Taxation of NRAs – Effectively Connected Income

Non-Resident Aliens (NRAs) have net basis tax on income “effectively connected” with a U.S. business. Income from U.S. sources is effectively connected income. However, payments under a covenant not to compete are “FDAP Income”, so the tax issue is where all services under covenant not to compete are performed, which source rule determines whether it is FDAP or ECI income.

Tax filing requirements for ECI mandate that failure to file by certain deadlines causes all deductions to be disallowed (cost of goods sold are not tax deductions). Under the relevant treasury regulations, the deadline for NRA tax filing is normal due date plus 16 months (however, the validity of this deadline is unclear, See: Swallow Holdings, Ltd. v. Commr. 12C TC96 (2006), invalid on facts presented, Swallow Holdings, Ltd. v.Commr., 515 F.3d 162 (3rd Cir. 2008) valid on facts).

Under applicable income tax treaties, business profits are taxable only if attributable to permanent establishment: (“PE”)

1. Generally, any office, place of management;

2. Facility to store or display goods;

3. Activities of dependent agency may result in deemed PE, (e.g., if habitually exercises authority to sign contracts).

Income from employment may be excluded if:

1. The NRA was present in the U.S. less than 183 days during the applicable 12 month period;

2. Remuneration not borne by U.S. resident or U.S. permanent establishment. Exceptions may apply to entertainers and sportsmen.

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