Welcome back. We previously learned the United States taxes non-residents and foreign corporations on their income that has a connection with the United States, or more precisely, income that is sourced to the United States under US law. Let's spend some more time talking about the taxation of non-residents and foreign corporations in a little bit more detail. Here the United States has two taxing regimes for non-resident taxpayers. One that focuses on passive type investment income, and one that targets active business income. A non resident taxpayer can be subject to just one of these regimes or both simultaneously. The regime that targets active business income, taxes effectively connected income, or ECI for short. ECI is income that is generated from a US trade or business. You may recall learning about the definition of a trade or business from an introductory tax class when attempting to distinguish hobby income from trade or business income. But as a reminder, a US trade or business requires activities that are considerable, continuous, and regular. Importantly, a US trade or business also includes the act of performing personal services in the United States. Now, effectively connected income is taxed much like the income of US citizens and residents; deductions are allowed, we have progressive rates for individuals or the flat 21 percent corporate tax rate for corporations, and then tax credits are available. Now, for non-residents whose country has a tax treaty with the United States, the ECI rules are replaced by the more favorable permanent establishment rules. Under these rules, a non-resident is only taxed on their US trade or business income if they have a permanent establishment. A permanent establishment requires a higher level of economic activity in the United States to trigger US taxation of business income. What counts as a permanent establishment? Well, a permanent establishment is a fixed place of business in the United States through which the foreign taxpayer conducts his business, or a permanent establishment could exist if the foreign taxpayer has employees or agents in the United States who have the authority to contractually bind the foreign tax payer. ECI or permanent establishment rules govern the taxation of a non-residents US source active business income. The second taxing regime used by the United States targets passive investment type income of non-residents. This is the tax on fixed or determinable annual or periodical gains, profits, and income, or for short, FDAP income. The most common categories of FDAP income are certain interests, payments, dividends, rents, and royalties, but importantly, FDAP income does not include most capital gains. Now, FDAP income is taxed much differently from ECI in that it is taxed on a gross basis, meaning that no deductions are allowed, and instead of being subject to the same tax rates that US citizens and residents face, FDAP income is subject to a flat 30 percent tax. This tax is collected through withholding, meaning that the payer is responsible for collecting the tax before making the payment of FDAP income to non resident taxpayers. Once the payer withholds the tax, there's generally nothing left for the foreign person to do with regards to the US tax obligations. Now, many countries with tax treaties with the United States have provisions that lower maybe even eliminate that 30 percent withholding rate. If a non-resident receives FDAP income, it's important to check to see if their home country has a treaty relationship with the US, and if so, what rate does that treaty impose on FDAP income? Let's do an example. Suppose Annie is a non-resident content creator who posts videos of recorded puppy on YouTube. Pretty cute. Well, Annie may generate royalty income from YouTube's advertising revenue related to her videos' views. Here, since Annie is not operating a trade or business within the United States, these royalties would be FDAP income. If we take a look at YouTube's disclosures, we see that for creators outside the United States, in order to get paid by YouTube, they must submit certain required information and their payments will be subject to the FDAP withholding rate of between zero percent and 30 percent depending on whether a tax treaty rate applies or that general 30 percent FDAP tax rate applies. Now, sometimes when a non-resident taxpayer earns both ECI and FDAP income in the United States, it can be a little tricky to determine which bucket certain payments fall into. Taxpayers may have different preferences on whether they prefer ECI or FDAP income. For example, if a non-resident's country has a favorable tax treaty provision that greatly reduces the rate on FDAP income, that taxpayer may prefer income being categorized as FDAP. On the other hand, if the FDAP income is subject to the full 30 percent withholding tax rate and no deductions are allowed, well then ECI, which is tax on a net basis after deductions, may be preferable. If we have a situation where we have FDAP type income, but it's related to a US trade or business, we may have to include it as ECI instead of FDAP income. We're going to include FDAP type income as ECI if one of these two tests is met. If under the asset use test, income is derived from assets used in trade or business, or if under the business activities tests, the activities of the US trade or business were material factor in the realization of that income. In summary, the effectively connected income tax regime is going to tax non-resident taxpayers on their US source active business income on a net basis in a manner very similar to how US persons are taxed on their income; allowing deductions, allowing credits, and applying the same rates the resident taxpayers face. If a tax treaty is in place between the United States and the non-residents home country, then the more favorable permanent establishment rules may take over. The FDAP regime, on the other hand, is going to tax non-resident taxpayers on a gross basis on their passive investment type US source income. When we say gross bases we mean no deductions are allowed and this tax is collected via withholding, so it's the payer that collects the tax before making the FDAP payment to the foreign tax payer. The general FDAP rate is 30 percent, although a tax treaty may reduce or eliminate that 30 percent rate.
