FDAP Income vs. ECI: What's the Difference

FDAP Income vs. ECI: What’s the Difference

What is FDAP Income vs ECI?

FDAP vs. ECI: When a person refers to FDAP income, they are referring to income which is generally considered investment income. FDAP refers to Fixed, Determinable, Annual and Periodic. Otherwise, when the income is ECI, it is considered Effectively Connected Income. FDAP income carries a 30% withholding, while ECI is taxed at graduated rates — and deductions can apply.  FDAP and ECI income relate to nonresident aliens (NRA) and other persons who are being taxed as non-U.S. persons. The IRS has provided some guidance on these different types of income, but the FDAP vs ECI analysis is complex. Let’s start with FDAP.

FDAP Definition

When considering the differences between FDAP vs ECI, it is important to understand what FDAP is. The acronym refers to Fixed, Determinable, Annual and Periodic – but we realize that is not much help, so let’s dive a bit further into it.

What does the IRS say

  • “Income is fixed when it is paid in amounts known ahead of time. Income is determinable whenever there is a basis for figuring the amount to be paid. Income can be periodic if it is paid from time to time. It does not have to be paid annually or at regular intervals. Income can be determinable or periodic, even if the length of time during which the payments are made is increased or decreased.”

Generally, passive income (although it may qualify for a tax reduction under treaty benefits) is withheld at 30% and there are no deductions available (e.g., such as deductions a property owner takes for rental income).

Some common examples of FDAP, includes:

  • Compensation for personal services (such as commissions and gross proceeds from performances)
  • Dividends
  • Interest
  • Original issue discount
  • Pensions and annuities
  • Alimony
  • Real property income, such as rents, other than gains from the sale of real property
  • Royalties
  • Scholarships and fellowship grants
  • Other grants, prizes and awards
  • A sales commission paid or credited monthly
  • A commission paid for a single transaction

How is FDAP Income Taxed vs ECI

As provided by the IRS:

  • “Tax at a 30% (or lower treaty) rate applies to FDAP income or gains from U.S. sources, but only if they are not effectively connected with your U.S. trade or business. The 30% (or lower treaty) rate applies to the gross amount of U.S. source fixed or determinable, annual or periodical gains, profits, or income. Deductions and netting are not allowed against FDAP income.”

What does this mean?

This refers to the general straight or flat 30% tax that is withheld on FDAP income from U.S sources. If the income is ECI and not FDAP, then it is not taxed at 30% straight – and different rules apply.

FDAP Example: Periodic and Dividends

Something is periodic when it is received from time to time. Once example would be dividends, which are issued by companies generally when certain milestones are met. Since dividends are a type of periodic income, it would qualify as FDAP.

Capital Gains is More Complex

As indicated above, capital gains generated from U.S. companies is generally not taxable to the NRA and therefore FDAP does not apply. But, there are some exceptions:

  • U.S. real estate
  • 183 day rule

The 183 Day Rule

The 183 day rule is not the same as the substantial presence test. Rather, it refers specifically to the current year and presence in the U.S.

As provided by the IRS:

  • If you were present in the United States for 183 days or more during the tax year, and you are still a nonresident alien, your net gain from sales or exchanges of capital assets is taxed at a 30% (or lower treaty) rate.
  • For purposes of the 30% (or lower treaty) rate, net gain is the excess of your capital gains from U.S. sources over your capital losses from U.S. sources. This rule applies even if any of the transactions occurred while you were not in the United States.
  • The183-day test mentioned above is not the same as the 183-day test used in the substantial presence test. See The Taxation of Capital Gains Of Nonresident Alien Students, Scholars and Employees of Foreign Governments for further information.

As further provided by the IRS:

  • “If you were in the United States for less than 183 days during the tax year, you will not be taxed on your capital gains, except for the following types of gains:
  • Gains that are effectively connected with a trade or business in the United States during your tax year
  • Gains on the disposal of timber, coal, or domestic iron ore with a retained economic interest
  • Gains on certain contingent payments received from the sale or exchange of patents, copyrights, and similar property
  • Gains on certain transfers of all substantial rights to, or an undivided interest in, patents
  • Gains on the sale or exchange of original issue discount obligations
  • Many tax treaties contain provisions which reduce or eliminate taxation on capital gains.

What Capital Gains Are Taxed?

  • These rules apply only to those capital gains and losses from sources in the United States that are not effectively connected with a trade or business in the United States. They apply even if you are engaged in a trade or business in the United States. These rules do not apply to the sale or exchange of a U.S. real property interest, or to the sale of any property that is effectively connected with a trade or business in the United States.

