UPDATE 1-U.S. urged to close tax loophole for paper makers

(Adds U.S. industry reaction, paragraphs 8-9)

By Roberta Rampton

WASHINGTON, May 21 (Reuters) - The U.S. Congress should immediately close a tax loophole used by paper makers that distorts world pulp markets and violates trade rules, ambassadors from the European Union, Canada, Brazil and Chile said on Thursday.

A tax credit designed to boost biofuel use in the United States has turned into an unintended windfall for U.S. paper manufacturers, who stand to receive up to $8 billion in 2009, the ambassadors said in a joint statement.

"From a legal perspective, it is clear that this tax credit amounts to an actionable subsidy and that any adverse effects ... could be subject to remedies in the (World Trade Organization) or through domestic countervailing duty investigations," the ambassadors said in a letter to top trade lawmakers in Congress.

The global economic downturn has hurt demand for paper, but the tax credit gives U.S. producers an incentive to overproduce pulp, the ambassadors said, noting that some U.S. companies claimed tax credits that amount to about 30 percent of the selling price of pulp.

At issue is a byproduct called "black liquor," produced when wood is processed into pulp to make paper. Paper makers have traditionally used the byproduct to fuel their mills and cogeneration facilities. [ID:nN24434222]

But last year, companies such as International Paper Co (IP.N), Verso Paper Corp (VRS.N) and Temple-Inland Inc (TIN.N) began adding small amounts of diesel to the byproduct to qualify for a biofuel tax credit.

"Ironically ... the paper companies end up creating a fuel that burns more fossil fuel than they would have done by using the black liquor substance on its own, thus creating the opposite effect which the legislation was intended to achieve," the ambassadors said.

A U.S. industry group denied the credit was spurring pulp overproduction, and said revoking it before it is scheduled to expire at the end of the year could have "serious consequences" for mills and their employees.

"The tax credit supports clean energy generation at a critical time as our nation seeks to increase its current supply of renewable energy in the fact of the most difficult economic picture in 70 years," the American Forest & Paper Association said.

The Obama administration proposed in its 2010 budget to exclude black liquor from the tax credit, but the ambassadors noted the Senate Finance Committee and the House Ways and Means Committee continue to discuss the issue.

"We are informed that there is still a strong resistance from some committee members to closing this loophole," the ambassadors said in the letter, addressed to the chairmen and ranking members of the committees.

Canada says it will take steps to help its pulp producers if the U.S. tax credit is not ended quickly. (Additional reporting by Allan Dowd in Vancouver; editing by Rob Wilson)