To comprehend the US tax treatment of income received by non residents foreigners, we must understand three concepts:
US Sourced Income
Effectively Connected Income (ECI)
Fixed, determinable, annual, or periodical income (FDAP)
Understanding these concepts will help you interiorize why non-resident foreigners can form a US LLC, operate through this LLC, and not pay taxes in the US.
The USA will only tax a non-tax resident foreign person if this person has either income effectively connected with a trade or business in the U.S. (ECI); or fixed, determinable, annual, or periodical income from sources within the U.S. that is not effectively connected with a trade or business in the U.S.(FDAP).
For an income to fall under the ECI or FDAP category, it must first be US Sourced income.
What is US-sourced income?
Source of income in international taxation usually means the right that a jurisdiction has to treat that income as generated from within that jurisdiction, and to have the right to tax it. There are cases where multiple jurisdictions may have the right to tax that income based on their domestic tax code.
So the US will treat income as US-sourced depending on each type of income factor of determination.
For example, if the payment concept is Salaries, wages, personal services, professional services, etc., the factor to determine the source is where the person receiving the payment performs the service. Since in this case it is irrelevant the residency of the payor, if a Foreign Person provides services to a US person while physically located outside of the USA, then this income will not be considered US Sourced, hence not subject to US taxes.
On the other hand, if a Foreign Person receives income in the concept of Interest, Dividends, Royalties, from US persons, this income will be considered US Sourced, regardless if the recipient of payment is not located in the USA.
Rents received from, or sales of, properties located in the USA will be considered US Sourced income as well.
If an income is not considered US Sourced income, it will not be taxed in the US as it is not considered ECI nor FDAP. On the other hand, if the income is US Sourced, we have to determine whether it is ECI or FDAP, as this will influence its taxation in the USA.
Note: the fact that the income is earned through a US LLC does not mean the income is US Sourced, so if it is not US Sourced it will not be income is derived from US business or trade. In contrast, if a company formed in Singapore has US-sourced income, it is engaged in US trade business or trade.
What is Effectively Connected Income in the USA?
ECI is US Sourced income derived from business or trade in the USA, generally from the performance of personal or professional services in the USA, or from selling products or merchandise in the USA.
For example, the provision of professional services while physically in the USA. i.e. a foreigner fighter performs a boxing match in Las Vegas, Nevada, or a company sends a technician to the US to repair a client’s infrastructure, etc.
What is Fixed, determinable, annual, or periodical income (FDAF)?
In layman terms, FDAF income is basically passive income from US sources like royalties, rents, dividends, interests, etc.
So if a Corporation pays you dividends, or you receive royalties from a book deal or music royalties from US Sources, this will be considered FDAF.
What is the difference between ECI and FDAF?
While both are US-sourced income, the classification will determine its tax treatment.
Income that is FDAF will be subject to a 30% withholding tax at the source, without allowing you to claim deductions like expenses or credits. FDAF income only allows a lower tax rate or tax exemption based on tax treaties to avoid double taxation. So if you sell a book on Amazon, this income will be subject to 30% tax rate regardless if the total royalty for that month is just US$30 or US$1,000.
In contrast, ECI is taxed at a progressive tax rate and allowing you to claim deductions from expenses you incurred to generate that income. The tax rate for this type of income is graduate and will go from 10% to 37%, and allowing you to claim deductions.
Summary:
For an income to be ECI or FDAF it must first be US Sourced income.
For an income to be US Sourced it will be determined by several factors. Professional or Personal Services provided while outside of the USA are not US-sourced income even if the payor is from the USA, while passive income like royalties, interests, dividends, etc. is US-sourced if used in the USA, comes from a US person/entity, or the property is located in the USA, depending on the type of income.
ECI is taxed at a progressive tax rate from 10% to 37% and allowing deductions. Reduced tax rate or tax exemption is allowed by virtue of tax treaty.
FDAP is taxed at a fixed 30% tax rate, not allowing deductions, and only allowing a reduced tax rate or tax exempltion if there is a tax treaty.
Disclaimer: The information provided herein is for informational purposes only and should not be construed as, relied upon as, or be a substitute for financial, tax, and/or legal advice. It is recommended to seek the guidance of a licensed attorney and/or advisor for personalized advice tailored to your specific situation.
About the author:
Jean Franco Fernández Clark, Corporate & International Tax Lawyer. Speaks English, Spanish, French, Italian, Russian, Chinese Mandarin. Founder of Offshore Affairs.