International Taxation – Inbound
Foreign corporations, foreign partnerships, foreign trusts and estates and individuals who are neither citizens nor residents of the United States are taxed only on the income earned or derived within the United States.
Learn more about the two categories of income subject to U.S. taxation:
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Effectively Connected Income (ECI)
Nonresident alien individuals that are engaged in a trade or business within the United States are subject to U.S. income tax on any “effectively-connected” income, from sources both within and outside the United States. Effectively connected means that the trade or business conducts any management, production, distribution, or other major business functions within the borders of the United States, that is regular, substantial and continuous. Another strong determinant of the income source is if the nonresident alien has an office in the United States.
While ECI is essentially a type of income, the mechanics of its taxation requires attention to the activities engaged in by the nonresident alien. A nonresident alien cannot have ECI unless he or she participated at some point in a U.S. trade or business. The general rule is that income will be taxed in the jurisdiction (the United States, in this case) where such income is earned. The ECI of a nonresident alien is taxable in the United States on a net basis at graduated income tax rates. Deductions from the income are allowed for business expenses, and specific itemized deductions are allowed. U.S.-sourced passive income (FDAP income that is not ECI) is not included in this ECI calculation, and such income, if any, will generally be taxed at a flat rate, or not at all.
If income is effectively connected with a U.S. trade or business, then the taxable income is computed in the same manner that applies to U.S. persons, except that the gross income that is not effectively connected with a U.S. trade or business is excluded from ECI, and deductions are then limited to those that are directly connected with the ECI.
Meeting ECI Requirements
Generally, a nonresident alien must be engaged in a trade or business during the tax year to be able to treat income received in that year as ECI. The nonresident alien is usually considered to be engaged in a U.S. trade or business when he or she performs personal services in the United States. Whether one is engaged in a trade or business in the United States depends on the nature of the activities performed by that individual.
In determining whether someone is engaged in a U.S. trade or business, relevant facts and circumstances will dictate the resulting conclusion. Because these situations are highly-specific and unique to each particular situation, the IRS has been reluctant to issue any rulings on the determination procedures. Oftentimes,
courts will look to the nature of the activities, the level, extent and continuity of the activities, and the time required to perform the activities. As an aside, the examination of the conduct of the activities is not limited to the foreign persons, but also includes those individuals who are acting as agents on their behalf.
The following are examples of situations where a nonresident alien would be considered connected with a trade or business in the United States, and ECI would exist:
- A nonresident alien 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.
- A nonresident alien owns and controls the business activity of a single-member operating LLC that is organized and conducts business in the United States.
- A nonresident alien performs personal services are performed in the United States.
- A nonresident alien owns and operates a business in the United States selling services, products or merchandise. For example, profit from the sale in the United States of inventory, purchased either in the United States or in a foreign country, is effectively-connected trade or business income.
- A nonresident alien realizes gains from the sale or exchange of U.S. real property interests (whether or not they are capital assets.)
- A nonresident alien owns real property that generates rental income (if the taxpayer elects to do so.)
- A nonresident alien is temporarily present in the United States as a nonimmigrant on an F, J, M or Q visa. The taxable part of any U.S.-sourced 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.
Generally, if a nonresident alien’s only U.S. business activity is trading in stocks, securities or commodities (including hedging transactions) through a U.S. resident broker or other agent, he or she is NOT engaged in a trade or business in the United States.
Fixed, Determinable, Annual or Periodical (FDAP) Income
FDAP income can be considered either effectively-connected income (ECI) or not effectively-connected income. The determination of such will ultimately determine how this income is taxed.
FDAP income is broadly defined by the Internal Revenue Service (IRS) by what it is not. Thus, FDAP is all income except:
- Gains derived from the sale of real or personal property (including market discount and option premiums, but not including original issue discount)
- Items of income excluded from gross income, without regard to the U.S. or foreign status of the owner of the income, such as tax-exempt municipal bond interest and qualified scholarship income
Since this category can include income that is fixed or otherwise determinable, and is income that is paid annually or is periodically in non-regular intervals, FDAP income encompasses many types of income, including:
- Compensation for personal services
- Original issue discount
- Pensions and annuities
- Real property income, such as rents, other than gains from the sale of real property
- Scholarships and fellowship grants
- Other grants, prizes and awards
- A sales commission paid or credited monthly
- A commission paid for a single transaction
- The distributable net income of an estate or trust that is FDAP income, and that must be distributed currently, or has been paid or credited during the tax year, to a nonresident alien beneficiary
- A distribution from a partnership that is FDAP income, or such an amount that, although not actually distributed, is includible in the gross income of a foreign partner
- Taxes, mortgage interest or insurance premiums paid to, or for the account of, a nonresident alien landlord by a tenant under the terms of a lease
- Prizes awarded to nonresident alien artists for pictures exhibited in the United States
- Purses paid to nonresident alien boxers for prize fights in the United States
- Prizes awarded to nonresident alien professional golfers in golf tournaments in the United States
FDAP income can also include income gained from the sale of intellectual property if compensation for the intellectual property is contingent upon the use, productivity or sale of the property. Capital gains from the sale of personal property may also be considered FDAP income if the nonresident alien has been in the United States for 183 days or more in the tax year.
By default, FDAP income, is income that is not connected with a trade or business (i.e., not ECI), and is taxed on the gross amount, at a flat rate of 30%. However, FDAP income may be taxed at a lower rate, if a tax treaty provides for it, or if other permissible reductions are available. By contrast, ECI is taxed at normal graduated income tax rates and deductions and credits are available. By categorizing income as ECI, and by utilizing other strategic measures, it is possible for a nonresident alien to reduce his or her overall tax obligation.
As a practical concern, it is important to note that if an FDAP income obligation exists, the 30% tax payment on the income is collected by withholding at the source. This may require a nonresident alien to withhold and remit tax to the Internal Revenue Service.