstrated above, the FSC does not constitute a subsidy, let alone an export subsidy,
under the SCM Agreement.  Moreover, while the European Communities has not made a claim under
Article XVI of GATT 1994, the discussion above demonstrates that the FSC would not constitute a
subsidy for purposes of Article XVI.  In particular, the FSC is consistent with the terms of the 1981
Council Decision, a decision which, pursuant to paragraph 1(b)(iv) of GATT 1994, constitutes part ofGATT 1994, and which, pursuant to Article XVI:1 of the WTO Agreement , must guide the WTO.
4.1271  Thus, in light of the fact that the FSC is not a subsidy or an export subsidy for purposes of the
SCM Agreement or GATT 1994, and in the absence of anything in the AA that would indicate a
contrary result, the FSC cannot be considered an “export subsidy” for purposes of Article 1(e) of the
AA.
The FSC Does Not Constitute an Export Subsi dy Within the Meaning of Article 9.1(d) of
the AA
4.1272  The FSC also does not constitute an export subsidy for purposes of Article 9.1(d) of the AA.
There are two criteria that must be satisfied in order for a measure to fall under Article 9.1(d).  First,
the measure must be an export subsidy.  Second, the export subsidy must be provided “to reduce the
costs of marketing exports of agricultural products (other than widely available export promotion andadvisory services) including handling, upgrading and other processing costs, and the costs of
international transport and freight.”  The FSC satisfies neither criterion.
4.1273  With respect to the first criterion, as demonstr ated above, the FSC is not an export subsidy
within the meaning of Article 1(e) of the AA.  Thus, even assuming arguendo  that the FSC is
provided to reduce the costs of marketing expenses , etc., it would not be covered by Article 9.1(d).
4.1274  Second, assuming arguendo  that the FSC is an export subsidy, it is not provided to reduce the
costs of marketing expenses, etc.  Based on the ordinary meaning of the terms used, the FSC does not
reduce marketing expenses.  Instead, the FSC statute increases the after-tax net income of a FSC.  It
does so not by reducing marketing costs but by reducing the tax liability. The costs incurred by a firm
for marketing expenses do not change depending upon whether or not the firm files an income taxreturn as a FSC.
544
4.1275  In addition, as a contextual matter, an examin ation of the SCM Agreement reveals that the
drafters of the WTO subsidy rules knew how to distinguish between potential tax-related subsidies
and other types of subsidies.  For example, paragraphs (e) through (h) of the Illustrative List establish
specific rules for different types of tax measures.  In light of this, it is inconceivable that those samedrafters would have intended that tax measures be covered by a provision such as Article 9.1(d) that,
by its terms, deals with subsidies provided to reduce marketing expenses and that does not even
mention the word “tax”.
545
4.1276   With respect to the European Communities' claims under the AA, the
European Communities' failure to meet its burden of proof is even more manifest.  With respect to the
European Communities' assertion that the FSC falls under Article 9.1(d), one searches the First EC
Submission in vain for any explanation, let alone proo f, that the FSC constitutes an export subsidy for
                                                     
544  Indeed, if Article 9.1(d) were construed in the manner suggested by the European Communities,
then that provision would apply to rebates of a VAT.
545 The European Communities has not alleged that the FSC falls under any other paragraph of
Article 9.1 of the AA.  However, to complete the analysis, the United States submits that none of those otherparagraphs would cover an income tax measure, such as the FSC.WT/DS108/R
Page 218
purposes of the AA, one of the prerequisites for an Article 9.1(d) subsidy.  In addition, the
European Communities' assertion that the FSC “reduce[s] the costs of marketing exports” is untenable
in light of the ordinary meaning of the words in Article 9.1(d).
4.1277  Likewise, with respect to its assertion that FSC constitutes an “[e]xport subsid[y] not listed in
paragraph 1 of Article 9" within the meaning of Article 10 of the AA, the European Communities hasnot offered any explanation or evidence as to why the FSC constitutes an export subsidy within the
meaning of Article 1(e) of that Agreement.  Instead, the European Communities relies on Article 10.3
of the AA in an attempt to avoid its burden of proof.  Assuming arguendo  that Article 10.3 is
applicable, at most it shifts the burden to the responding Member to establish that products exported
in excess of a reduction commitment level did not take advantage of a particular measure alleged to bea subsidy, or, alternatively, that the measure is not an export subsidy.  However, Article 10.3 cannot
be construed to shift any evidentiary burden where the exported product either does not appear in
Section II, Part IV of the Member’s schedule or the quantity reflected in the schedule is zero.  Only
products listed in Section II along with a specific positive quantity are subject to reduction
commitments, and the scope of Article 10.3 is limited expressly to quantities of any product “exportedin excess of a reduction commitment.”  Thus, only in those specific circumstances could Article 10.3
relieve the complaining Member of the obligation to make a prima facie  case that the measure in
question is, in fact, an export subsidy.  In the context of this case, this means that if the burden of
proof shifts to the United States at all under Article 10.3, it shifts only with respect to wheat, the only
agricultural product identified by the European Communities for which the United States has a
positive reduction commitment.
4.1278  In any event, the United States has established that the FSC is not an export subsidy for
purposes of the AA.
The European Communities  rebuts the United States' response in its Oral Statement at the First
Meeting of the Panel as follows:
Introduction
4.1279  The European Communities has explained in its First Written Submission
546 that the FSC
scheme also violates Articles 3 and 8 of the AA r ead in conjunction with its Articles 9.1(d), 10.1, and
10.3 AA.  The European Communities presented two lines of argument; the first based on the
assumption that FSC subsidies fall under Article 9.1(d) of the AA547 and the second on the assumption
that they do not548.
4.1280  Apart from raising a procedural objection549, the United States has made a number of
arguments in reply.
The United States claim that there is no subsidy within the meaning of the AA
4.1281  The first United States objection is that although many provisions of the AA regulate “export
subsidies” and there are definitions of “export subsidies” in Article 1 (e) and 9 of the AA, there is no
definition of the term “subsidy”.
4.1282  The European Communities assumed and now submits formally that in view of the similarity
between Article 1(e) of the AA and Article 3.1(a) of the SCM Agreement, the term used in the AAmust have the same meaning as in the SCM Agreement, at least insofar as export subsidies are
concerned.  One reason for this is that Article 3.1(a) starts of with an exception for the export
                                                     
546 Paragraphs 167-192.
547 Paragraphs 183-188.
548 Paragraphs 189-191.
549 Dealt with separately [ ].WT/DS108/R
Page 219
subsidies allowed by the AA. The terms used in both Agreements must therefore have the same
meaning.
4.1283   The United States contends that Article XVI GATT needs to be taken into consideration and
that in the light in particular of Article XVI: 1 WTO and paragraph 1(b)(iv) of the language
incorporating GATT 1994 into the WTO, “it is obvious  that the FSC is not an export subsidy for the
purposes of the AA.”550
4.1284  This view seems to be based entirely on the reasoning (or rather alleged “controlling legal
standard”) that what a Member considers to be a foreign economic process may be exempted from tax
at the discretion of the Member which may include export contingency, which the European
Communities has already refuted.  If the European Communities should be mistaken and there aresome additional reasons, it would ask for this to be made clear.
Claim that the FSC does not reduce marketing costs under Article 9.1(d) of the AA
4.1285  Article 9:1 (d) of the AA requires to be scheduled and to be reduced:
“the provision of subsidies to reduce costs of marketing exports of agricultural
products (other than widely available export promotion and advisory services)
including handling, upgrading and other processing costs, and the costs of
international transport and freight.”
4.1286  Apart from repeating that the FSC is not a subsidy, the United States argument is that the FSC
scheme reduces tax liability, not marketing costs and that “costs incurred by a firm for marketing
expenses do not change depending upon whether or not the firm files an income tax return as a
FSC.”
551
4.1287  The European Communities would point out that the FSC scheme, by the United States’ own
admission, reduces tax payable on the “income of distributor functions” of an export transaction. In
this way the FSC scheme is partially compensating th e costs of marketing exports.  The United States
argument that the subsidy does not reduce costs, ju st tax liability” cannot be accepted since otherwise
a direct grant to companies marketing agricultural products would escape Article 9.1(d) – it could beargued that the grant was not reducing costs, just increasing revenue !  The existence of a subsidy
must surely be independent of the means by which it is delivered.
4.1288  The important point is that the FSC subsidies when applied to agricultural products are by
their nature related to the distribution or marketing of the products.  Marketing means advertising,
sales promotion and solicitation and these are all activities which the FSC is required to perform (orbe responsible for).
552
US rejection of burden of proof that it is not circumventing its commitments underArticle 10.3 of the AA
4.1289  As mentioned above, the European Communities brought an alternative claim under the AA
for the case that the FSC subsidies should not be considered to fall under Article 9.1(d).
4.1290  Article 10.1 of the AA provides that:
“Export subsidies not listed in paragraph 1 of Article 9 shall not be applied in a
manner which results in, or which threatens to lead to, circumvention of export
                                                     
550 Paragraphs 170-174 of the US First Written Submission.
551 Paragraph 179 of the US First Written Submission.
552 See Sections 924(e)(1) and 924 (d)(1)(A) IRC.WT/DS108/R
Page 220
subsidy commitments;  nor shall non-commercial transactions be used to circumvent
such commitments.”
4.1291  In view of the difficulty for Members to identi fy which export transactions are subsidised and
which are not, Article 10.3 of the AA reverses the burden of proof and provides that:
“Any Member which claims that any quantity exported in excess of a reduction
commitment level is not subsidized must establish that no export subsidy, whether
listed in Article 9 or not, has been granted in respect of the quantity of exports in
question.”
4.1292  The European Communities therefore claimed that it is for the United States to prove that its
agricultural products for which there were reduction commitments were exported without the benefitof FSC subsidies.
4.1293  The European Communities chose four products which the United States has been exporting
to the European Communities since 1995 in respect of which it invited the United States to provide
the required proof.  These are maize, soybeans, and cotton, for which the United States has scheduled
no reduction commitments and wheat in respect of which there are reduction commitments.  Thefactual background and the available data on United States exports were set out in Section III.C.3 and
Exhibit EC-16 of the European Communities' First Written Submission.
4.1294  The United States has in effect rejected the invitation to provide the proof required by
Article 10.3 of the AA. It makes three points:
• It repeats that the FSC does not give rise to export subsidies within the meaning of
the AA and adds in the alternative that the European Communities has not provedthis.
• Article 10.3 does not shift the evidentiary burden where the exported product either
does not appear in Section II, Part IV of the Member’s schedule or the quantity
reflected in the schedule is zero.
• The only agricultural product identified by the European Communities for which the
United States has a positive reduction commitment is wheat and therefore if the
burden of proof shifts to the United States at all under Article 10.3, it shifts only with
respect to wheat.
4.1295  The European Communities need not comment fu rther on the first point about whether the
FSC subsidies are export subsidies for the purpose of the AA.
4.1296  On the second point, there is a further major legal disagreement. The United States does not
appear to disagree that it is not allowed to give any export subsidies for maize, soybeans or cotton
issue, but argues that a shift the evidentiary burden occurs only when the quantity reflected in the
schedule is a specific positive amount.  It supports this by selective and misleading quotation formArticle 10.3 of the AA.  The European Communities will remedy this and show the United States is
wrong by re-quoting the provision emphasizing the parts it has omitted.
“Any Member which claims that any quantity  exported in excess of a reduction
commitment level is not subsidized must establish that no export subsidy, whether
listed in Article 9 or not, has been granted in respect of the quantity of exports inquestion.”
4.1297  The European Communities sees no reason why a “reduction commitment level” should not
be or become zero.  Why should the reversal of the burden of proof disappear as soon as the reduction
commitment has reached zero?  It is after all easier for the Member concerned to prove that theWT/DS108/R
Page 221
exported quantities did not benefit from any subsidies if the commitment is zero than if it is a positive
number.  Also a zero commitment is more valuable to other Members and it is therefore more
important that it be properly respected.
4.1298  On the third point, the European Communities notes that the United States accepts that it has
reduction commitments, does not deny that it exports more than its reduction commitment asindicated in Exhibit EC-16, but does not attempt to prove that these amounts are not subsidised.
The United States  further responds in its Oral Statement at the First Meeting of the Panel as follows:
4.1299  Finally, the FSC does not violate the export subsidy provisions of the AA.  As explained in
the First US Submission, the FSC does not fall under any of the categories of export subsidies setforth in Article 9.1 of the AA, including Article 9.1(d).  With respect to the general definition of
export subsidy in Article 1(e) of the AA, the Panel must, absent anything to the contrary in the AA,
interpret Article 1(e) in light of the relevant provisions of GATT 1994 and the SCM Agreement.  In
the view of the United States, for the reasons previously explained, the FSC does not constitute a
subsidy, let alone an export subsidy, under those provisions.  Accordingly, the FSC does notconstitute an export subsidy for purposes of the AA.
4.1300  With respect to the AA, the European Comm unities' claim that the US interpretation of
Article 9.1(d) would allow direct payments to cover marketing expenses to go unremedied is specious
and raises a non-existent problem.  Direct paymen ts are covered by Article 9.1(a), and the Panel
should not distort the plain text of Article 9.1(d) to solve a non-problem.
The European Communities  further rebuts the United States' response in its Second Submission as
follows:
Introduction
4.1301  The European Communities has explained that the FSC scheme also violates Articles 3 and 8
of the AA read in conjunction with its Articles 9.1(d), 10.1, and 10.3 of the AA.  The EuropeanCommunities presented two lines of argument; the first based on the assumption that FSC subsidies
fall under Article 9.1(d) of the AA
553 and the second on the assumption that they do not554.
4.1302  The United States made a number of arguments in reply to which the European Communities
provided an initial response at the First Meeting of the Panel555. The European Communities will
simply refer the Panel to those arguments and not repeat them now except to the extent needed torespond to the arguments of the United States.
4.1303  The European Communities has a number of additional points to make.
The Meaning of the Term "Subsidy" in the AA
4.1304  The United States argues
556 that since there is no definition of the term “subsidy” in the AA
this term should be interpreted in the light not only of the SCM Agreement but also of Article XVI
GATT.  It then rather peremptorily concludes557 that it is therefore “obvious” that the FSC is not an
export subsidy for the purposes of the AA.
4.1305  The European Communities considers that the te rm “subsidy” used in the AA must have the
meaning given to it by Article 1 of the SCM Agreement.  That Article defines the term subsidy for all
                                                     
553 Paragraphs 183-188.
554 Paragraphs 189-191.
555 Paragraphs 96 to 113 of the European Communities' Statement to the First Meeting of the Panel.
556 Paragraph 170 to 174 of the US First Written Submission
557 Paragraph 174 of the US First Written Submission.WT/DS108/R
Page 222
the purposes of the SCM Agreement and Article 3.1(a) contains an exception for export subsidies
allowed by the AA.  The subsidies thus excepted must be the same as the measures which are allowed
by the AA and thus the word subsidy must have the same scope and meaning in both Agreements.
4.1306  The only difficulty that the European Communities can perceive with this approach is that the
term “subsidy” used in the AA would cover both specific and non specific subsidies.  However thisproblem does not arise since the AA only uses the term subsidy in connection with export subsidies.
4.1307  The United States does not explain how the definition of subsidy in Article XVI GATT would
be different but it is clear from both the interpreta tive note to Annex 1A to the WTO Agreement and
the negotiating history (the AA and the SCM Agreement were negotiated in parallel) that if there is
any conflict between the definitions to be used fo r the purposes of the AA, the definition in the SCM
Agreement must prevail.
4.1308  The European Communities would add that the definition of an export subsidy for the
purpose of the AA is simply a subsidy which is contingent upon export performance and these are
deemed to include those listed in Article 9 but not those contained in the Illustrative list in Annex I to
the SCM Agreement.  Therefore the United States contextual argument in paragraph 180 of its FirstWritten Submission appears misconceived.  For the purposes of the AA, the WTO members did not
wish to distinguish between the export subsidies delivered through the tax system and in other ways.
4.1309  Accordingly, the FSC subsidies are export subs ides for the purposes of the AA for the same
reason that they are subsidies under the SCM Agreement and are demonstrated to be contingent upon
export performance for the purposes of that agreement.
Article 9.1(d) of the AA
4.1310  In its Statement to the First Meeting of th e Panel, the European Communities refuted the
United States that the FSC scheme reduces tax liability, not marketing costs and that “costs incurred
by a firm for marketing expenses do not change depending upon whether or not the firm files an
income tax return as a FSC.”
558
4.1311  The European Communities argued that the existence of a subsidy must surely be independent
of the means by which it is delivered. It would add that this is in fact clear from the rest of
paragraph (d) where it is expressly provided that  reducing the costs of international transport and
freight is an example of the ways  in which marketing costs can be reduced.
4.1312  The European Communities further argued that FSC subsidies when applied to agricultural
products are by their nature related to the distribution or marketing of the products.  Marketing meansadvertising, sales promotion and solicitation and these are all activities which the FSC is required to
perform (or be responsible for).
559
4.1313  The United States preliminary reply at the First Meeting of the Panel was merely to say that
direct payments are covered by paragraph 9.1(a).  This is true only to the extent that they are
contingent upon exports and satisfy the other conditions of that provision.  Article 9.1(d) has aseparate purpose, to bring subsidies which reduce the costs of marketing exports under the disciplines
of Article 9.  That purpose applies whatever the means by which the subsidy is delivered.
US rejection of burden of proof that it is not circumventing its commitments under
Article 10.3 of the AA
4.1314  The United States attempted to avoid the European Communities' alternative claim under
Article 10.1 of the AA by simply rejecting the burden of proof that Article 10.3 of the AA provides
                                                     
558 Paragraph 179 of the US First Written Submission.
559 See Sections 924(e)(1) and 924 (d)(1)(A) IRC.WT/DS108/R
Page 223
that a Member must bear if it claims that any quantity exported in excess of a reduction commitment
level is not subsidised.  Curiously it did not even atte mpt to fulfil its burden of proof in respect of wheat
for which it accepted that it had reduction commitments.
4.1315  The European Communities replied to the United  States’ arguments at the First Meeting of
the Panel and since the United States has made no further argument, has nothing to add at present.
The United States  further responds in its Second Submission as follows:
4.1316  With respect to the European Communities' claim that the FSC violates United States
obligations under the AA, the United States previously has demonstrated that the FSC does not
constitute an export subsidy for purposes of the AA.560  In this section, the United States will comment
briefly on arguments made by the European Communities at the first meeting of the Panel.
4.1317  First, the European Communities does not appear to contest the fact that GATT Article XVI
is relevant for purposes of interpreting the export subsidy provisions of the AA.561  It acknowledges
the United States argument that Article XVI is relevant, and rather than disputing that argument, it
simply draws different conclusions than does the United States from the Article XVI precedents.
4.1318  Second, in support of its assertion that the FSC falls under Article 9.1(d) of the AA, the
European Communities argues that if this were not the case, “a direct grant to companies marketing
agricultural products would escape Article 9.1(d) ... .”562  However, as previously noted by the
United States, a direct grant would be covered by Article 9.1(a), and the Panel should not distort the
plain meaning of Article 9.1(d) in order to solve a non-existent problem.563
4.1319  Third, with respect to the European Communities' reliance on Article 10.3 of the AA, the
United States again notes the inconsistency between the European Communities' reliance on thisprovision and its position with respect to the fourth sentence of footnote 59.  The European
Communities asserts that it was not required to raise its concerns regarding the FSC administrative
pricing rules in an appropriate tax forum because the fourth sentence of footnote 59 is not identified as
a special or additional rule and procedure under the DSU.  However, Article 10.3, on which the
European Communities relies, also is not identified as a special or additional rule and procedure underthe DSU.
4.1320  Finally, the European Communities takes issue with the United States argument that
Article 10.3, at most, shifts the burden of proof with respect to scheduled products, arguing instead
that it “sees no reason why a ‘reduction commitment level’ should not be or become zero.”
564  The
simple answer to the European Communities is that the plain text of Article 10.3 limits its applicationto products for which a Member has a “reduction commitment level.”  Pursuant to Article 3.3, these
levels are specifically set forth in a Member’s Schedule.  The reduction commitments contained in a
Member’s Schedule show how the particular Member promised to reduce  the level of budgetary
outlays, as well as the volume of exports of specified products made with the benefit of export
subsidies during the implementation period.  The plain meaning of “reduction” presumes a positivequantity that can be reduced.  The plain meaning does not encompass a Member’s commitment to
continue not to subsidize agricultural products not being subsidized.  This latter commitment is not a
promise to reduce  quantities or budgetary outlays, but a promise to maintain the status quo .
4.1321  Moreover, the other main export subsidy provision of the AA which refers to reduction
commitment levels – Article 9 – further supports the interpretation of “reduction commitment levels”
as being limited to scheduled quantity commitments made on specified products.  As written, the
                                                     
560  First US Submission, paragraphs 169-180.
561  EC Oral Statement, paragraphs 98-99.
562  EC Oral Statement, paragraph 102.
563  US Oral Statement on the Merits, paragraph 38.
564  EC Oral Statement, paragraph 112.WT/DS108/R
Page 224
provisions of Article 9 do not make sense if “reduction commitment levels” is interpreted to refer to
the type of “zero commitment” Members made with regard to agricultural products not benefiting
from export subsidies.
4.1322  Article 9.1 provides that “[t]he following export subsidies are subject to reduction
commitments  under this Agreement . . .” (emphasis added), and goes on to list the six general types of
export subsidies, the products, quantities and outlays which had to be listed on Members’ Schedules.
On its face, Article 9.1 links “reduction commitments” to specific export subsidies, a definition that
does not encompass the kind of “zero” commitment Members undertook on all non-subsidized
exports.
4.1323  Likewise, Article 9.2(b)(ii) allows Members to provide export subsidies in excess of the
corresponding annual commitment levels (read “reduction commitment levels”), provided that “the
cumulative quantities exported with the benefit of such export subsidies . . . does not exceed the
cumulative quantities that would have resulted from full compliance with the relevant annual quantity
commitment levels specified in the Member’s Schedule by more than 1.75 per cent of base period
quantities.”  The formula in Article 9.2(b)(ii) implicitly presumes a positive quantity of subsidizedexports; otherwise, the “1.75 per cent of based period quantities” rule would make no sense in those
situations where a Member’s commitment is zero subsidized exports and the Member had positive
base period quantities of actual exports.
4.1324  With respect to the European Communities' claims under the AA, the European Communities
has failed to provide a coherent theory of how the FSC could be deemed an export subsidy for
purposes of the AA, and the European Communities has adduced no evidence that could support any
such theory.  Furthermore, the European Commun ities' contention that the FSC reduces the costs of
marketing exports is inadequate to show a viol ation of the Agreement in view of the text of
Article 9.1(d).
4.1325  Similarly, with respect to the European Comm unities' claims under Article 10 of the AA, the
European Communities has failed to establish that the FSC constitutes an export subsidy under
Article 1(e) of the Agreement, a necessary prerequisite.  The European Communities' attempts toevade its burden of proof through resort to Article 10.3 should be equally unavailing.  At most,
Article 10.3 shifts the burden to the responding Member to establish that products exported in excess
of a reduction commitment level did not benefit from the challenged measure or that the measure is
not an export subsidy.  In any event, even if Article 10.3 is considered as shifting the initial burden of
making a prima facie  case to the defending Member, the United States has shown that the FSC does
not amount to an export subsidy under the AA, thereby shifting the burden of proof to the European
Communities.
The European Communities  further rebuts the United States' response in its Oral Statement at the
Second Meeting of the Panel as follows:
Introduction
4.1326  The United States only makes two points in its Second Written Submission on the AA which
are not already dealt with in the European Communities' Second Written Submission.
4.1327  The first is that Article 10.3 of the AA is not mentioned as a special or additional rule of
procedure in Appendix 2 to the DSU.  The second is a continuation of its argument that Article 10.3
does not apply to “zero commitments.”  These will dealt with in order.
Article 10.3 of the AA not being included in Appendix 2 of the DSU
4.1328  The United States finds that the European Communities is inconsistent in arguing on the one
hand that the third sentence of footnote 59 cannot be a rule of jurisdiction or include an additional
precondition to dispute settlement because it is not mentioned in Appendix 2 and on the other handWT/DS108/R
Page 225
that Article 10.3 of the AA reverses the burden of proof in the case that a Member argues that its
exports exceeding the reduction commitment level are not subsidised.
4.1329  This argument is easily disposed of.  According to Article 1.2 DSU, Appendix 2 lists the
special or additional rules and procedures which de rogate from those in the DSU.  The DSU contains
no rule or procedure on the burden of proof for establishing whether there is a violation of a coveredagreement and therefore it was not appropriate to list Article 10.3 as a derogation.  The DSU however
does contain rules and procedures on when disputes may be brought before a panel and if the third
sentence of footnote 59 were a derogation from this it would have been listed in Appendix 2 DSU.
Application of Article 10.3 of the AA to Zero Commitment Levels
4.1330  The United States has rejected the burden of proof that Article 10.3 of the AA provides that a
Member must bear if it claims that any quantity exported in excess of a reduction commitment level is
not subsidised.  As the European Communities pointed out in its Second Written Submission, the
United States has not even attempted to fulfil its burden of proof in respect of products for which it
does have positive reduction commitments such as wheat !
4.1331  The United States’ argument as developed in its Second Written Submission is that
• Zero is not a “level” and the plain meaning of “reduction” presumes a positive
quantity that can be reduced not a promise to maintain the status quo ;
565
• Article 9 refers to “reduction commitment levels” in connection with specific
subsidies and this makes no sense for products for which no subsidies are allowed;566
•  Article 9.2(b)(ii) allows Members to provide export subsidies in excess of the
corresponding annual commitment levels provided that “the cumulative quantities
exported with the benefit of such export subsidies . . . does not exceed the cumulativequantities that would have resulted from full compliance with the relevant annual
quantity commitment levels specified in the Member’s Schedule by more than 1.75
per cent of base period quantities.”  According to the United States 1.75 per cent of
zero makes no sense.
567
4.1332  In making this argument, the United States is ignoring Article 3.3 of the AA, which provides
first that
“a Member shall not provide export subsidies listed in paragraph 1 of Article 9 in
respect of the agricultural products or groups of products specified in Section II of
Part IV of its Schedule in excess of the budgetary outlay and quantity commitment
levels specified therein”
4.1333  This makes clear that what the Agreement sometimes calls “reduction commitments” (and
sometimes “annual commitments”) are more precisely budgetary outlay and quantity commitment
levels.   Article 3.3 goes on to provide that agricultural products not listed in the Schedule should be
treated as having a “zero commitment”, saying that a Member:
“shall not provide such subsidies in respect of any agricultural product not specified
in that Section of its Schedule .”
4.1334  The European Communities also recalls that Article 10.3 provides that:
                                                     
565 Paragraph 156 of the US Second Written Submission.
566 Paragraph 157-8 of the US Second Written Submission.
567 Paragraph 159 of the US Second Written Submission.WT/DS108/R
Page 226
“Any Member which claims that any quantity  exported in excess of a reduction
commitment level is not subsidized must establish that no export subsidy, whether
listed in Article 9 or not, has been granted in respect of the quantity of exports in
question.”
4.1335  The European Communities submits that zero is  a “level”.  A reduction commitment of zero
can be easily understood as an obligation to reduce the quantity to zero and to keep it there .  The first
part of the obligation (reduce) makes no sense without the second (keep it there).  There is no reason
for the obligations of the parties to change radically at the moment the amount of the reduction
commitment reaches zero.
4.1336  As regards Article 9, the European Communities simply notes that where there is a zero
commitment, Article 9 becomes a simple prohibition on granting the listed subsidies as well as others
and the fact that 1.75 per cent of zero is also zero causes no problem in applying Article 9 to zero
commitment levels. There is simply no margin of  tolerance allowed when the reduction commitment
level is zero.
Conclusion
4.1337  Since the United States has not made any attempt to show that Agricultural products that are
exported in excess of reduction commitment levels (including the zero commitment level applying to
non-scheduled products by virtue of Article 3.3) do not benefit from FSC subsidies to an extent
exceeding the commitment level, the European Co mmunities submits that the Panel should find that
the United States has violated Articles 3 and 8 of the AA read in conjunction with its Articles 9(1)(d),
10(1) and 10(3) AA.
The European Communities  argues as follows in response to a question from the Panel following
the Second Meeting of the Panel:
4.1338  The European Communities argues both.568
                                                     
568 Paragraphs 4.1338-4.1346 reflect the European Communities' response to the following question
from the Panel: In the written version of its oral statement at the first meeting of the Panel, theEuropean Communities stated that its first submission should read as follows:
"The European Communities requests that the Panel find that, by maintaining the tax exemptions and
special administrative pricing rules contained in the FSC scheme, the US has violated . . . Articles 3 and 8 read
in conjunction with Articles 9.(1)(d), 10(1), and 10(3) of the Agreement on Agriculture by granting export
subsidies to agricultural products in excess of its reduction commitments  under that Agreement (e.g. wheat,
maize, soya beans, and cotton)." (emphasis added).
In response to an oral question from the Panel, the European Communities stated that:
"Our request to you is to find that the application of FSC subsidies to agricultural products, for
which there are reduction commitments . . . is a violation of the Agreement.  This ismandatory legislation , anybody who wants to export any agricultural product is entitled to the
FSC subsidy, and therefore the recommendation should be to remove the possibility of the
FSC subsidy being given to any agricultural product for which there is a reduction
commitment."
With respect to the Agreement on Agriculture, could the European Communities please clarify whether
it is arguing:
(a) that a violation arises to the extent that FSC subsidies are in fact  granted to agricultural products
that are exported in excess of US reduction commitments (without prejudice to who bears the
burden of proof on that point); orWT/DS108/R
Page 227
4.1339  Article 8 of the AA makes clear that Members must not grant “export subsidies otherwise
than in conformity with this Agreement” (which is also stated in Article 3.1).
4.1340  The principal provision of the Agreement that allows export subsidies are Article 9 (within
the reduction commitments – i.e. budgetary outlay and quantity commitment levels – referred to in
Article 3.3).  There may be other authorisations but the European Communities does not see any thatare relevant and the United States has not argued that there are any.
4.1341  The fact that no other export subsidies than those allowed by the AA may be granted for
agricultural products is also evident from the fact that the SCM Agreement prohibition on export
subsidies is only disapplied for those subsidies which are allowed by the AA (see opening words of
Article 3.1).
4.1342  Thus, if the FSC subsidies are not covered by Article 9.1(d) of the AA (and this is the
United States position), then, they are not allowed at all for agricultural products and, as the Panel
puts it in point (b), “the availability of the FSC sc heme with respect to any agricultural products is in
itself a violation of the Agreement on Agriculture”.
4.1343  Article 10.3 does not seem to lose its applicability even in this case, as the Member claiming
that the quantity exported in excess of a reduction commitment level is not subsidised must establish
that no subsidy has been granted. However, in the case of an subsidy, such subsidy could not be
considered legal even if it did not exceed the limits set in the Schedule.
4.1344  Problems of fact as suggested in point (a) of the question only arise if the FSC subsidies do
fall under Article 9.1(d).  It could then be that the amount of the subsidies granted or the quantity
exported with the benefit of the FSC subsidies exceed the limits specified in the US Schedule (which
as the European Communities has explained may be zero for some products).  This entails a violationof Articles 3 and 8 as indicated above.
4.1345  Given the fact that there are agricultural products for which the United States has a
commitment of zero level the mandatory availability of FSC to any agricultural product (i.e. the fact
that anybody who wants to export any agricultural produ ct is entitled to FSC subsidies) is in itself a
violation of Articles 3 and 8.
4.1346  Article 10.3 does also on its face apply in the case of exports of agricultural products
benefiting from export subsidies other than those described in Article 9 but this then gives rise to an
obligation on the United States to prove that the FSC scheme does not give rise to export subsidies
within the meaning of the AA.  Since the Euro pean Communities has demonstrated that the FSC
scheme does give rise to export subsidies within the meaning of the SCM Agreement and that theyshould therefore be considered export subsidies for the purpose of the AA, this reversal of burden of
proof probably becomes academic in respect of exports of agricultural products benefiting from
export subsidies other than those allowed by the AA.
The United States  argues as follows in response to a question from the Panel following the Second
Meeting of the Panel:
4.1347  The United States will not comment on what the European Communities is arguing.
However, in the view of the United States, the text of the Agreement makes clear that the mere
availability of an export subsidy does not constitute a violation of the AA.
569
                                                                                                                                                                    
