In the last post, I wrote about the system by which the U.S. attempts to tax mostly passive forms of income earned by foreigners. I mentioned that the rationale for that system derives from the reality that, because of the unique challenges in imposing tax liability on foreigners (who are for the most part outside the reach of U.S. courts and therefore are beyond effective enforcement of their tax bills by the usual means) the U.S. created an alternative system for the collection of such taxes which makes partners out of the U.S. payors who are the sources of these types of income. Through the rules found in IRC Section 1441 governing withholding agents and FDAP income, the U.S. imposes its will and insures that it will receive its share of the income of foreigners who invest in U.S. assets.
But the need for this system presumes the challenges we mentioned regarding the collection of these taxes and is therefore limited by design to such situations. What is the mechanism by which the Code identifies situations where it doesn't face this challenge of collecting and what then is the method by which it collects in these circumstances? Put another way, what will it take for the U.S. to relax when foreigners earn income and be reasonably assured that it doesn't need to impose draconian gross taxation on these foreigners?
The answer is that if a foreigner has what is called a "U.S. trade or business" and the income is effectively connected with that trade or business, or "ECI", then the income will not be taxed under IRC Section 871(a) (for individuals) and 881 (for corporations). Rather, under IRC Section 871(b) (for individuals) and 882 (for corporations), if a foreigner earns ECI then it is taxed the same way a U.S. person is taxed, i.e. under Sections 1, 11 and 55 of the Code. This means that the taxpayer will be able to net their effectively connected expenses against this income and, depending on the facts of the case, may be subject to a lower effective rate of tax as a result.
Presumably, the thinking behind this is, once a business has income which is connected to a "U.S. trade or business", the courts will have sufficient leverage to go after the business if they don't pay their taxes.
The question of whether or not income is ECI is a "facts and circumstances" type of question. The Code doesn't really define the term and leaves it up to the courts to decide. Different court cases speak about the factors to be consideed for different types of income, e.g. many court cases deal with the question of how much and how frequently must a business make loans to third parties to be deemed in the business of making loans, and therefore such loans will be ECI instead of merely "passive" investments. But every type of income is different and it can frequently be difficult to show that the usual categories of passive income are ECI in a particular case.
It is far more likely that, assuming certain other factors are present, income from sales or services are going to be treated as ECI. But it isn't enough to merely see these types of income. In general, courts will look for certain types of regular, substantial and continuous activities that will constitute the "U.S. trade or business" ("USTB") part of the ECI definition. Such business activities should not be demonstrably single or isolated incidents. The Regulations have some guidance for determining if income is effectively connected in Treas. Reg. 1.864-3 so that section of the Regulations should be consulted as well. This substantial and continuous presence is the reason why the U.S. feels more confident about its ability to enforce tax liability on the foreign business. At this point, the foreign business presumably has too much to lose if it dares ignore its tax responsibilities.
In practice, the ECI standard is generally replaced by application of one of the many US income tax treaties signed by the US with a wide network of foreign countries. Under the treaties, business income is generally exempt from taxation outside the country of residence as long as the business doesn't have what is referred to as a "permanent establishment" in the country where the income is being earned. "Permanent establishment", or PE is a similar but slightly more taxpayer friendly term than U.S. trade or business under the IRC. An example of when PE may be more friendly than USTB is where the only presence is based on a consignment arrangement. See Rev. Ruling 63-113 and Rev. Ruling 76-322. It is also worth noting that different treaties have different details regarding the definition of PE; for example, the U.S.-Israel income tax treaty specifically creates a PE where a foreign business both buys and sells inventory within the U.S. However, it is worth pointing out that just because you have a PE, it doesn't mean you can't try to be exempt from U.S. tax by referring to the USTB definition instead. I have seen cases where we could not take the position that a client didn't have a PE for the reason mentioned previously but were still able to take the position that no USTB existed.
Bearing in mind the explanation of ECI, USTB and PE above, there is an exception situation where the U.S. imposes withholding tax even on ECI. This is where the ECI is earned by a partnership which has one or more foreign partners. IRC Section 1446 imposes withholding tax at the highest rate of tax for either individuals or corporations under IRC Sections 1 and 11. Essentially, it imposes 39.4% withholding on individuals and 35% withholding on corporations who are foreign partners in a partnership with ECI. The policy rationale is fairly easy to guess; since the income is immediately recognized by the foreign partners at the partnership level, we return to the situation where the U.S. may not be able to coerce the partner to report and remit tax on that income since they are located outside the U.S. when it is accrued. This withholding regime does allow for reducing the effective withholding rate based on the partner's ability to substantiate that their effective tax rate will be lower than the top rate through deductions and other means.
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