Unlike FDAP income, the United States taxes effectively connected income (“ECI”) on a net basis. Effectively connected income is income that is effectively connected with the conduct of a U.S. trade or business. It also includes gains from the disposition of U.S. real property under FIRPTA, which are treated as ECI.
Generally, when determining whether income constitutes effectively connected income, the IRS employs two tests: (i) the asset-use test; and (ii) the business-activities test. The asset-use test looks to whether the income or gain is derived from assets used in, or held for use in, the conduct of the trade or business in the United States. The business-activities test looks to whether the activities of the trade or business were conducted in the United States and were a material factor in the realization of the income or gain at issue.
What Is Effectively Connected Income?
Generally, when a foreign person is engaged in a trade or business in the United States, all income from sources within the United States connected with the conduct of that trade or business is considered to be effectively connected income. This applies even if there is no connection between the income and the trade or business being carried on in the United States during the tax year. Among the more common traps, partners in a partnership and beneficiaries of an estate or trust are treated as engaged in a U.S. trade or business if the partnership, estate, or trust is so engaged.
A taxpayer is generally considered to be engaged in a U.S. trade or business when they perform personal services in the United States. Whether the taxpayer is engaged in a trade or business in the United States depends on the nature of the taxpayer’s activities.
What Income Is Effectively Connected With A U.S. Trade or Business?
In the case of U.S.-source capital gain and U.S.-source income that would be subject to gross-basis U.S. taxation, whether the income is ECI generally depends upon whether the income is derived from assets used in or held for use in the conduct of the U.S. trade or business and whether the activities of the U.S. trade or business were a material factor in the realization of the amount (the “asset use” and “business activities” tests). All other U.S.-source non-FDAP income is treated as effectively connected income.
The following categories of income are usually considered to be connected with a trade or business in the United States:
- If the taxpayer is a member of a partnership that at any time during the tax year is engaged in a trade or business in the United States, they are considered to be engaged in a trade or business in the United States.
- A taxpayer is usually engaged in a U.S. trade or business when they perform personal services in the United States.
- A taxpayer is considered to be engaged in a trade or business in the United States if they are temporarily present in the United States as a nonimmigrant on an “F,” “J,” “M,” or “Q” visa. The taxable part of any U.S. source scholarship or fellowship grant received by a nonimmigrant in “F,” “J,” “M,” or “Q” status is treated as effectively connected with a trade or business in the United States.
- If the taxpayer owns and operates a business in the United States selling services, products, or merchandise, the taxpayer is, with certain exceptions, engaged in a trade or business in the United States. For example, profit from the sale in the United States of inventory property purchased either in this country or in a foreign country is effectively connected trade or business income.
- Gains and losses from the sale or exchange of U.S. real property interests (whether or not they are capital assets) are taxed as if the taxpayer was engaged in a trade or business in the United States.
- Income from the rental of real property may be treated as ECI if the taxpayer elects to do so.
A foreign person’s income from foreign sources generally is considered to be ECI only if the person has an office or other fixed place of business within the United States to which the income is attributable and the income is in one of the following categories: (1) rents or royalties for the use of patents, copyrights, secret processes or formulas, good will, trademarks, trade brands, franchises, or other like intangible properties derived in the active conduct of the trade or business; (2) interest or dividends derived in the active conduct of a banking, financing, or similar business within the United States or received by a corporation the principal business of which is trading in stocks or securities for its own account; or (3) income derived from the sale or exchange (outside the United States), through the U.S. office or fixed place of business, of inventory or property held by the foreign person primarily for sale to customers in the ordinary course of the trade or business, unless the sale or exchange is for use, consumption, or disposition outside the United States and an office or other fixed place of business of the foreign person in a foreign country participated materially in the sale or exchange.
Foreign-source dividends, interest, and royalties are not treated as effectively connected income if the items are paid by a foreign corporation more than 50 percent (by vote) of which is owned directly, indirectly, or constructively by the recipient of the income.
Income, gain, deduction, or loss for a particular year generally is not treated as effectively connected income if the foreign person is not engaged in a U.S. trade or business in that year. If, however, income or gain taken into account for a taxable year is attributable to the sale or exchange of property, the performance of services, or any other transaction that occurred in a prior taxable year, the income or gain is effectively connected income if the income or gain would have been treated as such in the prior year. If any property ceases to be used or held for use in connection with the conduct of a U.S. trade or business and the property is disposed of within 10 years after the cessation of that activity, the income or gain attributable to the disposition of the property is effectively connected income if the income or gain would have been treated as such had the disposition occurred immediately before the property ceased to be used or held for use in connection with the conduct of a U.S. trade or business.
A foreign person’s gain or loss from the disposition of a U.S. real property interest (“USRPI”) is treated as effectively connected income. Thus, a foreign person subject to tax on such a disposition is required to file a U.S. tax return. In the case of a foreign corporation, the gain from the disposition of a USRPI may also be subject to the branch profits tax at a 30-percent rate (or lower treaty rate).
The payor of income that FIRPTA treats as ECI is generally required to withhold U.S. tax from the payment. The foreign person can request a refund with its U.S. tax return, if appropriate, based on that person’s overall tax liability for the taxable year.
Branch Profits Taxes
Under the branch profits tax, the United States imposes a tax of 30 percent on a foreign corporation’s “dividend equivalent amount.” The dividend equivalent amount is generally equal to the earnings and profits of a U.S. branch of a foreign corporation attributable to its ECI. Limited categories of earnings and profits attributable to a foreign corporation’s ECI are excluded in calculating the dividend equivalent amount.
In arriving at the dividend equivalent amount, a branch’s effectively connected earnings and profits are adjusted to reflect changes in a branch’s U.S. net equity (i.e., the excess of the branch’s assets over its liabilities, taking into account only amounts treated as connected with its U.S. trade or business).
What Is A U.S. Trade Or Business?
Whether a foreign person is engaged in a U.S. trade or business is a factual question. Characterization as a U.S. trade or business depends upon whether the activity rises to the level of a trade or business, whether a trade or business has sufficient connections to the United States, and whether the relationship between the foreign person and persons performing activities in the United States for the foreign person is sufficient to attribute those activities to the foreign person. Special rules govern whether trading in stock or securities or commodities constitutes the conduct of a U.S. trade or business.
The United States is a signatory to more than 60 income tax treaties. For eligible foreign persons, U.S. tax treaties restrict the application of net-basis U.S. taxation. Under each treaty, the United States is permitted to tax business profits only to the extent those profits are attributable to a U.S. permanent establishment of the foreign person. The threshold level of activities that constitute a permanent establishment is generally higher than the threshold level of activities that constitute a U.S. trade or business. For example, a permanent establishment typically requires the maintenance of a fixed place of business over a significant period of time.
Effectively Connected Income Is Taxed On A “Net” Basis
The Tax Code allows deductions against effectively connected income and it is taxed at the graduated rates that apply to U.S. citizens and resident aliens or lesser rates under a tax treaty.
Taxable ECI is computed by taking into account deductions associated with the gross ECI. Regulations address the allocation and apportionment of deductions between ECI and other income. Specific rules provide for the allocation and apportionment of certain items, such as research expenditures, legal and accounting fees, income taxes, losses on dispositions of property, and net operating losses.