A Case Study: Effectively Connected Income

Abstract

We have written a series of articles over the past five years that explores application of the effectively connected income (ECI) rules to common profit-shifting structures. For the most part, those articles provide hypothetical examples to demonstrate how the ECI rules should apply. The December 2019 release, however, of a Hong Kong Inland Revenue Board of Review decision (“Decision”), decided in early 2018, provides a real-life example of how a U.S. company shifting income into its wholly-owned Hong Kong subsidiary causes some portion of its income to be subject to ECI taxation.

Conveniently, the Decision provides considerable detail of the internal operations for an unidentified group that is assumed throughout this case study to be a U.S.-based multinational. We describe and analyze this detail within the case study and show how the facts result in ECI.
More specifically, this case study shows how the Hong Kong subsidiary, which would be a controlled foreign corporation under the subpart F rules, was engaged in a U.S. trade or business under U.S. tax law and how it had ECI, which is directly taxable in the U.S. Thus, the Hong Kong subsidiary was required to file and report its ECI on Form 1120-F (U.S. Income Tax Return of a Foreign Corporation) for each year beginning from its 1999 incorporation.

This case study also briefly touches on subpart F and certain transfer pricing and re-characterization issues.

Keywords: ECI, Effectively Connected Income, International Taxation, U.S. Trade or Business, subpart F, section 482, transfer pricing ,

JEL Classification: H21, H25, K34, E62