What Are Examples of Effectively Connected Income?

Effectively Connected Income (ECI) is a tax concept for foreign individuals and corporations earning money within the United States. It refers to income linked to the conduct of a trade or business in the U.S. When a foreign person or entity operates a business in the U.S., the income from that business is often considered ECI, which determines how it is taxed by the U.S. government.

The purpose of ECI rules is to tax foreign persons on their U.S. business profits in a manner similar to how U.S. residents are taxed. This means that instead of a flat withholding tax, the income is subject to regular tax rates, and certain expenses can be deducted. Understanding this distinction is a starting point for navigating U.S. tax obligations for any foreign person earning income in the country.

The Core Tests for Determining ECI

For income to be classified as ECI, a foreign person must first be engaged in a U.S. trade or business (USTB). This foundational requirement means the person’s economic activities in the U.S. are regular, continuous, and substantial. Occasional or isolated transactions are not sufficient to meet this standard. For example, operating a branch office, having employees in the U.S., or selling inventory from a U.S. warehouse are activities that can establish a USTB.

Once a USTB is established, some income, such as profits from selling products or services, is automatically considered ECI. For other types of U.S. source income, particularly investment-style income, the Internal Revenue Service (IRS) applies specific tests to determine if there is a direct connection to the business.

The first of these is the asset-use test. This test examines whether an income-producing asset is used in, or held for use in, the conduct of the U.S. trade or business. An asset is considered held for use in the business if it is acquired and held for the principal purpose of promoting the business’s activities, such as machinery in a factory or the working capital for daily operations.

The second standard is the business-activities test. This test applies when the activities of the U.S. trade or business were a material factor in generating the income. For instance, if employees of a U.S. branch of a foreign investment bank actively negotiate a deal that results in the company earning a commission, their activities would be a material factor, making the income ECI.

Common Examples of Effectively Connected Income

The most direct examples of ECI arise from business operations or the performance of services within the United States.

Income from Personal Services

Compensation for personal services performed in the United States is considered ECI, applying to both employees and independent contractors. For example, if a Canadian software consultant is hired by a U.S. tech company and travels to their California office for a six-month project, the fees paid for her services are ECI.

Similarly, consider a marketing executive from Germany who is transferred to the New York office of her multinational employer for two years. The salary and bonuses she receives from the U.S. payroll for her work in the New York office are classified as ECI. In both cases, the physical performance of services within the U.S. creates the direct connection.

Income from Business Operations

When a foreign entity establishes a physical presence in the U.S. to sell goods or merchandise, the profits are ECI. Imagine a French artisan who opens a retail boutique in Boston to sell handmade leather goods imported from her workshop in France. The shop constitutes a U.S. trade or business because it is a fixed place of business operating regularly.

The income from selling these goods to U.S. customers is directly generated by the U.S. business operations. Therefore, the net profit from the Boston boutique is ECI.

Income from U.S. Real Property

The tax treatment of income from U.S. real estate is governed by the Foreign Investment in Real Property Tax Act (FIRPTA). Under FIRPTA, when a foreign person sells a U.S. real property interest, the gain is automatically treated as ECI. This means a non-resident who sells a vacation condo in Florida must treat the profit from that sale as ECI.

Rental income from U.S. property can also become ECI. While rental income is often considered passive, a foreign owner can elect to treat it as ECI. This election is common when the owner is actively involved in managing the property, such as by hiring a U.S. property management company to handle leasing and maintenance.

When Investment Income Is Treated as ECI

U.S. source investment income earned by a foreign person, such as interest and dividends, is often categorized as Fixed, Determinable, Annual, or Periodical (FDAP) income. This income is subject to a different tax regime, a flat 30% withholding tax on the gross amount. However, this income can be reclassified as ECI if it has a close connection to a U.S. trade or business.

This reclassification often occurs when the investments are not held for passive purposes but are instead integrated into the operations of a U.S. business. The determination hinges on whether the income is generated from assets used in the business or as a result of the business’s activities.

Example Using the Asset-Use Test

Consider a foreign manufacturing corporation that operates a sales branch in the United States. This U.S. branch needs to maintain working capital to cover expenses like payroll and rent. To manage this cash flow, the branch manager invests excess working capital in short-term, interest-bearing U.S. Treasury bills.

The interest earned on these Treasury bills would be treated as ECI. This is an application of the asset-use test because the cash used to purchase the bills was an asset held and used directly in the U.S. sales business to meet its financial needs.

Example Using the Business-Activities Test

Imagine a foreign investment bank with a licensed branch office in New York City. The bankers and analysts in the New York office structure a complex financing arrangement for a U.S. corporation. As part of its compensation, the investment bank acquires shares of stock in the U.S. corporation.

When the U.S. corporation later pays dividends on this stock, that dividend income is considered ECI. This outcome is based on the business-activities test. The activities of the U.S. branch were a material factor in the acquisition of the stock and the subsequent realization of the dividend income.

Tax Treatment of Effectively Connected Income

The tax treatment of ECI is different from that of other U.S. source income earned by foreign persons. ECI is taxed on a net basis, at the same graduated tax rates that apply to U.S. citizens and resident aliens. This approach means the foreign person can deduct ordinary and necessary business expenses connected to generating that income.

For example, a foreign corporation with ECI from a U.S. branch can deduct expenses such as employee salaries and office rent before calculating its taxable income. This contrasts with the treatment of FDAP income, which is subject to a flat 30% withholding tax on the gross amount, with no deductions permitted.

A nonresident individual earning ECI would report it and calculate the tax using the progressive rate brackets applicable to U.S. individuals. This net basis taxation puts the foreign person on a more level playing field with a U.S. competitor engaged in the same business.

Filing and Reporting Requirements for ECI

Once income is determined to be ECI, specific reporting obligations must be met. Foreign individuals and corporations are required to file U.S. tax returns to report this income, calculate allowable deductions, and pay any tax due.

Non-resident alien individuals who earn ECI must file Form 1040-NR, U.S. Nonresident Alien Income Tax Return. This form is used to report all income effectively connected with a U.S. trade or business and compute the tax using the graduated rates.

Foreign corporations with ECI are required to file Form 1120-F, U.S. Income Tax Return of a Foreign Corporation. Filing these returns is mandatory even if a tax treaty reduces or eliminates the tax, or if the business operates at a loss.