Income earned by a foreign person or a foreign company is taxed by the United States only when the income has a U.S. source, and the rules for U.S. source income assign each category of earnings to a specific geographic marker: where the work was done, who owes the debt, where the corporation was chartered, where the property sits, where title passes. Once income is sourced to the United States, it moves onto one of two tax tracks with very different rates. Getting the classification right is the difference between a 30% flat withholding on gross receipts and graduated rates applied to a net figure.
Who the Sourcing Rules Apply To
U.S. citizens and green card holders are taxed on worldwide income, so for them sourcing mostly affects foreign tax credits rather than whether income is taxable at all. The sourcing rules matter most to nonresident aliens and foreign corporations, because they generally owe U.S. tax only on income the IRS treats as U.S. source.
The threshold question for an individual is whether physical presence in the country has turned them into a U.S. tax resident. You meet the substantial presence test for a calendar year if you were in the United States at least 31 days that year and at least 183 days across a three-year weighted lookback: all days in the current year, one-third of days in the prior year, and one-sixth of days in the year before that.1Internal Revenue Service. Substantial Presence Test Someone who spends 120 days a year in the country crosses the line by the third year. Cross it, and worldwide income becomes taxable; stay below it, and only U.S. source income is on the table.
Sourcing Rules for Compensation and Services
Income from personal services is sourced to the place the work is performed. If you were physically in the United States when you did the work, the pay is U.S. source, and it does not matter where the employer sits, where the contract was signed, or what currency the paycheck was written in.2Internal Revenue Service. FTC Sourcing of Income
A narrow commercial traveler exemption spares brief visitors. A nonresident alien present 90 days or fewer during the year, paid no more than $3,000 in total for U.S. services, and working for a foreign employer not engaged in U.S. business (or the foreign office of a U.S. employer) can treat the pay as foreign source. Miss any one of those three conditions and the full amount becomes U.S. source.3Office of the Law Revision Counsel. 26 USC 861 – Income From Sources Within the United States The $3,000 ceiling has not been adjusted for inflation, so it rules out most professional-level pay.
Scholarships and fellowship grants break from the place-of-performance rule. They are sourced to the residence of the grantor. A grant from a U.S. university is U.S. source income even if the student studies in Berlin. Grants earmarked for research or study performed outside the country are the exception and are foreign source.4Internal Revenue Service. Taxation of Scholarships and Fellowship Grants Paid to a Nonresident Alien Any portion that is really compensation for services reverts to the ordinary rule and is sourced where the work is done.
Sourcing Rules for Investment Income
Interest
Interest is sourced to the residence of the person or entity that owes the debt. A bond issued by a U.S. corporation pays U.S. source interest even if the bond certificate is held abroad and the coupon is paid in euros.3Office of the Law Revision Counsel. 26 USC 861 – Income From Sources Within the United States
Two exceptions matter for foreign investors. Interest on U.S. bank deposits held by nonresident aliens is exempt from U.S. tax. And the portfolio interest exemption removes the 30% withholding tax on most publicly traded and registered debt when the foreign holder owns less than 10% of the issuer’s voting stock (or, for partnerships, less than 10% of the capital or profits interest) and the interest is not contingent on the debtor’s income or cash flow.5Office of the Law Revision Counsel. 26 USC 871 – Tax on Nonresident Alien Individuals
Dividends
Dividend sourcing follows where the payer is incorporated. A dividend from a U.S. corporation is U.S. source income regardless of where the company earns revenue or where the shareholder lives. A foreign corporation’s dividends are generally foreign source, even if the company’s operations sit largely inside the United States.3Office of the Law Revision Counsel. 26 USC 861 – Income From Sources Within the United States
Capital Gains
Nonresident aliens generally owe no U.S. tax on capital gains from stocks, bonds, and other personal property, unless the gains are connected to a U.S. trade or business. There is one trap: a nonresident alien physically present in the country for 183 days or more during the tax year pays a flat 30% on net U.S. source capital gains for the whole year, including gains realized while abroad.5Office of the Law Revision Counsel. 26 USC 871 – Tax on Nonresident Alien Individuals The 183-day count here is a simple calendar-year tally, not the weighted formula from the substantial presence test.6Internal Revenue Service. The Taxation of Capital Gains of Nonresident Students, Scholars, and Employees of Foreign Governments
Sourcing Rules for Rents and Royalties
Rents from tangible property are sourced to where the property sits. Machinery leased for use in Texas produces U.S. source rent no matter where the lease was negotiated. Royalties on intangible property follow the place the intellectual property is used: a foreign licensee running a U.S. patent at an Ohio plant pays U.S. source royalties, and the same rule holds for copyrights, trademarks, and trade secrets.3Office of the Law Revision Counsel. 26 USC 861 – Income From Sources Within the United States
Sourcing Rules for Sales of Property
Real Estate and FIRPTA
Gain from the sale of U.S. real estate is always U.S. source and always taxable to a foreign seller. The Foreign Investment in Real Property Tax Act enforces this by requiring the buyer to withhold 15% of the total amount realized and send it to the IRS.7Internal Revenue Service. FIRPTA Withholding If the buyer intends to use the property as a residence and the amount realized is $300,000 or less, no FIRPTA withholding is required. A foreign seller who expects the actual tax to be lower than 15% of the sale price can apply for a reduced withholding certificate on Form 8288-B before closing, and the standard route otherwise is to file a return afterward and claim a refund.