(b) that the availability of the FSC scheme with respect to any agricultural products is in itself a
violation of the Agreement on Agriculture?
569 Paragraphs 4.1347-4.1350 reflect the United States' comment on the following question to the
European Communities from the Panel: In the written version of its oral statement at the first meeting of the
Panel, the European Communities stated that its first submission should read as follows:WT/DS108/R
Page 228
4.1348  Article 3.3 of the AA, for example, provides  that a Member “shall not provide export
subsidies . . . in excess of the budgetary outlay and quantity commitment levels specified [in the
Member’s Schedule].”  This language clearly contemplates that a Member may provide export
subsidies, and violates its obligations only if the amount of export subsidies provided exceeds that
Member’s commitment levels.  This language is inconsistent with the notion that the mere availabilityof an export subsidy violates the AA.
4.1349  Likewise, while the United States does not agree with the European Communities that the
FSC system is described by any of the paragraphs of Article 9.1, the language of Article 9.2
nevertheless indicates that the mere availability of a subsidy is not enough.  For example,
Article 9.2(a)(ii) refers to the “quantity . . . in respect of which such export subsidies may be grantedin that year.”
4.1350  In a similar vein, Article 10.1 states that “[e]xport subsidies not listed in paragraph 1 of
Article 9 shall not be applied  in a manner which results in, or which threatens to lead to,
circumvention of export subsidy commitments ... .”  (Emphasis added).  Article 10.3, which the
European Communities has asserted is relevant to this  dispute, refers to the need to “establish that no
export subsidy . . .  has been granted  in respect of the quantity of exports in question.”  (Emphasis
added).  The use of the word “applied” and the phrase “has been granted” is also inconsistent with the
notion that the mere availability of an export subsidy violates the AA.
E. 
ARGUMENTS RELATING TO THE PANEL 'S RECOMMENDATIONS
The European Communities  argues as follows:
4.1351  Article 4.7 of the SCM Agreement provides as follows:
“If the measure in question is found to be a prohibited subsidy, the panel shall
recommend that the subsidizing Member withdraw the subsidy without delay.  In this
regard, the panel shall specify in its recommendation the time-period within which
the measure must be withdrawn.”
                                                                                                                                                                    
"The European Communities requests that the Panel find that, by maintaining the tax
exemptions and special administrative pricing rules contained in the FSC scheme, the US hasviolated . . . Articles 3 and 8 read in conjunction with Articles 9.(1)(d), 10(1), and 10(3) of the
Agreement on Agriculture by granting export subsidies to agricultural products in excess of
its reduction commitments  under that Agreement (e.g. wheat, maize, soya beans, and cotton)."
(emphasis added).
In response to an oral question from the Panel, the European Communities stated that:
"Our request to you is to find that the application of FSC subsidies to agricultural products, for
which there are reduction commitments . . . is a violation of the Agreement.  This is
mandatory legislation , anybody who wants to export any agricultural product is entitled to the
FSC subsidy, and therefore the recommendation should be to remove the possibility of theFSC subsidy being given to any agricultural product for which there is a reductioncommitment."
With respect to the Agreement on Agriculture, could the European Communities please clarify whether
it is arguing:
(a) that a violation arises to the extent that FSC subsidies are in fact  granted to agricultural products
that are exported in excess of US reduction commitments (without prejudice to who bears theburden of proof on that point); or
(b) that the availability of the FSC scheme with respect to any agricultural products is in itself a
violation of the Agreement on Agriculture?WT/DS108/R
Page 229
4.1352  The European Communities recognises that the principle of immediate withdrawal may be
difficult to apply in the present case. It submits that a reasonable period of time for withdrawal of the
two FSC subsidies would be until the beginning of the next tax year (fiscal 2000) and requests the
Panel to recommend accordingly.
4.1353  The European Communities requests the Panel to  recommend that the United States withdraw
the two FSC subsidies before the beginning of the next tax year (fiscal 2000).
The United States  responds as follows:
4.1354  The European Communities, invoking Article 4.7 of the SCM Agreement, stated “that a
reasonable period of time for withdrawal of the tw o FSC subsidies would be until the beginning of the
next tax year (fiscal 2000)” and requested “the Panel to recommend accordingly.”570
4.1355  In the view of the United States, there are se veral factors that go into any determination
concerning the amount of time reasonably necessary to implement a panel’s recommendations and
rulings.  Among these are:  (a) the legal form of implementation ( e.g., legislation, regulation, decree,
etc.); (b) the period of time in which the implementing Member can achieve the proposed legal formof implementation, assuming that the Member applies itself in good faith; and (c) the nature of the
legislative or regulatory change to be made.
4.1356  At this time, it is difficult to assess these factors because the Panel has not yet made findings
as to how, if at all, the FSC violates any United States obligations under the SCM Agreement or the
AA.  Thus, it is particularly difficult to assess the third factor cited above – the nature of the
legislative or regulatory change to be made – without knowing what that change, if any, may be.
4.1357  In light of this, and recognizing that Article 4.7 requires the Panel to make a recommendation
regarding the time period in which a measure must be withdrawn, the United States submits that a
more orderly approach would be to use the interim review stage under Article 15 of the DSU as a
vehicle for the parties to comment on the time to be allowed for implementation, should any
implementation be required.  The Panel then could take these comments into account for purposes of
making a recommendation in its final report.
4.1358  Having said that, the United States nevertheless has some initial comments on the
European Communities' suggestion.  First, as previously noted
571, because the European Communities
has invoked Article 4.7, a special or additional rule  that benefits the complainant, then it becomes
even more important that the Panel not let the European Communities' violation of Article 4.2, a
special or additional rule that benefits the defendant, go unremedied.
4.1359  Second, in the United States, fiscal year 2000 begins on October 1, 1999.  Should there be an
appeal of this Panel’s findings, that appeal undoubtedly would be pending as of October 1, 1999.
Therefore, the European Communities' suggestion clearly is inappropriate and unrealistic.
4.1360  Third, because the only measure properly before this Panel is the FSC statute itself, any
changes to that statute would have to be made by legislative, rather than administrative, means.  Asprevious arbitrators have recognized in proceedings under Article 21.3(c) of the DSU, where
legislative means are required, a longer period of time may be necessary than would be the case if
administrative means could be used.
572
The European Communities  rebuts the United States' response as follows:
                                                     
570  EC Oral Statement, paragraph 120.
571  Oral Statement of the United States on the Merits (9 February 1999), paragraph 39.
572 See, e.g.,  Australia - Measures Affecting Importation of Salmon , WT/DS18/9, Award of the
Arbitrator issued 23 February 1999, paragraph 38, citing to EC Measures Concerning Meat and Meat Products
(Hormones) , WT/DS26/15, WT/DS48/13, Award of the Arbitrator issued 29 May 1998, paragraph 25.WT/DS108/R
Page 230
4.1361  The European Communities has submitted that a reasonable period of time for withdrawal of
the two FSC subsidies would be un til the beginning of the next tax year (fiscal year 2000).  The
United States  responds that in the United States  fiscal year 2000 begins on 1 October 1999 and that
an appeal may be pending at that time.  It also argues that abolishing the FSC will require legislativeaction and that this will take a longer time than administrative action.
4.1362  Accepting the plausibility of these arguments, the European Communities requests that the
Panel fix two alternative dates for withdrawal. In the absence of an appeal the United States will have
the final Panel Report on 6 July 1999 and should be able to revise its legislation before
1 October 1999.  In the event of an appeal, the United States should be required to withdraw the FSCsubsidies by 1 October 2000 (which is presumably the beginning of its fiscal year 2001).  Since tax
legislation is revised every year, there should be no difficulty in the United States modifying its
legislation by that date.
F. 
CONCLUDING ARGUMENTS
The United States  argues in its First Submission as follows:
Institutional and Process Considerations, as well as the Facts and the Law, Warrant a
Rejection of the European Communities' Claims
4.1363  In the view of the United States, both the legal principles applicable to the
European Communities' claims and the factual evidence before the Panel warrant a ruling in favor of
the United States on the merits.  As discussed above, the European Communities' main legalarguments fail to correctly identify the controll ing legal standard, and its case is accordingly
predicated on a wishfully simple, but legally incorrect, predicate.  Beyond that, the
European Communities' case is barren of factual support, as is evidenced by both the
European Communities' failure to cite supporting evidence during consultations and its failure to
adduce factual support in its First Submission.
4.1364  Beyond the merits, however, there are additional considerations that argue in favor of a
decision rejecting the European Communities' claims.  The first is found in a highly unusual provision
in the SCM Agreement; namely, the language in footnote 59 indicating that disputes of the type raised
here should be addressed, in the first instance, in an appropriate international tax forum.  This
remarkable, explicit provision reflects an institutional preference, borne of previous forays into issuesof fundamental tax policy, to defer on such issues to institutions that have been designed, and are
better equipped, to address technical tax issues than is the world’s pre-eminent trade forum.  The
admonition in footnote 59 applies to the substance of this dispute and should not be lightly
disregarded.
4.1365  In addition, were this Panel to render a decision abandoning the principle that economic
activities occurring outside the taxing authority’s territory need not be taxed, it would undercut the
historic 1981 Council Decision that resolved an acrimonious, parallel dispute under the GATT 1947.
For more than 17 years, the United States and other Members, including European Communities
member States, have relied on that decision, and a decision now to disavow the principle on which the
GATT Council ultimately resolved the Tax Legislation Cases  would harm the WTO dispute
settlement process and the WTO.  WTO “rules” would be perceived as ephemeral standards on which
governments and private parties could rely only at their peril and re-litigate at their pleasure.
4.1366  Finally, any decision rejecting or qualifying the principle that economic processes occurring
outside a taxing authority’s territory may, but n eed not, be taxed would upset the finely calibrated
bargain reflected in the 1981 Council Decision and the SCM Agreement, both of which incorporate
that principle.  That principle expressly recognizes that different Members have different tax systems
and that the WTO Agreement  does not impose on any Member the obligation to adopt a territorial tax
system over a global one, or vice versa.  Disturbing the compromise solution achieved in 1981 andWT/DS108/R
Page 231
thereafter would effectively return the parties to the status quo ante  that existed prior to the 1981
Council Decision.  That would mean that features of both European tax systems and the US FSC –
both of which enjoy disciplined protection under the 1981 Council Decision – would again be at risk,
as would the welfare of the private firms that have planned their activities on the basis of those
features.  Invalidating the 1981 solution would raise anew the vexing policy questions of how best to
reconcile differing national tax systems under international trade rules that were designed to deal with
national trade practices, not issues of national tax policy.
The European Communities  argues in its Oral Statement at the First Meeting of the Panel as
follows:
4.1367  The United States finally makes some comments573 on what it calls “institutional and process
considerations” as to why the Panel should dismiss the European Communities' claims. Apart from
repeating its previous position on the merits, it pretends in almost emotive language that the Decision
adopting the reports on the Tax Legislation Cases  and footnote 59 to the SCM Agreement is a “finely
calibrated bargain” and that upsetting it would “harm the WTO dispute settlement process and theWTO”.
4.1368  As the European Communities has explained at some length today and will no doubt have to
repeat, the 1981 decision is not applicable an d that it and footnote 59 do not say what the
United States claims or would wish them to say.  If the “controlling legal standard” of the
United States was really so important, the United States has had ample opportunity since 1981 to
attempt to negotiate it.
4.1369  It is also quite clear that the European Communities and at least seven other WTO Members,
who participated in the GATT 1947 dispute settlement consultations in 1985, did not share the view
of the meaning of the “bargain” that the United States now claims to have.
4.1370  The FSC subsidies are clear prohibited subsidies under the WTO SCM Agreement. The
pretended tax complexities are nothing but a fig leaf  behind which the United States seeks to hide its
violations. For the European Communities and, we trus t, the Panel, the matter is clear.  Exemptions
from direct taxes are export subsidies at least when specifically related to exports.  No tax system is
going to be undermined by having to adopt principles and rules which are of general applicability and
being required not to specifically exempt exports.
4.1371  The danger to the WTO dispute settlement process and the WTO lies not in upholding the
agreed rules of the SCM Agreement but in allowing a powerful Member to escape its disciplines.
The United States  argues in its Second Submission as follows:
A Decision Against the FSC Would Ensnarl the WTO in Issues of Fundamental Tax
Policy, Invite Additional Tax Policy Disputes, and Undercut the Reasonable Expectations
of Members that Relied on the 1981 Council Decision
4.1372  For the reasons discussed above, it is the view of the United States that, as a matter of law,
this case should either be dismissed or, if decided on the merits, decided against the European
Communities.  It is also the view of the United States that such an outcome is also supported by
considerations of sound trade policy and trade policy administration.
4.1373  Given the multiplicity of issues presented to the Panel, this case could be resolved on a
number of possible grounds, either procedural or substantive.  A ruling that the FSC is contrary to
WTO principles could, in the view of the United States, have far-reaching reverberations.  Such a
decision could carry profound implications for national tax systems, including territorial systems, and
could enmesh the WTO in a range of technical issues relating to national tax policy.  Although certain
                                                     
573 Paragraphs 196-199 of the US First Written Submission.WT/DS108/R
Page 232
tax measures, such as discriminatory provisions that protect or subsidize a favoured national industry,
may offend WTO subsidy rules and may be easy to resolve, broad questions of international tax
policy and the structure of national tax systems are less clearly a matter for WTO adjudication or
harmonisation.
4.1374  The tax policy issues raised by this challenge are fundamental ones.  Although the European
Communities seeks to invoke a broad principle against the United States from which it appears to
claim immunity for itself and its member States, WTO principles must apply equally to all Members,
and, to the extent possible, distinctions should not be maintained that are based on form over
substance.  Any WTO principle applicable to worldwide tax systems must also be applicable to
territorial tax systems, and the effects that are inherent in a territorial system cannot be distinguishedfrom parallel effects incorporated into worldwide systems in an effort to achieve parity.
4.1375  In this case, a decision rejecting the 1981 GATT Council principle that income from foreign
economic activities need not be taxed would unavoidably prompt additional cases invoking that same
principle against “territorial” systems, as the Tax Legislation Cases  did in the 1970s.  The unavoidable
result of either a series of rulings against both worldwide and territorial systems or of asymmetricalresults would necessarily be to force renegotiation of WTO principles affecting the ability of
Members to structure their national tax systems and to achieve rough parity with systems that are
structured differently.  Not only would such a controversy reopen the principle that Members are not
obligated to tax income from foreign economic activity, but it also would be likely to reopen
traditional, if conceptually dubious, GATT distinctions between direct and indirect taxes and the
border tax adjustment practices that relate to them.
4.1376  In the view of the United States, it is doubtful that such a scenario would advance the interests
of the international trading system or that th e still young WTO would be the optimum forum for
undertaking so fundamental a review of national tax policies.  That the scale of such an undertaking is
incompatible with the timetable Members have established for WTO panels is reflected in the
language in footnote 59 indicating that the WTO shou ld not be the forum for considering such issues,
at least not before being considered in an appropriate tax forum.
4.1377  Finally, a decision against the FSC would directly undercut the 1981 Council Decision on
which both the United States and European countries have since relied.  It was the principles
articulated in that decision on which the US C ongress in good faith relied in designing the FSC.
Absent a compelling showing that the Members intended to discard the principles of the Council
Decision – and the European Communities has made no such showing – this Panel should be loath to
read this historic decision out of the SCM Agreement, particularly in light of the WTO provisions
designed to assure continuity between the GATT and the WTO regimes.  Among the risks of doing so
is opening the door for Members to relitigate matters that have otherwise become settled principles
under the GATT and the WTO.
4.1378  In short, it is the view of the United States that the legal arguments set forth above
conclusively point to a Panel decision to dismiss European Communities' claims or to reject them on
the merits.  These legal arguments are reinforced by policy considerations relating both to the
effective administration of WTO rules and dispute settlement processes and to the optimum
examination of issues involving the interface between national tax systems.
The European Communities  argues in its Oral Statement at the Second Meeting of the Panel as
follows:WT/DS108/R
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4.1379  The United States makes some more comments574 seeking to scare the Panel into deciding in
its favour by arguing that a decision in the European Communities' favour would “ensnarl” or
“enmesh” the WTO in a range of  technical issues relating to tax policy.
4.1380  The European Communities must protest against these tactics.
4.1381  The WTO SCM Agreement clearly provides that direct tax practices are subject to its
disciplines. Indeed subsidies granted through tax systems are regularly countervailed by the
United States in particular. Why should clearly export contingent and local content contingent
subsidies escape the agreed disciplines on export subsidies simply because they are part of the tax
system of a powerful Member ?  Far from damaging the “still young WTO,” a correct decision by the
Panel in this case will restore confidence of Members that the agreed disciplines apply to all equally.The European Communities also expects it to sh ow the WTO dispute settlement system to be
objective and judicial and an improvement over the political processes that prevailed at the time of the
Tax Legislation cases.
4.1382  It is disingenuous for the United States to claim that the FSC scheme was enacted in good
faith when it was contested from the beginning, notably by the European Communities and thelegislative record shows that the US Congress knew this at the time.
4.1383  If other countries grant tax based subsidies similar to the FSC subsidies then they should
clearly also be liable to dispute settlement and removal.  The truth is that most countries operate their
tax systems in an objective way for the purpose of raising revenue fairly and efficiently and do not use
them as export incentives as the United States is clearly doing (and has admitted as the European
Communities pointed out in the Introduction to its First Written Submission
575).
4.1384  If the WTO rules should prove inadequate and need to be renegotiated that is nothing to be
afraid of.  The European Communities however believes in the correctness of its case and does not see
why these  rules  should be rendered “inadequate”.
4.1385  The danger to the WTO dispute settlement process and the WTO lies not in upholding the
agreed rules of the SCM Agreement but in distorti ng them to allow export-contingent subsidies to
escape their disciplines under pressure from a powerful Member.
The United States  argues in its Oral Statement at the Second Meeting of the Panel as follows:
4.1386  In conclusion, the numerous defects in the European Communities' arguments, whether taken
individually or together, are fatal to the European Communities' case.  The European Communities
has failed to abide by the procedural rules that govern these proceedings and the EuropeanCommunities has failed to present the Panel with sufficient arguments and evidence to meet its burden
of presenting a prima facie case.  Therefore, the United States requests that the Panel dismiss this case
or rule on the merits that the European Communities has not established a violation of SCM
Agreement Article 3.1(a), SCM Agreement Article 3.1(b), AA 9.1(d) or AA Article 10.
4.1387  In these closing remarks, we will attempt to step  back from the details of this controversy and
comment briefly on the overarching issues and distinctive features that the United States believes
should figure prominently in your resolution of this matter.
4.1388  There are a number of features of this case that the United States finds troubling, and that the
United States respectfully suggests should trouble this Panel as well.  Several are threshold matters.
As previously discussed, the United States believes that the European Communities' failure toconform to WTO procedural requirements is, and properly should be, fatal to its case.  The
                                                     
574 Paragraphs 188 to 194 of the US Second Written Submission following similar comments in
paragraphs 196 to 199 of the US First Written Submission.
575 Where the European Communities refers to the title to Exhibit EC-3.WT/DS108/R
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complexity of this case, its technical tax issues, th e potentially far-reaching implications it may have,
and the applicability of the one provision of the SCM Agreement that urges that parties go first to a
more specialized forum – these factors all serve to emphasize the importance of adhering to
procedural requirements designed to assure full exploration and development of the issues.
4.1389  Likewise, by failing to advance credible evidence in support of its claims and seeking instead
to argue an ipso facto legal theory, the European Communities has failed to meet its burden of proof.
The European Communities' repeated reliance on a sensationalized article in a popular news magazine
reveals the paucity of credible evidence that th e European Communities has been able to marshal in
support of its claims.  Although it does not have the burden of proof, the United States is the one party
that has offered empirical factual evidence, evidence that contradicts the European Communities'conclusory assertions.  Accordingly, the European Communities' evidentiary failures are a second
threshold that the European Communities' case has failed to clear.
4.1390  On the merits, the European Communities has sought to repudiate an established GATT
principle on which European Members and the United States have both relied for nearly 20 years.
The contention that this historic principle has been rescinded, or modified so as not to apply to the
United States, is supported by no textual language in subsequent agreements, no negotiating record to
that effect, and no understanding among the affected parties.  A proposition so bold as that advanced
by the European Communities would face a difficult road even with extensive factual support.  On an
evidentiary record that is largely barren of fa ctual and legal support, however, the proposition is
unsustainable.
4.1391  Yet another issue of process is raised by the timing of the European Communities' claim.  The
principle that the European Communities now claims that it “does not recognize” is not a principlethat has recently come to light.  Nor is it a principl e that was buried in the voluminous text of a newly
negotiated agreement.  Rather, this principle was one that was prominent, if not historic.  It was the
principle that broke the celebrated GATT logjam over four landmark tax cases.  That resolution was
achieved not through the usual mechanisms of GATT dispute settlement, but instead through action
by the entire GATT Council.  The Council did not me rely broker a compromise; it articulated a broad
principle of general applicability.
4.1392  To be sure, the European Communities claims that it had reservations about how the
United States conformed its law to that new principle, nearly a decade and a half ago.  It expressed
reservations at that time, and the United States responded.  However, the fact is that the European
Communities did not challenge the United States implementation of the GATT Council Decisionwhen the United States acted.  Nor did it challenge it the following year, or the year after that.  Rather,
it stood by as the new United States law became an established part of the US tax code and became a
part of the tax system and structure for all of the affected United States corporations.  The European
Communities now maintains that it never waived its objections.
4.1393  The notion that a Member can elect not to challenge another Member’s implementation of a
GATT or WTO decision and can instead indefinitely maintain a place-holder for future litigation at
the time of its choosing is inconsistent with the spirit, if not the letter, of the GATT and the WTO
dispute settlement system.  Members should not be free, in the name of long latent objections or
otherwise, to re-litigate previously resolved disputes, and an attempt to do so does raise questions of
process.  The European Communities was, by its own admission, attuned to the issue at the time,aware of the recourse available to it at the time, and fully informed in its decision not to pursue the
issue.  Its decision to do so now threatens the ability of Members to rely in good faith on the final
resolution of a dispute.
4.1394  Finally, the European Communities' resuscitated objections to the FSC are also troubling
because of the asymmetry they propose to create.  It can not fairly be disputed that territorial tax
systems confer an inherent tax advantage over worldwide tax systems in the case of exports jointly
undertaken with foreign branches or affiliates.   The result that the European Communities now
espouses is that the GATT Council Decision that overrode three GATT panel holdings that territorialWT/DS108/R
Page 235
tax systems inherently subsidize exports remains in full force and effect for territorial systems, but is
no longer good law for competitor countries with different tax systems.  Although the European
Communities has advanced theories for such an asymmetrical result in its Second Submission, they do
not obscure the fact that they are conveniently self-serving.
4.1395  In short, the United States is of the view that this case is not ripe for a decision on the merits;
that this distinguished Panel is, at least at this st age, not the proper forum for this dispute; that the
European Communities has, in every respect, failed to satisfy its burden of proof; that the fundamental
principle that the European Communities now disavows cannot now be summarily discarded; that
those who have relied on it in good faith have a stake in both its continued existence and its even-
handed application; and that the genuinely complex issues of tax parity and tax competition cannot befairly adjudicated on the basis of a set of WTO provisions that, at the very least, provide quite
imperfect guidance on the issues put before this Panel.  For these reasons, the United States urges that
the European Communities' claims be rejected on the basis of the preliminary objections made by the
United States, on the merits, or both.
V. ARGUMENTS PRESENTED BY THIRD PARTIES
A. 
BARBADOS
Barbados  argues as follows in response to questions from the European Communities at the First
Meeting of the Panel:
5.1 The purpose of requiring companies to licence with the Government is to:
• Monitor the establishment of Foreign Sales Corporations (FSCs);  and
• Ensure that they meet the criteria for the concessions under the FSC Act Cap. 59C of
the Laws of Barbados.
The licence is granted for a period of one year. A copy of a licence is attached.576
5.2 There is no reporting requirement. The status of the company is reviewed annually.577
5.3 The United States of America and the Commonwealth of Puerto Rico have been included in
the First Schedule to the FSC Act.578
5.4 Barbados does not know of any other country that has laws under which a company may be
designated a foreign sales corporation. If there are any such countries, Barbados, subject to the
legislative process of scheduling such countries, would be pleased to include them in the Schedule.579
                                                     
576 Paragraph 5.1 reflects the response of Barbados to the following question from the European
Communities: The Barbados Foreign Sales Corporations Act 1984, as amended in 1994, provides taxexemptions and other privileges to "foreign sales corporations".  Section 3(1) states that, to benefit from theseexemptions a company has to have a licence and Section 3(2)(d) provides that the Registrar can only give
licences to a company that satisfies him that it is designated or qualifies to be designated as a foreign sales
corporation under the laws of a country specified in the First Schedule.  What is the purpose of these licences?On what terms are they granted and, in particular, for what length of time?  Would Barbados please provide atypical example of a licence with all company-specific information removed?
577 Paragraph 5.2 reflects the response of Barbados to the following question from the European
Communities: What are the reporting requirements for foreign sales corporations in Barbados?
578 Paragraph 5.3 reflects the response of Barbados to the following question from the European
Communities: The only country mentioned in the Schedule is the United States.  Can Barbados confirm that noother country has been included in the First Schedule?WT/DS108/R
Page 236
5.5 Barbados cannot confirm that only companies that satisfy United States of America legal
requirements relating to FSCs will be granted a licence. The legislation does not seek to discriminate
against persons from other countries. Barbados' policy is to seek investment worldwide for the
conduct of service activity from Barbados. Barbados is prepared to work with countries to facilitate
investment. In fact, under the provisions of Arti cles 118 to 120 of the Lomé IV Convention, the
European Communities recognised the need for and ag reed to cooperate in fostering trade in services
in the African, Caribbean and Pacific States.580
5.6 The Barbados law was first enacted in 1985 and there was no intention to exclude
GATT/WTO members from these tax privileges. Barbados would wish to cooperate with all WTO
members.581
B. CANADA
Canada  argues as follows in its Third Party Submission:
5.7 Canada has supported the European Commission's request for the establishment of a panel
regarding elements of the legislation governing the FSC. In this context, Canada wishes to highlightits specific concerns with respect to the FSC.
5.8 The FSC is a prohibited export subsidy as defined in Article 3 of the SCM Agreement.
5.9 The FSC programme clearly provides what constitutes a prohibited export subsidy as defined
in Article 3.1(a) and 3.1(b) of the SCM Agreement.
5.10 The prohibited subsidy is delivered in the form  of a reduction in the effective US tax rate on
export income earned in qualifying export transactions conducted through offshore foreign sales
corporations. As such, the FSC is tied to export or export earnings, contrary to Article 3.1(a). Inaddition, the provision of the reduction in the effective US tax rate on export income is also
contingent upon the use of domestic over imported goods, contrary to Article 3.1(b).
5.11 Article 1.1 of the SCM Agreement identifies as a subsidy "government revenue that is
otherwise due" which is foregone or not collected and which thereby confers a benefit. The tax
reduction offered to United States exporters through the FSC programme clearly represents taxrevenue which would otherwise be due were it not for the operation of the FSC programme. By
foregoing such revenue, the United States is conferring a benefit on the users of the FSC programme
by allowing them to retain funds that would otherwise be collected in taxes. Since such tax relief is
contingent on export performance, i.e. the sale, lease or rental of "export property", the programme is
in obvious contravention of Article 3.1(a) of the SCM Agreement.
5.12 The Illustrative List of Export Subsidies in Annex I of the SCM Agreement refers
specifically, in paragraph(e), to:
The full or partial exemption, remission, or deferral specifically related to exports, of
direct taxes or social welfare charges pa id or payable by industrial or commercial
enterprises.
                                                                                                                                                                    
