A nonresident alien of the United States will be subject to U.S. taxation if they have income that is “effectively connected” with a U.S. trade or business (“ECI”). This applies to both nonresident individuals and entities alike, as they can both have ECI.
Remember here, that if an individual is either a resident alien or a nonresident citizen, then they will be taxable on their worldwide income, from whatever source derived. Accordingly, this rule pulls in persons and entities who would not normally be subject to taxation in the U.S. and makes them taxable on the U.S. sourced profits arising from their trade or business operations in America.
So, what exactly counts as ECI? Well, under the Internal Revenue Code, ECI will be generated where income is produced by U.S. assets in, or held for use in, the conduct of the U.S. trade or business. Thus, a retailer will generate ECI if they hold inventory within the U.S. inventory for the purposes of selling or leasing them to customers within the U.S. ECI may also be produced where a retailer sells a part interest or whole interest in their U.S. business. Additionally, income will be effectively connected with a U.S. trade or business even if the trade or business is service-based, as it is U.S. profit that is tied to the performance of personal services within the U.S.
Luckily ECI is limited to the earnings and profits of the U.S. trade or business. So, for example, if a foreign company has $1,000,000 of earnings and profits and $2,000,000 of ECI, then they will only be liable to pay and report U.S. tax on $1,000,000 of the ECI under this limitation.
While this analysis seems quite simple, it can actually be quite complex as the Code does not provide a definition of what entails a “U.S. trade or business.” We will dive into this concept, however, in our next blog post so be sure to check back.
In the meantime, if you or your advisor needs assistance in determining whether you have ECI, or how much ECI is taxable within the U.S., then please have your advisor reach out to to us at AsenaAdvisors.com.