BACKGROUND AND FACTS The Japan Liquor Tax Law, or Shuzeiho, taxes liquors sold in Japan based on the type of beverage. There are ten categories of beverage (the categories are sake, sake compound, shochu, mirin, beer, wine, whiskey/brandy, spirits, liqueurs, and miscellaneous). Shochu is distilled from potatoes, buckwheat, or other grains. Shochu and vodka share many characteristics. However, vodka and other imported liquors fall in categories with a tax rate that is seven or eight times higher than the category for shochu. Foreign spirits account for only 8 percent of the Japanese market, whereas they account for almost 50 percent of the market in other industrialized countries. The United States, the European Union, and Canada called for consultations and brought this complaint at the WTO. The panel held that the Japanese tax law violated GATT, and Japan appealed to the Appellate Body. REPORT OF THE APPELLATE BODY The WTO Agreement is a treatythe international equivalent of a contract. It is self-evident that in an exercise of their sovereignty, and in pursuit of their own respective national interests, the Members of the WTO have made a bargain. In exchange for the benefits they expect to derive as Members of the WTO, they have agreed to exercise their sovereignty according to the commitments they have made in the WTO Agreement. One of those commitments is Article III of the GATT 1994, which is entitled National Treatment on Internal Taxation and Regulation. The broad and fundamental purpose of Article III is to avoid protectionism in the application of internal tax and regulatory measures. More specifically, the purpose of Article III is to ensure that internal measures not be applied to imported or domestic products so as to afford protection to domestic production. Toward this end, Article III obliges Members of the WTO to provide equality of competitive conditions for imported products in relation to domestic products. [T]he intention of the drafters of the Agreement was clearly to treat the imported products in the same way as the like domestic products once they had been cleared through customs. Otherwise indirect protection could be given. Italian Discrimination Against Imported Agricultural Machinery, BISD 7S/60, para. 11. Moreover, it is irrelevant that the trade effects of the tax differential between imported and domestic products, as reflected in the volumes of imports, are insignificant or even nonexistent. Article III protects expectations not of any particular trade volume but rather of the equal competitive relationship between imported and domestic products. Members of the WTO are free to pursue their own domestic goals through internal taxation or regulation so long as they do not do so in a way that violates Article III or any of the other commitments they have made in the WTO Agreement. * * * [I]f imported products are taxed in excess of like domestic products, then that tax measure is inconsistent with Article III... [We must determine first] whether the taxed imported and domestic products are like and, second, whether the taxes applied to the imported products are in excess of those applied to the like domestic products. If the imported and domestic products are like products, and if the taxes applied to the imported products are in excess of those applied to the like domestic products, then the measure is inconsistent with Article III:2. We agree with the Panel also that the definition of like products in Article III:2 should be construed narrowly. How narrowly is a matter that should be determined separately for each tax measure in each case. [A 1970 GATT Report] set out the basic approach for interpreting like or similar products: [T]he interpretation of the term should be examined on a case-by-case basis. This would allow a fair assessment in each case of the different elements that constitute a similar product. Some criteria were suggested for determining, on a case-by-case basis, whether a product is similar: the products end-users in a given market; consumers tastes and habits, which change from country to country; the products properties, nature and quality. Report of the Working Party on Border Tax Adjustments 18S/97, para. 18. * * * The concept of likeness is a relative one that evokes the image of an accordion. The accordion of likeness stretches and squeezes in different places as different provisions of the WTO Agreement are applied. [The definition of likeness must be narrowly interpreted.] The Panel determined in this case that shochu and vodka are like products. A uniform tariff classification of products can be relevant in determining what are like products. Tariff classification has been used as a criterion for determining like products in several previous adopted panel reports... There are risks in using tariff bindings that are too broad as a measure of product likeness.... It is true that there are numerous tariff bindings which are in fact extremely precise with regard to product description and which, therefore, can provide significant guidance as to the identification of like products. Clearly enough, these determinations need to be made on a case-by-case basis. However, tariff bindings that include a wide range of products are not a reliable criterion for determining or confirming product likeness under Article III:2

The only remaining issue under the first sentence of Article III:2 is whether the taxes on imported products are in excess of those on like domestic products. If so, then the Member that has imposed the tax is not in compliance with Article III. Even the smallest amount of excess is too much. The prohibition of discriminatory taxes in Article III is not conditional on a trade effects test nor is it qualified by a de minimis standard. If imported and domestic products are not like products... those same products may well be among the broader category of directly competitive or substitutable products that fall within the domain of the second sentence of Article III:2. How much broader that category of directly competitive or substitutable products may be in any given case is a matter for the Panel to determine based on all the relevant facts in that case. In this case, the Panel emphasized the need to look not only at such matters as physical characteristics, common end-uses, and tariff classifications, but also at the market place. This seems appropriate. The GATT 1994 is a commercial agreement, and the WTO is concerned, after all, with markets. It does not seem inappropriate to look at competition in the relevant markets as one among a number of means of identifying the broader category of products that might be described as directly competitive or substitutable. Nor does it seem inappropriate to examine elasticity of substitution as one means of examining those relevant markets. In the Panels view, the decisive criterion in order to determine whether two products are directly competitive or substitutable is whether they have common end-uses, inter alia, as shown by elasticity of substitution. We agree. Our interpretation of Article III is faithful to the customary rules of interpretation of public international law. WTO rules are reliable, comprehensible and enforceable. WTO rules are not so rigid or so inflexible as not to leave room for reasoned judgements in confronting the endless and ever changing ebb and flow of real facts in real cases in the real world. They will serve the multilateral trading system best if they are interpreted with that in mind. In that way, we will achieve the security and predictability sought for the multilateral trading system by the Members of the WTO through the establishment of the dispute settlement system. Decision. The Japan Liquor Tax Law was found to violate the national treatment provisions of GATT Article III. Shochu is a like product and is directly competitive and substitutable with other imported spirits. The imported spirits were taxed higher than the shochu. The decision of the panel was upheld and Japan was requested to bring its tax law into compliance with the WTO agreements. Comment. In 1997, the United States was forced to seek binding arbitration when it became apparent that Japan did not intend to bring its liquor tax into WTO compliance within a reasonable period as required by WTO rules. The arbitration ruling supported the U.S. position. Japan agreed to revise its tariff system in stages and to eliminate tariffs on most spirits. The U.S. distilled spirits industry reported that, as expected, the change in taxation has increased exports of U.S. distilled spirits to Japan.

Case Questions

1. What is the purpose of GATTs Article III and how is that purpose served?

2. Is it necessary that the complaining party show that a discriminatory tax has a negative effect on trade? Is a remedy possible even where the discrimination has no adverse impact on the sales volume of the imported products?

3. How does a WTO panel determine whether two products are like products for purposes of the first sentence of Article III:2 or directly competitive or substitutable products that fall within the domain of the second sentence of Article III:2

Answer the questions.