MORE THAN 50 YEARS OF TRADE RULE DISCRIMINATION ON TAXATION: HOW TRADE WITH CHINA IS AFFECTED Trade Lawyers Advisory Group Terence P. Stewart, Esq. Eric P. Salonen, Esq. Patrick J. McDonough, Esq. Stewart and Stewart August 2007 Copyright © 2007 by The Trade Lawyers Advisory Group LLC This project is funded by a grant from the U.S. Small Business Administration (SBA). SBA’s funding should not be construed as an endorsement of any products, opinions or services. All SBA-funded projects are extended to the public on a nondiscriminatory basis. MORE THAN 50 YEARS OF TRADE RULE DISCRIMINATION ON TAXATION: HOW TRADE WITH CHINA IS AFFECTED TABLE OF CONTENTS PAGE EXECUTIVE SUMMARY.............................................................................................. iv INTRODUCTION ................................................................................................................ 1 I. U.S. EXPORTERS AND PRODUCERS ARE COMPETITIVELY DISADVANTAGED BY THE DIFFERENTIAL TREATMENT OF DIRECT AND INDIRECT TAXES IN INTERNATIONAL TRADE .............................................. 2 II. HISTORICAL BACKGROUND TO THE DIFFERENTIAL TREATMENT OF INDIRECT AND DIRECT TAXES IN INTERNATIONAL TRADE WITH RESPECT TO BORDER ADJUSTABILITY................................................................. 21 A. Border Adjustability of Taxes ................................................................. 21 B. 18th and 19th Century Examples of the Application of Border Tax Adjustments .......................................................................... 23 C. 1946-1948 – Creation of the General Agreement on Tariffs and Trade (GATT) ...................................................................................... 26 D. 1955 – Review of the GATT Adds Export Subsidy Provisions to GATT Article XVI.............................................................. 30 E. 1960 – GATT Working Party on Subsidies – Illustrative List of Export Subsidies ........................................................................... 31 F. Why the U.S. Agreed to the Existing GATT Rules on Border Tax Adjustments .......................................................................... 33 G. 1963-1967 – Kennedy Round and Growing Concern Regarding Non-Tariff Barriers (including border tax adjustments)................................................................................................ 37 H. 1967-68 – U.S. Balance of Payments Problem Grows; President Johnson Issues Statement on Balance-of- Payments Problem on January 1, 1968 ................................................. 44 I. 1968-1970 – GATT Working Party on Border Tax Adjustments................................................................................................. 58 i MORE THAN 50 YEARS OF TRADE RULE DISCRIMINATION ON TAXATION: HOW TRADE WITH CHINA IS AFFECTED TABLE OF CONTENTS PAGE J. 1969-1971 – Nixon Administration’s Concerns Regarding Border Tax Adjustments .......................................................................... 75 K. 1970-1972 – Williams Commission Report............................................. 85 L. 1968-73 – Reflections of U.S. Business Concerns Regarding the Trade Disadvantages Resulting from GATT Rules on Border Tax Adjustments .......................................................................... 88 M. Trade Act of 1974 – For the Tokyo Round, Congress Identifies Reform of Border Tax Adjustment Rules as a U.S. Negotiating Objective....................................................................... 96 N. Omnibus Trade and Competitiveness Act of 1988 – For the Uruguay Round, Congress Again Identifies Revision of Border Tax Adjustment Rules as a U.S. Negotiating Objective ...................................................................................................... 102 O. Trade Act of 2002 – For the Doha Round, Congress Once More Identifies Reform of Border Tax Adjustment Rules as a U.S. Negotiating Objective............................................................... 105 P. Multiple U.S. Efforts to Partially Compensate for the Inequity of GATT Border Tax Rules Have Been Thwarted by GATT and WTO Dispute Settlement Decisions ............................. 108 III. LEGISLATIVE EFFORTS TO REFORM THE U.S. TAX SYSTEM TO ADDRESS THE DISCRIMINATORY TRADE EFFECTS OF THE DIFFERENTIAL TREATMENT OF INDIRECT AND DIRECT TAXES HAVE NOT BEEN SUCCESSFUL ........................................................................................ 113 IV. CHINA’S TAX SYSTEM AND ITS USE OF DIRECT AND INDIRECT TAXES ............. 133 A. Background ................................................................................................. 133 B. Recent Amendments to the Chinese VAT System .............................. 