The term may sound a little confusing, but it is something you will have to deal with if you are a non-resident alien conducting business in the United States. Such individuals who engage in business or some type of trade in the U.S. will be obligated to pay income tax on any of their gross income that is considered "effectively connected_,"_ whether the income comes from income sources within or outside of the U.S.
What Is Effectively Connected Income?
So what, exactly, does the term effectively connected mean? It refers to the fact that the business or trade has conducted production, management, distribution or pretty much any other major business function within the boundaries of the U.S. Furthermore, those business functions should be regular, continuous and substantial. Another thing that might factor into whether the income is considered effectively connected is if the alien has an office or a branch of operations within the U.S.
Effectively connected income may be considered a type of income, but it isn’t taxed as easily as other types of income. Some factors must be taken into consideration. These include the activities that the nonresident alien engages in.
An alien cannot be considered to have earned effectively connected income unless they have participated in a U.S business or trade at some point or other. The rule of thumb is that any effectively connected income earned will be taxed within the jurisdiction where that income is earned. This is a rule that is followed by the U.S., just like it is followed in other countries in the world.
The ECI of a nonresident alien in theU.S. becomes taxable within the country at different tax rates graduated on a net basis. There are, of course, deductions allowed for various itemized deductions, business expenses and so on.
Passive income that is sourced from the U.S. is not included as part of the effectively connected income. Such income, if it exists, will either be taxed at a constant rate or not be taxed at all.
Guideline on Effectively Connected Income
When a foreign company decides to do business in the U.S., there are some risks it should consider. It could do business directly in the U.S. and get taxed directly as a U.S. company, or it could establish a U.S. subsidiary and risk having disputes over what portion of the income of the company can be allocated to that subsidiary.
Most businesses tend to go for the option of having a U.S. subsidiary as tax laws favor them. Most foreign businesses operating in the U.S. do business in the form of a parent-subsidiary dynamic.
Sometimes, a company may find it a good idea when planning for transfer pricing to limit the functions of the U.S. subsidiary to justify a low-profit-margin. When they do this, less of the amount earned is taxable under U.S. law, and so it seems like an advantage. However, when you do that, you might risk reducing your subsidiary to nothing more than an agent. The Internal Revenue Service could then successfully claim that the subsidiary is itself a dependent agent of the foreign company and tax all of the income that the agent has earned, including the share of its earnings that are attributable to the foreign parent.
What Is the Point of ECI?
When trying to figure out whether a foreign company is meant to pay U.S. tax, there is a distinction: Is the company engaged in business or trade in the U.S.? Figuring out whether this is the case depends on analyzing a few facts about the business. Because a foreign company is running a subsidiary in the U.S. does not mean that it is running either a trade or a business. Also, having an agent in the U.S. handling the business of the foreign company doesn’t necessarily mean that the foreign company is engaged in a trade or business. The main problems come in when the subsidiary acts on behalf of its foreign parent. In that case, it is acting in the capacity of both a subsidiary and an agent.
Whenever an agent or affiliate, such as a subsidiary, of a foreign company, partakes in economic activities in the U.S., the tax may or may not be charged in the home country of the foreign company. However, if that business is continuous, substantial or regular, then it can be inferred that the company is engaged in a U.S. trade or business and the company is taxed accordingly.
If the foreign company, according to the rules, is engaged in a U.S. trade or business, and there is no treaty protection between the U.S. and the home country of that foreign corporation, then the corporation will be taxed on what the IRS refers to as its effectively connected income. This is income that is sourced in the U.S. from the sale of inventory by that corporation. An interesting point to note is that the foreign corporation could also be taxed on sales it did not make in the U.S. if those sales were made through the foreign corporation's U.S. office. The only way this can be avoided is if a foreign office of the foreign company substantially participates in the sales.
What is a Form 8805?
