Definition of Foreign Persons

For purpose of this short article, foreign persons include nonresident aliens and foreign business entities. For example, a Japanese citizen who does not have a US green card, who travels to the US periodically but does not satisfy the substantial presence rule, and a corporation incorporated in Korea.

Taxable Income: FDAP and ECI

Withholding of payments is necessary when tax is due on a payment to foreign persons. Such payments are often categorized as either FDAP income (Fixed, Determinable, Annual, or Periodic Income) or ECI (Effectively Connected Income) from a US trade or business.

Note that a nonresident alien is generally not taxed on US capital gains unless the gains are effectively connec with his US trade or business.

Why Is the Categorization Important?

A payer is generally required to withhold 30% of tax on FDAP income, but is generally not required to withhold tax on ECI income if a Form W-8ECI is received. Common exceptions where withholding are required with respect to ECI include:

  • Payer is a partnership making distribution to a foreign partner, or
  • Payer is a withholding agent distributing proceeds from sale of US real property to foreign persons.

 

FDAP Income

Common examples of FDAP income include the following:

  • Compensation for personal service
  • Dividends
  • Interest
  • Pension and annuities
  • Real estate rental income
  • Royalties
  • Partnership distribution

ECI from a US Trade or Business

Common examples of ECI include the following:

  • Compensation for personal service performed in the US
  • Rental income that the taxpayer elects to be treated as ECI under IRC § 871(d)
  • Investment income deemed effectively connected to a US trade or business under the “Asset-Use Test” or “Business Activities Test”
  • Gain from sales of US real property
  • Partnership distribution to foreign partners

 

Tax Rates

FDAP income is taxed at a flat rate of 30% unless a tax treaty provides a lower rate. FDAP is taxed on a gross basis without deductions.

ECI is taxed at progressive rates applied to nonresident aliens, but taxpayer usually may deduct expenses incurred against such income.

 

Forms Commonly Involved

  • W-8BEN & W-8BEN-E, and W-8ECI
  • W-8IMY
  • Form 8804 & Form 8805
  • Form 8813
  • Form 1042, Form 1042-S, & Form-1042-T
  • Form 5472