The Elements of ECI Made Simple

Who is impacted?

Any personnel working with U.S. withholding agents or payers that make payments to non-U.S. persons of income that is effectively connected (ECI) with the conduct of a U.S. trade or business may be interested in a quick refresher on the elements of ECI.

What changed?

Teams change, personnel change, and knowledge transfer does not always happen as expected. This article provides a quick overview of the key elements, tests, and requirements of ECI. 

What is ECI?

There are two questions to ask when determining whether a non-U.S. person has ECI:

• Is the non-U.S. person engaged in a U.S. trade or business?
• What income is from sources within the U.S. and connected to that U.S. trade or business?

The Internal Revenue Code (IRC) does not define a U.S. trade or business. Instead, we look to case law for clarity in determining the types of activities that constitute a U.S. trade or business. In order for a non-U.S. person to be engaged in a U.S. trade or business, there must be regular, substantial, and continuous business contact with the United States.  

Below are a few examples of what engaging in a U.S. trade or business might involve:

• Non-U.S. individuals performing personal services in the U.S. or in certain instances, when temporarily present in the U.S. with nonimmigrant status on an "F," "J," "M," or "Q" visa.
• Non-U.S. persons owning and operating a business in the U.S. that is selling services, products, or merchandise. 
• Non-U.S. persons receiving gains and/or losses from the sale or exchange of U.S. real property interests.  

Simply trading in stocks, securities, or commodities (including hedging transactions), through a U.S. resident broker or other agent generally does not constitute engaging in a U.S. trade or business. 

U.S. Source Income as ECI

Our December article on FDAP income explained that non-U.S. persons generally are subject to U.S. income taxes on U.S. source FDAP income. As a quick refresher, some examples of FDAP income include U.S. source interest, dividends, rents, and royalties – to name a few.  

Under the ECI rules, U.S. source FDAP income is treated as ECI with a U.S. trade or business if it meets either an “asset use” test or a “business activities” test.  

Under the asset use test, income must be derived from assets used or held for use in the conduct of a U.S. trade or business. This means, the asset must be either: 

• Held for the principal purpose of promoting the present conduct of the U.S. trade or business (e.g., plant and equipment). 
• Acquired and held in the ordinary course of the U.S. trade or business – like accounts receivable. 
• Held in a direct relationship to the U.S. trade or business, such as a bank account, to meet present needs. The asset must be for present use at and not for potential future needs.

Under the business activities test, the activities of the U.S. trade or business must be a material factor in the realization of the income. This test generally applies to income, gain, or loss generated directly from the active conduct of a U.S. trade or business and applies where:

• A dealer in stocks or securities generates dividends or interest. 
• A sale or exchange of capital assets in the active conduct of a trade or business by an investment company generates a gain or loss. 
• The active conduct of a licensing business generates royalties. 
• The active conduct of a servicing business generates service fees. 

It is important to remember that although ECI or FDAP may be treated as such for income tax purposes, they may be treated differently for withholding tax purposes.

Withholding Tax on ECI

Generally, individuals are taxed at a graduated rate for ECI since they are taxed as a U.S. person; however, U.S. federal withholding tax does not apply to income that is ECI if the payee provides a Form W-8ECI certifying that:

• The payee is not a U.S. person and is the beneficial owner of the income.
• The income is effectively connected with the conduct of a trade or business in the United States, and,
• The payee will include this income in its gross income.

This withholding exemption applies to income for services performed by a non-U.S. partnership or corporation. Some examples of when this withholding exemption does not apply include:

• Pay for personal services performed by an individual. 
• Effectively connected taxable income of a partnership that is allocable to its non-U.S. partners.
• Income from the disposition of a U.S. real property interest, or 
• Payments to a non-U.S. corporation for personal services if all of the following apply: Withholding under the Foreign Account Tax Compliance Act does not apply to ECI.  

 Partnerships 

 For information on the impact of ECI to partnerships, please see our December 2018 article on year end partnership considerations.

How to implement

Personnel working with payors and withholding agents that may be paying or receiving ECI should consider the following questions:

• Is the non-U.S. person engaged in a U.S. trade or business?
• Does the non-U.S. person have a business address in the U.S.? 
• What income is effectively connected with that U.S. trade or business?
• Is there a Form W-8ECI on file to exempt withholding tax?

In working through these questions, communicate with vendors and other business areas in order to apply consistent business practices in determining whether a payment is ECI – including how to apply U.S. federal tax withholding and reporting where required.  

ECI can be very tricky and may require manual review or approval of classifications by tax departments or tax legal. Be sure to document any approved policies and procedures related to determining and applying rules to payments of ECI.

References

• IRC §§ 862, 864, 871, 873, and the related Treasury Regulations
• Business Activities Test, Treas. Reg. §1.864-4(c)(3)
• Asset Use Test, Treas. Reg. §1.864-4(c)(2)
• Publication 519, U.S. Tax Guide for Aliens

This article contains general information only and is not a substitute for accounting, tax, or any other professional advice or services. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor.

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