Effectively Connected Income

Effectively Connected Income (ECI) is income derived from activities performed in the United States or connected with a trade or business. This includes compensation income from employment or business, interest, rent royalty, gains from the sale of U.S. real property under the Foreign Investment in Real Property Tax Act, FIRPTA for short, and other non-cash items. The IRS uses two tests to determine whether a foreign-source payment constitutes ECI: the asset-use and business-activities tests. The asset-use test determines whether the payment is derived from assets used in, or held for use in, the conduct of the trade or business. The business-activities test looks to whether the income or gain is a material factor in the conduct of the trade or business.

Effectively Connected Income (ECI) and Fixed, Determinable, Annual, and Periodic Income are both types of passive income, but how they are taxed differs. Generally, ECI is taxed at the graduated rates that apply to U.S. citizens and resident aliens. It is often subject to deductions that minimize its tax burden. In contrast, FDAP is generally taxed at a fixed rate, with no deductions allowed, and is taxed on the gross amount of the U.S.-source income or gains. However, certain kinds of FDAP may be exempt from tax under a treaty or the Code.

What Are ECI Rules?

ECI rules are the IRS’s rules governing when foreigners receive income effectively connected to a trade or business in the United States. The income may be from the sale or exchange of property or the performance of services. It can include gains from the disposition of U.S. real property interests under FIRPTA. A nonresident alien must generally report the income received on a 1040-NR tax return. The income is taxable based on various factors, and deductions can be claimed for certain items. However, knowing what is taxable and what is not can help you reduce your tax burden in the future. If a foreign person is engaged in a trade or business in the United States, all of their income from sources in the United States that are connected with that trade or business is treated as effectively connected income. This includes dividends, interest, royalties from a U.S. corporation, and certain types of passive investment income. The income is taxed at the same rates as United States-source earnings and profits.

The IRS also taxes ECI on a net basis. This means that any foreign group member that has met the test of being engaged in a trade or business in the U.S. will be subject to tax on all of its U.S.-source ECI. This rule applies to all types of income, including those that would otherwise escape ECI treatment under the Code’s applicable income-sourcing rules. For example, if a foreign group member is a CFC under the Subpart F rules, and its related U.S. group members provide services to that foreign group member under service agreements, then the income from these activities will be ECI. In addition, any gain from the sale or exchange of these services will be taxed as ECI.

Effectively Connected Income is a key tax issue for many nonresidents and businesses that do business in the United States. Understanding what is taxable and what is not can make the process of filing your tax return much easier.