Connected taxable income is filed on Form 8805, which also includes any withholding tax payments that have been allocated to foreign partners in a partnership during the tax year. This is the form on which a foreign entity will report its effectively connected income when filing for taxes with the IRS at the end of the year. The form should be given to all foreign business partners whether any withholding tax has been paid or not.
The Concept of an Agent
In this case, there are two types of agents: An independent agent and a dependent agent. A foreign corporation will always want to have an independent agent as they won’t be taxed for their U.S. income that way. With a dependent agent, they will be taxed on all of the income that is earned in the U.S., including the share that belongs to the foreign corporation.
When a foreign corporation has an independent agent, that agent is not equivalent to a U.S. office of the foreign corporation. They also do not have the authority, nor exercises it in the name of the foreign corporation, such as when entering and concluding contracts.
When a foreign corporation has a dependent agent, it may or may not be a U.S. office of the foreign corporation. That agent will have the authority to engage in contracts on behalf of the foreign corporation. They will likely have some inventory that belongs to the foreign corporation and will fill orders on a regular basis on behalf of the foreign corporation.
Foreign corporations will, therefore, try to ensure that they have independent agents when they do have agents and will avoid giving the agent the kind of authority that would turn them into a dependent agent.
Types of Effectively Connected Income?
According to the IRS, there are some categories of income that are considered effectively connected income without a doubt.
You will be considered to be engaged in U.S. trade or business as long as you are a non-immigrant with one of the following visa types: “F,” “J," “M," or “Q.” As long as you have one of these visa types, even if you’re a student in the U.Ss and you have a scholarship that is sourced in the U.S. or a fellowship grant that is sourced in the U.S., then your income is treated as effectively connected income.
You will be considered to be engaged in business or trade in the U.S. if you were a member of a partnership at any point in the year and that partnership was engaged in U.S. trade or business at the time. Your income from the partnership will then be treated as effectively connected income and will also be taxed as such.
If you own a business in the U.S. that sells merchandise, products or services, unless you fall in the exceptions for agents and subsidiaries, then you are considered to be engaged in a U.S. trade or business. For example, in the case of merchandise, if you sell merchandise in the U.S., whether that merchandise was bought locally in the U.S. or a foreign country, then your income from those sales will be treated as effectively connected income. Trade and business expenses should, therefore, be treated as part of the effectively connected income.
If you own real estate in the U.S. and you sell it, the gains and losses from that property are treated as effectively connected income, even if the property you were selling consisted of capital assets. The property will be treated like property you traded while being engaged in a U.S. trade or business.
Income you obtain from real estate that you have rented out is treated as effectively connected income only if you choose to have it considered as such.
At this juncture, it’s interesting to note a point that has something to do with the concept of an agent. Say you want to trade in the financial markets in the U.S. You may want to buy and sell commodities, securities or stocks. So you do the trading through a broker who is a resident of the U.S. or some other kind of agent. You will not be considered to be engaging in trade or business in the U.Ss and whatever income you get from this will not be considered effectively connected income.
The reason for this is that the broker or other agent is considered an independent agent. They do not have the authority to conclude contracts on your behalf and in your name. A stockbroker needs to ask you for permission to buy any amount of stock for you. Without you giving them permission, they are pretty much helpless. They also do not hold any stock on your behalf, and their offices are in no way affiliated to yours. This makes all the difference in the question of whether you will be taxed on effectively connected income.
Tax Rate: Effectively Connected Income?
Any income you receive in a tax year that is considered effectively connected income will be given allowable deductions and will be taxed at the same graduated rates that U.S. citizens and resident aliens are usually taxed at.
How Do Tax Years Work?
As long as you’re a non-resident alien that engages in trade or business in the U.S. in a given tax year, your income is considered as effectively connected income. The question arises whether income you received in another tax year from the exchange or sale of property, the rendering of services or any other economic transaction, should be treated as effectively connected income. The answer is yes. As long as it is paid in that year and it would have been considered as effectively connected income in the year that you earned it, then it is considered effectively connected income in that year as well.