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Nonresidents Beware of Effectively Connected Income Tax Trap
Effectively Connected Income (ECI) US Tax
When a nonresident alien (non-US person) has US-sourced income, they are still required to pay tax on that income to the US Government — and possibly file an IRS Tax Return on Form 1040-NR. Tax may be avoided if the income is exempt or the Taxpayer qualifies for treaty election or other tax minimization strategy. For non-resident aliens, income tax is usually broken down into two categories: FDAP and ECI. ECI refers to Effectively Connected Income. The concept behind ECI is that the income is associated with the income earned from a trade or business in the United States. In general, nonresident aliens prefer ECI to FDAP – because with ECI the Taxpayer can take deductions (such as when a nonresident alien elects to treat their U.S. rental income as ECI instead of FDAP). The Internal Revenue Service provides the following summary on how to determine Effectively Connected Income:
What is Effectively Connected Income?
As provided by the IRS:
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Generally, when a foreign person engages 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 (ECI). This applies whether or not there is any connection between the income, and the trade or business being carried on in the United States, during the tax year.
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Generally, you must be engaged in a trade or business during the tax year to be able to treat income received in that year as ECI. You usually are considered to be engaged in a U.S. trade or business when you perform personal services in the United States. Whether you are engaged in a trade or business in the United States depends on the nature of your activities. Deductions are allowed against ECI, and it is taxed at the graduated rates or lesser rate under a tax treaty. The discussions that follow will help you determine whether you are engaged in a trade or business in the United States.
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Certain kinds of Fixed, Determinable, Annual, or Periodical (FDAP) income are treated as ECI income because:
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Certain Internal Revenue Code Sections require the income to be treated as ECI,
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Certain Internal Revenue Code Sections allow elections to treat the income as ECI,
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Certain kinds of investment income are treated as ECI if they pass either of the two following tests:
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The Asset-Use Test – The income must be associated with U.S. assets used in, or held for use in, the conduct of a U.S. trade or business.
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Business Activities Test – The activities of that trade or business conducted in the United States are a material factor in the realization of the income.
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In limited circumstances, some kinds of foreign source income may be treated as effectively connected with a trade or business in the United States. Refer to Publication 519, U.S. Tax Guide for Aliens.
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The following categories of income are usually considered to be connected with a trade or business in the United States.
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You are considered to be engaged in a trade or business in the United States if you 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.
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If you are a member of a partnership that at any time during the tax year is engaged in a trade or business in the United States, you are considered to be engaged in a trade or business in the United States.
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You usually are engaged in a U.S. trade or business when you perform personal services in the United States.
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If you own and operate a business in the United States selling services, products, or merchandise, you are, 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.
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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 you are engaged in a trade or business in the United States. You must treat the gain or loss as effectively connected with that trade or business.
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Income from the rental of real property may be treated as ECI if the taxpayer elects to do so.
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NOTE: If your only U.S. business activity is trading in stocks, securities, or commodities (including hedging transactions) through a U.S. resident broker or other agent, you are NOT engaged in a trade or business in the United States.
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NOTE: Certain kinds of income, which are normally treated as ECI or FDAP for income tax purposes, may not be treated as ECI or FDAP for withholding tax purposes.
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Applicable Tax Rate for ECI
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Income you receive during the tax year that is effectively connected with your trade or business in the United States is, after allowable deductions, taxed at the graduated rates that apply to U.S. citizens and resident aliens.
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Tax Year
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Generally, you can receive effectively connected income only if you are a nonresident alien engaged in a trade or business in the United States during the tax year. However, income you receive in another tax year from the sale or exchange of property, the performance of services, or any other transaction is treated as effectively connected in that year, if it would have been effectively connected in the year the transaction took place or you performed the services.
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References/Related Topics
Withholding of ECI
Generally, if you are not a partnership, you do not need to withhold tax on ECI income (income which is effectively connected with a U.S. trade or business) if you receive a Form W-8ECI on which a foreign payee represents that:
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The foreign payee is the beneficial owner of the income,
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The income is effectively connected with the conduct of a trade or business in the United States, and
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The income is includible in the payee’s gross income.
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The W-8ECI must include the payee’s U.S. TIN.
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Income effectively connected with the conduct of a trade or business in the United States is not a withholdable payment under chapter 4 and thus is not subject to withholding under FATCA.
This withholding exemption also applies to income for services performed by a foreign partnership or foreign corporation (unless item (4) below applies to the corporation).
However, withholding is normally required on any of the cases listed below:
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Payments for independent personal services performed by a foreign individual,
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Effectively connected taxable income of a partnership that you are allocating to a foreign partner (refer to Partnership Withholding on Effectively Connected Income),
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Income from a foreign person’s disposition of a U.S. real property interest or certain partnership interests (refer to U.S. Real Property Interest), or
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Payments to a foreign corporation for personal services if all three of the following apply:
- The foreign corporation otherwise qualifies as a personal holding company for income tax purposes (refer to IRC 542),
- The foreign corporation receives amounts under a contract for personal services of an individual whom the corporation has no right to designate, and
- 25% or more in value of the outstanding stock of the foreign corporation at some time during the tax year is owned, directly or indirectly, by or for an individual who has performed, is to perform or may be designated as the one to perform, the services called for under the contract.
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The beneficial owner of the income should provide Form W-8ECI or Form 8233 to the withholding agent to claim an exemption from NRA Withholding on ECI income.
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