On October 11, Congress passed a tax bill intended to end a trade war with Europe while overhauling the way multinationals are taxed on foreign earnings. The major component of the bill is the repeal of U.S. export tax breaks that were ruled to be illegal subsidies by the World Trade Organization (WTO).
Earlier this year, the WTO authorized the European Union to levy $40 billion of trade sanctions on U.S. exports of 1,600 farm goods and manufactured products, including steel, textiles, and paper. Those sanctions took effect in March 2004, with a penalty tax starting at 5% and rising 1% each month to a cap of 17%.
The trade war with Europe began over four years ago. The European Union complained to the WTO during the Clinton administration that the U.S. tax rules granting tax breaks to the foreign subsidiaries of U.S. companies called “foreign sales corporations” (FSC) were an illegal tax subsidy under international trade law. The WTO upheld the European Union’s claims. In November 2000, the U.S. repealed the FSC rules and replaced them with a new “extraterritorial income tax exclusion” (ETI) regime. The European Union was not satisfied with the replacement rules and again argued successfully to the WTO that the ETI regime was an insufficient remedy to the prohibited export subsidy. As a result, the WTO authorized sanctions on U.S. goods if the ETI rules were not replaced by January 31, 2003. The U.S. was granted an extension to draft new rules but missed the revised deadline. In late October 2004, President Bush signed the bill passed by Congress on October 11, and the WTO subsequently lifted the sanctions.
Both the FSC and ETI tax rules were drafted in order to help U.S. businesses compete with foreign companies. European companies are taxed only on the income they earn in Europe, whereas the U.S. system of corporate taxation imposes tax on a corporation’s sales at home and abroad. The FSC and ETI rules granted tax breaks to U.S. corporations so that the tax burden on income they earned from sales outside the U.S. was comparable to that of foreign companies.
As part of the new corporate tax package, U.S. companies with foreign subsidiaries are encouraged to repatriate their earnings under a one-year tax holiday: the foreign subsidiaries will be able to issue dividends to their U.S. parent company at a 5.25% tax rate rather than the usual 35% rate. Another measure included in the package that should ease corporate tax compliance for multinationals is a simplification of the foreign tax credit system. In addition, a wide variety of industries will receive specialized tax breaks.
For more information on tax issues, please contact Elaine Campbell at ecampbell@kmclaw.com.