Effectively connected income — meaning in cross-border tax

Two things have to be true. There has to be a US trade or business, meaning an activity carried on in the country that is considerable, continuous and regular rather than occasional. And the income has to be connected with it, which is tested by the part the activity played in producing the income and by where the assets used are. Once income is effectively connected it is taxed on a net basis at graduated rates on a return, and expenses become relevant. Income that fails the test is generally left to gross withholding at source, where expenses are irrelevant. That is why the distinction is worth arguing about.

Because the payer treated the income as falling outside a US trade or business. Withholding at source is applied to the amount paid, with no deduction for the costs of earning it, so it routinely exceeds the tax that would be due on the profit. If the income is in fact effectively connected, the route back is a return: the income is reported net, deductions are taken, and the tax withheld is set against the liability with the balance repaid. There is also a certification route that tells the payer to stop withholding on effectively connected amounts in future, worth using as soon as the position is settled.

Not by itself. Selling into a country from outside it is usually not enough. What matters is what is done inside the country, by whom, and how regularly. Staff or a dependent agent concluding contracts there, a fixed place of business, inventory held and sold locally, or services performed on the ground all point towards a trade or business. Taking orders from abroad and shipping goods in generally does not. The analysis is fact-heavy and worth doing before the first filing season rather than after a notice, because the answer also decides whether a treaty position is available and what has to be disclosed.

Only if the rental income is treated as effectively connected. Left alone, rents paid to a non-resident are withheld on a gross basis, and mortgage interest, property tax, repairs, insurance and depreciation give no relief at all, which is how a property running at a loss still produces tax. There is an election that puts the rentals onto a net basis so the ordinary deductions apply and the return reports a profit or loss. The election carries conditions and consequences for later years, including on sale, so it is a decision to take with the whole holding period in view rather than one year's figures.

No, although the two overlap. A US trade or business is a domestic law threshold. A permanent establishment is a treaty threshold, and it is usually the higher of the two. So a business can have effectively connected income under domestic law and still be protected by the treaty because it has no permanent establishment. But the protection has to be claimed on a filed return, with the position disclosed. Assuming the treaty applies and filing nothing is the version that goes wrong, because a treaty removes the tax rather than the filing obligation. The thresholds turn on different facts and should be analysed separately.

Filing is usually the right course. A return is what puts the loss on record, starts the period within which the authority can assess, and preserves deductions and credits that are lost where a return goes in late or not at all. It is also the document establishing that the income was reported on a net basis in the first place. Where nothing is filed the fallback treatment is gross, with income counted and expenses ignored, and a loss year can end up producing tax. The cost of a nil or loss return is small measured against reopening a position years later.

A branch keeps one taxpayer: results consolidate at home, losses are usable sooner, and the exposure is that the branch is a permanent establishment whose profit the host country taxes, sometimes with a branch tax on repatriation. A subsidiary is a separate taxpayer with limited liability and local rates, at the cost of withholding on dividends home and transfer pricing on everything between them. The deciding facts are usually expected losses, liability and exit plans. See branch against subsidiary.

No — and if you came here to calculate FTP, this is not it. Fund transfer pricing is a bank's internal allocation of funding costs and benefits between its own business units, a treasury and asset-liability management discipline used to measure branch or product profitability. Tax transfer pricing is about prices between legally separate related parties across borders, and about which country taxes the resulting profit. The words overlap; the fields do not. See our transfer pricing work.