Trade and Taxes

Domestic taxes and international trade don't usually get snarled together. But the U.S. is teetering on the edge of a trade war with the European Union over a corporate tax break for U.S. exporters. This tax exemption, which the World Trade Organization has ruled to be an illegal subsidy for U.S. exporters, is financially dear to the chemical industry.

The American Chemistry Council (ACC) estimates that the tax break, which allows companies to exclude a portion of their foreign sales income from federal taxes, is worth as much as $500 million per year for basic chemical manufacturers. If companies in the life sciences are included, this tax break, known as the extraterritorial income (ETI) exclusion, is worth up to $1 billion annually, according to ACC.

Under the ETI exclusion, companies pay a 29.75% tax rate on earnings from exports instead of the standard rate of 35%. Some businesses have a greater export market than others, so this tax break is more important to them than to companies with few or no exports.

Many corporations, including many chemical manufacturers, agree that to foster trade liberalization around the world, the U.S. must comply with WTO's ruling and thus must get rid of the ETI exclusion. "It's absolutely critical if we expect other governments to comply" with international trade rules, says Calman Cohen, president of the Emergency Committee for American Trade, an organization of major U.S. exporters that include Rohm and Haas and ExxonMobil.

Congress is trying to phase out the ETI exclusion and replace it with other corporate tax benefits. But the debate over what tax breaks should replace the ETI exclusion is generating controversy and is hindering passage of legislation to repeal this policy. "It's taking longer than anyone had hoped," Cohen says.

For nearly every replacement option under consideration on Capitol Hill, some businesses will profit more than under the current law while others will hand over more taxes to the government. Thus, industry is divided over what should replace the current tax break for exporters, Cohen explains. Stephen Elkins, tax team staff leader for ACC, says the chemical sector, like businesses in general, is split over what should take the place of the export tax break.

If Congress doesn't act in early 2004 to eliminate the tax exemption, the EU is poised to slap up to $4 billion in WTO-approved retaliatory tariffs on U.S. goods. The EU has been waiting for nearly two years since the WTO ruled in its favor for congressional action on the ETI exclusion. The EU is particularly aggravated because Congress in 2000 created the ETI exclusion to replace a similar tax break--the foreign sales corporation system. This former policy allowed a tax exemption for part of the income generated by corporate subsidiaries that U.S. firms established outside of U.S. territory. WTO determined that the foreign sales corporation policy was an illegal subsidy for U.S. exporters--later ruling that its replacement, the ETI exclusion, also was an illegal subsidy.

Last month, the EU upped the pressure on Congress by unveiling plans to impose extra duties on U.S. products starting in March 2004 (C&EN, Nov. 17, 2003, page 17). Though the chemical industry, the largest exporting industrial sector of the U.S. economy, is a major benefactor of the current ETI exclusion, few, if any, chemical products are on the EU's list of goods targeted for the retaliatory tariffs, Elkins says. But other exporting sectors of the U.S. economy with powerful political allies, including agriculture, would get hit hard by the EU's jacked-up tariffs.

TO FORESTALL the EU's retaliation, Congress must eradicate the ETI exclusion. A legislative provision that would do just that was included in 2003 in a bill to revise the corporate tax system. That measure got bogged down in political wrangling and did not make it to the floor of the House of Representatives or the Senate before Congress adjourned for the year.

Legislators are as divided as industry over how to offset the controversial export exemption with other tax breaks for business. Some lawmakers, especially those in the House of Representatives, want the revised corporate tax policy to benefit domestic manufacturers. Others stress the importance of lowering the tax rate for the "repatriated" overseas income of U.S. exporters.

