Effectively Connected Income: Introduction | US International Tax Lawyer & Attorney
Let’s suppose we find a US trade does exist. If it doesn’t, then we’ll talk about the FDAP a little bit later in the presentation.
If a non-US person engages in US trade or business activities, then the next question is: Is the income that he derives connected to these US trade or business activities, called ECI or Effectively Connected Income? Now, ECI is arguably the most important concept concerning inbound transactions. It may be the only source of income, per se, that is inbound, but ECI is such a central concept and a complex issue as well.
Basically, ECI includes three different types of income:
All active US-source income: One thing to keep in mind is the attraction rule; I give you an example here. A German corporation sells washing machines through a US office in the United States; in addition, it sells dryers directly to the distributors in the United States, but without any involvement of that US office. The sales are structured so that they are considered to be US-source income. For one reason or another, let’s say they signed a contract here in the United States. Even though the sale of dryers is not related to a US trade or business, because of the attraction rule, the income from both the washing machines and the dryers is considered to be the same. Obviously, this is all active-source income.
The second category: General passive US-source income – sales of capital assets and other passive income is considered to be ECI, if this income passes one of two tests: the Asset-Use test and the Business Activities test. I gave you the definition; but we wont have the time to go into more details on this. But, be aware that even passive US-source income may be considered ECI.
What I mentioned before: Certain foreign-sourced income may be considered ECI; generally speaking, in order for this to happen, the non-US person has to have an office or other permanent establishment here in the United States.
Only these three types of income which I have listed are related to this exception from the general rule that foreign-sourced income of a non-US person is non-taxable in the United States.
Let’s suppose that we indeed had ECI income. The next question is going to be: How is the income going to be taxed? There are special tax regimes that exist in the United States, for example, Branch taxes or BEAT, which is something that was introduced by the 2017 tax reform. If an ECI income falls under the special tax regime, it’s going to be taxed according to the special tax regime; however, if no special tax regime applies, the ECI is going to be taxed at US graduated rates, including, by the way that’s important to keep in mind, including capital gains tax rates.