579 Paragraph 5.4 reflects the response of Barbados to the following question from the European
Communities: Does Barbados know of any other country in the world which has laws under which a companymay be designated a foreign sales corporation?  If yes, why is it not included in the First Schedule?
580 Paragraph 5.5 reflects the response of Barbados to the following question from the European
Communities: Can Barbados confirm that only companies which satisfy United States legal requirementsrelating to FSCs will be granted a licence?
581 Paragraph 5.6 reflects the response of Barbados to the following question from the European
Communities: How does Barbados justify granting tax privileges to subsidiaries of United States corporationswhich are not available to those of other WTO Members?  Is this not a violation of Article II GATS?WT/DS108/R
Page 237
In sum, the FSC legislation excludes from United States taxation income generated by export
performance. In the absence of the legislation, this income would be subject to United States taxation.
Accordingly, the subsidies provided by the FSC  programme are contingent upon export performance
in the sense that they are tied directly to export earnings and take the form of an exemption of direct
taxes payable by United States commercial enterprises.5.13 The scope of paragraph(e) of Annex I is modified by footnote 59 which provides in part that:
Paragraph (e) is not intended to limit a member from taking measures to avoid the
double taxation of foreign source income earned by its enterprises or the enterprises
of another Member.
The clear subsidy offered by the FSC programme cannot be justified on the grounds that FSC is a
measure designed or intended to avoid the double taxation of foreign source income earned by
United States enterprises. The FSC programme was never intended to alleviate double taxation, but
rather to enhance United States exports. Other US tax measures ensure that United States corporations
are not subject to international double taxation. FSC subsidies are available to United States exporters
regardless of whether the export income in question is or would be subject to double taxation.
5.14 In this context, United States tax law prov ides for foreign tax credits to ensure that
United States companies are not subject to double taxation with respect to foreign source income
earned by their overseas subsidiaries. The foreign tax credit offers relief from both the withholding
tax the foreign country may have imposed on any dividend remitted by the subsidiary to its parent
corporation, as well as the underlying income tax, that is the income tax paid by the overseas
subsidiary to the foreign country in which its profits are earned. Absent the FSC legislation, theincome earned by the overseas sales subsidiaries of United States corporations would be subject to
either one of the following regimes: (1) deferral of US taxation until dividends are remitted to the
United States parent, where they would then be taxed and subject to a foreign tax credit; or (2) where
the income of the subsidiary is considered "forei gn base company sales income", taxation on a current
basis in the United States, subject to a foreign tax credit. In both cases, where foreign source incomeis included in the taxable income of a United States taxpayer and subject to US tax, a foreign tax
credit is provided for foreign income taxes paid. There can, therefore, be no international double
taxation which is unrelieved after the application of US tax rules. Further, many FSCs are located in
low or tax free territories in which double taxation is clearly not a consideration.
5.15 In addition, Article 3.1(b) of the SCM Agreement prohibits subsides that are contingent on
the use of domestic over imported goods. Under the FSC programme, the tax relief offered is only
available in relation to income earned from the sale, lease or rental of "export property" of which not
more than 50 per cent of the fair market value is attributable to articles imported into the
United States. This provision is a legal requirement for companies to use at least some domestic goods
in order to qualify for their subsidy. Such a subsidy is contingent on the use of domestic overimported goods and is therefore inconsistent with Article 3.1(b).
5.16 It is the clear intent of the FSC programme to enhance United States exports through the
discriminatory application of a prohibited export subsidy. There is no legitimate tax policy rationale to
support or excuse the operation of such a subsidy. As a country whose corporations compete with
United States corporations for third market sales, Canada is very concerned about the trade distortiveeffects of the FSC subsidies on international trade and therefore supports efforts to seek its
elimination through adjudication in the context of United States international trade obligations under
the World Trade Organization.
Canada  argues as follows in its Oral Statement at the First Meeting of the Panel:
5.17 Canada welcomes the opportunity to present its views to the panel exam ining the US Foreign
Sales CorporationWT/DS108/R
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5.18 As we stated in our written submission, Canada’s position is that the FSC programme
provides a prohibited export subsidy, as de fined in Article 3 of the SCM Agreement
5.19 The programme provides for a reduction in the effective US tax rate, which is available only
on export income earned in qualifying export transactions
5.20 As such, the FSC is tied to export or export earnings, contrary to Article 3.1(a) of the
Agreement.
5.21 In addition, the reduction in the effective US tax rate on export income is contingent upon the
use of domestic over imported goods, contrary to Article 3.1(b).
5.22 The tax reduction offered to United States exporters through the FSC programme constitutes a
subsidy, since it is "government revenue that is otherwise due" which is not collected, and whichthereby confers a benefit, within the meaning of Article 1.1
5.23 Since such tax relief is contingent on export performance – that is, the sale, lease or rental of
"export property" – the programme is in contravention of Article 3.1(a).
5.24 The Illustrative List of Export Subsidies in Annex I refers specifically to the full or partial
exemption, remission, or deferral specifically related to exports, of direct taxes paid or payable byenterprises.
5.25 In sum, the FSC legislation excludes from US taxation income generated by export
performance.
5.26 In the absence of this legislation, such income would be subject to US taxation.
5.27 Accordingly, the subsidies provided by the FSC programme are contingent upon export
performance in the sense that they are tied directly to export earnings and take the form of an
exemption of direct taxes payable by United States commercial enterprises.
5.28 Moreover, as noted in our written submission, the subsidy offered by the FSC programme
cannot be justified on the grounds that this is a measure intended to avoid the double taxation of
foreign source income earned by United States enterprises.
5.29 FSC subsidies are available to United States exporters regardless of whether the export
income in question is or would be subject to double taxation.
5.30 The FSC programme was never intended to alleviate double taxation, but is designed instead
to enhance United States exports.
5.31 Article 3.1(b) of the Agreement prohibits subsides that are contingent on the use of domestic
over imported goods.
5.32 Under the FSC programme, the tax relief offered is only available in relation to income
earned from the sale, lease or rental of "export property", of which not more than 50 per cent of the
fair market value is attributable to articles imported into the United States.
5.33 This requires companies to use at least 50 per cent domestic goods in order to qualify for their
subsidy.  This subsidy is thus contingent on the use of domestic over imported goods, which is
inconsistent with Article 3.1(b).
5.34 In conclusion, it is Canada’s position that the FSC programme benefits only United States
exports through the discriminatory application of a prohibited export subsidy.WT/DS108/R
Page 239
5.35 There is no legitimate tax policy rationale to support or excuse the operation of such a
subsidy.
5.36 As a country whose corporations compete with United States corporations for third market
sales, Canada is very concerned about the trade distortive effects of the FSC subsidies on international
trade.
5.37 We therefore urge this panel to find that these subsidies are not consistent with United States
obligations under the SCM Agreement.
Canada  argues as follows in response to a question from the Panel at the First Meeting of the Panel:
5.38 The question of whether the FSC programme provides a prohibited export subsidy is
answered by examining whether the subsidy is cont ingent, in law or in fact, upon export performance,
and whether it is contingent upon the use of domestic over imported products.  The trade effects of
such subsidies are irrelevant:  if they are so contingent, they are prohibited.  It is Canada's submission
that tax benefits under the FSC are contingent upon export performance, and are contingent upon the
use of domestic over imported products.  They are thus ipso facto  prohibited.
5.39 Nevertheless, Canada is naturally concerned about the potentially distorting trade effects of
the FSC programme.  This concern is primarily re lated to the potential effects in third markets.
Products exported by FSCs can be shipped anywhere in the world, and can therefore compete unfairly
with Canadian exports in an unlimited number of markets.  Moreover, neither Canada nor Canadian
producers have any direct remedy in respect of third markets:  there are no countervailing measures
available.  There is thus an unlimited potential for distortion, making this our greatest concern.
5.40 That said, Canada is concerned with the potential bilateral affects, and that concern was
reflected to some degree in our written and oral submissions.
5.41 Tax remission under the FSC is contingent upon the use of domestic over imported products.
This provides American-origin inputs with a competitive advantage over Canadian inputs in respect of
sales to FSCs, and it is precisely why Canada is supporting the European Communities challenge
under Article 3.1(b) of the Agreement on Subsidies and Countervailing Measures.
5.42 With respect to potential distortions in the Canadian market, Canada is, of course, concerned
about the possibility of becoming a target for subsidized United States products.  However, this is not
of immediate importance in this case, given that our  own trade laws would be available to remedy the
situation.
C. JAPAN
Japan  argues as follows in its Third Party Submission:
5.43 This third party submission is made by the Go vernment of Japan ("GOJ") in support of the
case brought by the European Communities against the favorable tax treatment accorded by the
Government of the United States ("USG") to profits arising from the export of United States productsthrough FSCs.
5.44 The provisions of the United States law (Sections 921-927 of the US Internal Revenue Code)
that have created the FSC scheme providing subsidies are designed to reduce the tax level for
United States companies on the condition of exporting certain goods (i.e. goods not more than 50 per
cent of the fair market value of which is attributab le to articles imported in the United States). The
FSC scheme allows corporations to conduct modest levels of overseas activities and then use those
activities to justify tax exemption on large portions of export earnings unrelated to those activities.
Those United States companies exporting other goods  or selling goods in the domestic market, are atWT/DS108/R
Page 240
a disadvantage because of their higher tax burden.  Furthermore, the USG applies special rules for
transfer pricing which is only applied to FSCs.
5.45 GOJ urges the Panel to find that the FSC scheme is in violation of the SCM Agreement, since
the tax exemptions under the scheme constitute subsidies under Article 1 and are prohibited under
Article 3 of the SCM Agreement.
5.46 The FSC has been introduced in place of th e Domestic International Sales Corporation
("DISC").  The law on DISCs provided tax exem ptions on income from exports through DISCs.
5.47 Several European countries challenged the DISC law under the GATT,  claiming that tax
exemptions on income from exports through DISCs violated Article XVI:4 of the GATT as
prohibited export subsidies. The GATT panel supported the European claim and, in 1976, found theUS DISC law to be incompatible with GATT.
582  Though initially resisting the panel decision, the
USG in 1981 finally agreed to adopt the panel report in exchange for an understanding ("the 1981
Understanding") to be adopted by the GATT Council.  The report was thus adopted
"on the understanding that with respect to these cases, and in general, economic
processes (including transactions involving exported goods) located outside theterritorial limits of the exporting country need not be subject to taxation by the
exporting country and should not be regarded as export activities in terms of
Article XVI:4 of the General Agreement.  It is further understood that Article XVI:4
requires that arm's-length pricing be observed, i.e., prices for goods in transactions
between exporting enterprises and foreign buyers under their or the same control
should for tax purposes be the prices which would be charged between independent
enterprises acting at arm's length."
583
5.48 After adoption of the report, the USG amended the DISC law.  In 1984, the US Congress
enacted a law which was to replace the DISC with th e FSC. As we show below, however,  this revised
scheme continues to be incompatible with the WTO rules, in particular, the SCM Agreement.
5.49 The United States law creating FSCs sets forth economic process requirements and foreign
management requirements which a FSC would ha ve to meet to qualify for tax exemption.
5.50 Furthermore, the new law allows a FSC to choose administrative pricing rules or arm's length
pricing to determine the transfer price between th e FSC and its parent corporation.  By providing
administrative pricing rules as well as arm’s length pricing rule, the law allows FSCs to increase
profits subject to the exemption compared to the profits resulting from arm’s length pricing.  These
pricing rules will be examined in more detail below.
5.51 As stated above, FSCs must meet certain foreign economic process and foreign management
requirements to qualify for tax exemption benefits on export sales.
5.52 For a given transaction to meet the foreign economic process requirements, both a
participation test and a direct cost test must be met.  To satisfy the participation test, the FSC or its
agent must participate in export transactions outside the United States  For this purpose, exporttransactions mean: solicitation (other than advertising), negotiation, or contracting.  Only one of these
activities needs to be initiated abroad for the re lated transaction to qualify for FSC tax benefits.
5.53 The direct cost test focuses on five activities involving expenses: (1) advertising and sales
promotion; (2) processing orders and making delivery arrangements; (3) delivering the export
                                                     
582Panel Report "US - Tax Legislation (DISC)," L/3851, adopted on 7-8 December 1981, BISD
23S/98, 114.
583 GATT, BISD 28S, p. 114.WT/DS108/R
Page 241
property to the customer; (4) determining and tran smitting the invoice or statement of account and
receiving payment; and (5) assuming credit risk.
5.54 For a given export transaction, the direct cost test can be satisfied in two alternative ways.
First, the test is met if at least half of the aggregate direct costs the FSC incurs in the five categories
above are foreign direct costs.  Second, the test is met if at least 85 per cent of the direct costs incurredby the FSC in any two of the five categories above (tested separately) are foreign direct costs.
5.55 The United States law dictates that FSCs must be "managed"  abroad.  This requirement,
however, can be met with three easy steps.  First, all formally-convened board of director and
shareholder meetings must be held outside the United States  Second, the FSC's principal bank
account must be maintained in a qualified foreign country or United States possession.  Third, all cashdividends, legal and accounting fees, and salaries of board members and officers must be paid from a
bank account maintained abroad.
5.56 FSCs are required to be located outside the United States in a qualifying country or eligible
possession. Comparing with the DISCs , this appears,  on its face, to be positive move towards the
compatibility with “the 1981 Understanding”. Yet the regulations define an office as a building or aportion of a building consisting of at least one room, regularly used and operated for some corporate
business, and owned or leased by the corporation or the corporation's dependent or independent
agent.
584  Practically, this means that the parent corp oration can hire a management firm in the tax
haven country to lease a room in which to conduct the minimum business required under the law.
5.57 The USG also allows the FSC to organize itself in one of the qualifying United States
possessions such as Guam or the US Virgin Islands.
5.58 To make a proper accounting of profits between domestic activities and  foreign activities of a
controlled subsidiary, arm's length pricing should be used.  The US Internal Revenue Code
specifically requires that the prices of transactions between related subsidiaries be at arm's length.
Furthermore, footnote 59 to the SCM Agreement declares that:
The Members reaffirm the principle that prices for goods in transactions between
exporting enterprises and foreign buyers under their or under the same control shouldfor tax purposes be the prices which would be charged between independent
enterprises acting at arm's length.
5.59 The FSC law, however, did not adopt the method of Internal Revenue Code and the principles
laid out in the SCM Agreement. The FSC law provides two alternative administrative pricing methodsfor calculating the transfer price between the FSC and its parent: (1) the combined taxable income
(CTI) method, which allocates profit to the FSC in an amount equal to 23 per cent of the net profit
from the export sale; and (2) the foreign trading gross receipts (FTGR) method, which allocates profit
to the FSC in an amount equal to the lesser of 1.83 per cent of export receipts or 46 per cent of the net
profit from the export sale.
5.60 Although arm's length pricing may be used as well, in practice most FSCs use either or both
of the administrative pricing methods.  This is because the CTI and FTGR methods allow for a larger
allocation of profits to the FSC. An "administrative convenience" would be a system whereby the CTI
23 per cent method, for example, was mandatory across the board–no other methods would be
permitted.  A system in which exporters are allowed to choose, after a transaction has been completed,which of three transfer pricing methods they would li ke to use is not an "administrative convenience."
5.61 The USG has established a system by which, according to its submission, companies can
"approximate" the arm's-length method.  However, the basic rationale for using the arm's-length
                                                     
584 49 Fed. Reg. 48288-89.WT/DS108/R
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method of pricing is to procure exact accounting of profits between domestic activities and foreign
activities, thereby avoiding  an approximation.  Special administrative price ruling methods are
inherently imperfect; they may make allocation more convenient, but the accounting under these
methods are clearly different from the actual accounting.  Applying a 23 per cent allocation to all
transactions will clearly distort actual calculations.
5.62 The difference between the amount of taxes collected under the FSC scheme and the amount
that would be collected under the US tax law is revenue foregone.  The USG has itself calculated the
amount of revenue foregone as a result of the application of the FSC laws.  According to a Treasury
Report published in 1997, "the revenue cost of the FSC programme is estimated at $1,380 million for
calendar year 1992."585  Given the minimal overseas activities involved in most FSCs, this substantial
revenue "otherwise due" illustrates the magnitude of the problem.
5.63 Article 1.1 of the SCM Agreement provides that a subsidy shall be deemed to exist if:
• there is a "financial contribution" by a government or public body, and
• a "benefit" is thereby conferred.
5.64 Both of these elements exist with respect to the tax exemptions and the special administrative
pricing rules under the FSC scheme, thus constituting subsidies under the SCM Agreement.
5.65 The tax exemptions accorded under the FSC scheme is by itself the equivalent of a financial
contribution in the meaning of the forgoing or not collecting government revenue that is otherwise
due as specified in Article 1.1(a)(1)(ii).  Essen tially, the FSC scheme operates to allow a company to
evade taxes on income that would otherwise be due.  Moreover, while normal United States
corporations are required to use the arm's-leng th pricing method to allocate income,  special
administrative pricing rules under the scheme allows  FSCs to choose  the arm's-length, CTI, or FTGRmethods of income allocation. FSCs will naturally choose the method which results in the least
amount of taxes paid.  As a result, the amount of tax collected by the USG is smaller than that under
the arm's-length method.
5.66 The second prong of the definition of a subsidy under Article 1.1 of the SCM Agreement is
that a "benefit" must be incurred.  The financial advantage to the parent corporation of a FSC is
logically clear: the tax burden of the FSCs and their parents is substantially reduced as a result of
applying the FSC scheme and benefits them.
5.67 Article 3.1(a) of the SCM Agreement provides that:
Except as provided in the Agreement on Ag riculture, the following subsidies, within
the meaning of Article 1, shall be prohibited:
(a) subsidies contingent, in law or in fact, whether solely or as one of several
other conditions, upon export performance, including those illustrated in Annex I.
586
5.68 Both the FSC tax exemptions per se and the increase in the amount of those tax exemptions
arising out of the application of the administrative pricing rules depend on export performance. The
whole purpose of the FSC law is to facilitate export sales which, in turn, will be subject to tax
exemptions.  Thus, the subsidies are contingent on export performance.
5.69 Item (e) of Annex I of the SCM Agreement lists measures to be deemed as a prohibited export
subsidy:
                                                     
585 "The Operation and Effect of the Foreign Sales Corporation Legislation 1 July 1992 to
30 June 1993," at p. 16, Dept. Treas. Rept. (November 1997).
586 Footnotes omitted.WT/DS108/R
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The full or partial exemption remission, or deferral specifically related to exports, of
direct taxes or social welfare charges pa id or payable by industrial or commercial
enterprises.587
5.70 The tax exemptions under the FSC scheme also have all the main elements in the text of
Item (e). They are:
• exemptions
• specifically related to exports
• of direct taxes
• payable by industrial or commercial enterprises
5.71 Article 3.1(b) refers to the other type of subsidies prohibited under the SCM Agreement,
"subsidies contingent, whether solely or as one of several other conditions, upon the use of domestic
over imported goods."
5.72 The FSC tax exemptions are limited to income from the export of products "not more than
50 per cent of the fair market value of which is attributable to articles imported in the United States"Thus, the subsidies are contingent upon the use of United States goods over imported goods, contrary
to Article 3.1(b).
5.73 Footnote 59 reaffirms the principle of arm’s length methods and, as the United States notes in
its first submission, paragraph 112, implies that Members may rely on administrative practices to
allocate income as long as they do not contravene the arm’s length principle and cause a significantsaving of direct taxes. The United States has not demonstrated that the actual operation of
administrative pricing rules does not contravene the arm’s length principle while we note the facts as
described in the preceding paragraphs, in particular paragraph 20.
5.74 The USG's reliance to the "significant savings" language of footnote 59 is particularly
inappropriate.  The claim of the USG is that the revenue reduction of $1,380 million for calendar year1992 does not constitute "significant savings" because that amount is only 0.93 per cent of the total
gross receipts for that year.  The USG suggests that the standard found in Article 11.9 of the SCM
Agreement, which sets up a one per cent de minimis threshold for challenging "actionable" subsidies,
should properly be the standard by which "significant savings" are determined.  The USG relies on
Annex IV to the SCM Agreement and footnote 64 for the notion that subsidy savings should be
calculated based on the total sales for that fiscal year.  The USG thus concludes that because 0.93 per
cent does not meet on per cent de minimis threshold, it should not be considered significant.
5.75 According to USG calculation, application of  the CTI method results in a 15 per cent tax
exemption of the total income of both the FSC and its related supplier. Article 11.9, Annex IV, and
footnote 64 all apply to subsidies which are not prohibited but merely "actionable," as defined in
Article 5.  Export  subsidies of the type challenged here are per se prohibited.  The de minimis
threshold was established specifically for actionable subsidies, not prohibited subsidies.  Evenassuming that the USG had some basis for claiming that a de minimis standard should apply, why
does it feel that a one per cent threshold is appr opriate?  Section351.106(c)  of the US Antidumping
and Countervailing Duty Regulations states that, in reviewing a countervailing duty order, the USG
will treat as de minimis any “countervailable subsidy rate that is less than 0.5 per cent  ad valorem  .
The USG has clung to this 0.5 per cent rate through successive trade negotiations, so it obviously feelsthat 0.5 per cent is an appropriate de minimis threshold.
                                                     
587 SCM Agreement, Annex I, Illustrative List of Export Subsidies (footnotes omitted).WT/DS108/R
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5.76 The USG bases portions of its argument on the notion that the FSC Scheme does not violate
the SCM Agreement because it is in accordan ce with the 1981 Understanding.  The 1981
Understanding set forth two principles to apply to the tax exemption of foreign-source income.  Those
principles are: (1) GATT does not require an exporting country to tax economic processes that occur
outside its territorial limits; and (2) arm's-length  pricing is mandatory, under GATT, in transactions
between exporting enterprises and foreign buyers under common control.
5.77 However, the FSC law fails to live up to either of these principles adopted by the GATT
Council. In particular, the FSC administrative pric ing rules is different from the Understanding's
arm's-length pricing.  The FSC scheme allows comp anies not to use normal transfer pricing rules, but
to choose the most favourable method out of th e "arm's-length" standard, CTI and FTGR methods.
5.78 In relation to the 1981 Understanding, the United States states in its first submission,
paragraph 106,  that the exemption of some or all of the income generated from foreign economic
activities, through whatever means, is not an export subsidy. The 1981 Understanding provides no
basis for such argument but only states that economic activities outside territorial limits need not be
taxed. It should be judged in light of the SCM Agreement whether the tax exemption constitutes anexport subsidy.
5.79 The USG requests the panel to dismiss European Communities' claim by arguing that the
European Communities has not correctly addressed the request  for consultations and the European
Communities should seek its claim under an appropriate tax forum.
5.80 The USG cites to Article 4.2 of the SCM Agreement, which states:
A request for consultations under paragraph 1 shall include a statement of available
evidence with regard to the existence and nature of the subsidy in question.
5.81 The USG appear to read this provision strictly, however, Article 4.2 requires only that the
requesting member provide a statement of  "available evidence with regard to the existence and nature
of the subsidy in question" .  In this case,  the United States law (Sections 921-927 of the IRC) can be
considered as a statement of available evidence.
5.82 Moreover, footnote 59 does not require  Members to bring certain disputes to forum outside
WTO.  It merely holds that Members may draw atte ntion of another Member to the measure at issue
and that, in such circumstances, the Members shall attempt to resolve their differences in certain fora
other than WTO.
5.83 Furthermore, while footnote 59 applies to the resolving of certain differences arising over the
principle of arm's-length pricing, the current disput e focuses on issues much broader than arm's-length
pricing.  The European Communities is challengin g the tax exemptions under the FSC scheme as a
subsidy on the export of certain goods.  WTO is the only forum dealing with the relationship of the
rights and obligations under the WTO Agreement.
5.84 For the above reasons, GOJ requests that the Panel find that the tax exemptions and
administrative pricing rules in the FSC scheme violate the SCM Agreement by granting subsidiescontingent in law upon export performance and upon the use of domestic over imported goods.  The
FSC scheme meets the definition of "subsidy" in Article 1.1 and falls within the definition of
prohibited subsidies in both subparagraphs (a) and (b) of Article 3.1.
Japan  argues as follows in its Oral Statement at the First Meeting of the Panel:
5.85 On behalf of the GOJ, we would like to express our appreciation for the acceptance by the
European Communities and the USG of Japan's request to participate as a third party in the Panel
proceedings under Article XXIII relating to the tax treatment of FSCs.WT/DS108/R
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5.86 The GOJ urges the Panel to find that the FSC scheme is in violation of the WTO Agreement,
in particular, the SCM Agreement.
5.87 The FSC scheme provides for tax exemptions that would otherwise be due for companies if
the FSC scheme did not exist.  Furthermore, FSCs can choose among an arm's-length pricing and two
administrative pricing methods to minimize their tax obligation.  The difference between the amountwhich the FSCs pay by using the most beneficial pricing methods and the amount which the FSCs
would have to pay if there were only one pricing method available is foregone or uncollected
"government revenue that is otherwise due."  Thus, there is a “financial contribution” by the USG.
Substantially reduced tax burdens under the FSC scheme clearly “benefit” corporations.
5.88 Thus, the FSC scheme constitutes a subsidy as defined under Article 1 of the SCM
Agreement.
5.89 Subsidies contingent on export performance are prohibited per se  under the SCM Agreement.
The FSC scheme provides for tax exemptions for “exempt foreign trade income” which depends on
export performance by FSCs.
5.90 Furthermore, the amount of the tax exemption can be increased substantially through the
application of administrative pricing rules.  Only export income can take advantage of this tax
exemption.  Thus, the FSC scheme constitutes an export subsidy prohibited under Article 3.1(a).
5.91 The USG attempt to apply a de minimis standard to a prohibited subsidy outright is
misplaced. Moreover, the 1981 Understanding provid es no basis for the USG argument but only states
that economic activities outside territorial limits need not be taxed. FSC Scheme should be judged in
light of the SCM  Agreement as the tax exemption under the scheme constitutes an export subsidy.
5.92 Moreover, the FSC tax exemptions and the special administrative pricing rules are available
only to income from the export of products not more than 50 per cent of the fair market value of
which is attributed to articles imported into the United States  Thus, the FSC subsidies are contingent
upon United States over imported goods, contrary to Article 3.1(b).
5.93 As to the procedural issues, the GOJ finds that the USG claim has no legitimacy and should
be declined.  The GOJ believes that Article 4.2 requires that a party requesting consultations mustprovide whatever basis for the claim is "available" at the time of the request for consultations.  The
European Communities satisfied this by pointing out the provisions of United States law (Sections
921-927 of the IRC) at issue in its request.  Furtherm ore, the USG points to the text of footnote 59 to
the SCM Agreement in claiming that the European Communities has to bring its case under a tax
forum or under bilateral tax treaties.  The GOJ believes that footnote 59 does not require Members tobring disputes to forum outside the WTO. Above all,  while footnote 59 applies to the issue over price
ruling, the dispute at issue has much broader scope.
5.94 For these reasons, the GOJ requests that the Panel find that the FSC scheme is in violation of
the WTO Agreement and would like to request that the FSC scheme be amended to be in conformity
with WTO obligations.
VI. INTERIM REVIEW
6.1 On 23 July 1999, the Panel issued its interim report to the parties.  On 6 August 1999, the
European Communities and the United States requested the Panel to review precise aspects of the
interim report, in accordance with Article 15.2 of the DSU.  The European Communities also
requested the Panel to hold a further meeting, with  both parties requesting that the further meeting not
be held during the month of August.  The meeting was held on 6 September 1999.
6.2 The European Communities requests that we modify the last sentence of paragraph 7.6 of the
interim report to state that, "[I]n conclusion, there is no basis for holding that the EC's request forWT/DS108/R
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consultations does not contain a statement of available evidence", a conclusion that the European
Communities considers to flow from the previous statements. Because the existing language
accurately reflects the nature of our consideration of the matters discussed in paragraph 7.6, we
decline to make the change requested by the European Communities.
6.3 The European Communities considers that the term "due process", used by the Panel in
paragraph 7.10, arises exclusively out of US law, and requests that we replace it by a more "neutral"
term, such as "rights of defence".  We note, however, that the term "due process" has been used
extensively in WTO dispute settlement proceedings.  See, e.g., India – Patent Protection for
Pharmaceutical and Agricultural Chemical Products , WT/DS50/AB/R, Report of the Appellate Body
adopted 16 January 1998, paragraph 94 (referring to ". . . the demands of due process that are implicitin the DSU . . .").  Further, we note that the concept of due process, unlike that of rights of defence,
encompasses the rights of both complaining and defe nding parties.  Accordingly, we decline to make
the change requested by the European Communities.
6.4 The European Communities requests that, in the second sentence of paragraph 7.34 relating to
the United States' preliminary objection to our examination of any "related measures", we replace theterm "legal instruments" with "measures" and restructure the sentence.  The United States considers
that there is no lack of clarity in the sentence.  We have made certain modifications in order to clarify
the second sentence of paragraph 7.34.
6.5 The European Communities considers that the Panel erred in failing to rule on the FSC
administrative pricing rules (paragraphs 7.124-7.129).  The European Communities argues that it
presented its case in the form of two distinct export  subsidy complaints in order to ensure that the
Panel would consider and rule on both elements of the FSC scheme (i.e., the FSC exemptions and theFSC administrative pricing rules).  The European Communities does not agree that to make an
independent ruling on the consistency of the administrative pricing rules would require the Panel
either to perform a legal analysis based upon legal interpretations to which it has already objected, or
to examine a hypothetical scheme in which the FSC exemptions are eliminated but the administrative
pricing rules continue to be utilised in another c ontext.  In the view of the European Communities, if
the FSC administrative pricing rules cannot be considered as an independent or separate export
subsidy, then they should logically be considered as an integral element of the FSC scheme along with
the FSC exemptions.  While the United States does not agree with the Panel's finding with respect to
the FSC exemptions, it considers that, by findin g the FSC exemptions to be a prohibited export
subsidy, regardless of how they are calculated, the Panel has completely resolved this dispute.
6.6 We remain of the view that we have addressed those claims on which a finding is necessary in
order to enable the DSB to make sufficiently precise findings and rulings so as to allow for prompt
compliance by the United States. In particular, we consider that to address the WTO consistency of
administrative pricing rules in the situation where the exemptions to which they relate no longer exist
would require us to analyse a hypothetical scheme  with undetermined parameters.  We further recall
that, from its first submission onward, the European Communities has requested that we address the
administrative pricing rules as a separate prohibited subsidy independent of the FSC exemptions, and
it is only in its request for interim review that it asks for the first time that we examine the FSC
exemptions and administrative pricing rules toge ther.  Accordingly, we decline to make the
modifications requested by the European Communities.  We have however made certainmodifications to the language of paragraphs 7.127 and 7.129 with an eye to clarifying the reasoning
and removing unnecessary language.
6.7 The European Communities requests that we modify our discussion (paragraphs 7.41-7.48) of
the meaning of "otherwise due" such that we re fer to the situation that would exist but for the
"scheme" or programme" in question, rather than the "measures in question".  In the view of the
European Communities, the use of the term "measures" can give rise to misunderstanding because as
used in Article 6.2 of the DSU it is defined by the complaining party, and because the existence of asubsidy cannot depend on how narrowly or widely a complaining party has formulated its legal
provisions.  The United States argues that the terms "programme" and "scheme" are less precise thanWT/DS108/R
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the term "measure", and that the Panel in any event clearly identifies the measures in question in this
dispute.  We note that, whether the term "measure", "scheme" or "programme" is used, the application
of the concept of "otherwise due" in other disputes would require panels to apply their best judgement
on a case-by-case basis ( See paragraph 7.93 and footnote 664).  We consider, moreover, that we have
been sufficiently clear in our application of the general principle to this case.  Accordingly, we declineto make the modifications requested by the European Communities.
6.8 The European Communities considers that we should clarify paragraph 7.43 to make clear
that a tax regime is defined by both the levels of taxation and the basis for taxation.  We have made
certain modifications to paragraph 7.43.
6.9 The European Communities requests that we ut ilise the term "derogation" or "deviation"
rather than "exemption" when referring to the special source rules in paragraphs 7.94 and 7.95.  We
decline to make the modification requested by the European Communities.  As suggested by the EC in
its submissions, and for the sake of simplicity, we have used the term "exemptions" when referring to
certain aspects of the FSC scheme.  We note, however, that the term as used in our Report may extend
beyond the technical meaning of that term.
6.10 The European Communities argues that, in our discussion of the application of the concept of
"otherwise due" to the FSC exemptions (paragra ph 7.98), our example relating to the non-application
of Subpart F is "inapposite".  In the view of the European Communities, a FSC and its parent would
have no interest in the FSC not distributing all its income since they benefit from an even greater
advantage, i.e., exemptions.  Thus, the importance of the controlled foreign corporation exemption is
that it allows the FSC scheme to function withou t interference from the rules in Subpart F.  The
European Communities suggests that we replace the Subpart F example with an example based uponthe FSC special source rules or, if we decide to address the FSC administrative pricing rules in the
context of our examination of the FSC exemptions, based upon those rules.  The United States
responds that the FSC exemption from Subpart F has been a key aspect of the European Communities'
claims throughout this dispute.  Further, the United States considers that the discussion in the interim
report is perfectly clear.  If the FSC measures did not exist, income from FSC transactions would besubject to Subpart F; this in turn would mean th at the tax on such income would not, because of the
provisions of Subpart F, be deferred, deferral being the norm of US tax law.  Because in our view
paragraph 7.98 is sufficiently clear, we decline to  make the modification suggested by the European
Communities.
6.11 The European Communities argues that the Panel should have ruled on its claim under
Article 3.1(b) of the SCM Agreement.  In the view of the European Communities, our invocation of
the principle of judicial economy (paragraph 7.132) is inappropriate because "it would be
(theoretically) possible" for the local content subsidy to be maintained even if the export subsidies are
removed.   The European Communities further considers that what it refers to as "the final reason" for
our not reaching this claim – that the legal issues were not thoroughly explored – is "unacceptable"because the European Communities set out its case and responded to all arguments made by the
United States.  The United States contends that the Panel correctly noted that the definition of "export
property" serves simply to define the scope of the FSC tax exemption, and that, having declared that
exemption to be WTO-inconsistent, the Panel has achieved a complete resolution of the dispute.  The
United States further contends that a finding on the Article 3.1(b) claim would be an entirely newfinding with respect to which the United States wo uld be entitled to interim review under Article 15.2
of the DSU.
6.12 We continue to believe that a finding on the European Communities' Article 3.1(b) claim is
not necessary to enable the DSB to make sufficiently precise rulings so as to allow for prompt
compliance by the United States in this dispute.  As stated in our report and acknowledged by the
European Communities, the definition of "export property" at issue serves simply to define the scope
of the FSC exemptions, which we have found to be prohibited export subsidies.  Although at our
interim review meeting the European Communities suggested that we should reach this claim because
the United States could offer a tax subsidy to all US goods that met a particular local contentWT/DS108/R
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requirement, whether sold in the United States or abroad, any such approach would in our view
involve an entirely new and hypothetical scheme not before this Panel.  In respect of our statement
(footnote 698) that the legal issues regarding the Article 3.1(b) claim were not thoroughly explored, a
review of the argumentation relating to the claim clearly reveals that it was not the focus of the
parties' attention.  As far as the legal status of the claim is concerned, we have noted that the claimwas not abandoned.  We consider that this is a factually correct account of the matter.
6.13 We have made additional minor modifications to paragraphs 2.1, 4.1133, 7.10, 7.23 and 7.95
and footnote 710 of the report.
VII. FINDINGS
A. REQUESTS FOR PRELIMINARY RULINGS
1. Statement of Available Evidence
7.1 The United States contends that the European Communities' request for consultations in this
dispute failed to include a "statement of available evidence" as required by Article 4.2 of the
Agreement on Subsidies and Countervailing Measures (hereinafter "SCM Agreement").  In the view
of the United States, this failure deprived the United States of its right to learn of the existence of such
evidence in advance of the consultations held in th is matter and the dispute settlement system of the
benefits that Article 4.2 was designed to provide.  Because the European Communities failed to
comply with this mandatory requirement, the Pane l should dismiss the European Communities' claims
under Article 3 of the SCM Agreement.  In the view of the United States, to fail to dismiss these
claims would allow a complainant to ignore Article 4.2 with impunity, thereby reducing that Article to
redundancy or inutility, which would be contrary to basic principles of public international law.
7.2 The European Communities argues that, in a disp ute relating to a subsidy arising out of a
generally applicable law, the available evidence may be the law itself.  In this case, the
European Communities' request for consultations contained a statement of available evidence in that it
referred to the relevant US legal provisions.  The European Communities further contends that, even
if its request for consultations were not deemed to comply fully with Article 4.2 of the SCMAgreement, there would still not be any basis to dismiss its claims under Article 3 of the SCM
Agreement.  In the European Communities' view, non- dismissal of a claim for failure to comply with
the "statement of available evidence" requirement would not reduce that requirement to "redundancy
and inutility", as Article 4.2 was intended to have its effectiveness in the consultation  phase of the
dispute settlement process.  Thus, the United States' remedy would have been to request furtherinformation and possibly to decline to enter into further consultations until the European Communities
had done so.  Finally, the European Communities considers that the United States has in no sense
been denied its right of defense in this dispute.
7.3 In considering the United States' objection, we first recall that Article 4.2 of the
SCM Agreement provides as follows:
"A request for consultations under paragraph 1 [of Article 4] shall include a statement
of available evidence with regard to th e existence and nature of the subsidy in
question."
7.4 The European Communities contends that its request for consultations contains a "statement
of available evidence" within the meaning of Article 4.2 because it refers to the relevant US legalprovisions.  Accordingly, we presume that the European Communities is referring to the following
language in its request for consultations as representing its "statement of available evidence":
"The European Communities wish to convey to the United States of America a
request for consultations under Article 4 of the "Understanding on Rules andWT/DS108/R
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Procedures Governing the Settlement of Disputes" ("hereinafter referred to as the
"Understanding"), Article XXIII:1 GATT 1994 and Article 4 of the Agreement on
Subsidies and Countervailing Measures (ASCM) with respect to Sections 921-927 of
the Internal Revenue Code and related measures establishing special tax treatment
for "Foreign Sales Corporations" (FSC). "588(emphasis added).
7.5 We note that the word "evidence" has been defined as "available facts, circumstances, etc.,
supporting or otherwise a belief, proposition, etc.", the word "available" has been defined as "at one's
disposal", and the word "statement" has been defined as "expression in words".589  Thus, in its
ordinary meaning Article 4.2 requires that a Member include in its request for consultations an
expression in words of the facts at its disposal at the time it requests consultations in support of itsview that it has, in the words of Article 4.1, "reason to believe that a prohibited subsidy is being
granted or maintained".  On the basis of the ordina ry meaning of Article 4.2, it is evident that a
complainant must identify, but need not annex, available evidence to its request for consultations.
7.6 In view of the ordinary meaning of Article 4.2, the European Communities' request for
consultations could reasonably be considered to contain a statement of available evidence. In thisrespect, we note the United States' acknowledgement at the first meeting of the Panel that there may
be cases where the only evidence relied on by a complainant is a statute, regulation or other legal
instrument.  In this case, in fact, the primary evidence on which the European Communities relies is
Sections 921 through 927 of the US Internal  Revenue Code and related measures. The
European Communities request for consultations, in  as much as it specifically refers to these
materials, contains an expression in words of evidence with regard to the existence and nature of the
subsidy in question.  Although the European Communities did not recite the formulation "statement ofavailable evidence" when referring to these materials,  we do not consider that the explicit use of that
descriptive term is necessary provided that the relevant evidence is itself referred to.  It is true, of
course, that the European Communities in its first submission referred to a variety of additional
materials, primarily in the form of secondary sources
590, and that these additional materials were not
identified in the request for consultations.  Even assuming that these materials represent "evidence"and that a Member is required to identify all available evidence in its request for consultations, we are
not in a position to determine whether as a factual matter these materials were at the disposal of the
European Communities at the time it made its request for consultations and that the
European Communities knew at that time that it would rely on those materials.  In short, it may well
be that the European Communities' request for consultations does contain a statement of availableevidence.
7.7 Even assuming that the European Communities' request for consultations does not contain a
statement of available evidence, the question remains whether we are required to dismiss the
European Communities' claims under Article 3 of the SCM Agreement for this reason.  In considering
this question, we note that a Member generally has a right to request establishment of a panel underArticle 4.7 of the DSU if consultations "fail to settle a dispute within 60 days after the date of receipt
of the request for consultations".
591  Where, as here, the claim relates to a violation of Article 3 of the
SCM Agreement, Article 4.4 of the SCM Agreement authorizes a Member to request establishment of
a panel if no mutually agreed solution has been agreed within thirty days of the request for
                                                     
