Foreign vendors being paid by U.S. organizations may include foreign enterprises that are engaged in a U.S. trade or business. Income of a foreign vendor that is effectively connected with the enterprise’s U.S. trade or business is subject to U.S. income tax after allowable deductions at graduated rates. Such effectively connected income (called ECI), when paid by a withholding agent, is subject to 30 percent withholding (called NRA withholding) unless the income: 1) is not of a type that is subject to NRA withholding; or, 2) an exemption from NRA withholding is available and procedures for claiming the exemption from withholding are followed. A foreign vendor receiving ECI may be either an entity or a foreign national who is a nonresident alien for U.S. tax purposes. Resident aliens are generally taxed like U.S. citizens.
Some types of income are deemed to be effectively connected income by U.S. tax law. Examples include, as a general rule, income from personal services performed in the U.S. (exceptions are described in IRS Publication 515) and sales of U.S. real estate. When a foreign vendor is a resident of a tax treaty country, the Business Profits Article of the applicable treaty might deem the income to be business profits (these treaty deeming rules vary by treaty). Some types of income, such as rents from U.S. real property, may be treated as ECI by election. Income that is usually from investments and subject to gross basis taxation (such as interest, rents of U.S. property and royalties for the use, or right to use, intangible personal property in the U.S.) are also taxed on a net basis if they meet either the assets test or the activities test. Income meets the assets test if the income is associated with U.S. assets used in, or held for use in, the conduct of a U.S. trade or business. For example, interest earned on bank deposits in an account used for a U.S. rental property covered by an ECI election is also ECI. Income meets the activities test if the activities of the enterprise conducted in the U.S. are a material factor in the realization of the income.
The ECI of foreign vendors is subject to reporting to the beneficial owner and IRS on Form 1042-S (whether exempt from withholding or not) unless an exception applies. For example, there is an exception from NRA withholding and Form 1042-S reporting for sales of U.S. real estate by foreign persons because this ECI is subject to a different set of rules for withholding, reporting and IRS forms. Also, ECI might be exempt from tax under the provision of an available income tax treaty. ECI that is exempted from withholding is reported under Exemption Code 01 (for ECI) or 04 (for treaty-exempt income). Otherwise, the Exemption Code is 00, indicating that taxes were withheld.