Reporting Gains and Losses

  • Report your gains and losses from the sales or exchanges of capital assets that are not connected with a trade or business in the United States on Schedule NEC, Tax on Income Not Effectively Connected with a U.S. Trade or Business, of Form 1040NR. Report gains and losses from sales or exchanges of capital assets (including real property) that are connected with a trade or business in the United States on a separate Form 8949, summarized on Schedule D (from Form 1040) and page 1 of Form 1040NR. Attach Form 8949 and Schedule D to Form 1040NR.

FDAP Exception for Real Estate and USRPI

Unlike other U.S. based capital gains, the sale of U.S. real estate and other real property interests are taxable. This is covered under FIRPTA (again with the acronyms), and we have a separate article on the Foreign Interest in Real Property Tax Act (FIRPTA).

U.S. Social Security

As provided by the IRS:

  • U.S. source FDAP income includes 85% of any U.S. Social Security benefit (and the Social Security equivalent part of a Tier 1 railroad retirement benefit). This income is exempt under some tax treaties. Refer to Table 1 in Publication 901, U.S. Tax Treaties, for a list of tax treaties that exempt U.S. Social Security benefits from U.S. tax.”

What does this mean?

This refers to the 85/15 rule for FDAP and social security. It reduces the portion subject to social security down to 85% — and some treaty countries exempt tax.

The following are provided by the IRS, with a brief explanation put into layman terms by Golding & Golding.

Installment Payments

  • “Income can be FDAP income whether it is paid in a series of repeated payments or in a single lump sum. For example, $5,000 in royalty income would be FDAP income whether paid in 10 payments of $500 each or in one payment of $5,000.”

What does this mean?

Even if income is paid via an installment payment, it can still otherwise qualify as FDAP.

Insurance Proceeds

  • Income derived by an insured nonresident alien from U.S. sources upon the surrender of, or at the maturity of, a life insurance policy, is FDAP income. The proceeds are income to the extent they exceed the cost of the policy.
  • However, certain payments received under a life insurance contract on the life of a terminally or chronically ill individual before death (accelerated death benefits) may not be subject to tax. This rule also applies to certain payments received for the sale or assignment of any portion of the death benefit under contract to a viatical settlement provider. See Publication 525, Taxable and Nontaxable Income, for more information.

What does this mean?

Certain life insurance policy may still be taxable to a nonresident alien — although there are exception, exclusion and limitations.

Racing Purses

  • Racing purses are FDAP income and racetrack operators must withhold 30% on any purse paid to a nonresident alien racehorse owner in the absence of definite information contained in a statement filed together with a Form W–8BEN that the owner has not raced, or does not intend to enter, a horse in another race in the United States during the tax year.
  • If available information indicates that the racehorse owner has raced a horse in another race in the United States during the tax year, then the statement and Form W–8BEN filed for that year are ineffective. The owner may be exempt from withholding of tax at 30% on the purses if the owner gives you Form W–8ECI, which provides that the income is effectively connected with the conduct of a U.S. trade or business and that the income is includible in the owner’s gross income.

What does this mean?

This a specific rules for income involving racing purses.

Covenant Not to Compete

  • “Payment received for a promise not to compete is FDAP income. Its source is the place where the promisor forfeited his or her right to act. Amounts paid to a nonresident alien for his or her promise not to compete in the United States are subject to withholding.”

What does this mean?

A covenant not to compete may be taxable. For the NRA, it depends on whether or not the forfeited right occurred in the U.S. are not.

Signing On

  • “A fee paid to a professional athlete, such as a soccer or hockey player for “signing on” with the effect of preventing any other team from negotiating with the player and preventing the player from negotiating with any other team is pay for a covenant not to compete. The source is the place where the right to play is given up. If a league is made up of both foreign and U.S. teams, the fee is from sources partly in and partly outside the United States. The part of the fee that is from U.S. sources is subject to withholding. If there is no reasonable basis for an allocation of the fee, the entire sign-on fee is income from the United States and is subject to withholding.”

What does this mean?

Similar to covenant not to compete, the signing on fee (to prevent an athlete from signing onto another team) is also considered payment for a covenant not to compete. If the right was given up in the US – FDAP may apply.

In conclusion, a nonresident alien who generates income in the US may still be subject to income tax. If the income is FDAP, then there is a 30% withholding unless an exception or treaty rule applies.

What is Effectively Connected Income (ECI)

ECI: When a foreign resident (non-US Person) has effectively connected income (ECI) then they will generally have to file a tax return. The tax return is referred to as a 1040-NR (NR means nonresident). ECI is taxed based on various factors, and deductions can be claimed. For example, an NRA landlord of a US Property who elects to treat the income as ECI instead of the default FDAP (Fixed, Determinable, Annual and Periodic), can claim deductions associated with the income.

Let’s review the basics of ECI:

IRS Definition of ECI

How does the IRS categorize ECI?

