While nothing is certain in a Presidential election year, there is a strong chance that Congress will enact major international tax legislation in 2004 that, among other things, would significantly change the US federal income tax rules applicable to export income. The names of the bills - The American Jobs Creation Act and The Jumpstart Our Business Strength (JOBS) Act - reflect the need to package any bill as stimulating the economy. In fact, the reality is considerably more ambiguous and uncertain.

The legislation is being driven by a long running dispute between the US and the European Union over US income tax breaks for export income. Largely due to the threat of tariffs imposed by the EU, Congress will ultimately accede to their demands for a more equitable competitive environment.

The open question is what impact any change will have on US foreign trade? Until the specifics of new regulations are written, it's premature to say. But even at this point, one can predict the general contours of the outcome: there will be increased effective tax burden on exporters. Although there will likely be theoretical compensation through a mix of benefits and tax breaks, these will also be available to non-exporting US companies. The 'net net' could be the movement of production outside the United States as the effective tax rate goes up.

Some background is in order.

In 1970 in order to assist US exporters against competitors from countries subject to lower tax on export income, Congress enacted the Domestic International Sales Corporation regime (the "DISC"). A DISC is a US corporation that is exempt from income tax on certain income derived from export sales. US companies were able to defer US income tax on approximately half of their export income until 1981 when GATT held that the failure to charge interest on the deferred income tax was an export subsidy inconsistent with its principles.

In 1984, Congress tried again and enacted the foreign sales corporation ("FSC") regime to replace the DISC. Under a complex system of rules, an FSC is exempt from US income tax on a portion of income from export sales of US property to the extent attributable to foreign activities.

Once again, in February, 2000, the World Trade Organization ruled that the FSC was an export subsidy inconsistent with the international trade agreements. The WTO rejected the argument that the FSC is necessary to address the structural disadvantage the US faces with respect to its major trading partners because it, alone, does not levy indirect taxes such as a value added tax.

Once again Congress responded and, in November 2000, replaced the FSC with the extraterritorial income exclusion regime (or "ETI"). Under ETI, qualifying foreign trade income is excluded entirely from gross income and from the corporate income tax base at a threshold level. Nonetheless, in January 2002 the WTO held that the ETI regime was a prohibited export subsidy because it applied only to companies with export income.

In response to the failure by Congress to repeal the ETI regime, on March 1, 2004 the EU began to raise tariffs on certain US imports in accord with the WTO decision. The initial increase raise tariffs 5% on a wide range of products including food, industrial products, electronic products and steel. The estimated aggregate increase in tariffs for the remainder of 2004 is approximately $315 million. The EU rule provides for annual upward adjustments of the tariff increases.

We now come to the legislation currently before Congress. The House and Senate Bills would replace ETI with a reduction in the effective tax rate on all income derived from US manufacturing (whether or not the product is exported). Both bills also contain a diverse mix of provisions that would modify or ease the US tax burden on foreign business activities of US companies. These provisions do not, however, apply specifically to exporters.

What does this mean in practical terms? There are many competing interests that make passage of a clean ETI repeal bill unlikely. On the other hand, the EU has begun implementation of tariffs and if Congress does nothing the tariffs will eventually trigger a response - possibly in the form of retaliatory tariffs on EU imports to the US.

If Congress does pass a bill this year it will almost certainly include a general rate reduction on manufacturing income (effectively conceding the export subsidy issue to the EU). Notwithstanding statements from advocates of the competing bills, it is not clear whether the combination of gradually implemented rate reduction on US manufacturing income coupled with a mix of international tax reforms will, at the end of the day, be tax neutral to US exporters. If the changes result in increased income tax on export income, one possible response by US exporters may be to move production of export products offshore.

Should exporters do anything now in light of the possible repeal of ETI? The answer is not until the details of the final bill are known. However, if a bill does pass, all exporters should carefully review its impact and at that point restructuring of operations may be a real option.