588 WT/DS108/1, 28 November 1997.
589 Concise Oxford Dictionary , Ninth edition, 1995.
590 The materials in questions were comprised of testimony before the US Congress, reports and other
descriptive materials relating to the FSC prepared by US government officials, articles in tax, legal and business
publications about the FSC, copies of the requests for consultations and establishment of a panel in this dispute,and excerpts from OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations .
All of these materials are explanatory of the FSC except for the OECD Guidelines , which were submitted in
support of the European Communities' view of the meaning of the concept of the "arm's length" principlereferred to in footnote 59 to the SCM Agreement.
591 Of course, a Member may also request establishment of a panel under Article 4.3 of the DSU if a
Member does not respond within ten days after the date of the receipt of the request, or does not enter intoconsultations within a period of no more than 30 days, or a period otherwise mutually agreed.WT/DS108/R
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consultations.  Although these provisions differ with respect to timing and in certain other respects,
we consider that they both embody the principle that the sole prerequisite to requesting establishment
of a panel is that consultations have been held or requested to be held and that the relevant specified
time-period has elapsed.592  We found no specific provisions either in the DSU or Article 4 of the
SCM Agreement requiring a panel to dismiss a claim under Article 3 of the SCM Agreement becausethe complaining Member failed to respect the requir ement that the request for consultations contain a
statement of available evidence.
7.8 We note that the United States argues, based upon the Appellate Body Report in Guatemala –
Cement
593, that a panel must dismiss a claim if the complainant has failed to respect a relevant
procedural requirement.  Guatemala – Cement , however, dealt with a different factual situation than
the case at hand.  Specifically, the complainant in that dispute failed in its request for establishment of
a panel to identify a cognisable measure at issue.  As the Appellate Body explained in European
Communities – Bananas594, a panel must scrutinize a request for establishment of a panel very
carefully because it often forms the basis for the terms of reference of the panel and because it
informs the defending party and third partie s of the legal basis for the complaint.  Guatemala –
Cement  simply does not address the issue of procedural flaws at the prior consultation phase.
7.9 We note the United States' argument that the requirement to include a "statement of available
evidence" would be reduced to "redundancy or inutility" if panels did not enforce non-compliance
through the dismissal of claims where that requ irement was not met.  In our view, however, the
requirement that a statement of available evidence be included in a request for consultations is not
reduced to "redundancy or inutility" because a failure  to comply with it is not enforceable through the
dismissal by a panel of claims arising under Article 3.  Rather, the principle to which theUnited States refers, which is sometimes called the "principle of effective treaty interpretation",
requires that a treaty be interpreted so as to gi ve meaning to all its terms.  In this case, the
United States is in fact contending that a failur e to dismiss the European Communities' claims would
preclude an effective sanction for failure to comply w ith the requirement, rather than that it would fail
to give meaning to the terms of Article 4.2.
7.10 The United States contends that it has been denied its right to learn of the existence of
available evidence in advance of the consultations he ld in this dispute.  We do not consider that the
United States' due process rights in this dispute have been abridged by the alleged failure of the
European Communities to include a statement of available evidence in its request for consultations.
First, we note that the legal basis of the Europ ean Communities' claims and the evidence which is at
the core of the European Communities' Article 3 claims (that is, the relevant provisions of the Internal
Revenue Code) was certainly made clear by the European Communities' request for consultations.
Second, the additional "evidence" which the European Communities has placed before the Panel in its
first submission – and which the United States suggests might have been evidence available to the
European Communities at the time it requested consultations – is all public information readilyaccessible to, and in most cases prepared by, the United States.  Finally, the United States
acknowledged at the first meeting of the Panel that it was of the view at the time it was made that the
request for consultations was "procedurally flawed", but that it "did not feel, and still [does] not feel,
that there is any rule in either the DSU or the S ubsidies Agreement that requires us to perfect the
European Communities' pleadings for it".  While this  may well be the case, it appears to us that the
United States consciously chose not to seek clarification regarding the evidence in question at the
                                                     
592 See Korea – Taxes on Alcoholic Beverages , WT/DS75/R-WT/DS84/R, Report of the Panel adopted
on 17 February 1999, paragraph 10.19 (stating, in the context of an argument relating to the adequacy ofconsultations, that "[t]he only requirement under the DSU is that consultations were in fact held, or were at leastrequested, and that a period of sixty days has elapsed from the time consultations were requested to the time arequest for a panel was made.")
593 Guatemala – Anti-Dumping Investigation Regarding Portland Cement from Mexico,
WT/DS60/AB/R, Report of the Appellate Body adopted on 25 November 1998.
594 European Communities – Regime for the Importation, Sale and Distribution of Bananas,
WT/DS27/AB/R, Report of the Appellate Body adopted on 25 September 1997, paragraph 142.WT/DS108/R
Page 251
point it received the request for consultations, and consequently is not now well-situated to complain
of an abridgement of its due process rights.
7.11 For the foregoing reasons, we deny the United States' request to dismiss the
European Communities' claims under Article 3 of the SCM Agreement on the grounds that the
European Communities failed to include in its request for consultations a statement of availableevidence regarding the existence and nature of the subsidy in question.
2. Appropriate Tax Forum
7.12 The United States argues that footnote 59 to item (e) of the Illustrative List annexed to the
SCM Agreement expressly directs WTO Members to resolve certain issues raised by exemptions from
direct taxes in an appropriate tax forum before reso rting to WTO dispute settlement.  Specifically, the
United States considers that, when disagreements over technical transfer pricing practices or
fundamental tax policy arise, the WTO Member should seek to resolve those issues through the
facilities of existing bilateral tax treaties or other specific international mechanisms.  In this case, the
United States contends that a focus of the European Communities' complaint is FSC administrative
pricing rules.  In the view of the United States, the European Communities should have raised thismatter in the Organization for Economic Cooperation and Development ("OECD") or in the
competent authority process under the relevant bilateral tax treaties.  Accordingly, the United States
requests the Panel to defer or dismiss all EC claims relating to the FSC administrative pricing rules
until the European Communities has attempted to resolve the issues it raises in those fora.
7.13 The European Communities considers that, while footnote 59 represents a reminder to
Members of the existence of tax mechanisms which may provide a better forum than WTO dispute
settlement for resolving differences relating to ar m's length pricing, that footnote is couched in
hortatory language and it is left to the discretion of Members whether to resort to such alternative
mechanisms.  The European Communities contends that, because it is complaining about an export
subsidy, the WTO is the appropriate forum; neither the OECD nor bilateral tax treaties are appropriate
fora or offer facilities for the resolution of the issues it raises in this dispute.  The
European Communities further argues that, if footnote 59 had been intended to constitute arequirement to exhaust alternative fora before resorting to WTO dispute settlement, it would have
been identified as a special or additional disput e settlement provision in Appendix 2 to the DSU.
Finally, the European Communities considers that because, the United States did not raise its concern
before establishment of this Panel, it is estopped from raising its objection before the Panel.
7.14 We recall that footnote 59 is a footnote to item (e) of the Illustrative List of Export Subsidies,
concerning the exemption, remission or deferral, specifically related to exports, of direct taxes or
social welfare charges.  Footnote 59 provides that:
"The Members recognize that deferral need not amount to an export subsidy where,
for example, appropriate interest charges are collected. The Members reaffirm the
principle that prices for goods in transactions between exporting enterprises andforeign buyers under their or under the same control should for tax purposes be the
prices which would be charged between independent enterprises acting at arm's
length. Any Member may draw the attention of another Member to administrative or
other practices which may contravene this principle and which result in a significant
saving of direct taxes in export transactions. In such circumstances the Membersshall normally attempt to resolve their differences using the facilities of existing
bilateral tax treaties or other specific international mechanisms, without prejudice to
the rights and obligations of Members under GATT 1994, including the right of
consultation created in the preceding sentence.
7.15 Paragraph (e) is not intended to limit a Member from taking measures to avoid the double
taxation of foreign-source income earned by its enterprises or the enterprises of another Member."
(emphasis added).WT/DS108/R
Page 252
7.16 We further recall that footnote 59 is not identified as a special or additional rule or procedure
in Appendix 2 to the DSU.
7.17 In considering the preliminary objection raised by the United States, we take as a starting-
point that, under Article XXIII of GATT 1994, the DSU and Article 4 of the SCM Agreement, a
Member has the right to resort to WTO dispute settlement at any time by making a request forconsultations in a manner consistent with those provisions. This fundamental right to resort to dispute
settlement is a core element of the WTO system.  Accordingly, we believe that a panel should not
lightly infer a restriction on this right into the WTO Agreement; rather, there should be a clear and
unambiguous basis in the relevant legal instruments for concluding that such a restriction exists.
7.18 In light of the foregoing, we believe that the question before us is whether footnote 59 limits
the right of a Member to resort to dispute settlement at any time, i.e., whether footnote 59 requires a
Member to resort to what the United States refers to as "alternative tax fora" before  resorting to WTO
dispute settlement.  In our view, footnote 59 provides that, in certain circumstances, "Members shall
normally attempt to resolve their differences using the facilities of existing bilateral tax treaties or
other specific international mechanisms . . . ."  The parties to this dispute disagree as to theimplications of the words "shall normally", with  the European Communities contending that this
means that the resort to such facilities is with in the discretion of the complaining Member, and the
United States contending that, while there may be unusual circumstances where the recourse to other
fora is not practicable, it would be incumbent upon the European Communities to demonstrate that
this is the case.  In our view, however, this difference of view need not be here decided.  Even
assuming that footnote 59 requires Members to attempt to resolve their differences through alternative
tax fora, that footnote does not provide that the right to resort to WTO dispute settlement at any timeis circumscribed by that alleged requirement.
7.19 Not only does footnote 59 not provide a clear and unambiguous basis for circumscribing the
right to resort to WTO dispute settlement at any time,  but it arguably indicates to the contrary.  In this
respect, we recall that, while footnote 59 provides that Members shall normally attempt to resolve
their differences using the facilities of existing bi lateral tax treaties or other specific international
mechanisms, it further states that this is "without prejudice to the rights and obligations of Members
under GATT 1994, including the right of consultation created in the preceding sentence."  We
consider that a restriction on the ability of a Memb er to pursue dispute settlement at any time would
prejudice the rights of a WTO Member.  Thus, this  clause at a minimum strongly suggests that
footnote 59 was not intended to restrict a Member's right to pursue dispute settlement at any time. Weacknowledge that the reference to rights and obligations under GATT 1994 leaves us somewhat
puzzled, in particular given that "the right of consultation created in the preceding sentence" would
appear to be a right provided under the SCM Agreement itself and not under GATT 1994.  In
response to a question from the Panel, both parties have expressed the same view that the reference to
GATT 1994 reflects the fact that this provision was carried over from the Tokyo Round SubsidiesCode, and that it should properly be read to refer to rights and obligations under the WTO Agreement.
Whether or not this is the case, this clause reinforces our view that the drafters did not intend
footnote 59 to limit a Member's rights under other provisions, including those relating to dispute
settlement.
7.20 Finally, the fact that footnote 59 is not identified as a special or additional dispute settlement
provision provides substantial additional confirmation of our understanding of the ordinary meaning
of footnote 59. It will be recalled that Appendix 2 to the DSU contains a list of all special or
additional rules in the covered agreements, including numerous provisions of the SCM Agreement.  If
footnote 59 had been intended to circumscribe the right of a Member to pursue dispute settlement at
any time, we believe that it would have been identified as a special or additional dispute settlement
provision in that Appendix. Nor do we consider th at the United States' argument that Article 10.3 of
the Agreement on Agriculture, on which the European Communities relies in its first submission, isnot identified in Appendix 2, undermines this conclusion.  In our view, Article 10.3, which relates toWT/DS108/R
Page 253
allocation of the burden of proof with respect to certain claims under the Agreement on Agriculture595,
is qualitatively different in its implications from footnote 59 as interpreted by the United States, which
allegedly relates to the fundamentally procedural issue of when a Member may resort to dispute
settlement.
7.21 We note the arguments of the parties regarding whether or not "facilities" exist in the OECD
and under bilateral tax treaties appropriate for the resolution of the differences between the parties
regarding what they characterise as "arm's length pricing" issues.  We further note the differences of
view among the parties regarding whether the European Communities could be considered already to
have attempted to resolve these issues in the OECD .  We consider, however, that footnote 59 does not
require a Member to resort to alternative tax fora before resorting to WTO dispute settlement.Accordingly, we need not decide those questions here.
7.22 For the foregoing reasons, we deny the United States' request that we dismiss or defer the
European Communities' claims regarding the FSC administrative pricing rules until the
European Communities has attempted to resolve the issues it raises through the facilities of existing
bilateral tax treaties or other specific international instruments.
3. Specificity of the Request for Establishment of a Panel
7.23 The United States contends that the European Communities' request for establishment of a
panel fails to comply with the requirement of Article 6.2 of the DSU to "identify the specific measures
at issue".  In particular, the United States relies on the Appellate Body report in European
Communities – Computer Equipment
596 for the view that, in certain cases, in order to identify the
specific measures at issue, it is necessary to iden tify the products subject to the measures in dispute.
In the view of the United States, because the nature of the export subsidy obligations imposed by theAgreement on Agriculture differ depending on the products at issue and the commitments made by
the United States thereunder, the European Communities' request for establishment of a panel should
have, but had not, identified the specific products in question.  Rather, the United States had to wait
until it received the European Communities' first submission to learn of the products in question.
Accordingly, the Panel should dismiss the European Communities' claims under the Agreement onAgriculture.  In its second submission, the United States narrows and limits its preliminary objection
to the European Communities' failure to identify the scheduled  agricultural products in question.
597
7.24 The European Communities contends that the m easure at issue in this dispute is the FSC
scheme and that the legal basis for its complaint is a violation of certain provisions of the Agreement
on Agriculture specified in its request for establishment of a panel with respect to all agriculturalproducts.  This is not comparable to the tariff binding situation in European Communities – Computer
Equipment , where the measure (the applied tariff) applies to a particular product.  The
European Communities identified examples  of products in its first submission because it is invoking
what it considers to be the reversal of the burden of proof provided for in Article 10.3 of the
Agreement on Agriculture for these products and it wanted to limit the burden on the United States tojust those products, which the United States exports to the European Communities.
7.25 The preliminary objection of the United States is based upon an alleged failure of the
European Communities' request for establishment of a panel to comply with Article 6.2 of the DSU.
Article 6.2 provides, in relevant part, that the request for the establishment of a panel:
                                                     
595 See paragraphs 7.134 - 7.143, infra .
596 European Communities – Customs Classific ation of Certain Computer Equipment ,
WT/DS62/AB/R-WT/DS67/AB/R-WT/DS68/AB/R, Report of the Appellate Body adopted on 22 June 1998,
paragraph 67.
597 Footnote 65, supra .WT/DS108/R
Page 254
". . . shall indicate whether consultations were held, identify the specific measures at
issue and provide a brief summary of the legal basis of the complaint sufficient to
present the problem clearly."
7.26 The Appellate Body has, in European Communities – Bananas , explained that "it is
incumbent upon a panel to examine the request fo r establishment very carefully to ensure its
compliance with both the letter and spirit of Article 6.2 of the DSU".  It further explained that:
"It is important that a panel request be sufficiently precise for two reasons: first, it
often forms the basis for the terms of reference of the panel pursuant to Article 7 of
the DSU; and, second, it informs the defending party and the third parties of the legal
basis of the complaint."598
7.27 In European Communities – Computer Equipment , the Appellate Body has further explained
that:
". . . Article 6.2 of the DSU does not explicitly require that the products to which the
'specific measures at issue' apply be identified.  However, with respect to certain
WTO obligations, in order to identify the 'specific measures at issue', it may also benecessary to identify the products subject to the measures in dispute."
599
7.28 In applying these principles to the case at hand, we are of course required to examine very
carefully the European Communities' request for es tablishment of a panel.  With respect to the
European Communities' claims under the Agreement on Agriculture, that request states that:
"The FSC scheme is an export subsidy within the meaning of Article 1(e) of the AA.
Since the United States has declared that the Scheme is not taken into account for the
purpose of compliance with their commitments under the AA, theEuropean Communities considers that there is a violation of Articles 3 and 8 AA read
in conjunction with Articles 9(1)(d), 10(1) and 10(3) of the same Agreement."
600
7.29 The question before us is whether the European Communities' request for establishment is
sufficiently precise to satisfy the requirements of Article 6.2 of the DSU.  We consider that it is.  In its
request for establishment of a panel, the European Communities states that in its view the FSC is an
export subsidy and that "the United States has declared that the [FSC] Scheme is not taken into
account for the purpose of compliance with their commitments under the AA . . . ."  Accordingly,
given the inherently all-encompassing nature of this claim, it constitutes a claim that the FSC could
give rise to violations of the Agreement on Agriculture with respect to any agricultural product.
Consequently, and in the absence of any specification as to the products at issue, this request puts the
United States and third parties on notice that the European Communities asserts the existence of
violations of the Agreement on Agriculture with respect to all agricultural products.
7.30 Further, we see no meaningful distinction between the case where a request for establishment
simply alleges that a Member has breached its commitments with respect to all agricultural products,
and the case where a Member makes such an allegation and attaches a list of all agricultural products.In either event, the scope of the products at issue will be known.  Whether or not the complaining
Member attaches such a list, the terms of reference are clear and both the defending party and third
parties are fully informed regarding the legal basis of the complaint.
                                                     
598 European Communities – Regime for the Importation, Sale and Distribution of Bananas ,
WT/DS27/AB/R, Report of the Appellate Body adopted on 25 September 1997, paragraph 142.
599 European Communities – Customs Classific ation of Certain Computer Equipment ,
WT/DS62/AB/R-WT/DS67/AB/R-WT/DS68/AB/R, Report of the Appellate Body adopted on 22 June 1998,
paragraph 67.
600 WT/DS108/2, 9 July 1998.WT/DS108/R
Page 255
7.31 Of course, the fact that a complainant in its request for establishment complains about
violations relating to a broad range of products does not discharge it from its obligation to present
such evidence and argument as is necessary to raise a presumption of a violation of the WTO
Agreement.  Thus, to the extent that the existence of a violation depends upon product-specific
information, a complainant which casts its complaint broadly in terms of the products to which itapplies must as a general rule be prepared to present the necessary evidence and argument to sustain
its claims if it hopes to prevail on the substance of the dispute.  ( See paragraph 7.163)
7.32 For the foregoing reasons, we consider that the European Communities request for
establishment of a panel sufficiently identifies the "specific measures at issue" within the meaning of
Article 6.2 of the DSU.  Accordingly, we deny the United States' request that we dismiss theEuropean Communities' claims under the Agreement on Agriculture.
4. Related Measures
7.33 The European Communities requested establishment of a panel "with respect to Sections 921-
927 of the Internal Revenue Code and related measures establishing special tax treatment for 'Foreign
Sales Corporations' (FSC)".
601  The United States contends that any "related measures" not identified
by the time of the European Communities' first submission are not properly before the Panel.  The
European Communities responds that its complaint relates to the tax exemption and transfer pricing
subsidies accorded to United States exported goods under the body of law it has described as the
"FSC scheme", that the European Communities had already identified many other provisions related
to that scheme, and that the Panel should therefore reject the United States' request for a ruling.
7.34 In our view, this dispute relates to certain tax treatment under the FSC scheme which is
alleged by the European Communities to be incons istent with the SCM Agreement and the Agreement
on Agriculture.  The primary legal instruments governing this tax treatment may be found in Sections
921-927 of the US Internal Revenue Code, which are identified in the European Communities' request
for establishment of a panel.  In our examination of the WTO-consistency of this tax treatment, we
have not found it necessary to examine any other legal instruments governing this tax treatment not
specifically identified by the European Communities by the time of its first submission to the Panel.602
Accordingly, we do not consider it necessary to rule on the United States' request in this regard.
B. CLAIMS UNDER ARTICLE 3.1(a) OF THE SCM AGREEMENT
1. Overview of the parties' arguments
7.35 The European Communities claims that the FSC scheme confers subsidies within the meaning
of Article 1 of the SCM Agreement which are contingent upon export performance within themeaning of Article 3.1(a) of that Agreement and are t hus prohibited under the latter provision.  In the
view of the European Communities, the FSC scheme involves two subsidies.  First, the
European Communities identifies certain exemptions from income taxes for FSCs and their parent
companies provided by the FSC scheme.  Second, the European Communities identifies
administrative pricing rules which it considers derogate from the normal transfer pricing rules and toincrease the amount of income shielded from taxation by the FSC exemptions. In the
European Communities' view, these exemptions and administrative pricing rules represent a financial
contribution within the meaning of Article 1.1(a)(1)(ii) because "government revenue that is
otherwise due is foregone or not collected", and a benefit is conferred because the revenue foregone is
                                                     
601 WT/DS108/2 dated 9 July 1998.
602 We have examined Section 245(c) of the US Internal Revenue Code in respect of the dividends-
received deduction for shareholders of a FSC and Section 951(e) of the US Internal Revenue Code in respect of
the exemption of foreign trade income of a FSC from the anti-deferral rules.  See paragraphs 7.96-7.97, infra .
Sections 245(c) and 951(e) were however identified in the European Communities' first written submission
(paragraph 65).  Accordingly, the terms of the Unite d States' preliminary objection do not extend to these
provisions.WT/DS108/R
Page 256
equal to the amount of money which does not have to be paid in taxes by FSCs and their parents.  The
European Communities further considers that the subsidies arising from the exemptions and
administrative pricing rules are contingent upon export performance within the meaning of
Article 3.1(a) because they depend upon the existence and amount of "exempt foreign trade income"
which can only be produced by the export of US goods.  Finally, the European Communitiesconsiders that the subsidies conferred by the FSC scheme fall within the scope of item (e) of the
Illustrative List of Export Subsidies ("Illustrative List"), thus confirming the application of the
Article 3.1(a) prohibition.
7.36 The United States contends that the FSC scheme does not confer any export subsidy.  In the
view of the United States, footnote 59 to item (e) of the Illustrative List contains the "controlling legal
standard" applicable to the European Communities' export subsidy claims. The United States
considers that footnote 59 indicates that income generated from foreign economic processes need not
be taxed, and that the exemption of some or all of such income, by whatever means, is not a
prohibited export subsidy. The United States further argues that a 1981 decision and understanding of
the GATT 1947 Council
603 (hereinafter "1981 understanding") establishes that the exemption from tax
of income attributable to foreign economic processes does not constitute the foregoing of revenue that
is "otherwise due" within the meaning of Article 1.1(a)(1)(ii) of the SCM Agreement, and that
exempting income from foreign economic processes is not therefore to be considered to be contingent
upon export performance.  In the United States' view, footnote 59 further allows Members to use
administrative or other practices to distinguish income derived from economic processes outside their
territory from income derived from economic processes within their territories, so long as the overall
allocation of income approximates arm's length results and does not result in a "significant saving" ofdirect taxes in export transactions. The United States considers that the FSC scheme merely exempts
from taxation certain income attributable to foreign economic processes, and that its FSC
administrative pricing rules are administrative practices to distinguish foreign- from domestic-source
income which do not result in a significant saving of direct taxes in export transactions.
Consequently, it considers that the FSC scheme does not confer any export subsidy within the
meaning of Article 3.1(a) of the SCM Agreement.
2. Order in which the issues will be addressed
7.37 In structuring and ordering their arguments, the parties have taken different approaches.  The
European Communities begins its analysis with Articles 1 and 3 of the SCM Agreement, and then
proceeds to item (e) of the Illustrative List as "confirmation" for its conclusions.  In its first
submission, on the other hand, the United States urges the Panel to begin its analysis with footnote 59
of item (e) of the Illustrative List.  The United States relies on the Appellate Body report in European
Communities – Bananas  for the proposition that, where the issues before a panel implicate two
provisions, the panel should examine the more specific provision first.
604  In subsequent submissions,
and in response to the European Communities' approach, the United States begins its argumentationfrom Article 1, without however abandoning its view  that we should begin our analysis with the
"more specific provision".
7.38 We note that the statements in the Appellate Body report in European Communities –
Bananas  relied upon by the United States relate to the order in which the Panel should have addressed
certain claims , rather than the order in which it should have addressed various provisions relating to a
particular claim. In this case, the European Communities has presented a claim under Article 3.1(a) of
the SCM Agreement, and the parties have pointed to a number of legal provisions, including
Articles 1 and 3 of the SCM Agreement and the Illustrative List (as well as to the 1981 understanding)
that they consider relevant to our analysis. Here, the European Communities as claimant has based its
arguments primarily on Articles 1 and 3 of the SCM Agreement, rather than on the Illustrative List,
                                                     
603 Tax Legislation , BISD 28S/114, 7-8 December 1981.
604 European Communities – Regime for the Importation, Sale and Distribution of Bananas ,
WT/DS27/AB/R, Report of the Appellate Body adopted on 25 September 1997, paragraph 204.WT/DS108/R
Page 257
and we consider that our analysis would best be structured by looking first at those Articles.605  I n
addition, and in light of the fact that the European Communities has alleged the existence of two
distinct subsidies, we will first address the issue of FSC exemptions, and thereafter will address the
issue of FSC administrative pricing rules.
3. Existence of a subsidy: FSC exemptions
7.39 Article 3.1(a) of the SCM Agreement provides th at subsidies "within the meaning of Article1"
which are contingent upon export performance are prohibited.  Consequently, in order for a measure
to be an export subsidy within the meaning of Ar ticle 3.1(a) of the SCM Agreement, it must be a
subsidy within the meaning of Article 1 of that Agreement.  Accordingly, we will first examine
whether the exemptions identified by the European Communities under the FSC scheme are subsidieswithin the meaning of Article 1.1 of the SCM Agreement.
7.40 Article 1.1 of the SCM Agreement provides, in relevant part, that:
"For the purpose of this Agreement, a subsidy shall be deemed to exist if:
(a)(1) there is a financial contribution by a government or any public body within
the territory of a Member (referred to in this Agreement as "government"), i.e. where:
………………………..
(ii) government revenue that is otherwise due is foregone or not collected (e.g.
fiscal incentives such as tax credits)[footnote omitted];
………………………..
and
(b) a benefit is thereby conferred."
It is evident from Article 1 that two elements must be met in order for a subsidy to exist within the
meaning of that Article.  First, there must be a financial contribution by a government.  Second, a
benefit must thereby be conferred.  We will consider each element in turn.
(a) Financial contribution
(i) When foregone revenue is "otherwise due"
7.41 Before turning to the case at hand and considering whether, in the case of the FSC scheme,
revenue is foregone which is otherwise due, we first consider whether, as a general rule, the tax
regime of a Member represents the proper benchmark for assessing whether foregone revenue is
"otherwise due".
7.42 It will be recalled that, under Article 1 of the SCM Agreement, there is a financial
contribution and hence a possible subsidy where "government revenue that is otherwise due is
foregone or not collected (e.g. fiscal incentives such as tax credits)".  The adjective "due" has been
defined, inter alia , to mean "that is owing or payable, as a debt".
606  Furthermore, the financial
contribution must be by a government  (or any public body within the territory of a Member) and
arises only where government  revenue which is "otherwise due" is foregone or not collected.  Thus,
                                                     
