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U.S. tax plan would break WTO rules, lawyers say, as EU business frets

By Tom Bergin and David Morgan

By Tom Bergin and David Morgan

LONDON/WASHINGTON (Reuters) - A proposed U.S. corporate tax reform would almost certainly contravene international trade rules if implemented, lawyers told Reuters, risking the biggest dispute in the history of the World Trade Organization.

With signs growing that the United States may become more protectionist under President Donald Trump, European business groups said the tax plan - which could impose de facto import tariffs of up to 20 percent - raised the danger of a trade war.

Republican (GOP) members of Congress are pushing to replace the existing tax on corporate income with one linked to turnover. This would allow firms to deduct their costs for purchasing goods and services produced in the United States, but would give no such deduction for purchases of imports.

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Trump has criticized the complexity of the plan but also said such a measure could help to cut the U.S. trade deficit.

Kevin Brady, head of the tax-writing House of Representatives Ways and Means Committee, brushed off suggestions that it would fall foul of the World Trade Organization.

While there were "1,000 different opinions on whether this is WTO compliant", Brady said he was confident the reform did comply with the body's rules.

However, six trade lawyers with experience in litigating WTO disputes said they believed the plan would likely be deemed an unlawful subsidy on domestic goods, export subsidy or a de facto tariff on imports.

All the lawyers, based in the United States, Britain and continental Europe, said the 'destination-based cash flow tax' would fail WTO rules on more than one legal basis. So serious were the breaches that any challenges might be handled under WTO mechanisms that allow legal processes, which normally take years, to be short-cut, they said.

"It would be plainly WTO-inconsistent," said Philippe De Baere, Brussels-based partner at Van Bael & Bellis.

"It has manifest violations which could even justify the use of the expedited procedure for dispute settlement in the WTO," said De Baere, who has also advised governments on accession to the WTO and negotiations on new WTO deals as well as fighting trade cases.

Trade experts said any legal case would be the biggest WTO dispute ever, since it could involve all products imported into the United States and all U.S. exports. Previous WTO cases have involved narrow market sectors or individual companies.

European business groups said the plan threatened to upend the international system of trade rules, and expressed hope that their governments could help to persuade the United States not to adopt it.

The Ways & Means Committee declined to answer detailed legal questions about the plan. A spokesman for the WTO said the organization didn't comment on whether planned taxes conformed to its rules

OLD IDEA WITH A NEW TWIST

The House Republican plan involves abolishing corporate income tax and replacing it with a tax of 20 percent levied on revenues, less allowable deductions.

A 'border adjustment' would be applied whereby companies which import products for resale or use in a manufacturing process would not receive a tax deduction for the cost. Domestic purchases and labor costs could be deducted while U.S. exports would be exempt from the tax.

No major economy has adopted a corporate cash flow tax. Former Bank of England governor Mervyn King is among those to support such a tax, saying in a 1987 study that it could reduce excessive corporate debt and encourage better investment.

King, who retired from the bank in 2013, told Reuters in an email this week that he still believed the idea had its merits -provided "it does not have to have the impact on imports that seems to be implied by the proposed scheme in the U.S.".

Lawyers said the impact of the border adjustment and deductions for U.S. costs meant that imports would face an effective tariff of up to 20 percent.

"The total tax rate on the 100 percent domestically-produced good is going to have a lower effective tax rate than the rate on the import," said Scott Lincicome, counsel with White & Case in Washington.

That would breach Article 3 of the General Agreement on Tariffs and Trade, which is policed by the WTO. This allows signatory states to impose permitted tariffs on goods entering their country, but precludes them from treating a domestic item more favorably than an imported one when it comes to internal taxes like sales or income taxes.

The WTO Agreement on Subsidies and Countervailing Measures also provides a basis for challenging the U.S. plan, the lawyers said.

While this treaty allows border adjustments, it bars them in relation to direct taxes such as income or profit taxes.

Hence, the plan could be deemed a subsidy on domestic production in the United States and on U.S. exports, Folkert Graafsma, with VVGB Avocats in Brussels said.

The Ways and Means Committee says the cash flow tax is an indirect tax, and therefore legal.

Lawyers say that argument would be hard to sell to WTO judges or trade partners because the tax is calculated on a business entity's revenue, less the allowable input costs, rather than being applied to the product being traded.

"You're still essentially taxing the entity and that's where the problem comes," said Iain MacVay, partner at King & Spalding in London.

EUROPEAN BUSINESS WORRIED

The BDI, the trade body for Germany's largest businesses, said the plan risked introducing double taxation on imports. "A border tax adjustment would be a deviation from the existing system (on corporate taxation)," BDI chief Markus Kerber said in a statement.

Robin Winkler, a strategist at Deutsche Bank, said the growing protectionist mood in the United States meant politicians there could adopt the plan even if they didn't believe it complied with WTO rules. "A border tax akin to the GOP proposal remains more likely than the market appreciates," he said in a note to clients on Wednesday.

The British, German and French governments said they didn't comment on other countries' tax proposals. A spokesman for the executive arm of the European Union said: "The Commission expects all its trade partners to abide by and uphold the international rules."

Andy Goss, board member and global sales boss for carmaker Jaguar Land Rover, one of Britain's biggest exporters, said he expected the government from Prime Minister Theresa May down to be active on the issue.

"Our expectation when potential policies like this are mooted is that the prime minister and those in government can represent us in the right places in the U.S., and we are confident that they would do that," he added.

Some economists said the border adjustment would increase the value of the dollar, easing the actual impact of the tax on foreign exporters. Others doubted this, partly because of Trump's statements about the trade benefits of weak currencies.

The WTO allows countries to impose retaliatory measures against offending trade partners but it can take years to get a ruling. Some countries may not wait that long or may not use only WTO-authorized retaliatory measures.

For example, China could simply order its massive state-owned enterprises to adopt a "Buy No America" policy, analysts at Morgan Stanley said. The Chinese Ministry of Finance did not respond to requests for comment.

Edward Roosens, Chief Economist with Belgium's Federation of Enterprises, said that if companies in Europe started to lose U.S. contracts and shed jobs as a result, Europe could also act rashly.

"The political pressure would be really strong to go for an all-out trade war. It's a bizarre idea, to be involved in a trade war with Europe's closest ally, but political pressure would grow," he said.

(Additional reporting by David Lawder in Washington and Tom Miles in Geneva; editing by David Stamp)