When a non-U.S. person, corporation, partnership, or other entity engages in a trade or business within the United States, all of the income from U.S. sources connected to such trade or business is considered effectively connected income (ECI) and subject to federal income taxes.
The U.S. tax code does not clearly define what it means to be engaged in a U.S. trade or business (USTOB). Therefore, it is often difficult for foreign individuals and corporations to assess whether they have a USTOB and ECI.
In general, income is considered ECI if it meets either of the following two tests:
- Business Activities Test. The trade or business activities conducted in the U.S. are a material factor in generating income.
- Asset Test. The income must be associated with U.S. situs assets used in, or held for use in, the conduct of a U.S. trade or business.
Certain types of income and activities will automatically be considered engaged in a USTOB and generate ECI. For example, personal services performed by a nonresident while physically present in the U.S. will constitute being engaged in a USTOB.1 The compensation received for those services is effectively connected with a trade or business in the U.S.
Example USTOB and ECI Fact Pattern
Company ABC Ltd (the “Company”) is a limited company (Ltd) formed in the Cayman Islands. It operates several supermarket locations in the Cayman Islands and wants to expand internationally, so it opened a location in Orlando, FL.
On May 15, 2023, the Company formed a Florida limited liability company (LLC), owning 100% of the LLC membership units. The single-member LLC is a disregarded entity for U.S. federal tax purposes.
The LLC purchased a building location in Orlando, hired employees to work in the supermarket, and opened for business on June 30, 2023. For the 2023 fiscal year, the LLC generated $200,000 in net profit.
The Company, via the activities of its disregarded LLC, is engaged in a U.S. trade or business and has income effectively connected with the U.S. trade or business. The following factors are relevant:
- The Company is a foreign corporation for U.S. federal tax purposes.
- The LLC owns U.S. situs real estate
- The LLC employs individuals who physically work within the U.S.
- The LLC sells inventory products to customers physically located in the U.S.
Even if the Company and the LLC argue that the head office of the operation is based in the Cayman Islands, the activities conducted within the U.S. gives rise to a USTOB.
The Company must file an annual Form 1120-F (US Income Tax Return of Foreign Corporation) to pay federal income taxes on its net effectively connected taxable income. In addition, the Company may also be liable for Branch Profits Taxes (BPT). The Florida LLC, as a foreign-owned disregarded entity, should also separately file Form 5472 (Information Return of a 25% Foreign-Owned US Corporation)
Foreign Corporations and Protective Income Tax Returns
In many cases, a foreign corporation may conduct limited activities within the U.S., but those activities are insufficient to give rise to a USTOB or ECI. As a cautionary measure, the foreign corporation can file a “protective” Form 1120-F filing with the IRS.
The protective tax filing preserves the foreign corporation’s right to receive deductions and credits if, in the future, the IRS audits the corporation and determines that it was engaged in a USTOB and liable for corporate income taxes.
Please view our video tutorial on protective Form 1120-F tax returns.
Additional Information
Taxpayers can find more information on ECI by visiting the IRS website.