Source of Income Rules for US Tax Purposes: FIRPTA and Treaties

The source of income rules for US tax purposes assign every category of income a geographic origin using a separate test for each category: where you physically perform work, who owes you money, where a corporation is organized, where property sits, or where a seller resides. That classification is what decides whether the United States has the right to tax the income and, for US taxpayers, how much foreign tax credit they can use against US tax on the same dollars.¹

Why the Source of Each Dollar Matters

Two audiences care about sourcing, and they care for opposite reasons.

For nonresident aliens and foreign corporations, sourcing is the threshold question for US taxation. The US generally taxes foreign persons only on income from US sources, plus income effectively connected with a US trade or business. Income sourced outside the US is usually beyond the IRS’s reach. Every rule below is, for a foreign taxpayer, a rule about whether US tax is owed at all.

For US citizens and residents, worldwide income is taxable regardless of source, but the foreign tax credit prevents double taxation on foreign earnings. The credit is capped by the ratio of foreign source taxable income to worldwide taxable income.¹ Misclassifying foreign source income as domestic shrinks that ratio and destroys credit capacity. Getting the source right is what makes the credit work.

Compensation for Personal Services

Pay for personal services is sourced where the work is physically performed. The employer’s location, the place the contract was signed, and the bank account receiving the deposit are all irrelevant. Code from a desk in Chicago for a company in Berlin, and the pay is US source.²

A narrow exception treats short US visits as foreign source. A nonresident alien’s compensation for work done in the US is treated as foreign source only if all three of these are true:

Presence in the US is 90 days or fewer during the tax year.
Total compensation for the US services does not exceed $3,000.
The employer is a foreign person not engaged in a US trade or business, or the foreign office of a US employer.

Miss one condition and the whole amount becomes US source.²

Splitting Compensation Between Countries

When the same job spans both US and foreign work, you allocate on a time basis. Divide US workdays by total workdays and multiply by total compensation. A consultant earning $100,000 who works 40 of 200 total workdays in the US reports $20,000 as US source.³ Keep detailed travel logs. Without them, the IRS will make its own allocation.

Stock Options and Deferred Compensation

Multi-year compensation gets a longer measuring window. For stock options, the relevant period runs from grant date to the date all employment-related vesting conditions are satisfied. Compensation recognized at exercise is sourced by comparing US workdays inside that vesting window to total workdays inside it. Days worked after the options become exercisable do not count.⁴

Vest over five years, spend three and a half in the US and one and a half abroad, and 70% of the income recognized at exercise is US source. The same time-basis method applies to any multi-year bonus or deferred compensation covering work in more than one country.⁴

Fringe Benefits

Fringe benefits do not use the time-basis rule. Housing allowances, education reimbursements, and local transportation are sourced by the employee’s principal place of work. A housing allowance tied to a Tokyo office is foreign source even during weeks spent at the New York office. Tax reimbursements are sourced by the country that imposed the tax being reimbursed, and hazardous-duty pay is sourced where the hazardous conditions exist.⁵

Interest Income

Interest is sourced by the residence of the debtor. If the borrower is a US resident or a domestic corporation, the interest is US source, no matter where the lender lives, where the loan was signed, or what currency is used.² Interest paid by a foreign borrower is generally foreign source under the mirror rule in Section 862.⁶

The Portfolio Interest Exemption

US source interest paid to a foreign person is generally subject to a 30% withholding tax, but “portfolio interest” on registered obligations to foreign beneficial owners is exempt. Conditions apply: the obligation must have been issued after July 18, 1984, the withholding agent must hold documentation that the owner is not a US person, and the interest cannot be contingent on the borrower’s profits, sales, or cash flow.⁷

Some holders are excluded outright. If you own 10% or more of the voting power of the issuing corporation, the exemption is unavailable. Banks receiving interest on ordinary-course loans are excluded, and so are controlled foreign corporations receiving interest from related parties.⁷

Dividends

Dividends are sourced by the paying corporation’s place of incorporation, not by the shareholder’s residence. A dividend from a corporation formed under the laws of a US state is US source income whether the shareholder sits in London, Lagos, or Los Angeles.² A dividend from a foreign corporation is generally foreign source. A company with US headquarters but Irish incorporation pays foreign source dividends, and that distinction can drive foreign tax credit results more than investors expect.