Let’s break it into bite-sized pieces:

Foreign Person U.S. Trade or Business

  • “Generally, when a foreign person engages in a trade or business in the United States, all income from sources within the United States connected with the conduct of that trade or business is considered to be Effectively Connected Income (ECI). This applies whether or not there is any connection between the income, and the trade or business being carried on in the United States, during the tax year.”

What does this mean?

When a nonresident foreigner conducts business in the U.S. the U.S. sourced income is reportable as ECI and included on the U.S. 1040NR tax return.

Engaged in Trade or Business

  • “Generally, you must be engaged in a trade or business during the tax year to be able to treat income received in that year as ECI. You usually are considered to be engaged in a U.S. trade or business when you perform personal services in the United States. Whether you are engaged in a trade or business in the United States depends on the nature of your activities.”

What does this mean?

This paragraph summarizes what the filer must do to possibly qualify for ECI — which is to be engaged in a U.S. trade or business and (usually) that means performing services in the US (but not always). The idea is that nonresident foreigner can only claim ECI (and claim deductions) for income that meets the ECI requirements. Otherwise, the other income is deemed FDAP and the U.S. payor withholds 30% unless a treaty position reduces the income (or an exception, exclusion, or other limitation applies).

Deductions

  • “Deductions are allowed against ECI, and it is taxed at the graduated rates or lesser rate under a tax treaty. The discussions that follow will help you determine whether you are engaged in a trade or business in the United States.”

What does this mean?

When reporting ECI, the taxpayer is entitled to apply the graduated rates to income, after deductions are factored in. In addition, a treaty may reduce or eliminate the tax.

Additional Information about ECI

Certain kinds of Fixed, Determinable, Annual, or Periodical (FDAP) income are treated as ECI income because:

  • Certain Internal Revenue Code Sections require the income to be treated as ECI,
  • Certain Internal Revenue Code Sections allow elections to treat the income as ECI,
  • Certain kinds of investment income are treated as ECI if they pass either of the two following tests:
    • The Asset-Use Test – The income must be associated with U.S. assets used in, or held for use in, the conduct of a U.S. trade or business.
    • Business Activities Test – The activities of that trade or business conducted in the United States are a material factor in the realization of the income.

Foreign Sources Income as ECI

In limited circumstances, some kinds of foreign source income may be treated as effectively connected with a trade or business in the United States. Refer to Publication 519, U.S. Tax Guide for Aliens.

The following categories of income are usually considered to be connected with a trade or business in the United States.

  • You are considered to be engaged in a trade or business in the United States if you are temporarily present in the United States as a nonimmigrant on an “F,” “J,” “M,” or “Q” visa. The taxable part of any U.S. source scholarship or fellowship grant received by a nonimmigrant in “F,” “J,” “M,” or “Q” status is treated as effectively connected with a trade or business in the United States.
  • If you are a member of a partnership that at any time during the tax year is engaged in a trade or business in the United States, you are considered to be engaged in a trade or business in the United States.
  • You usually are engaged in a U.S. trade or business when you perform personal services in the United States.
  • If you own and operate a business in the United States selling services, products, or merchandise, you are, with certain exceptions, engaged in a trade or business in the United States. For example, profit from the sale in the United States of inventory property purchased either in this country or in a foreign country is effectively connected trade or business income.
  • Gains and losses from the sale or exchange of U.S. real property interests (whether or not they are capital assets) are taxed as if you are engaged in a trade or business in the United States. You must treat the gain or loss as effectively connected with that trade or business.
  • Income from the rental of real property may be treated as ECI if the taxpayer elects to do so.

NOTE: If your only U.S. business activity is trading in stocks, securities, or commodities (including hedging transactions) through a U.S. resident broker or other agent, you are NOT engaged in a trade or business in the United States.

NOTE: Certain kinds of income, which are normally treated as ECI or FDAP for income tax purposes, may not be treated as ECI or FDAP for withholding tax purposes.

Applicable Tax Rate

  • Income you receive during the tax year that is effectively connected with your trade or business in the United States is, after allowable deductions, taxed at the graduated rates that apply to U.S. citizens and resident aliens.

Tax Year

Generally, you can receive effectively connected income only if you are a nonresident alien engaged in a trade or business in the United States during the tax year. However, income you receive in another tax year from the sale or exchange of property, the performance of services, or any other transaction is treated as effectively connected in that year, if it would have been effectively connected in the year the transaction took place or you performed the services.

Accurate ECI Reporting is Important

In conclusion, when a foreign nonresident has U.S. sourced income, they may have either FDAP or ECI — or both. When ECI is involved, the taxpayer files a Form 1040-NR to report the ECI income. The foreign nonresident may be able to take deductions against the income — and claim treaty benefits if applicable.

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