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Foreign persons are generally subject to net basis tax in the United States on income effectively connected with the conduct of a trade or business in the United States (ECI). Although this concept has been part of U.S. tax law since 1966, there is very little guidance on what it means to be "engaged in a trade or business" (ETB). In the vacuum of guidance or meaningful case law, conspiracy theories generated by idle minds seem to appear with increasing regularity.
There was a time when most people had a pretty good idea of what ETB meant - it meant you produced widgets, or hung out a shingle as in the case of a commercial bank. But now that most of the widgetproducing has moved offshore and the traditional banking business has become fractionalized, specialized, and taken private, the IRS and the tax bar have turned their attention to nontraditional activities, trying to divine what rises to the level of a trade or business and what does not.
The hot button issues today are whether activities such as loan origination, distressed debt investing, and promotion of businesses are businesses, and, if so, where these activities can be said to take place geographically. Hardly a day passes without a new article on the subject.1 The attention devoted to these issues is a product of the growth in private equity investing, but the issues are not limited to private equity. Worldwide, passive investors such as sovereign and pension funds seeking enhanced returns have taken advantage of loosened regulatory laws to engage in these and other activities that they would not have dreamed of undertaking even 25 years ago. And they are doing so in the face of great uncertainty concerning the U.S. tax consequences of doing so.
This commentary sets out my simple thesis: Despite all the hoopla, one either is an investor or is in business. There is no middle ground. There is no such thing as a "trader." Loan origination outside the conduct of traditional banking is usually not a business; distressed debt investing and "promotion" most certainly never rise to that level. While drawing lines is always hard, the line between investing and business exists, and can be understood in a way that...