Rents and Royalties

Rent from tangible property is sourced where the property physically sits. Industrial equipment leased for use in a US factory produces US source rent even if the owner lives abroad and negotiated the lease overseas.⁶

Royalties on intangibles like patents, copyrights, and trademarks are sourced by where the rights are exercised. A royalty for the right to use a patent within the US is US source; the same patent licensed for use in Japan generates foreign source royalty. If a contract instead transfers all substantial rights to the intangible, the IRS may treat the transaction as a sale, which pulls in the sales rules below.

Digital Content and Cloud Transactions

When copyrighted content like software, e-books, or digital media is sold as an electronic download, the older “title passage” test does not fit. Final regulations source the sale at the purchaser’s billing address, with an anti-abuse rule allowing the IRS to look through arrangements structured primarily to exploit favorable billing addresses. Cloud-based services such as SaaS subscriptions are classified as the provision of services rather than the license or sale of property. Specific sourcing rules for cloud transactions were still in proposed form as of early 2025, so the general services framework applies for now.⁸

Sales of Personal Property and Inventory

Section 865 splits personal property into inventory and everything else, and the two paths lead to very different results.

For non-inventory personal property (a car, artwork, an investment asset), the rule is the seller’s tax residence. A US resident selling a painting at a London auction house reports US source gain. A nonresident selling the same painting in New York reports foreign source gain. Transaction location does not enter the analysis.⁹

Purchased Inventory

Goods bought for resale are sourced where legal title passes from seller to buyer. Shipping terms usually settle this. FOB origin transfers title at the shipping dock; FOB destination transfers it at the buyer’s receiving point. The location of that title transfer is the source of the income.¹⁰

Produced Inventory

When the taxpayer manufactures the goods, sourcing follows the production activity, not the sale. The allocation uses a production-assets fraction: the average adjusted basis of production assets inside the US over the average adjusted basis of all production assets worldwide. That ratio determines the US source share of gross income.¹¹ All factories in the US, all production income US source. Factories split between countries, income splits proportionally.¹²

Businesses most often trip on the line between purchased and produced inventory. The allocation methods are entirely different, and treating one as the other can inflate the US tax bill while disqualifying foreign tax credits that would otherwise be available.

Real Property and FIRPTA

Real estate has the simplest rule in the code: income follows the land. Gain from selling US-located real property is US source, whether the seller is a citizen, a resident, or a foreign person who has never entered the country. Land in Texas produces US source gain; land in France produces foreign source gain.¹³

A “US real property interest” is not limited to physical land and buildings. It includes any interest in a domestic corporation that qualifies as a US real property holding corporation, meaning the fair market value of its US real property interests equals or exceeds 50% of the combined fair market value of its US real property, its foreign real property, and its other trade-or-business assets.¹³ The reach blocks foreign investors from wrapping US real estate in a corporate shell to escape the sourcing rule.

When a foreign person sells US real property, the buyer must withhold 15% of the total amount realized (cash, fair market value of other property transferred, and any liabilities assumed) and remit it to the IRS. For a foreign corporation distributing a US real property interest, the rate is 21% of the gain recognized.¹⁴ Because the 15% withholding often exceeds actual tax on the gain, the seller can apply on Form 8288-B for a withholding certificate that reduces or eliminates it before closing.¹⁵

Pensions and Social Security

Pension distributions use a split rule that surprises many retirees. The share attributable to employer contributions and the employee’s own service is sourced by where those services were performed: twenty US years of service produces US source pension for that portion; split years allocate proportionally. The share attributable to investment earnings inside the trust is sourced by the trust’s location, so a domestic trust generates US source investment income.¹⁶

US Social Security benefits paid to nonresident aliens are US source income. The Social Security Administration withholds a flat 30% tax on 85% of each monthly benefit, an effective rate of 25.5%.¹⁷ Many treaties reduce or eliminate that withholding for residents of the treaty country.

How Treaties Change the Default Rules

The code’s sourcing rules are the default. Tax treaties can override them, sometimes sharply.

