Generally, for a nonresident “engaged in a trade of business” in the United States, the net income that is “effectively connected” with the conduct of that trade or business is taxed in the same manner as net income earned by a U.S. resident (individual or corporation). If there is no U.S. trade or business, then only certain U.S. source income (usually investment income) is taxed at a 30 percent or lower treaty rate. The key feature is identifying what constitutes a “U.S. trade or business.” For this, the international tax provisions are vague but relevant regulations and rulings have provided guidelines to follow.
ENGAGED IN A U.S. TRADE OR BUSINESS
Certainly, a passive activity such as investing does not rise to the level of a trade or business but the courts have asserted activities that are “considerable, continuous, and regular” do constitute the conduct of a U.S. trade or business. The clearest example of this interpretation is when nonresidents conduct activities in the United States through an agent. For example, the sale of inventory on a regular basis in the United States is a U.S. trade or business. However, the courts have also said that foreign taxpayers present in the United States merely to demonstrate their product or solicit orders is also conduct of a U.S. trade or business. Special agency rules apply for nonresidents trading in stock, securities, or commodities.
If a foreign taxpayer actively trades stocks, securities, or commodities, the activity can rise to the level of a U.S. trade or business. This occurs when transactions are conducted through a resident independent contractor if directed through an office of the taxpayer located in the United States. Conversely, in absence of a U.S. office, the nonresidents trading activities will not create a U.S. trade or business. Additionally, a nonresident who is not a dealer may trade for the investor’s own account through an employee or other dependent agent without having a U.S. trade or business even if the nonresident operates through a U.S. office.
Like activity directed through a U.S. office location, the performance of personal services in the United State by a nonresident is a U.S. trade or business. However, personal services are subject to a de minimis (minimum importance) exception. Rendering a de minimis level of services does not constitute a trade or business if:
- The services are performed while the taxpayer is temporarily present in the United States
- The taxpayer is present in the United States for no more than 90 days during the taxable year
- The compensation for the services in the United States does not exceed $3,000, and
- The employer is not engaged in a trade or business in the United States or a foreign office of a U.S. person.
EFFECTIVELY CONNECTED
If a taxpayer is engaged in a U.S. trade or business, generally, all sales, services, or manufacturing income from U.S. sources is effectively connected income. Thus, a foreign corporation conducting activity through a United States branch will be effectively connected income. Furthermore, to the extent that title passes in the United States the income will be deemed effectively connected.
On the other hand, U.S. source investment income is considered effectively connected if either the income is derived from assets used in a the conduct of a U.S. trade or business (“asset use”) or the activities of the trade or business are a material factor in the realization of the income (“business activities”).
Not only income from U.S. sources but also foreign source income can also be treated as effectively connected with the conduct of a U.S. trade or business. Although not generally taxable in the United State, there are some foreign source income exceptions for income that is attributable to a U.S. office or fixed place of business. To illustrate, if a foreign corporation operating a U.S. trade or business arranges to sell its inventory abroad even though the inventory is intended for use in the United States, under the internal revenue code the foreign source gain will be treated as effectively connected income. However, if a foreign office of the corporation materially participates in the sale and the inventory is not used in the United States, the gain will not be considered effectively connected income.
In most cases, a foreign taxpayer is deemed to have an office or other fixed place of business in the United States if it has a store, plant, or any place where business in conducted. An office or fixed place of business of an agent does not satisfy this requirement unless the agent possesses and regularly exercises the authority to negotiate and conclude contracts for the principal or maintains a stock of merchandise from which he regularly fills orders on behalf of the principal and is not an independent agent.
NET, RATHER THAN GROSS, TAXATION
The effectively connected income (ECI) of foreign persons and entities is taxable in the United States at standard graduated rates on a net basis. Deductions are allowed for effectively connected business expenses, and the same distinction is made between valid business and nondeductible personal expenses as with domestic taxpayers. Foreigners also must distinguish between deductible current expenses and capitalized expenses. Depreciation and amortization expenses are also available. Foreigners are taxed on ECI as though they were U.S. residents with no other investment income. In addition, U.S.-source investment income is taxed at a flat 30% unaffected by the existence of a U.S. trade or business.
There is no controlling and comprehensive definition of a “trade or business” in the IRC as to either U.S. or foreign persons and entities. There however exists several regulations applicable to foreign persons, which we will explore.
