What is effectively connected income? Generally speaking, if a foreign person or business entity 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 as “Effectively Connected Income” (ECI) regardless of whether there is any connection between the income and the trade or business being carried on in the United States, during the tax year or not. Needlessly to say, ECI is subject to U.S. tax.
Are you engaged in business in the US?
Normally, in order to treat income received in that taxable year as ECI, you have to be engaged in a trade or business during that year. You are usually perceived as engaged in a U.S. trade or business when you perform personal services in the United States. The nature of your activities can be important when determining whether you are engaged in a trade or business in the United States.
Two Tests to Determine Effectively Connected Income
There are two tests used to determine if income is effectively connected with the taxpayer’s U.S. business are: (1) the “asset use” test and (2) the “business activities” test.
The “asset use” test asks the question whether the received income was derived from assets used in, or held for use in, the taxpayer’s U.S. business. The asset-use test is often applied and of great significance, in cases, for example, where a foreign company is in the business of manufacturing or selling goods in the U.S. Ordinarily, an asset shall be treated as used in, or held for use in, the conduct of a trade or business in the United States if the asset is
(a) “Held for the principal purpose of promoting the present conduct of the trade of business in the United State; or”
(b) “Acquired and held in the ordinary course of the trade or business conducted in the United States,”
(c) “Otherwise held in a direct relationship to the trade or business conducted in the United States”
Tax Treatment for ECI
The “business activities” test is less frequently used. It asks the question whether the taxpayer’s US business activities were a material factor in obtaining the income. Business activities test is very helpful in cases where the business what otherwise would be considered as passive income, such as rents, royalties and dividends.
Tax Treatment
ECIs is taxed at the ordinary rates that apply to U.S. citizens and resident aliens. Deductions are allowed. As a nonresident alien, if you are engaged in a trade or business in the U.S., you may also need to file 1040NR. If you have a specific issue and would like to speak to a professional, contact us today.