Under the code, a foreign company engaged in a US trade or business owes tax on all effectively connected income. Under most treaties, the same company owes US tax on business profits only if it has a “permanent establishment” in the US, such as an office, factory, or branch. That threshold is generally higher than trade-or-business status, so a treaty can strip US taxing rights from a company with limited activities here.¹⁸

For dividends, interest, and royalties, treaties commonly cut the 30% withholding rate to 15%, 10%, 5%, or zero depending on the income and the relationship between payor and payee. The recipient claims the treaty rate by giving the withholding agent Form W-8BEN (individuals) or W-8BEN-E (entities), citing the treaty article and the applicable rate, and meeting any limitation-on-benefits requirement.¹⁹

Withholding and Filing on US Source Income

Sourcing is enforced at the payor. When a US person pays “fixed, determinable, annual, or periodical” (FDAP) income to a foreign person, the payor generally withholds 30% of the gross amount and remits it to the IRS. FDAP covers interest, dividends, rents, royalties, compensation, and similar recurring payments, and the 30% applies to gross income with no deductions.²⁰²¹

Income effectively connected with a US trade or business is taxed at the graduated rates that apply to US persons, with deductions allowed. A foreign payee can shut off the 30% FDAP withholding by giving the payor Form W-8ECI, certifying the income is ECI, is includible in gross income, and providing a US taxpayer identification number.²² A withholding agent that fails to withhold remains liable for the tax, interest, and penalties, though the tax itself can be relieved if the recipient later pays.²³

Nonresident alien individuals file Form 1040-NR if they were engaged in a US trade or business, received US source income not fully covered by withholding, or owe special taxes such as self-employment tax under a totalization agreement. The deadline is April 15 for those with wage withholding and June 15 for others.²⁴ Foreign corporations file Form 1120-F if they had a US trade or business (even with treaty-exempt income), effectively connected income, or US source income not fully covered by withholding; a foreign corporation with no US trade or business and fully withheld tax generally has no filing obligation.²⁵

On the payor side, every withholding agent files Form 1042-S to report US source income paid to foreign persons, even where no tax was withheld because a treaty or code provision exempted the income. Forms 1042-S are due March 15 of the following year and must be filed electronically by any withholding agent filing 10 or more information returns during the year.²⁶

1
Office of the Law Revision Counsel. 26 U.S. Code 904 – Limitation on Credit
2
Office of the Law Revision Counsel. 26 U.S. Code 861 – Income From Sources Within the United States
3
Internal Revenue Service. Source of Income – Personal Service Income
4
eCFR. 26 CFR 1.861-4 – Compensation for Labor or Personal Services
5
Internal Revenue Service. Sourcing of Fringe Benefits for FTC Limitation
6
Office of the Law Revision Counsel. 26 U.S.C. 862 – Income From Sources Without the United States
7
Internal Revenue Service. Publication 515 (2026), Withholding of Tax on Nonresident Aliens and Foreign Entities
8
Federal Register. Classification of Digital Content Transactions and Cloud Transactions
9
Office of the Law Revision Counsel. 26 U.S.C. 865 – Source Rules for Personal Property Sales
10
Internal Revenue Service. Source of Income for Nonresident Alien Individuals
11
eCFR. 26 CFR 1.863-3 – Allocation and Apportionment of Income From Certain Sales of Inventory
12
Office of the Law Revision Counsel. 26 U.S.C. 863 – Special Rules for Determining Source
13
Office of the Law Revision Counsel. 26 U.S. Code 897 – Disposition of Investment in United States Real Property
14
Internal Revenue Service. FIRPTA Withholding
15
Internal Revenue Service. About Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests
16
Internal Revenue Service. Publication 519 (2025), U.S. Tax Guide for Aliens
17
Social Security Administration. Nonresident Alien Tax Withholding
18
Internal Revenue Service. Creation of a Permanent Establishment Through the Activities of Seconded Employees in the United States
19
Internal Revenue Service. Tax Treaty Tables
20
Internal Revenue Service. Fixed, Determinable, Annual, or Periodical (FDAP) Income
21
Office of the Law Revision Counsel. 26 U.S.C. 871 – Tax on Nonresident Alien Individuals
22
Internal Revenue Service. Withholding Exemption on Effectively Connected Income
23
eCFR. 26 CFR 1.1441-1 – Requirement for the Deduction and Withholding of Tax on Payments to Foreign Persons
24
Internal Revenue Service. Instructions for Form 1040-NR
25
Internal Revenue Service. Instructions for Form 1120-F
26
Internal Revenue Service. Instructions for Form 1042-S (2026)