US 16 | Non-ECI Non-FDAP

US Tax

Non-ECI Non-FDAP – how is US sourced income that is neither ECI nor FDAP taxed in the US if derived by a non-resident? This is the point of contention. One school of thought says that all US-sourced income is taxable in the US unless there is a specific exemption. But this is the minority. The majority - and the speaker in this episode is one of them - argues that US-sourced income that is neither ECI nor FDAP is not taxable in the US if derived by a non-resident.

Let's use the example of an Australian Pty Ltd selling merchandise into the US from Australia. To what extent are the profits taxable in the US, disregarding the US – Australian Double Tax Agreement (‘DTA’ or ‘treaty’).

FDAP

Selling merchandise into the US is clearly not FDAP. FDAP stands for fixed or determinable annual or periodic income. So think of interest, dividends, royalties, salaries, wages, annuities and so on – any income you pay or receive following a certain formula. That is FDAP. Not the sale of inventory.

The taxation of FDAP is straight forward. If US-sourced and not connected to a US trade or business, the payer has to withhold 30% withholding tax unless a treaty applies.

If the Australian Pty Ltd has a US Trade or Business (‘USTB’) in the US and hence effectively connected income (‘ECI’) with this USTB, things are relatively clear as well. ECI is taxable in the US. Whoever this ECI is assigned to has to prepare a tax return and then pay tax in the US on this ECI unless a treaty applies.

Non-ECI Non-FDAP Income

Where it gets confusing is income that is neither ECI nor FDAP. How do you treat US-Sourced Non-ECI Non-FDAP? That is the point of contention

The minority argues that all US-sourced income is taxable in the US (disregarding any treaties). The only difference is how. So whether US-sourced income is ECI or not only matters for how it is taxed, not whether it is taxed.

But James Baker will argue in this episode that this is not correct. That a non-resident who derives income that is neither ECI nor FDAP has no taxable income in the US. And he bases his argument for ECI on s882 (a) (1) and for FDAP on s881 IRC.

s882 (a) (1) IRC

The majority of US tax advisers - at least the ones we spoke to - argues that s882 does not apply to non-ECI due to s882 (a) (1). They argue that a foreign corporation only needs to include income that is ECI.

s882 (a): “(1) In general

A foreign corporation engaged in trade or business within the United States during the taxable year shall be taxable as provided in section 11 or 59A, on its taxable income which is effectively connected with the conduct of a trade or business within the United States.”

s881 (a) IRC

And then there is s881 (a) that lists various forms of FDAP income (fixed or determinable annual or periodic) such as interest, dividends, royalties, wages, salaries, annuities and so on.

s881: “(a) Imposition of tax

Except as provided in subsection (c), there is hereby imposed for each taxable year a tax of 30 percent of the amount received from sources within the United States by a foreign corporation as—…”

Conclusion

And that’s it, they argue. Any income that is neither ECI nor FDAP is not taxable in the US if derived by a foreign corporation. You don’t even need the treaty to pull you out.

The speaker in this episode is James Baker of James Baker & Associates.

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