Effectively connected income (ECI) is income derived from a trade or business activity in the U.S. If a foreign individual actively engages in business operations within the U.S. and generates income from those activities, that income is classified as ECI.
As per the IRC Section § 864(c), ECI includes:
This encompasses income earned from operating a business or providing services within the United States. Income connected effectively with a U.S. trade or business is often associated with the fact that the foreign corporation has a fixed base or permanent establishment in the U.S. For example, a foreign corporation has some permanent office, factory, base of operations, etc., in the U.S. from which it generates its U.S. income.
Example: A French businessman, Sam, opens a retail store in New York City selling smartphones and laptops. The company earns $2 million annually from product sales to its U.S. Customers. This income constitutes ECI because it’s generated through the company’s active U.S. trade or business operations.
Most investment income is considered passive and is often referred to as FDAP (Fixed Determinable Annual Periodic) income. However, certain types of investment income can be classified as ECI (Effectively Connected Income) if they meet specific criteria under either the asset-use test or the business-activities test. Here’s a breakdown of each test:
Asset-use Test: This applies to income generated from assets that are used in a trade or business within the United States.
Business Activities Test: This applies to income generated from activities that are significant to the overall business.
Earnings from personal services performed in the United States, such as salaries, wages, and other types of compensation, are considered ECI.
Income effectively connected with U.S. trade or business (ECI) is likely subject to U.S. federal and state income tax. Foreign individuals are generally subject to graduated tax rates, while foreign corporations are subject to corporate tax rates, similar to those applied to U.S. citizens and residents.
This means that foreign individuals and foreign corporations with ECI can take advantage of certain deductions and credits, which may reduce their taxable income. They are usually required to file a U.S. tax return using Form 1040-NR for individuals or Form 1120-F for foreign corporations.
In most cases, ECI is taxable unless a tax treaty is in place that reduces or eliminates the tax liability.
Example: A Canadian restaurant, ABC Diner Inc., operates a diner in Buffalo, New York, earning $500,000 annually from its U.S. operations. This income constitutes Effectively Connected Income (ECI) because the foreign corporation is involved in a trade or business within the United States through its physical restaurant location and active business operations in the U.S.
As a foreign corporation with ECI, ABC Diner Inc. should file Form 1120-F (U.S. Income Tax Return of a Foreign Corporation) for reporting its U.S. business income. Generally, the company pays the regular 21% U.S. corporate tax rate on its ECI unless any US tax treaty rule applies.