605 We do not mean to suggest that it would never be appropriate to begin the analysis of an export
subsidy issue by reference to the Illustrative List – particularly in a case where the claimant relied primarily
upon that List – but merely that we have chosen to begin with Articles 1and 3 in this case.
606 Shorter Oxford English Dictionary  (Third Edition).WT/DS108/R
Page 258
the question to be asked in examining whether a financial contribution in the form of revenue
foregone exists is whether taxes are "owing or pa yable" to a government within the territory of a
Member.  When a taxpayer seeks to establish whether taxes are "owing or payable" to a government,
he must look to that government's own tax regime.  In our view, therefore, it is clear that whether tax
or other government revenue is otherwise "owing or payable" must, absent a clear indication to thecontrary in the SCM Agreement, be determined by  reference to that government's own tax regime.
7.43 The United States has argued that "if, under WTO rules, a WTO Member is not obligated to
tax certain categories of income, then the exemption of such income from taxation cannot constitute a
subsidy, let alone an export subsidy".
607  It need hardly be stated, however, that the WTO Agreement
does not impose any general obligation on Members to levy taxes or duties, nor to levy them at aparticular level.  To the contrary, however unlikely it might be in practice, a WTO Member is in
principle free not to levy any taxes or duties whatsoever.  In the case of import duties, in fact, it could
be said that the complete elimination of import duties would be consistent with the object and purpose
of the WTO Agreement.  That being the case, there is in the WTO Agreement no theoretical "correct"
benchmark for taxes that would represent the norm for taxes and duties "otherwise due".Accordingly, the determination whether revenue foregone is "otherwise due" must involve a
comparison between the fiscal treatment being provided by a Member in a particular situation and the
tax regime otherwise applied by that Member (or, in the case of tax treatment at a sub-Member level,
the tax regime otherwise applied by the taxing authority in question).
7.44 We note that, in the one WTO panel report adopted to date regarding an alleged subsidy in the
form of a financial contribution involving revenue foregone, it is implicit that the proper benchmark
for determining whether revenue foregone was "other wise due" involves a comparison with the tax
regime otherwise applied by the Member.  In Indonesia – Certain Measures Affecting the Automobile
Industry , the parties (including the United States) agreed, and the Panel found, that exemptions from
luxury taxes of up to 35 per cent and from import duties of up to 200 per cent involved the foregoing
of revenue otherwise due.
608  Clearly, however, Indonesia had no general WTO obligation to impose
such duties and taxes, much less to impose them at these levels.  Nevertheless, the Panel and theparties appear to have considered that revenue was foregone that was otherwise due because
Indonesia did not collect these otherwise applicable duties and taxes in the context of the national car
programme.
7.45 In accordance with its ordinary meaning, we took the term " otherwise  due" to refer to the
situation that would prevail but for the measures in question.  It is thus a matter of determiningwhether, absent such measures, there would be a higher tax liability.  In our view, this means that a
panel, in considering whether revenue foregone is "otherwise due", must examine the situation that
would exist but for the measure in question.  Under this approach, the question presented in this
dispute is whether, if the FSC scheme did not ex ist, revenue would be due which is foregone by
reason of that scheme.
7.46 The European Communities terms this a "formalistic" approach, and prefers an approach
under which the question posed is whether there is a "deviation from or exemption to the generally
applied rate or basis for collection"
609 of taxes.  In other words, the European Communities contends
that under this approach, a measure would involve revenue foregone which was otherwise due if it
resulted in the foregoing of revenue which would be due under the Member's "generally applicable"tax regime.  The European Communities further developed this approach in response to questions
from the Panel, explaining that there would only be foregoing of revenue that was otherwise due if the
exemption or exclusion from taxation is "not based on neutral and objective criteria, i.e., the
                                                     
607 Paragraph 4.526, supra .
608 Indonesia – Certain Measures Affecting the Automobile Industry , WT/DS54/R-WT/DS55/R-
WT/DS59/R-WT/DS64/R, paragraph 14.155, Report of the Panel adopted on 23 July 1998.
609 Paragraph 4.591, supra .WT/DS108/R
Page 259
exemption or exclusion is special or programmatic".610  We see no textual basis in Article 1 of the
SCM Agreement, however, to consider that whether revenue foregone is "otherwise due" generally
should be determined by other than the situation that would exist in the absence of the measures in
question.  Thus, although it may well be that, in many cases, the test proposed by the
European Communities would generate the same result as the "but for" test, we consider that it is thelatter test which is grounded in the actual text of the SCM Agreement.
7.47 It may be worth noting that, in the context of countervailing duties, the United States itself
uses a "but for" test as the basis for determining whether a subsidy exists in the case of revenue
foregone.  Thus, Section 351.509 of the US regulations governing countervailing duties provides that:
"[I]n the case of a program that provides for a full or partial exemption or remission
of a direct tax (e.g., an income tax), or a reduction in the base used to calculate a
direct tax, a benefit exists to the extent that the tax paid by a firm as a result of the
program is less than the tax the firm would have paid in the absence of the
program."
611 (emphasis added)
7.48 We hasten to add that the United States' explanation accompanying its regulation specifies
that, "in the case of a foreign tax measure that exempts from taxation (either in whole or in part)
income attributable to economic processes (including transactions involving exported goods) located
outside the territorial limits of the exporting country, the Department would not consider such a
measure to be an export subsidy. . ."612  This however does not detract from the general approach of
the regulations that whether revenue foregone is "otherwise due" should be determined on the basis of
an examination of the tax treatment that would be  applied by the Member in the absence of the
measures in question.
(ii) Does the 1981 Understanding Control When Revenue Foregone is "Otherwise Due"?
7.49 Having determined that, as a general rule, whether revenue foregone is "otherwise due"
should be determined by examining the situation that would exist under a Member's tax regime in the
absence of the measures at issue, we must next consider whether some different interpretation should
be applied in the context of this dispute.
7.50 The United States argues that the term "otherwise due"  must be interpreted in light of the
1981 understanding taken in conjunction with the adoption of certain panel reports involving
subsidies allegedly prohibited by Article XVI:4 of GATT 1947.  Specifically, the United States
considers that the 1981 understanding represents an interpretation of Article XVI:4 of GATT 1947
which is part of GATT 1994 by virtue of pa ragraph 1(b)(iv) of the language of Annex 1A
incorporating the GATT 1994 into the WTO Agreem ent. The United States further considers that,
when read in the light of the 1981 understanding, it is clear that the exemption of foreign source
income from taxation does not constitute the foregoing of revenue that is "otherwise due" within the
                                                     
610 The United States disputes that the reference point for determining whether revenue foregone is
"otherwise due" must as a general matter relate to the generally applicable tax regime of the Member inquestion, and describes at length the complexity of determining in particular circumstances which rules are the"general" rules and which are the "exceptions".  In the vi ew of the United States, this approach confuses the
issue of whether revenue foregone is "otherwise due" with the issue of specificity under Article 2 of the SCM
Agreement.  The United States has not, however, advocat ed application of a "but for" approach, nor has it been
able to identify any generally relevant alternative to a Member's own tax regime for determining when foregonerevenue is "otherwise due".  When asked by the Pane l what criteria it considered should be applied when
examining whether revenue foregone was "otherwise due", the United States responded that "one obviouscriterion is whether there has ever been a decision or  ruling under the same or a related agreement".  Other
criteria identified were "the desirability of avoiding results that exalt form over substance" and "the need to have
clear rules".  Paragraphs 4.1103-4.1114, supra .
611 19 Code of Federal Regulations, Section 351.509.
612 63 Federal Register 65376 (25 November 1998).WT/DS108/R
Page 260
meaning of Article 1.1(a)(ii) of the SCM Agreement.613  The United States argues, in the alternative,
that the 1981 understanding represents "subsequent practice" within the meaning of Article 31(3)(b)
of the Vienna Convention on the Law of Treaties, or constitutes a "decision" within the meaning of
Article XVI:1 of the WTO Agreement that shall "guide" the WTO.
7.51 The European Communities argues that the 1981 understanding represents, at most, a
decision under Article XXIII of GATT 1947, taken in the "dispute settlement rather than rule-making
mode",614 to adopt certain panel reports.  The European Communities relies on the Appellate Body
report in Japan – Alcoholic Beverages615for the proposition that the understanding, like an adopted
panel report, does not constitute an "other decision" within the meaning of paragraph 1(b)(iv) of the
language of Annex 1A incorporating the GATT 1994 into the WTO Agreement and therefore is not apart of the GATT 1994.  The European Communities further considers that the 1981 understanding is
not a "decision" within the meaning of Article XV I:1 of the WTO Agreement.  In any event, the
European Communities considers that the 1981 understanding is irrelevant to a dispute under the
SCM Agreement because it involved at most Article XVI:4 of GATT 1947. Finally, the
European Communities considers that the substance of the 1981 understanding does not support theposition of the United States in this dispute.
7.52 Background to the 1981 understanding.  In July 1973, the GATT Council established four
panels which are commonly referred to as the Tax Legislation Cases.  The first of these panels
involved a complaint by the European Communities that the United States' Domestic International
Sales Corporation ("DISC") legislation was inconsistent with Article XVI:4 of GATT 1947.  The
remaining three panels, which were established simultaneously with the DISC panel, involved
complaints by the United States that certain income tax practices of Belgium, France and theNetherlands were inconsistent with Article XVI:4 of GATT 1947. The four panels, which had the
same composition, issued their reports on 2 November 1976.  The panels found that both the DISC
legislation and the tax practices of Belgium, France and the Netherlands "had effects which were not
in accordance with [the contracting parties'] obligations under Article XVI:4" of GATT 1947.
616
7.53 The Tax Legislation  panel reports proved controversial, and five years passed before they
were adopted through the 1981 understanding.  The 1981 understanding provides as follows:
The Council adopts these reports on the understanding that with respect to these
cases, and in general, economic processes (including transactions involving exported
goods) located outside the territorial limits of the exporting country need not be
subject to taxation by the exporting country and should not be regarded as exportactivities in terms of Article XVI:4 of the General Agreement.  It is further
understood that Article XVI:4 requires that arm's-length pricing be observed, i.e.,
prices for goods in transactions between exporting enterprises and foreign buyers
under their or the same control should for tax purposes be the prices which would be
charged between independent enterprises acting at arm's length.  Furthermore,
                                                     
613 The United States further argues that the 1981 understanding is relevant to interpreting
Article 3.1(a), item (e) of the Illustrative List of Export Subsidies and footnote 59 to that item.  Ourconsideration of the legal status of the 1981 understanding to interpretation of the SCM Agreement is equally
applicable in these various contexts.
614 Paragraph 4.847, supra .
615 Japan – Taxes on Alcoholic Beverages , WT/DS8/AB/R-WT/DS10/AB/R-WT/DS11/AB/R, Report
of the Appellate Body adopted on 1 November 1996.
616 United States Tax Legislation (DISC) , adopted 7-8 December 1981, BISD 23S/98, paragraph 74;
Income Tax Practices Maintained by France , adopted 7-8 December 1981, BISD 23S/114, paragraph 53;
Income Tax Practices Maintained by Belgium , adopted 7-8 December 1981, BISD 23S/127, paragraph 40;
Income Tax Practices Maintained by the Netherlands , adopted 7-8 December 1981, BISD 23S/137,
paragraph 40.WT/DS108/R
Page 261
Article XVI:4 does not prohibit the adoption of measures to avoid double taxation of
foreign source income.617
7.54 The 1981 understanding was accompanied by the following statement by the Chairman of the
Council:
Following the adoption of these reports the Chairman noted that the Council's
decision and understanding does not mean that the parties adhering to Article XVI:4
are forbidden from taxing the profits on transactions beyond their borders, it only
means that they are not required to do so.  He noted further that the decision does not
modify the existing GATT rules in Article XVI:4 as they relate to the taxation of
exported goods.  He noted also that this decision does not affect and is not affected bythe Agreement on the Interpretation and Application of Articles VI, XVI and XXIII.
Finally, he noted that the adoption of these reports together with the understanding
does not affect the rights and obligations of contracting parties under the General
Agreement.
618
7.55 Whether the 1981 understanding is part of GATT 1994.  The first question we must consider
with respect to the 1981 understanding is whether it represents an "other decision of the
CONTRACTING PARTIES to GATT 1947" within the meaning of paragraph 1(b)(iv) of the
language of Annex 1A incorporating the GATT 1994 into the WTO Agreement.619  We recall that
Annex 1A to the WTO Agreement provid es, in relevant part, as follows:
"The General Agreement on Tariffs and Trade ("GATT 1994") shall consist of:
(a) the provisions in the General Agreement on Tariffs and Trade, dated 30
October 1947 . . . as rectified, amended or modified by the terms of legal instrumentswhich have entered into force before the date of entry into force of the WTO
Agreement;
(b) the provisions of the legal instruments set forth below that have entered into
force under the GATT 1947 before the date of entry into force of the WTO
Agreement:
(i)  protocols and certifications relating to tariff concessions;
(ii) protocols of accession . . .;
(iii) decisions on waivers granted under Article XXV of GATT 1947 and
still in force on the date of entry into force of the WTO
Agreement[footnote omitted];
                                                     
617 Tax Legislation , BISD 28S/114, 7-8 December 1981.
618 Ibid.
619 As noted above, the European Communities relies upon the Appellate Body Report in Japan –
Alcoholic Beverages  for the proposition that the 1981 understanding is not an "other decision" for the purposes
of paragraph 1(b)(iv) of the language of Annex 1A incorporating the GATT 1994 into the WTO Agreement.  Inthat case, the Appellate Body found that adopted panel reports do not "in themselves" constitute "other decisions
of the CONTRACTING PARTIES to the GATT 1947" within the meaning of that provision.  We do not
consider that Japan – Alcoholic Beverages  addresses the precise situation presented in this case.  In that dispute,
the issue was the status of adopted panel reports themselves. The 1981 understanding, however, was not limitedto the adoption of certain panel reports.  Rather, the text  of the understanding, when read against the background
of the Tax Legislation  cases, indicates disagreement with certain aspects of those reports.  Further, the reports
were adopted "on the understanding that with respect to these cases, and in general , economic processes . . .
located outside the territorial limits of the exporting country need not be subject to taxation by the exporting
country . . . ."(emphasis added).  Because the 1981 understanding is not simply a decision to adopt certain panelreports, Japan – Alcoholic Beverages  does not in itself offer a clear answer to the issue now before us.WT/DS108/R
Page 262
(iv) other decisions of the CONT RACTING PARTIES to GATT 1947;
(c) the Understandings set forth below:
(i) Understanding on the Interpretation of Article II:1(b) of the General
Agreement on Tariffs and Trade 1994;
(ii) Understanding on the Interpretation of Article XVII of the General
Agreement on Tariffs and Trade 1994;
(iii) Understanding on Balance-of-Payments Provisions of the General
Agreement on Tariffs and Trade 1994;
(iv) Understanding on the Interpretation of Article XXIV of the General
Agreement on Tariffs and Trade 1994;
(v) Understanding in Respect of Waivers of Obligations under the
General Agreement on Tariffs and Trade 1994;
(vi) Understanding on the Interpretation of Article XXVIII of the General
Agreement on Tariffs and Trade 1994; and
(d) The Marrakesh Protocol to GATT 1994."
7.56 It would appear to us that, taken on its own and read in isolation, the phrase "other decisions
of the CONTRACTING PARTIES to GATT 1947" in its ordinary meaning is broad enough to
encompass the 1981 understanding.620 In this respect, we note that the word "decision" has been
defined, inter alia , as "the action of deciding (a contest, question, etc.); settlement, determination;
(with  a and pl.) a conclusion, judgement: esp. one formally pronounced in a court of law".621  In our
view, even a decision to adopt a panel report, .i.e., to make appropriate recommendations or to give a
ruling under Article XXIII:2 of GATT 1994, falls within the ordinary meaning of the term "decision".The Appellate Body in Japan – Alcoholic Beverages  itself refers to the action of the CONTRACTING
PARTIES in adopting a panel report as a "decision"
622 and, as we have seen, the 1981 understanding
goes beyond simple adoption of the Tax Legislation  panel reports in several respects.  Further, there
                                                     
620 The parties have argued extensively about whether the 1981 understanding was adopted pursuant to
Article XXIII:2 or Article XXV of GATT 1947.  In our view, this is not the precise question that should be
posed.  Article XXV was an umbrella provision regarding decision-making by the CONTRACTING PARTIES.
That Article XXV joint action involved "decision-making" is confirmed by Article XXV:4 of GATT 1947,which provided that, "[e]xcept as ot herwise provided for in this Agreement, decisions of the CONTRACTING
PARTIES shall be taken by a majority of the votes cast".  One form of joint action by the CONTRACTINGPARTIES involved making appropriate recommendations or giving rulings under Article XXIII, and the 1981understanding involves, at least in part, joint action un der that provision.  There are however numerous other
provisions "which involve joint action" in GATT 1947 ( See John H. Jackson, World Trade and the Law of
GATT  (Bobs-Merrill, 1969), section 5.4) and Article XXV fu rther provided for joint action "with a view to
facilitating the operation and furthering the objectives of GATT 1947". Thus, even if one takes the view that the1981 understanding goes beyond making a recommendation or ruling under Article XXIII:2, such action wouldstill have been authorized under Article XXV:1, which allowed the CONTRACTING PARTIES broad power
for decision-making in order to facilitate the operation and furthering of the objectives of GATT 1947. This
does not of course mean that the 1981 understanding necessarily represents a decision within the meaning ofparagraph 1(b)(iv) of the language of Annex 1A incorporating the GATT 1994 into the WTO Agreement toadopt an "interpretation" of GATT 1947.  One can imagine numerous forms of joint action underArticle XXV:1, other than interpretations, to facilitate the operation and further the objectives of GATT 1947.
621 Oxford Shorter English Dictionary  (Third edition).
622 Japan – Alcoholic Beverages , p. 13 ("We do not believe that the CONTRACTING PARTIES, in
deciding to adopt a panel report, intended that their decision  would constitute a definitive interpretation of the
relevant provisions of GATT 1947.")(emphasis added).WT/DS108/R
Page 263
can be no doubt that the decision was taken by the CONTRACTING PARTIES, as the actions of the
GATT 1947 Council were referred to the CONTRACTING PARTIES for their approval.623
7.57 That the 1981 understanding was a decision by the CONTRACTING PARTIES of
GATT 1947 does not however necessarily mean that the 1981 understanding is the type of decision
which falls within paragraph (1)(b)(iv) of the language of Annex 1A incorporating GATT 1994 intothe WTO Agreement.  Clearly, it would not be appropriate for us to read the phrase "other decisions
of the CONTRACTING PARTIES to GATT 1947" in isolation.  Rather, we consider that "other
decisions of the CONTRACTING PARTIES to GATT 1947" are only incorporated into GATT 1994
through this language to the extent that they fulfill the criteria of the chapeau to that paragraph, i.e.
that they are "the provisions of the legal instruments set forth below that have entered into force underthe GATT 1947 before the date of entry into force of the WTO Agreement".  In other words, we
consider that only those "other decisions of the CONTRACTING PARTIES to GATT 1947" which
have the characteristics of a "legal instrument" that can "enter into force" form part of GATT 1994.
7.58 In interpreting these terms, we must of course begin with an examination of their ordinary
meaning.  In this respect, we note that the word "instrument" has been defined by one dictionary asfollows: " Law. A formal legal document whereby a right is created or confirmed, or a fact recorded; a
formal writing of any kind, as an agreement, deed, charter, or record, drawn up and executed in legal
form".
624  Similarly, a legal dictionary has defined the word "instrument" to mean, inter alia , "[a]
document or writing which gives formal expression to a legal act or agreement, for the purpose of
creating, securing, modifying or terminating a right; a writing executed and delivered as the evidence
of an act or agreement".625 Thus, the term "legal instrument" in  its ordinary meaning involves the
existence of a formal legal text that has a binding effect in determining the rights and/or obligations ofthe parties thereto, which in this case would be all GATT 1947 contracting parties.
626
7.59 This is in our view confirmed contextually by the references in Articles II.2 and II.3 of the
WTO Agreement to the Agreements "and associated legal instruments included in Annexes 1, 2 and
3" as "binding on all Members" or, in the case of Plurilateral Trade Agreements in Annex 4, on all
Members that have accepted them. We find further confirmation in the reference, in the chapeau toparagraph (1)(b) of the language of Annex 1A incorporating GATT 1994 into the WTO Agreement,
to "entry into force", which implies that the legal instrument has binding effect on the contracting
parties.  Further, it is not the legal instrument s themselves but the "provisions" of the legal
instruments that form part of GATT 1994. The reference to provisions again implies in our view the
existence of a binding and formal legal text.
7.60 Our understanding of the nature of the "legal instruments" that may constitute part of
GATT 1994 is also confirmed by a review of the type s of specific "legal instruments", in addition to
"other decisions of the CONTRACTING PARTIES to GATT 1947", which are identified in
paragraph 1(b) of the language of Annex 1A incorporating GATT 1994 into the WTO Agreement.
The other types of legal instruments specifically identified are protocols and certifications relating totariff concessions, protocols of accession and decisions on waivers granted under Article XXV of
GATT 1947.  These legal instruments share the comm on characteristics of being formal legal texts
which have a binding effect in determining the rights and/or obligations of all contracting parties.
7.61 Further, we consider it significant that all of the other items listed in paragraph 1 of the
language of Annex 1A incorporating GATT 1994 into the WTO Agreement share the commoncharacteristics identified above.  Thus, in addition to the text of GATT 1947 as rectified, amended, or
                                                     
623 CONTRACTING PARTIES, Thirty-Eighth Session, Summary Record of the First Meeting ,
SR.38.1, 15 December 1982.
624 Shorter Oxford English Dictionary  (Third edition).
625 Black's Law Dictionary  (Revised fourth edition).
626 In fact, the term "legal instrument" is used in the immediately preceding paragraph (a) in the context
of the rectification, amendment or modification of the text of GATT 1947.  This would appear to representfurther confirmation of our understanding of the term "legal instrument".WT/DS108/R
Page 264
modified, and the legal instruments whose characteristics we are now considering, the other items
identified as constituting part of GATT 1994 are a series of formal Understandings regarding the
interpretation of GATT 1994, the texts of which were part of the Final Act Embodying the Results of
the Uruguay Round of Multilateral Trade Negotiations627, and the Marrakesh Protocol of GATT 1994.
Again, these are formal legal texts which have a binding effect in determining the rights and/orobligations of the parties thereto.  Thus, the context of paragraph 1(b) confirms our view of the scope
of the term "legal instrument" as used in that paragraph.
7.62 Finally, we consider that our understanding of the scope of the items included in
paragraph 1(b) is appropriate in light of the implications of the inclusion of an item in that paragraph.
It will be recalled that the GATT 1994 "shall consist of" the items identified in paragraph 1 of thelanguage of Annex 1A incorporating GATT 1994 into the WTO Agreement.  In other words, an item
identified in paragraph 1 actually becomes part of GATT 1994, is of legal status equal to the
provisions of GATT 1947 itself, and thus becomes an "integral part" of the WTO Agreement which is
"binding on all Members" under Article II:2 of the WTO Agreement.  In our view, the purpose of the
language of Annex 1A incorporating GATT 1994 into  the WTO Agreement was to transpose into the
WTO system the rights and obligations of contracting parties to GATT 1947.  We do not consider that
this language should be interpreted to make legally binding on all WTO Members decisions of the
CONTRACTING PARTIES that lacked this character under GATT 1947.  Thus, the interpretation of
"legal instrument" set forth above is in our view fully consistent with the object and purpose of the
language of Annex 1A incorporating GATT 1994into the WTO Agreement.
7.63 In short, we conclude that, in order for a decision of the CONTRACTING PARTIES to
GATT 1947 to be a part of GATT 1994 within the meaning of paragraph 1(b)(iv), it must be a legalinstrument within the meaning of the chapeau to paragraph 1, i.e., it must be a formal legal text  which
represented a legally binding determination in respect of the rights and/or obligations generally
applicable to all contracting parties to GATT 1947.
7.64 Applying this interpretation to the issue at hand, we must consider whether the 1981
understanding was in fact a formal legal text which had a binding legal effect on all contractingparties to GATT 1947.  The United States has referred to the 1981 understanding as representing
"joint action" under Article XXV:1 of GATT 1947 which is "akin to an authoritative interpretation of
a WTO agreement by the Ministerial Conference".  In other words, the United States considers that
the 1981 understanding was an interpretation of Article XVI:1 which was legally binding on all
contracting parties to GATT 1947.
628
7.65  But did the CONTRACTING PARTIES in adopting the 1981 understanding effectively take
a decision which was legally binding on all contracting parties to GATT 1947?  An examination of
the text of the 1981 understanding itself is inconclusive.  As noted above, the 1981 understanding
provides that the GATT 1947 Council adopted certain panel reports subject to an understanding "with
respect to these cases, and in general"  (emphasis added).  Consequently, while the understanding is
couched primarily in terms of resolving certain disputes, the language "in general" could be taken to
extend its application beyond the disputes in question.  At the same time, the 1981 understanding is
not expressed in the mandatory language which usually characterizes binding legal instruments.  The
understanding uses terms such as "should not be regarded as export activities" and "should for tax
purposes be", where a binding legal instrument might be expected to use the term "shall".  In addition,
                                                     
627 MTN/FA (15 December 1993).
628 It may be noted that, unlike the WTO Agreement, GATT 1947 nowhere specifically provided the
CONTRACTING PARTIES with authority to make "interpretations" of GATT 1947 and, although suchauthority seems to have been widely recognized by the c ontracting parties, the existence of that power as a legal
matter was not entirely clear.  See John. H. Jackson, World Trade and the Law of GATT  (Bobs-Merrill, 1969),
section 5.5 ("In summary, although a careful legal analysis , having particular reference to the preparatory work,
could lead one to conclude that the CONTRACTING PARTIES of GATT do not have the legal power to make a
binding interpretation of the General Agreement, ne vertheless, in practice, the CONTRACTING PARTIES do
make interpretations and there seems to be remarkably little objection to those interpretations".).WT/DS108/R
Page 265
the phrases "on the understanding that" and "it is further understood that", expressed in the passive
voice (rather than, for example "the CONTRACTING PARTIES agree" or "the CONTRACTING
PARTIES decide") arguably suggest the non-binding nature of the understanding.  Finally, although
this is by no means a conclusive element, the understanding is not expressed in the precise manner
that might be expected of a binding legal instrument.
7.66   Given that the text of the 1981 understanding does not give us a clear answer as to its legal
status, we consider that it is appropriate for us to examine the circumstances in which the 1981
understanding was adopted.  Only in this way may we arrive at a conclusion as to the precise legal
implications of the 1981 understanding.
7.67 The GATT 1947 Council does not indicate the legal basis for the 1981 understanding. We
recall, however, that the Council was required to report to the CONTRACTING PARTIES on matters
considered between sessions of the CONTRACT ING PARTIES. The Council's Report to the
CONTRACTING PARTIES, adoption of which c onstituted approval by the CONTRACTING
PARTIES of the Council's actions, reported in full the discussion of the Council and its adoption of
the 1981 understanding.629  The item appeared under agenda item 15 of the Council's report, entitled
"Recourse to Articles XXII and XXIII."  The Council Report was approved by the CONTRACTING
PARTIES without any discussion of the 1981 understanding.630  In short, while the 1981
understanding was couched in general terms that go beyond the particular disputes under
consideration, the mechanism under which it wa s approved by the CONTRACTING PARTIES was
essentially concerned with dispute settlement in order to facilitate the resolution of certain disputes.
This would suggest that the 1981 understanding was adopted to resolve the Tax Legislation  disputes
as between the parties to those disputes, rather than to establish rights and obligations that werelegally binding on all contracting parties.
631
7.68 It is even more important, in our view, to take account of the actual circumstances
surrounding the adoption by the Council of the 1981 understanding, as that provides the most reliable
evidence as to what the Council thought it was doing by adopting the 1981 understanding.  In our
view, the most important element which must be examined in considering this question is thestatement of the Chairman of the Council in connection with the adoption of the understanding.  That
statement includes the following language:
"Finally, [the Chairman] noted that the adoption of these reports together with the
understanding does not affect the rights and obligations of contracting parties under
the General Agreement."
632
The United States contends that this language simply means that the Council was seeking to "restore"
or confirm its existing understanding of Article XVI:4, which the Tax Legislation  panel reports had
upset.633  We do not however consider that this statement can be dismissed so lightly.  In our view, it
is simply not possible to reconcile the view that the Council was providing an "authoritative [i.e.,
legally binding] interpretation" of Article XVI:4 with language indicating that the 1981 understanding"does not affect the rights and obligations of contracting parties under the General Agreement".  An
interpretation which was legally binding on all contracting parties would in our view by its very
binding nature "affect" rights and obligations of contracting parties under the General Agreement,
                                                     
629 Council of Representatives, Report on Work Since the Thirty-Seventh Session , L/5414,
12 November 1982.
630 CONTRACTING PARTIES, Thirty-Eighth Session, Summary Record of the First Meeting ,
SR.38.1, 15 December 1982.
631 As the Appellate Body explained in Japan – Alcoholic Beverages, WT/DS8/AB/R-
WT/DS10/AB/R-WT/DS11/AB/R, Report of the Appellate Body adopted on 1 November 1996, p. 13, underGATT 1947, "the conclusions and recommendations in an adopted panel report bound the parties to the disputein a particular case, but subsequent panels did not feel legally bound by the details and reasoning of a previous
panel report."[footnotes omitted]
632 Tax Legislation , L/5271, 7-8 December 1981.
633Footnote 341, supra .WT/DS108/R
Page 266
even if that interpretation simply served to "clari fy" the precise scope of those rights and obligations.
In our view, therefore, this statement demonstrates that the 1981 understanding was not perceived as
being legally binding on all contracting parties.
7.69 How much weight should be given to the Chairman's statement in assessing the legal status of
the 1981 understanding?  Although the Chairman's statement is described as having been made
"following the adoption of these reports", it is clear that the understanding and the accompanying
statement were part of a single integrated proposal, and that the statement did not represent
impromptu after-the-fact remarks by the Chairman. Rather, drafts of the 1981 understanding, which
were the basis for consideration of the proposed understanding and which were circulated to allmembers of the Council in advance of the meeting at which the 1981 understanding was adopted,
included both the 1981 understanding itself and the Chairman's statement.
634  The introductory
sentence to the draft understanding and accompanying Chairman's statement provides that:
"[t]he following text has emerged from informal consultations between interested
delegations and is being circulated to the members of the Council for consideration."
Further, it is notable that the 1981 understanding and the accompanying Chairman's statement were
published  together in their entirety in document L/5271 and subsequently in the Basic Instruments
and Selected Documents.635  Certainly, therefore, the Chairman's statement, including the caveats
discussed above, were an integral part of the overall package agreed among the contracting parties,
and must play a critical role in our assessment as to whether the 1981 understanding was a formal
legal text which represented a legally binding determination in respect of the rights and/or obligations
generally applicable to all contracting parties to GATT 1947.
7.70 The significance of the Chairman's statement,  and the importance that contracting parties
attached to it, are clearly reflected in the interventions of delegations both before and after the 1981
understanding was adopted.  Two of the three delegations which spoke prior to the adoption of the
1981 understanding referred to the Chairman's statement, with the European Communities statingthat:
"in document C/W/376/Rev.1 it was explicitly mentioned that the adoption of these
Reports, together with the proposed understanding, did not affect rights and
obligations of contracting parties under the General Agreement".
636
The United States and Canada also referred specif ically to the Chairman's statement prior to the
adoption of the 1981 understanding.  The delegate of Canada noted that "the proposed understanding
stated that the adoption of the Reports, including the DISC Panel Report, would not diminish rights
and obligations under Article XVI:4", a statement endorsed by the delegate of the United States.
7.71 The intervention of Brazil is notable, as it addressed precisely the issue now under
consideration by the Panel:
"The representative of Brazil said his delegation had not opposed the consensus to
take the decision because it did not want to be an obstacle to solving an old and
serious problem in the GATT, but could not support it because it was objectionable
on at least two grounds.  He said in respect of substance, the understanding was toocryptic.  Moreover, the decision purported to give an interpretation that – although
applicable to parties adhering to Article XVI:4 only – was of a general character.  It
was the understanding of his government that, under the rules in force, decisions on
cases submitted to the process of dispute settlement in the GATT should be
circumscribed to these individual cases only.  General interpretations, in GATT
                                                     