136 C. Concerns Regarding Chinese Manipulation of the VAT................... 142 V. IMPACT OF THE CHINESE VAT SYSTEM ON U.S.-CHINA TRADE FLOWS...................................................................................................................... 143 ii MORE THAN 50 YEARS OF TRADE RULE DISCRIMINATION ON TAXATION: HOW TRADE WITH CHINA IS AFFECTED TABLE OF CONTENTS PAGE VI. DISPUTES AND ISSUES THAT HAVE ARISEN CONCERNING CHINA’S APPLICATION OF VALUE-ADDED AND OTHER INDIRECT TAXES ON SELECTED PRODUCTS............................................................................................ 146 A. VAT on Semiconductors ........................................................................... 148 B. VAT Treatment of Certain Fertilizers................................................... 153 C. Consumption Taxes on Various Products............................................ 155 D. Border Trade VAT Policy ......................................................................... 157 E. Assessment of VAT on Antidumping Duty ........................................... 160 F. VAT Refund on Imported Capital Equipment Used for Production of Products for Export........................................................ 161 G. VAT Rebate on Purchases of Domestic Machinery and Equipment by FIEs .................................................................................... 162 H. VAT Rebate for Domestic Equipment Purchases by FIEs Engaged in Particular Projects .............................................................. 163 I. Agricultural VAT Policies ........................................................................ 164 VII. POTENTIAL UNILATERAL, BILATERAL AND MULTILATERAL ACTIONS THAT COULD BE TAKEN TO ELIMINATE BORDER TAX DISCRIMINATION OF U.S. EXPORTERS AND PRODUCERS................................... 166 iii 50 Years of Trade Rule Discrimination on Taxation: How Trade with China is Affected EXECUTIVE SUMMARY For more than 50 years, U.S. manufacturers and exporters have operated under GATT/WTO trade rules which distort trade through discriminatory treatment of different taxation systems. The global trading rules permit the imposition of certain forms of taxes on imports and the removal of certain forms of taxes on exports. The U.S. is the only major trading nation which has not modified its taxation system over time, with the result that U.S. exports face double taxation while U.S. manufacturers, agricultural producers and service providers compete in the U.S. with imports that have been relieved of a significant part of the taxation obligations of the exporting countries. Over this time, U.S. presidents, cabinet members, Congress, business leaders, and economists have sought to correct the discriminatory treatment of taxes which peculiarly distort trade to the disadvantage of the United States. The efforts to date, including in the current Doha Round, have failed to solve the problem. This is a problem not just with historical trading partners such as the EU, but also with new trading powers like the People’s Republic of China. Under GATT/WTO rules, indirect taxes, such as value-added taxes (VAT), excise taxes, and other types of consumption taxes, are treated more favorably than direct taxes, such as income taxes. In application, the differential treatment of direct/indirect tax systems means that countries that have indirect tax systems are permitted (1) to impose indirect taxes, such as the VAT, on incoming imports, and (2) are permitted to provide a rebate of the VAT on outgoing exports. However, the same treatment is not accorded to countries, such as the United States, that rely primarily on direct tax systems. In other words, under the GATT/WTO rules, indirect taxes are adjustable at the border, direct taxes are not. iv 50 Years of Trade Rule Discrimination on Taxation: How Trade with China is Affected EXECUTIVE SUMMARY The consequence of the GATT/WTO disparate treatment of direct and indirect taxes is that U.S. producers and exporters suffer a competitive disadvantage due to double taxation -- U.S. exporters must pay both U.S. taxes, which are not rebated, and foreign VAT; U.S. producers must pay U.S. taxes and compete with imports that do not pay U.S. taxes and which have received rebates of VAT and other indirect taxes. Economists have found that the disparate border adjustability of direct and indirect taxes produces significant economic distortions. Currently, 137 nations have some form of VAT. Based on international VAT rates and U.S. import and export data, it can be estimated that the total VAT disadvantage to U.S. exporters and producers in 2006 was more than $300 billion. China is one of the 137 countries that imposes a VAT and allows rebates of VAT on exports. Given the size of U.S. trade