ECI: Effectively Connected Income Tax Rules
Contents
ECI: Effectively Connected Income Tax
ECI: When a foreign resident (non-US Person) has effectively connected income (ECI) then they will generally have to file a tax return. The tax return is referred to as a 1040-NR (NR means nonresident). ECI is taxed based on various factors, and deductions can be claimed. For example, an NRA landlord of a US Property who elects to treat the income as ECI instead of the default FDAP (Fixed, Determinable, Annual and Periodic), can claim deductions associated with the income.
Let’s review the basics of ECI:
IRS Definition of ECI
How does the IRS categorize ECI?
Let’s break it into bite-sized pieces:
Foreign Person U.S. Trade or Business
- “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.”
What does this mean?
When a nonresident foreigner conducts business in the U.S. the U.S. sourced income is reportable as ECI and included on the U.S. 1040NR tax return.
Engaged in Trade or Business
- “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.”
What does this mean?
This paragraph summarizes what the filer must do to possibly qualify for ECI — which is to be engaged in a U.S. trade or business and (usually) that means performing services in the US (but not always). The idea is that nonresident foreigner can only claim ECI (and claim deductions) for income that meets the ECI requirements. Otherwise, the other income is deemed FDAP and the U.S. payor withholds 30% unless a treaty position reduces the income (or an exception, exclusion, or other limitation applies).
Deductions
- “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.”
What does this mean?
When reporting ECI, the taxpayer is entitled to apply the graduated rates to income, after deductions are factored in. In addition, a treaty may reduce or eliminate the tax.
Additional Information about ECI
Certain kinds of Fixed, Determinable, Annual, or Periodical (FDAP) income are treated as ECI income because:
- Certain Internal Revenue Code Sections require the income to be treated as ECI,
- Certain Internal Revenue Code Sections allow elections to treat the income as ECI,
- Certain kinds of investment income are treated as ECI if they pass either of the two following tests:
- 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.
- 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.
Foreign Sources Income as ECI
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.
The following categories of income are usually considered to be connected with a trade or business in the United States.
- 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.
- 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.
- You usually are engaged in a U.S. trade or business when you perform personal services in the United States.
- 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.
- 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.
- Income from the rental of real property may be treated as ECI if the taxpayer elects to do so.
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.
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.
Applicable Tax Rate
- 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.
Tax Year
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.
Accurate ECI Reporting is Important
In conclusion, when a foreign nonresident has U.S. sourced income, they may have either FDAP or ECI — or both. When ECI is involved, the taxpayer files a Form 1040-NR to report the ECI income. The foreign nonresident may be able to take deductions against the income — and claim treaty benefits if applicable.
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