634 Item 4 of the Agenda , C/W/376/Rev.1, 8 December 1981.
635 BISD 28S/114.
636 C/M/154, 28 January 1982, p. 6.WT/DS108/R
Page 267
practice, were formulated through different mechanisms.  He reserved all his
country's rights under the General Agreement and the MTN agreements to which
Brazil was a signatory."637
The United States considers that this statement establishes that, despite Brazil's reservations, the 1981understanding was accepted by the Council to be an interpretation binding on all contracting parties.In our view, however, the intervention of Brazil is a demonstration of the reluctance of some
contracting parties to accept the status of the 1981 understanding as an interpretation binding on all
contracting parties, and explains why the Chairman's statement contained the caveat discussed above.
In short, Brazil accepted the 1981 understanding as a resolution to certain disputes, but no more.
7.72 The United States points to the intervention of Chile as confirmation that the 1981
understanding was an interpretation that was legally binding on all contracting parties and not merely
the basis for the resolution of certain disputes.  Specifically, the representative of Chile stated that "it
would have been  more appropriate to adopt an understanding with a judicial approach rather than a
legislative one, as the present case seemed to be "
638 (emphasis added by the United States).  The
United States fails to mention the sentence immediately preceding that quoted by the United States, in
which the representative of Chile states that:
"his delegation had taken note that rights and obligations under the General
Agreement had in no way been affected or reduced by the understanding and by the
panel reports which had been adopted."639
7.73 The United States further points to discussions of the DISC in the Council subsequent to the
adoption of the 1981 understanding as confirmation that "the Council members considered the [1981
understanding] to be a substantive 'decision' by the Council, and not merely the routine adoption of a
panel report".640  The fact that the European Communities and other contracting parties referred to the
1981 understanding in discussions regarding the DISC, and that they criticised the DISC for not being
in conformity with that understanding, is hardly surprising, however.  After all, the DISC was one of
the measures at issue in the Tax Legislation  panel reports, and the purpose of a decision under
Article XXIII is precisely to resolve a particular dispute.  Thus, we see no inconsistency between the
view that the 1981 understanding did not establish generally applicable rights and obligations binding
on all GATT 1947 contracting parties and the discussions identified by the United States.
7.74 In conclusion, we consider that the circumstances surrounding the adoption of the 1981
understanding, and in particular the Chairman's statement which was inseparable from the 1981understanding itself, indicate that the understanding was not a legal instrument with binding legal
force on all contracting parties. In our view, it would appear that the disclaimer language of the
Chairman's statement was a sine qua non  for Council adoption of the understanding.  Under these
circumstances, it would not be appropriate for us to conclude that the 1981 understanding was an
"other decision" within the meaning of paragraph 1( b)(iv) of the language of Annex 1A incorporating
the GATT 1947 into the WTO Agreement.
7.75 Whether the 1981 understanding represents subsequent practice.  In its first submission, the
United States contends not only that the 1981 understanding is an "other decision" that is thus part of
GATT 1994, but also that it constitutes a "subsequent practice" within the meaning of Article 31(3)(b)
of the Vienna Convention on the Law of Treaties "with respect to GATT Article XVI:4, as amendedby the Subsidies Code."
641  Of course, the 1981 understanding could not represent a subsequent
practice with respect to GATT 1994, but at most only with respect to GATT 1947. In any event, we
consider that the 1981 understanding is not "subsequent practice" within the meaning of the Vienna
                                                     
637 Ibid.,  pp. 7-8.
638 Ibid. , p. 8.
639 Ibid. , p. 8.
640 Paragraph 4.1168, supra .
641 Paragraph 4.380, supra.WT/DS108/R
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Convention for the same reason as it is not a "part" of GATT 1994.  In this respect, we recall that,
under Article 31(3)(b) of the Vienna Convention, an interpreter must take into account, together with
the context, "[a]ny subsequent practice in the application of the treaty which establishes the agreement
of the parties regarding its interpretation".  Here, we have seen that the 1981 understanding was
conditioned by the statement of the Chairman of the GATT 1947 Council that the understanding "didnot affect the rights and obligations of contracting parties under the General Agreement", and it is
clear that many contracting parties considered that significant caveat as central to the adoption of the
understanding. To treat the 1981 understanding as subsequent practice "establishing the agreement of
the parties regarding the interpretation" of GATT 1947 would not be consistent with that explicit
qualification.
7.76 Whether the 1981 understanding is a "decision" within the meaning of Article XVI:1 of the
WTO Agreement.  Having concluded that the 1981 understanding is not a part of GATT 1994, we
must next consider the United States' argument th at it represents a "decision" within the meaning of
Article XV1:1 of the WTO Agreement by which the WTO shall be guided. In this respect, we recall
that Article XVI:1 of the WTO Agreement provides as follows:
"Except as otherwise provided under this Agreement or the Multilateral Trade
Agreements, the WTO shall be guided by the decisions, procedures and customary
practices followed by the CONTRACTING PARTIES to GATT 1947 and the bodies
established in the framework of GATT 1947."
7.77 As previously discussed,642 we consider that the 1981 understanding does represent a
"decision" by the CONTRACTING PARTIES to GATT 1947.  Further, Article XVI:1 of the WTO
Agreement on its face is not limited to decisions in the form of "legal instruments", but rather appliesto all decisions by the CONTRACTING PARTIES to GATT 1947 – including decisions to adopt
panel reports– as well as to procedures and cu stomary practices of the CONTRACTING PARTIES.
643
Thus, we conclude that the 1981 understanding is a decision within the meaning of Article XVI:1 of
the WTO Agreement.
7.78 In our view, the difference between the more particularly defined range of actions falling
within the ambit of Article XVI:1 of the WTO Agreement and the list of "legal instruments" that are
incorporated into GATT 1994 pursuant to the language in Annex 1A incorporating GATT 1994into
the WTO Agreement is explained by the different imp lications of the two provisions.  Inclusion of a
decision in the language of Annex 1A means that the decision actually becomes part of GATT 1994
and thus of the WTO Agreement.  Inclusion of a decision within the scope of Article XVI:1 of theWTO Agreement, on the other hand, means that the WTO "shall be guided" by that decision.  A
decision which is part of GATT 1994 is legally binding on all WTO Members (to the extent it is not
in conflict with a provision of another Annex 1A agreement), while a decision which provides
"guidance" in our view is not legally binding but provides direction to the WTO.
644 It is important to
                                                     
642 Paragraphs 7.55-7.56, supra .
643 A number of panels have explicitly or implicitly found that adopted GATT 1947 panel reports fall
within the scope of Article XVI:1 of the WTO Agreement.  See, e.g.,  India – Patent Protection for
Pharmaceutical and Agricultural Chemical Products , Report of the Panel adopted, as modified by the Report of
the Appellate Body, on 16 January 1998, WT/DS50/R, paragraph 7.19; European Communities – Regime for the
Importation, Sale and Distribution of Bananas , Report of the Panel adopted, as modified by the Report of the
Appellate Body, on 25 September 1997, WT/DS27/R/USA, paragraph 7.40.
644 Regarding the legal status of adopted panel reports, the Appellate Body in Japan – Alcoholic
Beverages (p. 14) explained that:
"[a]dopted panel reports are an important part of the GATT acquis .  They are often considered
by subsequent panels.  They create legitimate expectations among WTO Members, and,therefore, should be taken into account where they  are relevant to any dispute.  However, they
are not binding, except with respect to resolvin g the particular dispute between the parties to
that dispute."WT/DS108/R
Page 269
note that, as explained by the Appellate Body, adopted panel reports should be taken into account
"where they are relevant to a dispute".645  In our view, this consideration applies equally to any other
decision, procedure or customary practice of the CONTRACTING PARTIES to GATT 1947.646
7.79 Although we have found that the 1981 understanding is a decision within the scope of
Article XVI:1 of the WTO Agreement, we do not be lieve that the 1981 understanding, which relates
to the Tax Legislation  cases, is in fact relevant  in this dispute.  In this respect, we recall that the claims
under consideration here relate to violations of Part II of the SCM Agreement.  The Tax Legislation
cases, and hence the 1981 understanding, relate to Article XVI:4 of the GATT 1947.  The
United States considers that Tax Legislation panel reports are relevant to the interpretation of the
SCM Agreement because the SCM Agreement is an "interpretation" of Article XVI:4, and because"an examination of the text of the SCM Agreement makes clear that the SCM Agreement and
Article XVI are not to be construed in isolation from each other."
647  In our view, however, it would
not be appropriate to attribute relevance to an understanding regarding the application of
Article XVI:4 of the GATT 1947 to claims under the SCM Agreement, both because Article XVI:4
differs dramatically from the export subsidy disciplines in the SCM Agreement, and because thecontracting parties themselves limited the scope of their action to Article XVI:4.  Let us consider
these points in turn.
7.80 First, we note that the provisions of the SCM Agreement which we are called upon to
interpret in this dispute differ dramatically from those of Article XVI:4 of GATT 1947.  For example,
a core issue in this dispute is whether revenue fo regone was "otherwise due" within the meaning of
Article 1.1(a)(ii) of the SCM Agreement such that a financial contribution – and hence a potential
subsidy – may exist within the meaning of Article 1 of the SCM Agreement.  Although theUnited States would have us look to the 1981 understanding to derive the meaning of this provision,
the phrase "otherwise due" nowhere appears in Article XVI:4 of the GATT 1947.  Nor does the term
"financial contribution".  In fact, nowhere in  Article XVI of GATT 1947 is there any definition
whatsoever of the term "subsidy".  Rather, that term is first defined in the GATT/WTO context only
in Article 1 of the SCM Agreement, and the inclusion of this detailed and comprehensive definition ofthe term "subsidy" is generally considered to represent one of the most important achievements of the
Uruguay Round in the area of subsidy disciplines.
648  Under these circumstances, it would in our view
be inappropriate to place any weight in interpreting the definition of subsidy found in Article 1 of the
SCM Agreement on an understanding regarding Article XVI:4 of GATT 1947 which was adopted
more than a decade before that definition was formulated.
7.81 A similar situation exists with respect to th e concept of "export subsidy" as expressed in
Article 3.1(a) of the SCM Agreement.  Article 3.1(a) contains a precise definition of the concept of
"export subsidy", which subsidies are prohibited by the SCM Agreement.  While it is of course true
that Article XVI:4 contained a prohibition on what could be termed to be "export subsidies", in fact
the text of Article XVI:4 never uses the term "export subsidy", much less defines it.  Rather,Article XVI:4 provides that contracting parties "shall cease to grant either directly or indirectly any
form of subsidy on the export of any product other than a primary product which subsidy results in the
sale of such product for export at a price lower than the comparable price charged for the like product
to buyers in the domestic market".  Thus, the language of Article 3.1(a) of the SCM Agreement that
must be interpreted in this dispute has no counterpart in Article XVI:4 of GATT 1947.
649
                                                     
645 Japan – Alcoholic Beverages , p. 14.
646 To take an extreme example, it is highly unlikely that the 1981 understanding would provide
relevant guidance with respect to the interpretation of the Agreement on Sanitary and Phytosanitary Measures.
647 Paragraph 4.679, supra .
648 See, e.g. , C. Pouncey and K. J. Kuilwijk, WTO Disciplines on Subsidies: An Overview of Residual
Problems – Part I , in International Trade Law and Regulation, Vol. 4, Issue 5 (October 1998), p. 173.
649 We recognize that, although not part of the text of Article XVI:4 of GATT 1947, item (c) of the
"1960 list" found in the Report of the Working Party relating to the Provisions of Article XVI:4 (BISD 9S/185)
is similar, although by no means identical, to item (e) of the Illustrative List annexed to the SCM Agreement.We note, however, that item (e) of the Illustrative List is identical – except in regard to certain aspects ofWT/DS108/R
Page 270
7.82 We do not mean to suggest that Article XVI of GATT 1994 has somehow ceased to be legally
operative or has been simply replaced by the SCM Agreement.  The statement of the Appellate Body
in Brazil – Desiccated Coconut  that "the negotiators of the SCM Agreement  clearly intended that,
under the integrated WTO Agreement , countervailing duties may only be imposed in accordance with
the provisions of Part V of the SCM Agreement  and Article VI of the GATT 1994, taken together"650
is, in our view, equally applicable to the relationship between Part II of the SCM Agreement and
Article XVI of the GATT 1994.  Thus, we agree with the United States that "the SCM Agreement and
Article XVI are not to be construed in isolation from each other."651  This however demonstrates
precisely the problem with relying on an analysis of Article XVI:4 made at a time when the SCM
Agreement did not yet exist.  In our view, Brazil – Desiccated Coconut  in fact reinforces the view that
Article VI of GATT 1994 cannot be invoked independently of the SCM Agreement because, as the
Appellate Body explains, "[t]he SCM Agreement  contains a set of rights and obligations that go well
beyond merely applying and interpreting Articles VI, XVI and XXIII of the GATT 1947".652  Read in
this light, Brazil – Desiccated Coconut  confirms what we consider to be the self-evident proposition
that legal principles derived from Article XVI:4 of GATT 1947, read in isolation and without thebenefit of the detailed provisions of the SCM Agreement regarding the concepts of "subsidy" and
"export subsidy", can be of little, if any, interpretative guidance in understanding the scope of a
Member's obligations regarding export subsidies under the SCM Agreement.
7.83 Further, we note that the CONTRACTING PARTIES themselves limited the implications of
the 1981 understanding to Article XVI:4 of GATT 1947, and specified that it was not relevant to the
interpretation of the then-existing elaboration of Article XVI, the Tokyo Round Subsidies Code.
653
Specifically, the Chairman of the Council in his st atement in conjunction with the adoption of the
1981 understanding
"noted also that this decision does not affect and is not affected by the Agreement on
the Interpretation and Application of Articles VI, XVI and XXIII".654
7.84 We have already explained why we consider that the 1981 understanding cannot be read
without reference to the Chairman's statement.  It would in our view be incongruous, to say the least,
if the 1981 understanding could be relied upon in the interpretation of the WTO SCM Agreement,
when the Chairman's statement specifically excl uded reliance upon it in the interpretation of the
Tokyo Round Subsidies Code, which is in practical if  not legal terms the predecessor agreement to the
SCM Agreement.  This is particularly the case, in that the language of footnote 59 to the
SCM Agreement, on which the United States relies heavily in its defense in this dispute, is transcribedverbatim from footnote 2 to item (e) of the Illustrative List of Export Subsidies annexed to the Tokyo
Round Subsidies Code.
                                                                                                                                                                    
footnote 59 – to its counterpart in the Tokyo Round Subsidies Code, and that, as discussed below, the
Chairman's statement accompanying the 1981 understanding explicitly precluded the use of the 1981understanding to interpret the Tokyo Round Subsidies Code.
650 Brazil – Measures Affecting Dessicated Coconut , WT/DS22/AB/R, Report of the Appellate Body
adopted on 20 March 1997, p. 16.
651 Paragraph 4.679,  supra .
652 Brazil – Measures Affecting Dessicated Coconut , WT/DS22/AB/R, Report of the Appellate Body
adopted on 20 March 1997, p. 17.
653 Agreement on Interpretation and Application of Articles VI, XVI and XXIII of the General
Agreement on Tariffs and Trade.
654 Tax Legislation , 28S/114, 7-8 December 1981.  The United States has argued that, "[b]ecause the
Subsidies Code was an agreement that interpreted, inter alia , Article XVI, the [1981 understanding] would have
been equally applicable to the provisions of the Subsidies Code . . . . Thus, going into the Uruguay Round, theFSC was protected by the [1981 understanding] under both Article XVI and the Subsidies Code".  Second
Submission of the United States to the Panel, footnote 47.  Clearly, this view cannot be reconciled with
Chairman's statement that the 1981 understanding "does not affect and is not affected by" the Tokyo RoundSubsidies Code.WT/DS108/R
Page 271
7.85 In conclusion, we do not consider that the 1981 understanding is part of GATT 1994, nor that
it represents subsequent practice in the application of GATT 1947 establishing the agreement of the
contracting parties regarding its interpretation.  The 1981 understanding is in our view a "decision"
within the meaning of Article XVI:1 of the WT O Agreement which shall "guide" the WTO to the
extent relevant.  However, we consider that the 1981 understanding cannot provide guidance inunderstanding detailed provisions of the SCM Agreement which did not exist at the time the
understanding was adopted.
655
(iii) Footnote 59 as Context for the Interpretation Of Article 1.1(a)(1)(ii)
7.86 The United States' reference to the 1981 understanding is part of a broader argument that any
revenue foregone as a result of FSC exemptions is not "otherwise due" because it arises from incomewhich is attributable to "foreign economic processes".  In the view of the United States, the
"controlling legal principle" which serves as the "analytical starting-point" in this dispute is that
"Members are not obliged to tax income attributable to foreign economic activity".
656  T h e
United States considers that because, under this "controlling legal principle", Members are not obliged
to tax income attributable to foreign economic activity, revenue arising from such income is not"otherwise due" within the meaning of Article 1.1(a)(1)(ii) of the SCM Agreement.  Because in the
view of the United States the FSC scheme merely exempts from taxation certain income arising from
such foreign economic processes, it does not invo lve the foregoing of revenue "otherwise due".
657
7.87 The United States derives this "controlling legal standard" from two sources which it
considers to be context within the meaning of Article 31(1) of the Vienna Convention on the Law of
Treaties.658  As we have seen, the first source relied upon as relevant context is the 1981
understanding, which the United States considers to be part of GATT 1994.  For the reasons statedabove, we do not consider that the 1981 understan ding is "part of GATT 1994", and thus does not
constitute part of the context of Article 1.1(a)(1)(ii) of the SCM Agreement within the meaning of
Article 31(1) of the Vienna Convention.  The United States further argues, however, that the same
"controlling legal standard" (i.e., that income arising from foreign economic activities need not be
taxed) can be derived from footnote 59 to item (e) of the Illustrative List of Export Subsidies.Accordingly, it is to that footnote that we now turn.
7.88 It will be recalled that Annex I to the SCM Agreement contains an Illustrative List of Export
Subsidies ("Illustrative List").  Item (e) of the Illustrative List identifies as an export subsidy:
"The full or partial exemption remission, or deferral specifically related to exports, of
direct taxes
58 or social welfare charges paid or payable by industrial or commercial
enterprises.59"
-------------------------------------------------------------------------------------------------------
58  Footnote omitted.
                                                     
655 We note that Article XVI:1 of the WTO Agreement states that the WTO shall be guided by the
decisions, procedures and customary practices fo llowed by the CONTRACTING PARTIES to GATT 1947
"except as otherwise provided under [the WTO Agreement] or the Multilateral Trade Agreements".  In light ofour view regarding the lack of relevance of the 1981 understanding to this dispute, we need not and do not
address whether the SCM Agreement "provides otherwise" than the 1981 understanding in the sense of
Article XVI:1 of the WTO Agreement.
656 Paragraph 4.523, supra .
657 The United States asserts that this legal principle is relevant both to establishing whether there is a
subsidy within the meaning of Article 1 and whether there is an export subsidy within the meaning of Article 3.We address the latter issue in Section VII.B.4(c), infra .
658 Article 31(1) of  the Vienna Convention provides that "[a] treaty shall be interpreted in good faith in
accordance with the ordinary meaning to be given to the term s of the treaty in their context and in the light of its
object and purpose."WT/DS108/R
Page 272
59  The Members recognize that deferral need not amount to an export subsidy where,
for example, appropriate interest charges are collected.  The Members reaffirm the
principle that prices for goods in transactions between exporting enterprises and
foreign buyers under their or under the same control should for tax purposes be the
prices which would be charged between independent enterprises acting at arm'slength.   Any Member may draw the attention of another Member to administrative or
other practices which may contravene this principle and which result in a significant
saving of direct taxes in export transactions.  In such circumstances the Members
shall normally attempt to resolve their differences using the facilities of existing
bilateral tax treaties or other specific international mechanisms, without prejudice tothe rights and obligations of Members under GATT 1994, including the right of
consultation created in the preceding sentence.
Paragraph (e) is not intended to limit a Member from taking measures to avoid the
double taxation of foreign-source income earned by its enterprises or the enterprises
of another Member."
7.89 The United States considers that it must be implied from footnote 59 that income from foreign
economic activities need not be taxed.  In the view of the United States:
"The necessary predicate of footnote 59 is that income from foreign economic
processes may be exempted from direct taxes.  Were that not the case, the arm's
length principle would be irrelevant.  The arm's length principle prevents income
from being inappropriately shifted between parties or functions.  In the context of
export transactions, the principle focuses on ensuring that income properlyattributable to economic processes within  the taxing jurisdiction is not shifted to
another jurisdiction.  If the SCM Agreement were interpreted as requiring that income
attributable to both foreign and domestic economic processes be taxed by the
domestic taxing authority, the shifting of income between related parties would be
irrelevant (because no tax advantage would be gained), and the relevant portions ofthe footnote would be devoid of meaning."
659
The United States further considers that this footnote constitutes part of the context ofArticle 1.1(a)(1)(ii) of the SCM Agreement, and that  when read in light of this context it must be
concluded that the revenue from such foreign economic activities cannot be "otherwise due".
7.90 We note that the use of a footnote to an item in the Illustrative List of Export Subsidies as
context for the interpretation of Article 1 of the SCM Agreement poses certain interpretive problems.
It is of course the case that the text of Article 1 must be read in its context, and that context includes
the whole of the SCM Agreement (and, indeed, the WTO Agreement in its totality).
660  That said, we
consider that the degree to which a provision is relevant  context and the weight to be given to a
contextual element will differ from case to case, and may depend, inter alia , on the relationship
between the provision being interpreted and the provisio n being relied upon as context.  In this section
of the Report, we are considering US arguments regarding the interpretation of the definition of
"subsidy" as it appears in Article 1 of the SCM Agreement.  Footnote 59, on the other hand, relates to
the Illustrative List of Export  Subsidies, and is obviously thus of greater relevance to determining
when a measure is an export subsidy  than to determining whether it is a subsidy   as such.  Further, it is
worthy of note that most elements of the Illustrative List of Export Subsidies, including the relevant
portions of footnote 59, already existed in the Tokyo Round Subsidies Code, long before any
definition of the term "subsidy" was created. Thus, we must at a minimum exercise considerable
                                                     
659 Paragraph 4.366, supra .
660 United States – Anti-Dumping Duty on Dynamic Random Access Semiconductors (DRAMs) of One
Megabit or Above from Korea , WT/DS99/R, Report of the Panel adopted on 19 March 1999, paragraph 6.21.WT/DS108/R
Page 273
caution in the use of Illustrative List as context for the interpretation of Article 1 of the SCM
Agreement.661
7.91 The United States' view that footnote 59 is predicated on the assumption that "income from
foreign economic processes may be exempted from direct taxes" is not without some persuasive force.
It is in fact difficult to understand why the arm's length principle would be referred to in the secondsentence of footnote 59 if WTO Members were required to tax all income from foreign economic
processes.  In other words, if WTO Members were required to tax all income of all entities, whether
arising from activities within the territory of the Member in question or from activities outside the
territory of that Member, then the shifting of inco me from the exporting enterprise to a related foreign
buyer through non-arm's-length pricing would not as a general rule insulate that income from taxationin the exporting country, much less result in a "significant saving of direct taxes in export
transactions" within the meaning of footnote 59.  Even the European Communities appears to concede
this point, when it acknowledges that "this sentence [the second sentence of footnote 59] assumes that
the foreign related buyer may not be taxed at the same level as the exporter and this may lead to a
lower total tax charge for the income arising from the export transaction".
662  Thus, for the purposes of
our analysis, we will assume that the United States is correct in its assertion that footnote 59 is
"predicated on the assumption that income from foreign economic processes may be exempted from
direct taxes".
7.92 The United States would have us consider that this is dispositive with respect to the question
whether foregone revenue is "otherwise due" and thus as to whether exemptions of certain income
from taxation under the FSC scheme constitute a s ubsidy within the meaning of the SCM Agreement.
We do not agree.  First, and as noted above, because footnote 59 relates to an item in the IllustrativeList of Export Subsidies, it is unclear what conclusi ons can be drawn with respect to the existence of a
subsidy (as opposed to the existence of an export  subsidy). More importantly, we consider that the
United States has made an unwarranted leap of logic from the proposition that "income arising from
foreign economic processes may be exempted from direct taxes" to the proposition that "if countries
are under no obligation to tax income from foreign economic processes, then they should be free toexempt all such income or just part of it " (emphasis added).
663 As we have already discussed at some
length, it is as a general matter necessary in determining whether revenue foregone is "otherwise due"
to look to the situation which would exist under a Member's tax regime in the absence of the measures
in question. Thus, even assuming for the sake of argument that footnote 59 is predicated on the
assumption that income arising from foreign economic processes is not as a general matter "otherwisedue" within the meaning of Article 1.1(a)(1)(ii), we could at most conclude that a decision by a
Member not to tax any income arising from foreign economic processes would not represent the
foregoing of revenue "otherwise due". There is in  our view however nothing in footnote 59 which
would lead us to conclude that a Member that de cides that it will tax income arising from foreign
economic processes does not forego revenue "otherwise due" if it decides in a selective manner toexclude certain limited categories of such income from taxation.
(iv) Whether FSC exemptions represent the foregoing of revenue "otherwise due"
7.93 In the foregoing sections, we have concluded that whether revenue foregone is "otherwise
due" is to be determined on the basis of an ex amination of the fiscal treatment that would be
applicable "but for" the measures in question.  Of course, as in other areas under the WTO
                                                     
661 It should be noted that footnote 1 to Article 1 of the SCM Agreement refers, inter alia , to the
Illustrative List of Export Subsidies with respect to the issue when exemptions or remissions of duties andindirect taxes represent a subsidy within the meaning of Article 1.  That footnote clearly is not applicable in thecontext of this dispute, which relates to issues of direct taxes.
662 Paragraph 4.472, supra .  The European Communities continues to note, however, that "[t]he quoted
sentence does not say or even imply that the exporting country has the right to exempt from tax  income from an
export transaction which would otherwise bear tax."
663 Paragraph 4.699, supra .WT/DS108/R
Page 274
Agreement, the application of this test requires panels to apply their best judgement on a case-by-case
basis.664
7.94 Turning to the facts in this case, the Europ ean Communities has at various points described
the "exemptions" provided by the FSC scheme in slightly different terms.  As we understand it, the
following are the exemptions which the European Communities alleges are provided under the FSCscheme and the general or standard tax regime from which these exemptions deviate.  The first
exemption relates to the circumstances under which the income of a FSC itself is or is not treated as
taxable income of that corporation by the United States.  The second and third exemptions relate to
whether and when the US parent of a FSC is subject to taxation with respect to income generated by
that FSC.  It should be noted that the European Communities does not allege that each of theexemptions separately represents a prohibited export subsidy; rather, the European Communities'
allegation appears to be that these "interconnected exemptions" taken together "complement each
other and lead, as they are intended to lead, to less tax being paid than would be the case if the FSC
scheme did not exist (or rather if it did not contain the FSC exemptions)".
665
7.95 The first exemption alleged by the European Communities relates to the application by the
United States of "formulaic" rules for determining whether income of a FSC is domestic- or foreign-
source income.  Section 882(a) of the US Internal Revenue Code provides that the taxable income of a
foreign corporation engaged in trade or business in the United States includes only income "which is
effectively connected with the conduct of a trade or business in the United States", and Section 864 of
the US Internal Revenue Code sets forth the rule s for determining whether the income of a foreign
corporation is "effectively connected with the conduct of a trade or business in the United States".
Section 921(a) of the US Internal Revenue Code , however, provides that "[e]xempt foreign trade
income of a FSC shall be treated as foreign source income which is not effectively connected with the
conduct of a trade or business within the United States."  Section 923(a) of the US Internal Revenue
Code provides that either 32 per cent or 16/32 of a FSC's foreign trade income (depending upon
whether or not the administrative pricing rules are used) shall be treated as "exempt foreign trade
income".666  These source rules in the view of the European Communities represent a deviation from
Section 864 of the US Internal Revenue Code. In other words, the European Communities is alleging
that the rules provided for determining whether th e income of a FSC is "effectively connected with
the conduct of a trade or business within the United States" exempt from taxation certain income of a
FSC which in the case of a non-FSC would be treated as taxable by the United States.
7.96 The second exemption alleged by the European Communities relates to the non-application to
the foreign trade income of a FSC of the anti-def erral rules for "Controlled Foreign Corporations"
under subpart F of the US Internal Revenue Code.  The United States taxes the foreign-source income
of foreign subsidiaries of US corporations only at the time the income is transferred to the US parent
company in the form of dividends.  This principle is known as "deferral".  Under Section 951(a) of the
US Internal Revenue Code, however, a United States shareholder in a controlled foreign corporationmust include in his gross income each year a pro rata  share of certain forms of undistributed income,
known as Subpart F income, from the controlled foreign corporation.  Section 951(e) of the US
Internal Revenue Code exempts the foreign trade income of a FSC from the "anti-deferral" provisions
of Subpart F.  In other words, the European Communities is alleging that the foreign trade income of a
FSC is exempted from the requirements of Subpart F and that the parent of a FSC need not report as
                                                     
664 As the Appellate Body explained in the context of "like product" analysis under Article III of
GATT 1994, "[i]n applying the criteria cited in Border Tax Adjustments  to the facts of any particular case . . .
panels can only apply their best judgement in determining whether in fact products are "like".  This will alwaysinvolve an unavoidable element of individual, discretionary judgement."  Japan – Taxes on Alcoholic
Beverages , WT/DS8/11-WT/DS10/11-WT/DS11/8, Report of the Appellate Body adopted on
1 November 1996, pp. 20-21.
665 Paragraph 4.271, supra .
666 30 per cent or 15/23, in the case of a corporate shareholder.   See US Internal Revenue Code,
Section 291(a)(4).WT/DS108/R
Page 275
income undistributed income from the FSC that wo uld otherwise be subject to immediate taxation
under Subpart F.
7.97 The third exemption alleged by the European  Communities relates to the tax treatment of
dividends paid by FSCs to their parent corporations .  As a general matter, dividends received by a US
corporation derived from the foreign-source income of a foreign corporation are taxable.  UnderSection 245(c) of the US Internal Revenue Code, however, shareholders of a FSC are eligible for a
100 per cent dividends-received deduction from distributions made out of the "earnings and profits
attributable to foreign trade income" of a FSC.  In other words, the European Communities is alleging
that the parent of a FSC need not pay income taxes on income distributed to it and attributable to the
foreign trade income of a FSC that would otherwise be fully taxable at the time the income wasdistributed to it.
7.98 Applying the "but for" test to the FSC scheme , there can be no doubt that, in the absence of
the FSC scheme, income which is shielded from taxation by that scheme would be subject to taxation.
For example, in the absence of the FSC scheme a US shareholder of a controlled foreign corporation
would be required to include as income each year a pro rata  share of certain forms of undistributed
income, which under the FSC scheme that shareholder is exempted from the need to report, and to pay
immediately taxes, on that undistributed income.  In other words, but for the FSC scheme, the income
in question would not benefit from "deferral".  Similarly, and in the absence of the FSC scheme, the
parent of a foreign corporation would be required to pay income taxes on dividends made out of the
earnings and profits attributable to foreign trade income of that corporation.  Thus, it is clear to us
that, on the basis of the "but for" test, the FSC scheme shields from taxation income that would be
taxed in the absence of the FSC scheme.  It does not appear to us that the United States disputes thisconclusion.
7.99 It is conceivable that a particular exemption may not in every case individually result in the
foregoing of revenue that is otherwise due.  Thus, fo r example, the United States contends that, except
for FSCs, foreign corporations are virtually never subject to US taxation directly  on their foreign
source income under Section 864 of the US Internal Revenue Code.
667  In our view, however, our task
is not to analyse each separate "exemption" separately to determine whether revenue is foregone
which is otherwise due.  Rather, given that the European Communities has alleged that the various
exemptions are interconnected and that together they represent a single subsidy, we consider that our
task is to look at the various exemptions provided by the FSC scheme as a totality, and to assess
whether taken together they involve a financial contribution in the form of the foregoing of revenueotherwise due.
7.100  In our view, the various exemptions identified  by the European Communities, taken together,
involve the foregoing of revenue which is otherwis e due.  Viewed as an integrated whole, the
exemptions provided by the FSC scheme represent a systematic effort by the United States to exempt
certain types of income which would be taxable in the absence of the FSC scheme.  Thus, applicationof special source rules for FSCs serves to protect a certain proportion of the foreign trade income of a
FSC from direct taxation, whether or not that in come would be taxable under the source rules
provided for in Section 864 of the US Internal Revenue Code.  The exemption from the anti-deferral
rules of Subpart F of the US Internal Revenue Code  ensure that the undistributed foreign trade income
of a FSC is not immediately taxable to the US parent of a FSC, even though such income mightotherwise be subject to the anti-deferral rules.  Finally, the 100 per cent dividends-received deduction
ensures that, even when the FSC distributes earnings  attributable to foreign trade income to the US
parent company, the US parent will not be subj ect to US income taxes on that income.  Taken
together, it is clear that the various exemptions under the FSC scheme result in a situation where
certain types of income are shielded from taxes that would be due in the absence of the FSC scheme.
                                                     
