Aug. 31 (Bloomberg) -- The World Trade Organization agreed to probe a complaint by the U.S. and Mexico alleging that China illegally subsidizes domestic industries through tax reductions, the largest trade case yet against the Chinese government.

The U.S. and Mexico accuse China of using tax rebates as an export subsidy that violates WTO rules. The tax breaks give an unfair competitive advantage to Chinese exports of goods such as steel and wood products, according to the two governments.

``The establishment of this panel will allow the U.S. to continue to pursue its case,'' said Stephen Norton, a spokesman for the U.S. Trade Representative's office. ``China had agreed to dismantle'' those aid programs when it joined the WTO in 2001, he said.

U.S. manufacturers and lawmakers say China has rigged the rules of international commerce to favor its domestic industry. China's trade surplus surged 67 percent in July from a year earlier to $24 billion, helping send the country's foreign- exchange reserves to $1.3 trillion.

The U.S. and Mexico were joined by Australia, Canada, the European Union, Turkey, Japan and Chile in holding talks with China over the issue. The U.S. said it was unable to reach a negotiated solution, though Mexico is still seeking to do so.

A panel of judges will be set up to examine the complaint within 45 days, according to a WTO spokeswoman in Geneva. A ruling will follow about six months later, she said.

Semiconductor Tax

China scrapped a rebate on a value-added tax on semiconductors after the U.S. took a similar legal step in 2005. A dispute over anti-dumping duties on kraft linerboard, a type of heavy-duty paper used in cardboard boxes and other shipping applications, was settled the day the U.S. was to file its complaint to the WTO.

In March, the U.S. and the European Union filed a WTO complaint against China alleging that China uses unfair tariffs to block imports of U.S.-made auto parts. That case is being litigated by WTO arbiters in Geneva.

Also today, China blocked a separate U.S. request for a panel of judges to be established to rule on a complaint aimed at stopping what the Bush administration has called rampant piracy of copyrighted movies, music, software and books. Under WTO procedures, China won't be able to block a second request by the U.S.

To contact the reporter on this story: Jennifer M. Freedman in Geneva at jfreedman@bloomberg.net.

Last Updated: August 31, 2007 16:03 EDT