The FSC Tax Bill and Technology Exporters

(November 17, 2000) President Clinton signed a bill to replace the Foreign Sales Corporation tax regime. The bill benefits U.S. companies, such as Microsoft, Cisco, and Motorola, which sell products abroad. The EU is all but certain to challenge it at the WTO, and an EU U.S. trade war is possible.

Clinton signed signed HR 4986, the Foreign Sales Corporation Repeal and Extraterritorial Income Exclusion Act of 2000, on Thursday, November 16. The bill has long been supported by Clinton and large majorities in both the House and Senate. However, its passage was delayed by pre-election partisan posturing.

The House passed the bill in October, but as part of a larger tax reform package. HR 2614 passed in the House on a largely partisan vote of 237 to 174. 203 Republicans and 33 Democrats voted in favor. See, Roll Call No. 560. Clinton objected. The House passed HR 4986 as a stand alone bill on November 14 by a vote of of 316 to 72. See, Roll Call No. 597. The Senate had already passed the bill.

The current Foreign Sales Corporation (FSC) tax scheme allows a portion of a U.S. taxpaying firm's foreign-source income to be exempt from U.S. income tax. This benefits major software companies, such as Microsoft, and equipment makers, such as Cisco and Motorola.

The European Union (EU) filed a complaint about the FSC scheme with the WTO, alleging that it is a prohibited export subsidy. A WTO dispute settlement panel sided with the EU last fall, and the WTO Appellate Body upheld its findings in February. The EU also objects to the just signed replacement bill, HR 4986. The bill preserves the existing benefits for U.S. exporters.

Most nations have a territory tax regime, by which they tax the income of corporations within their territory. The U.S., in contrast, has a global tax regime dating back to the 19th Century. American corporations are taxed by the United States government for their domestic and foreign income. That is, under the basic rules, if an American corporation sells its products in France, the U.S. taxes the income. However, if a French corporation sells its products in the U.S., France does not the income of the corporation operating in the U.S.

This puts U.S. corporations at a competitive disadvantage with respect to their foreign competitors when competing in a global economy. Hence, Congress has enacted various exceptions to the general rule, through such methods as the foreign tax credit, the Domestic International Sales Corporation (DISC), the Foreign Sales Corporation (FSC), and finally, HR 4896.

U.S. exporters, and their many supporters in Congress and the administration, argue that this is simply leveling the playing field between U.S. and European companies.

John Richardson Deputy Head of EU Delegation to the US

The EU contends that by giving tax breaks to U.S. exporters, the U.S. is, in effect, subsidizing exports, in violation of its trade agreements. John Richardson, the Deputy Head of the EU Delegation to the US, adamantly insists that the basis of the EU complaint against the FSC tax regime, and HR 4986, is that it is an illegal export subsidy.

However, there is little real opposition in Europe to the bill itself. Few European companies are seeking protection from U.S. technology companies. However, aircraft exporter Boeing is in competition with the European Airbus, and many in Europe would like to impose a competitive disadvantage upon Boeing.

Rather, the FSC issue is interrelated with agricultural issues. The EU maintains protectionist policies to support its politically powerful but inefficient agricultural sector. The U.S. objects to this. Moreover, the U.S. has submitted complaints to the WTO, and won. This has greatly upset many in Europe. The EU complaint about the FSC is, in part, a strategy to obtain a bargaining chip to use in negotiations over agricultural trade.

By threatening the bottom line of technology, aircraft, and other industry sectors in the U.S., the EU hopes to deter the U.S. from continuing its efforts to terminate the EU's protectionist agricultural policies. But, if the EU and U.S. do not reach some sort of comprehensive trade agreement, and the WTO again finds the U.S. tax regime to be illegal, Europe may retaliate by imposing high tariffs on the products of U.S. technology companies.

Rep. Phil English (R-PA)

Some Members of Congress, such as Rep. Phil English (R-PA), who sits on the tax writing Ways and Means Committee, supported HR 4986, but would also like reform the tax code.

If a trade agreement is not reached, and a trade war ensues, this could prompt the U.S. to rewrite the tax code. If the U.S. were to shift from a global to a territorial system, this would give U.S. exporters their "level playing field," but also deprive the EU of the claim that the U.S. is maintaining an illegal export subsidy.

Of course, tax reform is always an emotional and difficult process. Even passage of HR 4986 prompted a small minority of Representatives and Senators wax indignantly about granting subsidies to "corporate welfare queens."

If a trade war ensues, U.S. high tech companies would be targeted with retaliatory tariffs. This would affect products, but not services. Tech Law Journal asked John Richardson if the EU's retaliation list would include software companies. He diplomatically stated that no plans have yet been prepared. He added that software which is sold over the Internet would not be affected by any retaliation, because it is classified as a service. However, he also stated that software sold on CD could be affected.

Hence, companies which currently sell most of their software products either in shrink wrap format or preinstalled on machines by OEMs, would be heavily impacted. Microsoft, in particular, predominantly sells its software by these methods. In contrast, software companies that sell their software online might escape the retaliatory tariffs.