667 Paragraph 4.1128, supra .  The caveat "directly" is significant, in that the foreign-source income of a
US-owned foreign corporation would be taxable either when distributed to the US parent or, in the case of the
Sub-part F income of a controlled foreign corporation, as an imputed dividend whether or not distributed.  Thisexample demonstrates the importance of looking at the FSC exemptions as a package rather than separately.WT/DS108/R
Page 276
7.101  We recognize that the application of the FSC scheme might not in all cases result in tax
treatment more favourable than that absent the FSC scheme and it could thus be argued that in those
cases there is no foregoing of revenue otherwise due.668  However, a corporation is free to elect for
each fiscal year whether or not to have the status of a FSC.669  Thus, in those cases where an exporter
considers that it is better off from a tax perspective exporting directly rather than using the FSCscheme, it has the option on an annual basis to opt out of the FSC scheme.  Accordingly, it would only
be in the case of a miscalculation by an exporter as to the tax advantages of FSC election that
application of the FSC scheme would not result in the foregoing of revenue that is otherwise due.  We
find empirical confirmation for our view in a US contribution to an OECD report on tax expenditures
which shows "revenue foregone" of US$1.4 billion in 1995 arising from the "exclusion of incomefrom foreign sales corporations". 
670
7.102  For the foregoing reasons, we conclude that the various exemptions under the FSC scheme,
taken together, result in the foregoing of revenue which is otherwise due and thus give rise to a
financial contribution within the meaning of Article 1.1(a)(1)(ii) of the SCM Agreement.
(b) Benefit
7.103  Having found that the various tax exemptions under the FSC scheme give rise to a financial
contribution, our next task is to consider whether a benefit is thereby conferred.  In our view, the
financial contribution clearly confers a benefit, in as much as both FSCs and their parents need not
pay certain taxes that would otherwise be due. Further, that benefit can be quite substantial: according
to the US Department of Commerce, "the tax exemption can be as great as 15 to 30 per cent on gross
income from exporting".671  We note that the United States has raised no contrary argument with
respect to the issue of benefit.
4. Contingency upon Exportation: FSC Exemptions
(a) Article 3.1(a)
7.104  In the previous section, we have concluded that the various exemptions under the FSC
scheme give rise to a financial contribution that confers a benefit, and thus represent a subsidy within
the meaning of Article 1 of the SCM Agreement.  We now consider whether that subsidy iscontingent upon export performance within the meaning of Article 3.1(a) of the SCM Agreement.
7.105  Article 3.1 of the SCM Agreement provides, in relevant part, that:
"Except as provided in the Agreement on Agriculture, the following subsidies, within
the meaning of Article 1, shall be prohibited:
(a) subsidies contingent, in law or in fact
4, whether solely or as one of several
other conditions, upon export performance, including those illustrated in
Annex I5;
------------------------------------------------------------------------------------------------------------------------------- -----------------------------------
4 This standard is met when the facts demonstrate that the granting of a subsidy,
without having been made legally contingent upon export performance, is in fact tiedto actual or anticipated exportation or export earnings.  The mere fact that a subsidy is
                                                     
668 Statement of Joseph H. Guttenag, International Tax Counsel, Department of the Treasury before the
United States Senate, 21 July 1995, p. 12.   
669 US Internal Revenue Code, Section 927(f).
670 Organisation for Economic Co-operation and Development, Tax Expenditures – Recent Experiences
(Paris, 1996), p. 107 et seq.
671 US Department of Commerce, Foreign Sales Corporations – A Tax Incentive for Exporters,  p. 1.WT/DS108/R
Page 277
granted to enterprises which export shall not for that reason alone be considered to be
an export subsidy within the meaning of this provision.
5 Measures referred to in Annex I as not constituting export subsidies shall not be
prohibited under this or any other provision of this Agreement."
7.106  As discussed in the previous section of this Report, the FSC scheme gives rise to a subsidy
through a series of interconnected exemptions from the taxation of certain income.  The first
exemption shields from taxation the "exempt foreign trade income" of a FSC, while the second and
third exemptions protect the US parent of a FSC from US taxation with respect to undistributed and
distributed "foreign trade income" of a FSC.  Unde r Section 923(b) of the US Internal Revenue Code,
the term "foreign trade income" is defined to mean the "gross income of a FSC attributable to foreign
trading gross receipts".  Section 924 of the US Internal Revenue Code, entitled "Foreign trading gross
receipts", provides in relevant part as follows:
"(a) In general.  Except as otherwise provided in this section, for purposes of this
subpart, the term "foreign trading gross receipts" means the gross receipts of any FSC
which are:
(1) from  the sale, exchange, or other disposition of export property,
(2) from the lease or rental of export property for use by the lessee
outside the United States,
(3) for services which are related and subsidiary to –
(A) any sale, exchange or other disposition of export property by
such corporation, or
(B) any lease or rental of export property described in
paragraph (2) by such corporation,
(4) for engineering or architectural services for construction projects
located (or proposed for location) outside the United States, or
(5)  for the performance of managerial services for an unrelated FSC or
DISC in furtherance of the production of foreign trading grossreceipts described in paragraphs (1), (2) or (3)."
7.107  Under Section 924 of the US Internal Revenue C ode, the income of a FSC relating to "foreign
trading gross receipts" arises (with the exception of subparagraph 4 relating to engineering or
architectural services) only from the sale or lease of "export property" or from services relating to the
sale or lease of such property.  Section 927(a) of the US Internal Revenue Code, in turn, defines theterm "export property" to mean property:
"(A) manufactured, produced, grown, or extracted in the United States by a person
other than a FSC,
(B) held primarily for sale, lease or rental, in the ordinary course of trade or
business, by, or to, a FSC, for direct use, consumption or disposition outside theUnited States, and
(C) not more than 50 per cent of the fair market value of which is attributable to
articles imported into the United States."WT/DS108/R
Page 278
7.108  In light of the above provisions, we consider that the subsidy conferred by the various
exemptions under the FSC scheme is "contingent upon export performance" within the ordinary
meaning of Article 3.1(a) of the SCM Agreement.  The subsidy is only available with respect to
"foreign  trading income"; foreign trading income arises from the sale or lease of "export property" or
the provision of services relating to the sale or lease of export property; and export property is limitedin effect to goods manufactured, produced, grown or extracted in the United States which are held for
direct use, consumption or disposition outside th e United States.  Thus, the existence and amount of
the subsidy depends upon the existence of income arising from the exportation of US goods or the
provision of services relating to the exportation of such goods. The existence of such income, in turn,
depends upon the exportation of US goods or, at a minimum, in the case of income from services
related to the exportation of US goods, upon "anticipated exportation" within the meaning of
footnote 4 to Article 3.1(a) of the SCM Agreement.
(b) Item (e) of the Illustrative List of Export Subsidies
7.109  In our view, the status of the FSC exemptions  as an export subsidy within the meaning of
Article 3.1(a) of the SCM Agreement is confirmed by item (e) of the Illustrative List.  It will berecalled that Article 3.1(a) includes the export subsidies "illustrated in Annex I", i.e., the Illustrative
List of Export Subsidies.  Under item (e) of the I llustrative List, the following is an export subsidy:
"The full or partial exemption remission, or deferral specifically related to exports, of
direct taxes
58 or social welfare charges paid or payable by industrial or commercial
enterprises.59" [footnotes omitted]
7.110  We consider that the FSC exemptions at issue in this dispute do constitute the "full or partial
exemption remission, or deferral . . . of  direct ta xes . . . paid or payable by industrial or commercial
enterprises".  In this respect, we note, first, that both FSCs and their US parents are "industrial or
commercial enterprises". Second, the exemptions provided under the FSC scheme are in our view
"exemptions" within the meaning of item (e) or, in the case of the exemption from the anti-deferral
rules of Subpart F, represent the "deferral" of direct taxes. Finally, we note that, under footnote 58 to
item (e), the term "direct taxes" means, in relevant  part, "taxes on wages, profits, interests, rents,
royalties and all other forms of income".  Thus, the US corporate income taxes from which the FSC
scheme provides exemptions are "direct taxes" within the meaning of item (e).
7.111  We further consider that the FSC exemptions are "specifically related to exports" within the
meaning of item (e).  In this respect, we reca ll our conclusion that the FSC exemptions in question
shield from taxation "foreign trading income", that fo reign trading income arises from the sale or lease
of "export property" or the provision of services relating to the sale or lease of export property, and
that export property is limited in effect to those goods manufactured, produced, grown or
manufactured in the United States which are held for direct use, consumption or disposition outside
the United States.
7.112  The United States does not appear to argue that the FSC exemptions do not fall within the
language of item (e).  To the contrary, the United States appears to concede implicitly that FSC
exemptions are exemptions from direct taxes which are specifically related to exports.  In the course
of criticizing what it considers to be the "simplis tic" approach of the European Communities in this
dispute, the United States complains that "[t]he EC, in effect, has done nothing more than point out
what is plain for all to see – namely, that the FSC is a tax exemption which pertains to exports".672
And in a description of the FSC scheme prepared by the United States and submitted to the Panel in
this dispute, the United States explains that the FSC provides a "partial exemption from taxation of
income derived by a FSC from export sales"673 and a "100 per cent dividends received deduction on
                                                     
672 Paragraph 4.975, supra .
673 Description of Foreign Sales Corporation (FSC) , Appendix A to the First Submission of the
United States to the Panel, paragraph 1.WT/DS108/R
Page 279
repatriation of that income".674  These descriptions are consistent with the characterization of the FSC
consistently provided in US government second ary sources.  Furthermore, the United States'
Government has stated that "[t]he FSC provisions provide a limited exemption from US tax for
income arising from certain export transactions"675 and that "[t]he tax incentive provided by the FSC
legislation is in the form of a permanent exemption from federal income tax for a portion of the exportincome attributable to the offshore activities of FSCs".
676
(c) Footnote 59 to item (e)
7.113  The United States argues that FSC exemptions are not prohibited export subsidies by reason
of footnote 59 to item (e).  The United States considers that, while paragraph (e) states the "general
rule" that the full or partial exemption, remission, or deferral specifically related to exports, of directtaxes is an export subsidy, footnote 59 "qualifies the scope" of item (e) of the Illustrative List and
"makes clear that exempting income attributable to foreign economic processes from direct taxation is
not a prohibited export subsidy" covered by that item.
677  The United States, citing footnote 5 to
Article 3.1(a), further argues the Illustrative List "gives specific meaning" to Article 3.1(a),
identifying practices that do or do not come within the prohibition of Article 3.1(a).  Accordingly,"[i]f the Illustrative List treats a measure as not being an export subsidy, it is not prohibited.  No
further analysis is needed to divine the meaning of  Article 3.1(a) with respect to measures addressed
by the Illustrative List".
678  In other words, and put simply, the United States' view is that, by reason
of footnote 59, FSC exemptions are not prohibited export subsidies within the meaning of item (e),
and that, as a result, FSC exemptions cannot be considered to be export subsidies within the meaning
of Article 3.1(a) of the SCM Agreement.
7.114  The European Communities contests the Unite d States' view regarding the relationship
between the Illustrative List of Export Subsidies and Article 3.1(a) of the SCM Agreement.  The
European Communities considers that the Illustrative List contains a number of subsidies which are
deemed to be included  in Article 3.1(a), but that it cannot be used a contrario  to determine whether a
subsidy is excluded  from the coverage of that Article.  Rather, the List can be used to establish that a
measure is not a prohibited export subsidy only in cases where, as provided by footnote 5, there is aclear statement to that effect in the Illustrative Li st.  In the view of the European Communities, there
is no such clear statement in footnote 59.  Thus, the European Communities is entitled to establish the
existence of an export subsidy within the meaning of Article 3.1(a) without reference to the
Illustrative List.  In any event, the European Communities does not consider that footnote 59
"qualifies" item (e) of the Illustrative List such that the FSC exemptions at issue in this case areremoved from the scope of item (e).
7.115  As discussed previously, we consider that the FSC exemptions at issue in this dispute fall
within the scope of the language of item (e) of the Illustrative List.  In our view, an analysis of the
issues raised by the parties with respect to footnote 59 should thus begin with a consideration of
whether, as argued by the United States, the FSC exemptions at issue in this case are taken outside thescope of item (e) by reason of that footnote.  If the United States is correct in its view that footnote 59
has the effect of excluding the FSC exemptions from the scope of item (e), then we must consider the
parties' arguments regarding the relationship of the Illustrative List to Article 3.1(a) of the SCM
Agreement.  If, on the other hand, we conclude that footnote 59 does not serve to remove the FSC
exemptions at issue from the scope of item (e), th en a discussion of the relationship between the
Illustrative List and Article 3.1(a) would be neither necessary nor appropriate for the resolution of this
dispute.
                                                     
674 Ibid. , paragraph 1.
675 Testimony of Joseph J. Guttenag, International Tax Counsel, Department of the Treasury, Before
the Committee on Finance, US Senate, 21 July 1995, p. 10.
676 US Department of Commerce, Foreign Sales Corporations – A Tax Incentive for US Exporters".
677 Paragraph 4.364, supra .
678 Paragraph 4.363, supra .WT/DS108/R
Page 280
7.116  We have already considered the relevance of footnote 59 as context for the interpretation of
Article 1 of the SCM Agreement, and quoted the footnote in full at that time.  Nevertheless, and in
light of the central role of that footnote to the Un ited States' position in this dispute, we recall that
footnote 59 provides as follows:
"The Members recognize that deferral need not amount to an export subsidy where,
for example, appropriate interest charges are collected.  The Members reaffirm the
principle that prices for goods in transactions between exporting enterprises and
foreign buyers under their or under the same control should for tax purposes be the
prices which would be charged between independent enterprises acting at arm's
length.  Any Member may draw the attention of another Member to administrative or
other practices which may contravene this principle and which result in a significant
saving of direct taxes in export transactions.  In such circumstances the Members
shall normally attempt to resolve their differences using the facilities of existing
bilateral tax treaties or other specific international mechanisms, without prejudice to
the rights and obligations of Members under GATT 1994, including the right ofconsultation created in the preceding sentence.
Paragraph (e) is not intended to limit a Member from taking measures to avoid the
double taxation of foreign-source income earned by its enterprises or the enterprises
of another Member." (emphasis added).
7.117  On what basis does the United States consider that footnote 59 would exclude the FSC
exemptions at issue in this case from the application of item (e)?  As we have seen in our discussion
of Article 1, the United States considers that "the necessary predicate of footnote 59 is that incomefrom foreign economic activity may be exempted from direct taxes".
679  In the context of Article 1, the
United States derived from this principle that revenue derived from foreign economic activity was not
"otherwise due" and that the FSC exemptions which exempt some or all  such revenue from taxation
could not be deemed to give rise to a subsidy within the meaning of Article 1 of the SCM Agreement.
In the context of item (e) of the Illustrative List, the United States' argument is much the same.  In theview of the United States, "the exemption of some or all  of the income generated by foreign economic
activities, through whatever means, is not an export subsidy".
680  Thus, the United States argues that
footnote 59 authorizes a Member to exempt from taxation revenue arising from foreign economic
processes related to export transactions, even if it does not exempt from taxation revenue arising from
foreign economic processes unrelated to export transactions.
7.118  In considering the United States' argument, we first note that footnote 59 nowhere explicitly
provides that it is "qualifying" (i.e., narrowing) the scope of item (e) in the manner argued by the
United States.  This is not to say that we agree with the European Communities that a footnote may
only "explain" and not "contradict" the provision to which it relates.681 In fact, several provisions of
footnote 59 itself could be considered to "qualify" item (e).  Thus, the first sentence of footnote 59could be considered to "qualify" item (e) in providing that "deferral need not amount to an export
subsidy where, for example, appropriate interest charges are collected", while the last sentence of
footnote 59 could be construed to have the same effect in providing that "[p]aragraph (e) is not
intended to limit a Member from taking measures to avoid the double taxation of foreign-source
income earned by its enterprises or the enterprises of another Member".
682  Nowhere, however, does
footnote 59 state that "item (e) is not intended to prevent Members from exempting from direct taxes
foreign-source income relating to export transac tions".  The existence of explicit "qualifying"
                                                     
679 Paragraph 4.366, supra .
680 Paragraph 4.382, supra  (emphasis added).
681 Paragraph 4.639, supra .  To the contrary, it could be observed – and not entirely in jest – that the
most important provisions of the WTO Agreement are found in footnotes, and it is certainly not the case that
language found in a footnote to the WTO Agreement is somehow subsidiary in legal terms to that found in the
body of the Agreement.
682 The United States has not asserted that either of these provisions is relevant to this dispute.WT/DS108/R
Page 281
language in footnote 59 regarding deferral and double taxation serves to underline the absence of any
explicit statement in respect of the principle which the United States contends may be found in
footnote 59.  If the Members had desired to exempt from the export subsidy prohibition certain
exemptions from direct taxation that were specifically related to exports, they might have been
expected to do so explicitly.
7.119  The question remains whether the "qualification" on the scope of item (e) asserted by the
United States can be implied from the language of footnote 59.  We think not.  In
Section VII.B.3(a)(iii) of this Report, we noted th e United States' view that it could be implied that
"income from foreign economic activity may be exempted from direct taxes".  Even assuming that the
United States is correct in this regard, however, this does not mean that a Member is also entitled tochoose to assert its taxing authority over income derived from foreign economic activities generally
and then create an exemption from such taxation specifically for income derived from export
activities. Under item (e) of the Illustrative List, it is only tax exemptions, remissions and deferrals
that are "specifically related to exports" that are prohibited export subsidies.  Arguably, a broad
exemption of income deriving from foreign economic activities from taxation would not be anexemption "specifically related to exports", because it would exempt income derived from any foreign
economic activity, whether involving the exportation of goods to a foreign market, the importation of
goods from a foreign source, or other economic activ ities not related to trade in goods between the
Member in question and a third country.  Thus, even assuming that "income arising from foreign
economic activity may be exempted from direct taxes", we see no contradiction between that principle
and the conclusion that the FSC exemptions are within the scope of item (e) because those exemptions
are "specifically related to exports".
7.120  The United States contends that footnote 59 "must be read in light of a history that dates back
to the inception of GATT Article XVI:4".
683  We are mindful of the fact that footnote 59 has its
origins in footnote 2 to the Illustrative List of Export Subsidies annexed to the Tokyo Round
Subsidies Code, and that the Code was negotiated against the background of the four – at that time
unadopted – Tax Legislation  panel reports.  Of course, reference to this historical background could at
most serve as a supplementary means of interpreta tion within the meaning of Article 32 of the Vienna
Convention684, and only to confirm the meaning of footnote 59 derived from the general rule of
interpretation or to determine its meaning if appl ication of that general rule left the meaning of
footnote 59 ambiguous or obscure or would lead  to a result which is manifestly absurd or
unreasonable. In any event, it should be recalled that the Tax Legislation  panel reports did not relate to
a programme like the FSC, which exempts foreign-source income specifically related to exports, but
rather to the general exemption of foreign-source in come by three European contracting parties, and
to the DISC, which did not purport to represent an exemption of foreign-source income at all.  Thus,
even if it could be suggested that the drafters of the Code, through footnote 59, implicitly rejected the
findings of those panel reports and reflected the principle that foreign-source income need not betaxed, it can hardly be concluded from this that they authorized an exemption of foreign-source
income specifically related to exports pursuant to a scheme that was not even contemplated at the time
the Code was negotiated.
(d) Territorial and World-Wide Tax Systems
7.121  The United States' argumentation in this case also focuses on the differences between world-
wide and territorial systems of taxation. The United States argues that world-wide systems of taxation,
such as that of the United States, place exporters at a disadvantage relative to exporters from countries
with territorial tax systems, because, under a territorial system, whenever activities relating to an
export transaction occur outside the territory of the taxing jurisdiction, income from such activities is
not taxed.  In the view of the United States, however, a WTO Member is free to maintain a world-
wide or territorial tax system, or one that incorporates elements of each.  Thus, and "[i]n recognition
                                                     
683 Paragraph 4.378, supra .
684 European Communities – Measures Affecting the Importation of Certain Poultry Products ,
WT/DS69/AB/R, Report of the Appellate Body adopted on 23 July 1998, paragraph 83.WT/DS108/R
Page 282
of principles of tax sovereignty, a country using a worldwide system is free to incorporate elements of
a territorial system (or vice versa ), so that a foreign subsidiary, or particular kinds of foreign
subsidiaries, such as a FSC, are taxed in a manner similar to foreign corporations under a territorial
system (exemption of income plus an exemption for dividends) or are taxed like a foreign branch
might be taxed under a territorial system (exemption)".685  In short, the United States concludes, the
WTO should not penalize a country using a world-wide system for incorporating elements of a
territorial system in order to obtain comparable tax treatment for its exporters.
7.122  We agree with the United States that neither the SCM Agreement specifically, nor the
WTO Agreement generally, is intended to dictate the type of tax system that should be maintained by
a Member.  On the other hand, certain WTO rules do have implications for specific tax practices ofMembers. In the area of subsidies, it is clear from Article 1 of the SCM Agreement itself that tax
measures of a WTO Member may give rise to subsidies subject to the disciplines of the
SCM Agreement.  It is further clear that, to th e extent that a subsidy is contingent upon export
performance, it is a prohibited export subsidy.  Thus , the United States is free to maintain a world
wide tax system, a territorial tax system or any other type of system it sees fit.  This is not the businessof the WTO.  What it is not free to do is to establish a regime of direct taxation, provide an exemption
from direct taxes specifically related to exports, and then claim that it is entitled to provide such an
export subsidy because it is necessary to eliminate a disadvantage to exporters created by the US tax
system itself.
686 In our view, this is no different from imposing a corporate income tax of, say, 75 per
cent, and then arguing that a special tax rate of 25 per cent for exporters is necessary because the
generally applicable corporate tax rate in other Members is only 25 per cent.
7.123  Finally, we note the United States' view that, if we were to rule in favour of the
European Communities and reject the principle that  foreign-source income need not be taxed, the
result would be to condemn not only the FSC, but also territorial tax systems, including the tax
systems of EC member States. The European Communities, on the other hand, has advanced the
theory that "WTO Members are not prevented by the ASCM from not taxing foreign source income if
this is done on a general basis".687  Here, we must emphasize that the WTO-consistency of other
Members' tax systems, whether territorial or otherwise, is outside our terms of reference.  Thus, we
should not and will not speculate on the implications of our findings in this dispute, if any, for other
Members' tax systems.  It would be up to any future panels that might be established to examine the
consistency of the tax regime before it in accordance with WTO requirements.
5. Administrative Pricing Rules
7.124  In the preceding section of this Report, we conclude that the exemptions provided by the FSC
scheme give rise to a subsidy within the meaning of Article 1 of the SCM Agreement which is
contingent upon export performance within the meanin g of Article 3.1(a) of that Agreement.  The
European Communities has not limited its claims to tax exemptions under the FSC scheme.  The
European Communities further alleges that certain ad ministrative pricing rules relating to the FSC are
a "separate prohibited subsidy" that gives rise to an "independent violation" of the SCM Agreement.
In light of our ruling regarding the tax exemptions under the FSC scheme, the question arises whether
we should proceed to a further and separate ruling on the WTO-consistency of these  administrative
pricing rules.
7.125  The European Communities considers that the Panel must make separate rulings on the
administrative pricing rules and the tax exemptions under the FSC because "each could exist in the
                                                     
685 Paragraph 4.320, supra .
686 As the Appellate Body has stated, "Members of the WTO are free to pursue their own domestic
policy goals through internal taxation or regulation so long as they do not do so in a way that violates Article III
or any of the other commitments th ey have made in the WTO Agreement " (emphasis added).  Japan – Taxes on
Alcoholic Beverages , WT/DS8/AB/R-WT/DS10/AB/R-WT/DS11/AB/R, Report of the Appellate Body adopted
on 1 November 1996, p. 16.
687 Paragraph 4.668, supra .WT/DS108/R
Page 283
absence of the other and it is important that both be held to be prohibited export subsidies so that both
will have to be withdrawn".688  The European Communities argues that, even if the FSC exemptions
were abolished, the administrative pricing rules could still give rise to revenue foregone since the
combined income of the FSC and its parent could still benefit from lower effective taxation than
under the general US transfer pricing rules.689
7.126  The United States contends that the FSC administrative pricing rules are not capable of giving
rise to an independent violation of the SCM Agreement in the absence of the FSC exemptions.  In its
view, the existence of the FSC exemptions is a necessary predicate to the administrative pricing rules,
and those rules would be superfluous and without effect if the exemptions did not exist.  The
United States further considers that the only way that the FSC exemptions could give rise to an"independent violation" would be if the Panel concluded that the FSC exemptions were permissible
(because foreign-source income need not be taxe d), but that the administrative pricing rules
nevertheless resulted in domestic-source income escaping taxation to a significant extent.
690
7.127  We consider that, having found that the exemptions provided by the FSC scheme are an
export subsidy inconsistent with the SCM Agreement, it would be neither necessary nor appropriatefor us to  make a further and independent ruling on the consistency of that scheme's administrative
pricing rules.  In our view, the allegation of the European Communities is in fact that the FSC
administrative pricing rules serve to increase the amount of the subsidy conferred by the FSC
exemptions. For example, the European Communities refers to "both the FSC tax exemptions per se
and the increase in the amount of those tax exemptions arising out of the application of the
administrative pricing rules".
691 Elsewhere, the European Communities refers to the FSC
administrative pricing rules as "compounding" th e subsidy provided by the FSC exemptions.692  I n
light of our conclusion that the FSC exemptions in their totality represent a prohibited export subsidy,
and because, in our view, FSC administrative pricing rules perform no role and serve no purpose
outside the functioning of those exemptions, we consider that we have discharged our duty under our
terms of reference to make such findings in re spect of the European Communities' Article 3.1(a)
claims as will assist the DSB in making its recommendations.693
7.128  In our view, acceding to the European Communities' request to examine the administrative
pricing rules in the case at hand would require us to perform one of two types of speculative and
inappropriate analysis.  First, we could disregard our conclusions regarding the WTO-consistency of
the FSC exemptions themselves, and examine whether, if the United States were  entitled to exempt
from taxation foreign-source income arising from e xport activities, the administrative pricing rules
nevertheless would give rise to an export subsidy because they treated income as foreign-source that
was in fact domestic-source. We do not consider it appropriate to perform a hypothetical analysis
based upon legal interpretations which we have already rejected.
7.129  Second, we could examine whether, if the United  States eliminated the exemptions provided
by the FSC scheme but utilised the administrative pricing rules in some other context, an exportsubsidy would nevertheless arise from the operation of the administrative pricing rules in themselves.
We are not entitled to speculate about the WTO-consistency of such a hypothetical scheme.
                                                     
688 Paragraph 4.273, supra .
689 Paragraph 4.1083, supra .
690 Paragraphs 4.1131-4.1135, supra .
691 Paragraph 4.296, supra .
692 Paragraph 4.272.
693 The Appellate Body has explained that a panel should address those claims on which a finding is
necessary in order to enable the DSB to make sufficient ly precise recommendations and rulings so as to allow
for prompt compliance by a Member with those recommendations and rulings "in order to ensure effective
resolution of disputes to the benefit of all Members" as provided by Article 21.1 of the DSU.  See Australia –
Measures Affecting Importation of Salmon , WT/DS18/AB/R, Report of the Appellate Body adopted on 6
November 1998, paragraph 223.WT/DS108/R
Page 284
Moreover, such a hypothetical scheme has not been the subject of meaningful argumentation by the
parties.694
6. Conclusion
7.130  For the foregoing reasons, we conclude that FSC exemptions constitute a subsidy which is
contingent upon export perfomance within the meaning of Article 3.1(a) of that Agreement.Accordingly, and "[e]xcept as provided in the Agreement on Agriculture", those subsidies are
prohibited.
C. CLAIMS UNDER ARTICLE 3.1(b) OF THE SCM AGREEMENT
7.131  The European Communities further claims that the FSC scheme represents a subsidy
contingent upon the use of domestic over imported goods within the meaning of Article 3.1(b) of theSCM Agreement, in as much as tax exemptions under the FSC scheme are limited to income from the
export of products "not more than 50 per cent of the fair market value of which is attributable to
articles imported into the United States".
695  The United States responds that, because the FSC scheme
does not involve a subsidy, it cannot constitute a subsidy contingent upon the use of domestic over
imported goods. The United States further argues that the FSC scheme is not prohibited byArticle 3.1(b) of the SCM Agreement because, as prov ided by footnote 5 to the SCM Agreement, it is
a measure referred to in Annex I as not constituting an export subsidy.  Finally, the United States
asserts that compliance with the 50 per cent requirement applies to the overall value of the exported
product, and not just to the domestic versus foreign content of its component parts.
696
7.132  As an initial matter, we must consider whethe r, in light of our finding that FSC exemptions
represent an export subsidy prohibited by Article 3.1(a) of the SCM Agreement, we should further
make findings regarding the European Communities' Article 3.1(b) claim.  As noted above697, we
should make findings with respect to a claim to the extent necessary in order to enable the DSB to
make sufficiently precise recommendations and rulings so as to allow for prompt compliance by a
Member. In this case, we have found that exemptions under the FSC scheme are prohibited export
subsidies.  The element of the definition of "export property" that is at the core of the
European Communities' claim under Article 3.1(b) of the SCM Agreement serves simply to assist indefining the scope of those exemptions, and does not serve any other practical purpose.
698
Consequently, we do not consider that it would be necessary or appropriate to make findings withrespect to this claim.
D. CLAIMS UNDER THE AGREEMENT ON AGRICULTURE
1. Overview of the Parties' Arguments
7.133  The European Communities argues that the FSC scheme represents an export subsidy listed in
Article 9.1(d) of the Agreement on Agriculture.  In the view of the European Communities, the
United States has provided FSC subsidies in respect of a quantity of exports in excess of the
United States export subsidy commitments under the Agreement on Agriculture and has thus acted
inconsistently with Articles 3.3 and 8 of that Agreement.  In the alternative, the
                                                     
