The World Trade Organization recently ruled that a tax provision designed to aid U.S. exporters is a subsidy. This means the European Union, which brought the case against the United States, can impose up to $4 billion in compensatory import taxes on American exports. For better or worse, the WTO probably made the right decision. America imposes tax on the worldwide income of corporations. But in an attempt to reduce the anti-competitive impact of this system, U.S. policy-makers created a provision of the tax code to help export-oriented companies. Called the Foreign Sales Corp., this provision imposed a lower tax rate on the profits generated by overseas sales.

By WTO rules, however, variations in law designed to help exports are considered prohibited subsidies. As a result, the EU got the WTO to rule against the Foreign Sales Corp. Congress rewrote the law last year in an attempt to satisfy the WTO, but that effort was rejected by last week's decision.

America can appeal this latest decision, but the odds of reversal are very slim. The rules are pretty clear. If a country maintains a worldwide tax system for its businesses, then it must impose the same tax on profits that are earned from domestic sales and international sales.

This leaves American policy-makers with three options. First, they can sit back and do nothing. This would be a bad idea since EU governments would be able to slap steep tariffs on a wide range of goods. The U.S. surely would complain, but any grousing would fall on deaf ears considering that America took the same route when the EU lost cases on bananas and hormone-treated beef.

The second option is to play tit-for-tat. The U.S. could bring WTO cases against a number of tax provisions in various EU nations. This also is an unattractive strategy, particularly since "success" would mean America could impose new trade barriers that would drive up prices for U.S. consumers. There also would be a risk that the EU would then bring new cases against the U.S., potentially escalating a limited fight into a full-blown trade war. Hardly an encouraging scenario.

The final alternative is to use the WTO decision as an excuse to junk our misguided "worldwide" tax regime and shift to a territorial system. This is the tax equivalent of making lemonade out of lemons. A territorial system is based on the common-sense notion that a government only imposes tax on income earned inside the country's borders. This is a good policy for several reasons:

* A territorial system will make American companies more competitive. When an American-based company tries to compete overseas, it is hobbled by the fact that foreign-earned profits are subject to the U.S. corporate income tax (minus a credit for any taxes paid to the country where the money is earned). This may not make much difference when the company is operating in a high-tax environment like France, but there are many jurisdictions that have very low corporate income taxes. Companies based in places like Ireland and Bermuda, for instance, have a competitive advantage over U.S.-based firms. The fact that policy- makers created the Foreign Sales Corporation - and its short-lived replacement - is good evidence that they understand that worldwide taxation harms America's export-oriented companies.

* A territorial system will significantly reduce compliance costs. Adding insult to injury, the current worldwide tax regime is one of the most complicated parts of the internal revenue code. Globally active companies have to file tax returns overseas. But then they also must include all their foreign earnings when preparing a U.S. tax return. To avoid double taxation, they get to claim a dollar-for-dollar credit for the taxes they pay to foreign governments. The paperwork burden generated by this process is extraordinary, especially because of the myriad rules and restrictions associated with foreign tax credits.

* A territorial system is clearly permissible according to the WTO. A territorial system is good tax policy. It is pro-competitive, and it would dramatically lower compliance costs compared to the current system. Perhaps most important, however, it undeniably passes muster with the WTO. Indeed, most of our trading partners have territorial tax systems. This is why shifting to a territorial system is the only good response to the most recent WTO decision.

While the arguments in favor of territorial taxation are strong, some will oppose this long-overdue tax reform. A few critics will argue that territorial taxation will create a "runaway plant" scenario. According to this fear, U.S. companies will close down local plants and set up factories in the Cayman Islands or some other fiscal paradise. But this simplistic attack mistakenly assumes that taxes are the only thing that matters when businesses decide where to invest. Yes, taxes are important, but companies also must consider transportation costs, access to raw materials, work-force quality, and dozens of other factors. Indeed, this is why so many foreign corporations build factories in America.

Another common attack is that a territorial system will reduce tax revenues. Given the way politicians waste money, this would not be a bad result, but a territorial system would not have a very big impact on tax collections.

Under a territorial system, after all, business cannot deduct any costs they incur overseas. Nor would companies be allowed a credit for taxes they pay to other governments. Last but not least, lawmakers also have all the extra money - $4 billion annually - that no longer can be used for the tax provision struck down by the WTO.

The WTO has given the Bush administration a golden opportunity to fix one of the worst parts of the tax code. Territorial taxation has strong support in Congress, and the business community would be a strong ally in the fight. If policy-makers do the right thing and free America's corporations from an archaic worldwide tax system, the EU will have won a costly victory.

Daniel Mitchell is the McKenna senior fellow in political economy at The Heritage Foundation, a Washington-based public policy research institute.