The controlling element to establish trade or business is the owner’s level of activity. A squishy unspecified level of activity aimed at generating a profit is required to establish a trade or business. A broad range of business activities of agents and third parties can be imputed to a nonresident alien or foreign entity to complicate having certainly regarding the requisite level activity.
REAL PROPERTY TRADE OR BUSINESS
The ownership of real property can be either passive or active. Holding undeveloped raw land for long term appreciate is passive investment activity where ownership of a sufficient amount of rental real estate may entail sufficient activity to be deemed to be the active conduct of a trade or business.
SALE OF MERCHANDISE
Sales of merchandise is often the final step to earning a profit and is frequently proceeded by manufacturing, distribution and marketing activities. If the property is sold after the conduct of the aforementioned activities, it is clear that the seller is running a trade or business. At the other end of the spectrum, occasional sales of pure investment type assets that are purchased and passively held with the hopes that they appreciate is not a trade or business as made clear by case law on the subject. Occasional sales of investment asset produce capital gains and losses from passive commitments of capital. The defining characteristics of sales that will constitute a trade or business is the level of activity along with a value added element inherent in the sale itself.
MONEY LENDING
Lending money can run the same spectrum from passive investment like activity (i.e. purchasing a T Bill) to overtly business activity as observed in a commercial lending institution (i.e. a bank). To classify money lending as a business requires known borrowers and lending with a degree of regularity and sufficient volume.
MANUFACTURING
Manufacturing and other form of active production on almost the minutest of scale is a trade or business.
DEFINING THE LOCATION OF A TRADE OR BUSINESS
U.S. nexus to tax inbound transactions turns on the active conduct of a trade or business by non-resident aliens and foreign entities in the United States. Quite often, the difficult question is not whether an active trade or business is being carried on but where?
Generally, solely promotional activity in the United States such as advertising, gathering and dispersing information, and the use of showrooms will not in itself rise to the level of a U.S. trade or business even where extensive. Adding the mere solicitation of orders and additional sales activity will result in a finding of U.S. trade or business activity.
The mere purchase of merchandise in the U.S. for resale offshore does not lead to a finding of a U.S trade or business. However, U.S. production or sales of the goods so purchased in the U.S. will.
Onshore sales of goods by offshore sellers solely in response to either mail or internet orders does not constitute the establishment of a U.S. trade or business regardless of where title to goods passes. However, add even the slightest degree of onshore physical presence like a sales office or warehouse and the scale swings the other way and can create significant tax hazards for the unknowing offshore seller.
Purely investigation activities seeking business opportunities in the U.S. will not generally in itself establish a U.S. trade or business.
PERSONAL SERVICES
Under section 864(b) the performance of personal services in the U.S. at any time during the taxable year is by definition a trade or business whether performed as an employee or an independent contractor.
SECURITIES AND COMMODITY TRADING
Generally, active securities and commodity trading for one’s account is not a trade or business.
Utilizing an Independent Agent
Investment trading through a resident broker, commission agent, custodian, or other independent agent is not a U.S. trade or business as long as the taxpayer maintains no U.S. office or other fixed place of business from which the trading is conducted.
IMPUTATION OF TRADE OF BUSINESS BASED ON THE ACTIONS OF THIRD PATTIES
Direct participation by a taxpayer is not required to reach a finding of the active conduct of a U.S. trade or business. A broad range of activities of third parties can by imputed to the taxpayer to arrive at a finding of the carrying on a U.S. trade or business. For corporations, which are viewed under the law as separate legal beings, third parties are a prerequisite to carry on trade or business.
ACTIONS OF EMPLOYEES AND AGENTS IMPUTED TO TAXPAYER
The most common cases of imputation of trade of business activity to occur with employees and other agents. Because of the concept of imputation, a taxpayer acting through an employee or agent is the same as acting directly.
The nature of the agency relation determines whether a trade or business is imputed from an agent to his or her principal and turns on the degree of control exercised by the principal. The common law employment relationship imparts a high degree of day-to-day control by master over the servant. Consequently, the imputation of a trade or business from W-2 employee to employer for acts that are within the scope of employment is certain. Agency relationships that impart a lesser degree of control as with independent contractors and independent brokers do not automatically result in imputation of a trade or business.
IMPUTATION VIA STATUTE (PARTNERSHIPS AND TRUSTS)
Under section 875, a trade or business is imputed from the partnership to each partner and from a trust / estate to each beneficiary. Consequently, any effectively connected income flows from general and limited partnerships and trusts to the individual partners and beneficiaries