694 The sole EC discussion of the consistency of this hypothetical scheme is comprised of a few
sentences in its response to questions from the Panel after the second meeting, responses to which the
United States has not had an opportunity to react.  While vigorous argumentation is always important to ensure
that a panel has before it all relevant considerations, this  is particularly the case where legislation as complex as
the US Internal Revenue Code is involved.
695 US Internal Revenue Code, Section 927(a)(1)(C).
696 See Section IV.C of this Report.
697 See supra , paragraph 7.127.
698 In this regard, it is perhaps no surprise that the arguments of the parties in this dispute focused on
the European Communities' Article 3.1(a) claim.  Although the European Communities' Article 3.1(b) claimclearly was not abandoned, the legal issues relating to that claim were not thoroughly explored by either party.WT/DS108/R
Page 285
European Communities argues that the FSC scheme represents an export subsidy not listed in
Article 9.1 of the Agreement on Agriculture, and th at by providing FSC subsidies in excess of its
export subsidy commitments under the Agreement on Agriculture the United States has circumvented
its export subsidy commitments in violation of Article 10.1 of that Agreement.  The United States
responds that the FSC scheme is not an export subsidy under the Agreement on Agriculture, and thataccordingly it has not violated its export subsidy commitments under that Agreement.
2. Article 10.3 and the Burden of Proof
7.134  It is by now well established that, in the WTO dispute settlement system, a complaining
Member, as a general matter, bears the burden of presenting evidence and argument sufficient to
establish a presumption of a violation of the WTO Agreement.
699  In the case of claims under the
Agreement on Agriculture relating to the provision of export subsidies in respect of a product in a
quantity in excess of a Member's reduction commitments for that product, however, there is a specific
provision, Article 10.3, which relates to the issue of burden of proof.  Accordingly, we must consider
the relevance of that Article for the allocation of the burden of proof in this case.
7.135  Article 10.3 of the Agreement on Agriculture provides as follows:
"Any Member which claims that any quantity exported in excess of a reduction
commitment level is not subsidized must establish that no export subsidy, whether
listed in Article 9 or not, has been granted in respect of the quantity of exports in
question."
7.136  We consider it evident, and the parties do not dispute, that Article 10.3 has the effect of
shifting from the complaining to the defending Memb er the burden of demonstrating that no export
subsidies have been granted with respect to any quantity of an agricultural product exported in excessof the reduction commitment level of that Member, if the defending Member claims – as does the
United States – that that quantity is not subsidized.  In this case, therefore, the European Communities
having alleged that the FSC is an export subsidy available with respect to agricultural products, and
once the European Communities has established that the United States has exported a quantity of an
agricultural product in excess of its reduction commitment level, it is up to the United States topresent evidence and argument sufficient to establish that no export subsidy has been granted with
respect to the quantity in question.  The United States could fulfill this burden by submitting evidence
and argument sufficient to establish that the FSC scheme does not represent an export subsidy, that
FSC benefits are not granted with respect to a quantity of the product in question in excess of its
reduction commitment level, or both.
7.137  The parties do not agree, however, as to which products are subject to a "reduction
commitment level" and thus subject to this reversal in the burden of proof.  In the view of the
United States, a product is subject to a reduction commitment only if it is listed in Section II, Part IV
of a Member's schedule; and that unscheduled products as such are not subject to a reduction
commitment.  The European Communities, on the other hand, considers that both scheduled andunscheduled products are subject to reduction commitments; in the case of an unscheduled product,
the reduction commitment level is zero. Because the European Communities has alleged that the
United States has breached its "reduction commitment levels" with respect to both scheduled and
unscheduled products, we must resolve whether Article 10.3 is applicable in the case of unscheduled
products before examining the substance of the claims before us.
700
                                                     
699 See, eg., United States – Measure Affecting Imports of Woven Wool Shirts and Blouses from India .
WT/DS33/AB/R, Report of the Appellate Body adopted on 23 May 1997, pp. 13-14 .
700 Although the parties also disagree as to whether products which appear in a Member's schedule but
at a zero level are subject to "reduction commitments", none of the products in the US schedule are scheduled ata zero level.  See Schedule XX – United States of America, Section II, Part IV.  Accordingly, we need notWT/DS108/R
Page 286
7.138  In considering this issue, the question before us is whether products which do not appear in a
Member's schedule are subject to "reduction commitm ent" within the meaning of Article 10.3.  In our
view, a Member which has not scheduled a given product may well have a commitment  with respect
to that product, in as much as it is precluded by Article 3.3 of the Agreement from providing export
subsidies listed in Article 9.1 with respect to that product.  We do not consider, however, that theMember has a reduction  commitment with respect to an unscheduled product.
7.139  The term "reduction commitment" in its ordinary meaning suggests that the Member was
granting export subsidies with regard to the product in the relevant base period when it prepared its
schedule but committed that it would reduce the quantity of the product benefiting from Article 9.1
export subsidies during the implementation period.  In the case of unscheduled products, however, theMember's commitment is that it will not provide  any export subsidies with respect to that product,
rather than that it will reduce  the quantity of the product with respect to which it provides the subsidy.
Thus, the term "reduction commitment" in its ordinary meaning would not apply to unscheduled
products.
7.140  Our conclusion is confirmed when the term "reduction commitment" as used in Article 10.3 is
read in its context.  In this respect, we note that the title of Article 10 is "Prevention of Circumvention
of Export Subsidy Commitments". While Article 10.3 refers to reduction commitment  levels,
Article 10.1, like the title of Article 10, refers more generally to circumvention of export subsidy
commitments .  We cannot assume that this distinction between two provisions in such close proximity
within the same Article was inadvertent.  Rather, it would appear that Article 10 distinguishes
between "export subsidy commitments", a broad term that refers to commitments with respect both to
scheduled and unscheduled products, and "reduction commitments", a narrower term relatingspecifically to scheduled products.
7.141  Further, we note that Article 3 of the Agreement on Agriculture, titled "Incorporation of
Concessions and Commitments", deals with export subsidy obligations in respect of both scheduled
and unscheduled products. If the term "reduction commitments" were applicable to both scheduled
and unscheduled products, the title of that Article could have been expected to refer to "reductioncommitments" rather than merely to  "commitments".  Again, this would appear to confirm that the
phrase "reduction commitment" refers to that subcategory of "commitments" which relates to
scheduled products.
7.142  Finally, we note the European Communities' view that there is no reason why Article 10.3
should apply to scheduled but not to unscheduled products.  We can however imagine a number ofreasons why the drafters might have made such a distinction.  In particular, it is reasonable to assume
that Article 10.3 places on the defending Member the burden of proof to establish that no export
subsidy has been granted in respect of  any quantity of a product exported in excess of its reduction
commitment level because of concern that a complainant will generally not have access to
information necessary to make a prima facie  case of a violation.  It should however be easier, in most
cases, for a complainant to establish that an export subsidy had been provided with respect to exports
of a particular product, irrespective of amount – as would be the case with respect to unscheduled
products, for which the commitment under Article 3.3 is not to provide any export subsidies listed in
Article 9.1 – than to demonstrate that an export s ubsidy has been provided with respect to a quantity
of product in excess of some given level.
701
                                                                                                                                                                    
decide whether products which are scheduled at a zero le vel are subject to "reduction commitments" within the
meaning of Article 10.3.   
701 The difficulties would be particularly great in cases where a number of different export subsidies are
granted with respect to a product subject to some non-zero level of commitment. In this case, even if the
complaining Member knew the quantity of exports benefiting from each export subsidy, it would not know
whether the different export subsidies were being provided with respect to the same exports or whether different
export subsidies were being provided with respect to distinct exports.WT/DS108/R
Page 287
7.143  In conclusion, we consider that Article 10.3 of the Agreement on Agriculture places the
burden on the United States to present evidence and argument sufficient to establish that no export
subsidy has been granted in respect of any quantity of a product exported in excess of the reduction
commitment levels found in its Schedule for that product. In the case of unscheduled products,
however, the burden remains with the European Communities to present evidence and argumentsufficient to establish that export subsidies have been provided with respect to that product.
3. Claim Under Article 3.3 of the Agreement on Agriculture
7.144  We now turn to the European Communities' claim that the United States has acted
inconsistently with Article 3.3 of the Agreement on Agriculture by providing FSC subsidies in excess
of its reduction commitments under that Agreement.
7.145  Article 3.3 of the Agreement on Agriculture provides as follows:
"Subject to the provisions of paragraphs 2(b) and (4) of Article 9, a Member shall not
provide export subsidies listed in paragraph 1 of Article 9 in respect of the
agricultural products or groups of products specified in Section II of Part IV of its
Schedule in excess of the budgetary outlay and quantity commitment levels specifiedtherein and shall not provide such subsidies in respect of any agricultural product not
specified in that Section of its Schedule."
7.146  A violation of Article 3.3 of the Agreement on Agriculture may be found to exist if it is
determined (a) that a Member is providing "export subsidies listed in paragraph 1 of Article 9 of that
Agreement"; and (b) in respect of a scheduled product, that those export subsidies are being provided
in excess of the budgetary outlay and/or quantity commitment levels specified in its Schedule, or, in
respect of an unscheduled product, that it is providing any such subsidies.
(a) Is the FSC Scheme an Export Subsidy Listed in Article 9.1 of the Agreement on Agriculture?
7.147  Turning to the first issue identified above,  the European Communities argues that the FSC
scheme gives rise to export subsidies within the scope of Article 9.1(d) of the Agreement on
Agriculture.  Article 9.1(d) provides as follows:
"The following export subsidies are subject to reduction commitments under this
Agreement:
………………………………………………………….
(d) the provision of subsidies to reduce the costs of marketing exports of
agricultural products (other than widely available export promotion and advisory
services) including handling, upgrading and other processing costs, and the costs ofinternational transport and freight."
7.148  In order for the FSC scheme to fall within th e scope of Article 9.1(d), two criteria must be
fulfilled.  First , there must be "the provision of subsidies".  Second , the provision of those subsidies
must be "to reduce the costs of marketing exports of agricultural products".  We will consider each of
these criteria in turn.
(ii) Is the FSC scheme  a "subsidy" within the meaning of the Agreement on Agriculture?
7.149  With respect to whether the FSC scheme is a subsidy within the meaning of the Agreement on
Agriculture, we note that, although the term "export subsidy" is defined in Article 1(e) of the
Agreement on Agriculture, the term "subsidy" is nowhere defined in that Agreement.  Accordingly,
the parties have referred to the term "subsidy" as defined in the SCM Agreement – and, in the case ofthe United States, to the concept of subsidy as used in Article XVI of GATT 1994 – as relevantWT/DS108/R
Page 288
context for the interpretation of that term as used  in the Agreement on Agriculture.  In effect, the
parties have relied upon the arguments they presented in the context of the European Communities'
claims under the SCM Agreement as the basis for their views regarding whether a "subsidy" exists
within the meaning of the Agreement on Agriculture.
7.150  We agree with the parties that Article 1 of the SCM Agreement, which defines the term
"subsidy" for the purposes of the SCM Agreement,  represents highly relevant context for the
interpretation of the word "subsidy" within the meaning of the Agreement on Agriculture, as it is the
only article in the WTO Agreement that provides a definition of that term.  This is not of course to say
that the definition of "subsidy" in the SCM Agreement, which applies "[f]or the purpose of this [i.e.,
the SCM] Agreement", is directly applicable to the Agreement on Agriculture. In particular, wecannot preclude a priori  that there could be cases where relevant provisions of the Agreement on
Agriculture might lead a panel to conclude that the term "subsidy" as used in the Agreement on
Agriculture has a different meaning in a particular context from that ascribed to it by Article 1 of the
SCM Agreement.  As a general matter, however, and subject to any provision of the Agreement on
Agriculture under which the contrary is to be inferred
702, we consider that a measure which represents
a subsidy within the meaning of the SCM Agreement will also be a subsidy within the meaning of the
Agreement on Agriculture.
7.151  In Section VII.B.3 of this Report, we considered in detail whether the FSC scheme confers
subsidies within the meaning of Article 1 of the SCM Agreement, and we concluded that it does.  In
light of our views regarding the relevance of Article 1 of the SCM Agreement to the interpretation of
the term "subsidy" as used in the Agreement on Agri culture, and in the absence of any argumentation
by the parties that any provision of the Agreement on Agriculture suggests a different interpretation,we consider that the FSC scheme confers a subsidy within the meaning of the Agreement on
Agriculture.
703
(iii) Do FSC subsidies "reduce the costs of marketing exports of agricultural products"?
7.152  Having determined that the FSC scheme confers subsidies within the meaning of the
Agreement on Agriculture, we must next consider whether those subsidies are provided "to reduce thecosts of marketing exports of agricultural products" within the meaning of Article 9.1(d).
7.153  The European Communities argues that, by reducing the tax liability rising out of foreign
sales, the FSC scheme reduces the costs of marketing exports.  The European Communities points out
that FSC subsidies are by their nature related to the distribution or marketing of exports, because
marketing means advertising, sales promotion and solicitation and these are all activities the FSC isrequired to perform or be responsible for.  The United States responds that the FSC scheme does not
reduce marketing expenses, but merely reduces a FSC's tax liability; the costs incurred by a firm do
not change depending on whether or not the firm files an income tax return as a FSC.  The
United States further argues that the drafters of the WTO Agreement knew how to distinguish
between tax-related and non-tax-related subsidies, and that, if the drafters of Article 9.1(d) hadintended that that item apply to tax-related measur es, they would have specifically provided to that
effect.
                                                     
702 For instance, a measure which is listed as an export subsidy in Article 9.1 of the Agreement on
Agriculture is an export subsidy for the purposes of the Agreement on Agriculture independently of the
definition of  subsidy in the SCM Agreement.
703 The United States argued that the term "subsidy" as used in the Agreement on Agriculture must be
interpreted in light both of Article 1 of the SCM Agreement and Article XVI:1 of GATT 1994.  It is howeverthe SCM Agreement, and not Article XVI of GATT 1994, that contains a definition of the term "subsidy".Further, we have already rejected the United States' arguments that the 1981 understanding is part of
GATT 1994 or that, in any event, Article 1 must be interpreted in light of that understanding not to encompass
the FSC scheme.  Accordingly, we see no basis to consider that the 1981 understanding should control ourinterpretation of the term "subsidy" as used in the Agreement  on Agriculture.WT/DS108/R
Page 289
7.154  In considering this question, we note first that FSC subsidies are provided with respect to
"marketing exports of agricultural products".  In this respect, we note that the term "marketing" has
been defined, inter alia , as "an aggregate of functions involved in transferring title and in moving
goods from producer to consumer including among others buying, selling, storing, transporting,
standardizing, financing, risk bearin g and supplying market information".704  Under US law, the
activities that must be performed by a FSC in order for income to be eligible for FSC exemptions with
respect to a transaction relate to advertising and sales promotion, processing of customer orders and
arranging for delivery of export property, transportation, the determination and transmittal of foreign
invoices, and the assumption of credit risks.705  These activities in our view fall squarely within the
ordinary meaning of the term "marketing".  While a FSC may of course perform additional functionswith respect to the sale of export property overseas, it is difficult to imagine any function that a FSC
might perform overseas with respect to export property that did not fall within the concept of
marketing.
7.155  While FSC subsidies are provided with respect to  marketing, are they provided to "reduce the
costs of marketing exports of agricultural products"?  We consider that they are.  In this respect, wenote that, as a practical commercial matter and in ordinary parlance, income taxes are a cost of doing
business.  Because FSC subsidies reduce an exporter's income tax liability with respect to marketing
activities, they effectively reduce the cost of marketing agricultural products.
7.156  In any event, a subsidy such as the FSC, which is provided to offset costs of marketing
agricultural products, should be considered to reduce the costs of marketing agricultural products. In
our view, the language "to reduce the costs of marketing exports of agricultural products" relates to
the purpose and role of the subsidies in question, rather than to their form.  To conclude otherwisewould in our view distinguish be tween subsidies based upon the way in which they are provided,
thereby elevating form over substance. This would effectively deprive Article 9.1(d) of any
operational meaning.  Under the purely formalistic in terpretation proposed by the United States, the
only conceivable ways in which the costs of mark eting exports of agricultural products could be
reduced would be through changes in either the efficiency of the firms concerned or the marketingcost structure which those firms face in the marketplace. Consequently, even the provision by a
government of marketing services at subsidized pr ices would not, on this reading, be deemed to
reduce  the costs of marketing, but would be deemed to merely shift some of those costs from the
exporter to the government.
7.157  In our view, it is necessary to read Article 9.1(d) in a manner which renders it operationally
effective.  From this perspective, the exporter's costs are reduced whether the government provides
the exporter with services at subsidized prices, grants subsidies to a third party so that the third party
provides the exporter with marketing services at reduced prices, or provides the exporter with
subsidies to offset a portion of the costs of marketing.
7.158  Finally, we note the apparent view of the United States that Article 9.1(d) cannot include tax-
related subsidies.  We see no sound basis for this view.  Article 9.1(d) simply refers to subsidies,  a
term which applies to a wide range of financial contributions which confer a benefit, whether in the
form of a direct transfer of funds such as a grant, revenue foregone, the provision of goods or services
or the purchase of goods.  If the drafters of the Agreement on Agriculture had intended to limit the
scope of Article 9.1(d) to non-taxed-based measures, we presume that they would have said so.
706
                                                     
704 Webster's Third International Dictionary , Vol. II.
705 US Internal Revenue Code, Section 924(e).
706 The United States further suggests that, under the European Communities' interpretation,
Article 9.1(d) would apply to rebates of VAT.  Valu e-added taxes, however, are not related primarily to
marketing, but rather relate to the entire chain of production.  In any event, the non-excessive rebate of VAT
would of course not  be a subsidy within the meaning of the SCM Agreement pursuant to footnote 1 to Article 1
of that Agreement, a conclusion we presume – but which we need not decide – would be equally applicable inthe context of the Agreement on Agriculture.WT/DS108/R
Page 290
7.159  For the foregoing reasons, we find that the FSC scheme involves the provision of a subsidy to
reduce the costs of marketing exports of agricultural products within the meaning of Article 9.1(d) of
the Agreement on Agriculture.707
(b) Are FSC Subsidies Provided for Scheduled Products in Excess of the United States' Quantity
Commitment Levels?
7.160  In the previous section, we have found that FSC subsidies are export subsidies listed in
Article 9.1 of the Agreement on Agriculture.  Under th e first limb of Article 3.3 of that Agreement, a
Member shall not provide such subsidies "in respect of the agricultural products or groups of products
specified in Section II of Part IV of its Schedule [i.e., its Schedule of export subsidy commitments] in
excess of the . . . quantity commitment levels specified therein."
7.161  We have further seen that, with respect to scheduled products, it is only once the complainant
has established that an agricultural product has been exported in excess of its reduction commitment
level that Article 10.3 reverses the burden of proof such that the defending Member must present
evidence and argument sufficient to establish  that no export subsidy has been granted in respect of
the quantity of an agricultural product exported in excess of the reduction commitment level for that
product specified in that Member's Schedule.
7.162  In this case, the European Communities has pres ented evidence with respect to the level of
exports of only one scheduled product, wheat.  This data, which is derived from a UN data base,
shows a quantity of wheat exports during each of the years 1995, 1996 and 1997 which substantially
exceeds the United States' quantity commitment levels for those years as indicated in its Schedule.708
The United States has not contested the accuracy of this data, nor has it asserted that a situation asdescribed in Article 9.2(b) of the Agreement on Agriculture exists.  Thus, the European Communitieshas in our view presented evidence and argument sufficient to establish that the United States
exported wheat in excess of its quantity commitment levels for those years.
7.163  In light of the evidence and argument submitted by the European Communities, it is
incumbent upon the United States pursuant to Article 10.3 of the Agreement on Agriculture to present
sufficient evidence and argument to establish that no export subsidies, including FSC subsidies, were
granted in respect of wheat exported in excess of its reduction commitment levels in any of the years
1995 through 1997.   The United States has however presented no evidence regarding the use of FSC
subsidies with respect to wheat nor with respect to  the volume of wheat exported without the benefit
of export subsidies.
709 Thus, the United States has failed to present evidence and argument sufficient
to establish that no export subsidies have been granted in respect of wheat exported by theUnited States in excess of the reduction commitment level specified in its Schedule.
7.164  The European Communities has not presented any evidence that the United States has
exported any other agriculture product in a quantity in excess of the reduction commitment levels
specified in its Schedule.  Thus, and for the reasons discussed in Section VII.D.2 of the Report, the
                                                     
707 The European Communities has not alleged that the FSC scheme represents an export subsidy listed
in any other item of Article 9.1 of the Agreement on Agriculture.  Consequently, although we do not preclude
the possibility that the FSC scheme might also represent an Article 9.1(a) export subsidy, we need not and do
not resolve that question here.
708The relevant data is summarised below:
Year Exports (1,000 tons) Quantity commitment levels (1,000 tons)
1995 32,413 20,2381996 31,131 19,0951997 25,744 17,952
Source:  Comext2 – Comtrade (HS).
709 In fact, the only evidence on the record relating to the use of FSC subsidies with respect to wheat
indicates that, in 1992, twenty-seven FSC returns were filed with respect to "grains and soybeans". Daniel S.Holick, Foreign Sales Corporations  (1992), Table 1, EC exhibit 12.WT/DS108/R
Page 291
reversal of the burden of proof under Article 10.3 does not come into play with respect to these
products, and there is accordingly no basis for us to find that export subsidies have been granted in
respect of scheduled products other than wheat in excess of the United States' reduction commitment
levels.
7.165  For the foregoing reasons, we find that the United States has provided export subsidies listed
in Article 9.1 of the Agreement on Agriculture in respect of wheat during the years 1995 through
1997 in excess of the quantity commitment levels specified in its Schedule, contrary to its obligations
under the first limb of Article 3.3 of that Agreement.710
(c) Are FSC Subsidies Provided in Respect of Unscheduled Products?
7.166  Under the second limb of Article 3.3 of the Agreement on Agriculture, a Member shall not
provide export subsidies listed in paragraph 1 of Article 9 in respect of any agricultural product not
specified in that Member's Schedule of export subsidy commitments.
7.167  In Section VII.D.3(a) of this Report, we have concluded that FSC subsidies are export
subsidies as listed in Article 9.1 of the Agreement on Agriculture.  We have further concluded inSection VII.D.2 of this Report that the reversal of the burden of proof provided for in Article 10.3 of
the Agreement only applies in the context of an alleged violation of export subsidy reduction
commitments under the first limb of Article 3.3.  Accordingly, the European Communities bears the
burden of presenting evidence and argument sufficient to establish that the United States, contrary to
the second limb of Article 3.3, provides FSC subsidies in respect of unscheduled products.
7.168  The European Communities argues that the simple  availability of FSC subsidies with respect
to any unscheduled agricultural product is in itself a violation of the Agreement on Agriculture.  TheUnited States contends that the mere availability of an export subsidy does not constitute a violation
of the Agreement on Agriculture.  Accordingly, we must consider whether the availability as such of
FSC subsidies in respect of unscheduled products constitutes a violation of the obligations of the
United States under the second limb of Article 3.3 of the Agreement on Agriculture.  In this regard we
note that the United States has not contested that FSC subsidies are in fact available to FSCs whichare engaged in the marketing for export of any agricultural product, nor does it contest that a FSC
which satisfies the relevant requirements thereby has entitlement under the relevant provisions of the
US Internal Revenue Code to FSC subsidies.
7.169  In addressing this issue, the main question which we must examine is whether, in the
prohibition in the second limb of Article 3.3, that a Member shall not "provide" export subsidies listedin paragraph 1 of Article 9 in respect of any agricultural products not specified in that Member's
Schedule of export subsidy commitments, the term "provide" is to be interpreted  to mean making
such export subsidies available, rather than just in the more restrictive sense of actually granting or
paying such subsidies in respect of exports of unscheduled agricultural products.  In accordance with
Article 31 of the Vienna Convention, we have to resolve this question in accordance with the ordinarymeaning to be given to the term "provide" in its context and in the light of the object and purpose of
the provisions of the Agreement on Agriculture as they relate to the use of export subsidies.
                                                     
710 The European Communities does not contend, in respect of scheduled  products, that the availability
of FSC subsidies – as opposed to their actual grant – represents the provision of export subsidies listed inArticle 9 in excess of the United States' reduction commitments and thus gives rise to a violation of the firstlimb Article 3.3 of the Agreement on Agriculture.  To the contrary, the European Communities – in response to
a question from the Panel – states that:
"[g]iven the fact that there are agricultural products for which the US has a commitment ofzero level the mandatory availability of FSC to any agricultural product (i.e. the fact that
anybody who wants to export any agricultural product is entitled to FSC subsidies) is in itself
a violation of Article 3 and 8."
We also recall that none of the products listed in the US schedule are scheduled at a zero level.
Accordingly, we need not and do not decide this issue.WT/DS108/R
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7.170  In our view, the ordinary meaning of the te rm "provide" includes the notion of making
something available, as well as that of actually granting or paying that thing (in the present case
export subsidies listed in Article 9.1 of the Agreement on Agriculture). Moreover, the following
definition in the Shorter Oxford English Dictionary  confirms that  the term "provide" is not restricted
in its ordinary, current usage to actually granting or paying such subsidies:  "6 v.t.  Supply or furnish
for use;  make available …".711
7.171  We note the argument of the United States that in several of the provisions of the Agreement
on Agriculture relating to export subsidies, including the first limb of Article 3.3, language is
employed which could be taken to suggest that, in and by itself, the availability of an export subsidy
does not constitute a violation of the provisions of the Agreement on Agriculture.712  With one
exception, however, each of the provisions cited by the United States in support of its  proposition that
the availability of an export subsidy, in and by itself, does not constitute a violation of the Agreement
on Agriculture, relates to the permitted use of export subsidies in the distinct context of reduction
commitments with respect to scheduled products.713 The one exception concerns the anti-
circumvention provision in Article 10.1. However, this provision deals only with export subsidies not
listed in Article 9.1, whereas Article 3.3 deals only with export subsidies that are listed in Article 9.1.
7.172  We further note the United States' argument that the language of Article 10.3 uses the term
"grant" with reference to the use of subsidies in ex cess of commitment levels and that this language in
Article 10.3 could be taken to imply that the term "provide" in the first limb of Article 3.3 has to be
given a more restrictive meaning, namely, that of actually granting.  However, even if this were so714
– an issue we need not and do not decide in this dispute715 – we do not consider that any such
narrower construction of "provide" as used in the first limb of Article 3.3 would in any case
necessarily control the meaning of the term "provide" as used in the second limb thereof.
7.173  With respect to object and purpose, we consider that the second limb of Article 3.3 establishes
a prohibition on the provision in respect of unscheduled products of export subsidies listed in
Article 9.1.  This prohibition reflects the long-term objective of the Agreement on Agriculture, as
expressed in its preamble,
"to establish a fair and market-oriented agricultural trading system and that a reform
process should be initiated through the negotiation of commitments on support and
                                                     
711 The New Shorter Oxford English Dictionary  (1993), at p. 2393.
712  The provisions cited by the United States in this regard are:
(a)  the first limb of Article 3.3, which provides that a Member:  "shall not provide export
subsidies … in excess of  the budgetary outlay and quantity commitment levels specified [in
the Member's Schedule]";
(b) Article 9.2(a)(ii), which refers to:  " … the maximum quantity … in respect of which such
export subsidies may be granted in that year.";
(c) Article 10.1, which states that:  "Export subsidies not listed in paragraph 1 of Article 9 shall
not be applied in a manner which results in, or which threatens to lead to, circumvention ofexport subsidy commitments; …";  and
(d) Article 10.3, which refers to the need to " … establish that no export subsidy … has
been granted in respect of the quantity of exports in question".
713 In respect of Article 10.3, please refer to our conclusion in paragraph 7.143 above that Article 10.3
applies only in the context of scheduled  products.
714 In this respect, however, we note that the Shorter Oxford English Dictionary  reflects a variety of
definitions of the term "grant", including: "3. An authorita tive bestowal or conferring of a right, etc.; a gift or
assignment of money, etc. out of a fund".  Further, it cannot simply be assumed a priori that Article 10.3 serves
to define the scope of the first limb of Article 3.3, much less that it defines the scope of the second limb of that
Article.
715 See footnote 710, supra .WT/DS108/R
Page 293
protection and through the establishment of strengthened and more operationally
effective GATT rules and disciplines".
7.174  In our view a restrictive interpretation of "pro vide" in the second limb of Article 3.3 would be
problematic from the point of view of the enforcem ent of this prohibition, since other Members would
not be able to assert their rights to challenge export subsidies when they were made available but onlyafter they had been actually granted and the damage done.
7.175  On the basis of the foregoing examination, we conclude that the second limb of Article 3.3 of
the Agreement on Agriculture prohibits making available  export subsidies listed in Article 9.1 in
respect of unscheduled products.
7.176  The United States has not contested that FSC subsidies are in fact available to FSCs which are
engaged in the marketing of any agricultural product,  nor does it contest that a FSC which satisfies the
relevant requirements thereby has entitlement to FSC subsidies under the relevant provisions of the
US Internal Revenue Code.  Accordingly, the Panel finds that the United States has acted
inconsistently with its obligations under the second limb of Article 3.3 of the Agreement on
Agriculture by making FSC subsidies available in respect of agricultural products not subject toreduction commitments in its WTO Schedule.
4. Claim Under Article 8 of the Agreement on Agriculture
7.177  Article 8 of the Agreement on Agriculture prov ides that "[e]ach Member undertakes not to
provide export subsidies otherwise than in conformity  with this Agreement".  We have found that the
United States has acted inconsistently with its obligations under Article 3.3 of the Agreement on
Agriculture in respect of wheat and in respect of all unscheduled products.  Consequently, we find
that the United States also has acted inconsistently with its obligations under Article 8 of thatAgreement.
716
VIII.  CONCLUSIONS AND RECOMMENDATIONS
8.1 In light of the above findings, we conclude that, through the FSC scheme:
(a) the United States has, except as provided in the Agreement on Agriculture,
acted inconsistently with its obligations under Article 3.1(a) of the SCM Agreementby granting or maintaining export subsidies prohibited by that provision;
(b) the United States has acted inconsistently with its obligations under
Article 3.3 of the Agreement on Agriculture (and consequently with its obligations
under Article 8 of that Agreement):
- by providing export subsidies listed in Article 9.1(d) of the Agreement
on Agriculture in excess of the quantity commitment levels specified in
the United States' Schedule in respect of wheat;
- by providing export subsidies listed in Article 9.1(d) of the Agreement
on Agriculture in respect of all unscheduled products.
8.2 Since Article 3.8 of the DSU provides that "[i]n cases where there is an infringement of the
obligations assumed under a covered agreement [including the SCM Agreement and the Agreement
on  Agriculture], the action is considered prima facie  to constitute a case of nullification or
impairment", we conclude that – to the extent the United States has acted inconsistently with the SCM
                                                     
716 In light of our finding that the FSC scheme is an export subsidy listed in Article 9.1 of the
Agreement on Agriculture, we need not address the European Communities' alternative claim under Article 10.1of that Agreement.WT/DS108/R
Page 294
Agreement and the Agreement on Agriculture – it has nullified or impaired benefits accruing to the
European Communities under these Agreements.
8.3 With respect to our conclusions regarding the SCM Agreement, we recommend,  pursuant to
Article 4.7 of that Agreement, that the DSB request  the United States to withdraw the FSC subsidies
without delay.
8.4 With respect to our conclusions regarding the Agreement on Agriculture, we recommend  that
the United States bring the FSC scheme into conformity with its obligations in respect of export
subsidies under that Agreement.
8.5 In regard to our recommendation pursuant to the SCM Agreement, Article 4.7 of that
Agreement provides that "the panel shall specify in its recommendation the time-period within whichthe measure [ i.e., the measure found to be a prohibited subsidy] must be withdrawn".
8.6 The European Communities requests that the Panel specify that the United States withdraw its
FSC subsidies by the beginning of the fiscal year 2000.  The United States responds that any changes
to the FSC scheme would require legislative rather than administrative action, and that consequently a
longer period may be necessary.  The United States further notes that its fiscal year 2000 begins on1 October 1999, and that, should this Report be appealed, the appeal would still be pending as of that
date.  In response, the European Communities suggests that the Panel specify two separate dates, one
of which would apply in the case of an appeal and the other in the absence of an appeal.
8.7 In considering this question, we first note that Article 4.7 of the SCM Agreement requires a
Member to withdraw a prohibited subsidy "without de lay" and "in this regard" a panel must specify a
time-period within which the measure must be withdrawn.  Accordingly, the specified time-period
must be consistent with the requirement th at the subsidy be withdrawn "without delay".
8.8 Given that implementation of the Panel's recommendation will require legislative action (a
fact recognized by the European Communities), that the United States fiscal year 2000 starts on 1
October 1999, and that this Report is not scheduled for circulation to Members until September 1999
(and, if appealed, might not be adopted until as late as early spring 2000), it is not in our view a
practical possibility that the United States could be in a position to take the necessary legislativeaction by 1 October 1999.  That being so, and acting in good faith, there is no way that this could be
described as a "delay".  However, this objective timing constraint would not be present with effect
from the following fiscal year (2001), which commences on 1 October 2000.  As this would be the
first practicable date by which the United States could implement our recommendation, it satisfies the
"without delay" standard set forth in Article 4.7.  Accordingly, we specify that FSC subsidies must bewithdrawn at the latest with effect from 1 October 2000.
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