The House Ways & Means Committee and the Senate Finance Committee approved separate bills to eliminate the disputed tax break (S. 1637 and H.R. 2896). Both would phase out the ETI exclusion in three to five years as well as overhaul the corporate tax law. The Ways & Means Committee counts among supporters of the House bill several chemical and pharmaceutical companies, including Air Products & Chemicals, Albemarle, Astra Zeneca, Bristol-Myers Squibb, Dow Chemical, DuPont, Eli Lilly, FMC, Johnson & Johnson, Merck, Pfizer, Procter & Gamble, Schering-Plough, Sigma-Aldrich, and Wyeth. Neither ACC nor Cohen's group is backing specific business tax legislation.

Congressional leaders intend for the House to pass a corporate tax bill first, then have the Senate move on the legislation. However, Speaker of the House Dennis Hastert (R-Ill.) did not bring up H.R. 2896 for a full House vote in 2003 because the legislation had not yet garnered enough backers to pass.

Whether a phaseout of the ETI exclusion over three to five years--rather than an immediate repeal--will satisfy the EU and prevent a trade battle remains to be seen.

The Senate Finance Committee, at least, is hedging that a phaseout will do, based on the slack the U.S. has cut the EU in a WTO-arbitrated dispute over banana imports. In that case, the EU is taking nine years to phase out its restrictions on banana imports--a time frame that goes beyond the deadline set by WTO for elimination of those restrictions. But the U.S. is holding off on retaliatory measures, which are allowed by WTO, even though the EU's banana import restrictions weren't eliminated in one fell swoop, the Senate panel notes in a draft report on S. 1637.

Given this situation, the EU may not impose its planned countermeasures if Congress passes a law by March 1 to remove the ETI exclusion through a several-year phaseout, the Senate committee says. But if Congress fails to pass legislation on ETI by March 1, the EU may well impose retaliatory duties.

Thus, ETI phaseout is likely to get some significant congressional attention early in 2004. Sen. Charles E. Grassley (R-Iowa), chairman of the Senate Finance Committee, and House Ways & Means Chairman William M. (Bill) Thomas (R-Calif.) both have expressed concern that the EU's planned countermeasures would hurt farmers--an important constituency of both these legislators--as well as manufacturers. Grassley and Thomas want to avert the sanctions by passing legislation.

The scrap over the ETI exclusion is taking place in an atmosphere of growing international unrest over trade.

Sushan Demirjian, manager of international trade at ACC, says the pace of trade liberalization has slowed as the international economy has slowed. Governments around the world are getting pressure from their constituents to protect domestic industries, she says. But trade liberalization efforts historically have come in cycles.

"It's a pendulum, and it shifts," Demirjian says. "We have to ride it out."

World trade talks collapsed at a September 2003 WTO meeting in Cancun, Mexico, amid a struggle between industrialized countries and developing nations over agricultural subsidies. Chemical makers had hoped for a timetable to emerge from that meeting for the elimination of global tariffs (C&EN, Sept. 22, 2003, page 8). International efforts are under way to restart those negotiations.

TENSIONS with major U.S. trading partners escalated after a November 2003 WTO decision against a Bush Administration policy to protect the U.S. steel industry against imports. President George W. Bush had placed temporary tariffs, labeled safeguards, on imported steel to give the beleaguered domestic steel industry time to restructure and recover. The spiraling tensions over the ETI tax break and the steel safeguards made a global trade war a real possibility, Cohen says. Under pressure at home and abroad, Bush in early December ordered an end to the temporary tariffs.

WTO decisions against the U.S. regarding the ETI exclusion, steel safeguards, and other policies are fomenting disillusionment with--and, in some cases, hostility against--the international trade body and its rules in the U.S., even among conservatives who have been important supporters of WTO. That bodes poorly for the chemical industry, which is the largest U.S. exporting industry and a major proponent of trade liberalization.

Averting the looming trade war between the EU and the U.S. remains squarely in the hands of Congress. After they return to Capitol Hill on Jan. 20, federal lawmakers face tough decisions on rewriting the corporate tax code. They have little time left to iron out legislation before the March 1 deadline set by the EU, and it remains to be seen whether legislators will be able to act in time to stop the retaliatory tariffs.