Stocks and Other Personal Property
Gain from selling personal property such as shares of stock is generally sourced to the seller’s residence. A nonresident selling U.S. stock therefore earns foreign source gain and typically owes no U.S. tax on it, subject to the 183-day rule described above.8Office of the Law Revision Counsel. 26 USC 865 – Source Rules for Personal Property Sales
Inventory
Inventory is the loud exception. Income from selling purchased inventory is sourced to the place where title passes. Ship goods that transfer to the buyer inside the United States, and the sale income is U.S. source, regardless of the seller’s home.9Federal Register. Source of Income From Certain Sales of Personal Property Different allocation rules apply to inventory the seller manufactured, based on where production and sales occurred.
Sourcing Rules for Transportation Income
A voyage or shipment that begins and ends inside the United States is entirely U.S. source. When international transportation begins or ends in the United States but not both, exactly 50% of the income is U.S. source.10Office of the Law Revision Counsel. 26 USC 863 – Special Rules for Determining Source The 50% rule applies to shipping and freight income and does not sweep in personal service income from transportation workers except on routes connecting the U.S. mainland with a U.S. possession.
What Happens After Income Is U.S. Source
Sourcing is only half the analysis. Once income is U.S. source, it lands in one of two very different tax categories.
Effectively Connected Income
Effectively connected income (ECI) is income tied to an active U.S. trade or business: running a storefront, providing services from a U.S. office, operating a factory. ECI is taxed the way U.S. residents are taxed on business income. You subtract allowable deductions and pay tax on the net at graduated rates that top out at 37% for individuals in 2026.11Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Being able to deduct expenses is the point: a foreign corporation with $1 million of gross U.S. receipts and $800,000 of costs pays tax only on the $200,000 net.
FDAP Income
Income that is not effectively connected with a U.S. trade or business is generally FDAP income (Fixed, Determinable, Annual, or Periodical). This is the passive bucket: dividends, interest, royalties, rents, and similar streams. FDAP income faces a flat 30% withholding on the gross amount, with no deductions.12Internal Revenue Service. Fixed, Determinable, Annual, or Periodical (FDAP) Income The obligation to withhold and remit sits with the U.S. payer, not the foreign recipient.
The Branch Profits Tax
A foreign corporation that operates a U.S. branch rather than a U.S. subsidiary pays regular tax on its ECI and then a 30% branch profits tax on the “dividend equivalent amount,” roughly the after-tax ECI that could be sent back to the foreign parent.13Office of the Law Revision Counsel. 26 USC 884 – Branch Profits Tax The tax exists to mimic the withholding that would apply if a U.S. subsidiary paid dividends to its parent, closing off branch structures as a way around that second layer.
How Tax Treaties Change the Rate
Tax treaties routinely override the default 30% FDAP rate. Common treaty rates cut dividends to 15% for portfolio investors and 5% for qualifying parent-subsidiary holdings; interest often drops to 0%; royalty rates vary by treaty and property type. Benefits do not apply automatically. A foreign person has to give the withholding agent a Form W-8BEN (individual) or W-8BEN-E (entity) certifying eligibility, and without it the payer must withhold at the full 30%.14Internal Revenue Service. Instructions for Form W-8BEN
Most U.S. treaties also contain a saving clause that lets the United States tax its own citizens and residents as if the treaty did not exist, so U.S. citizens abroad generally cannot use treaty rates to trim their U.S. bill, apart from narrow carveouts written into individual treaties.15Internal Revenue Service. Tax Treaties Can Affect Your Income Tax When you take a treaty position that reduces or eliminates a tax the Internal Revenue Code would otherwise impose, disclose it on Form 8833 with your return. Skipping the form draws a $1,000 penalty per position for individuals and $10,000 for C corporations.16Internal Revenue Service. Form 8833, Treaty-Based Return Position Disclosure
Filing Returns and Withholding Paperwork
Nonresident aliens with U.S. source income file Form 1040-NR. Wages subject to U.S. withholding make the return due April 15; if you had no wage withholding and no U.S. office, the deadline shifts to June 15. Form 4868 buys an automatic extension when filed by the original due date.17Internal Revenue Service. Taxation of Nonresident Aliens
A foreign corporation files Form 1120-F if it was engaged in a U.S. trade or business, had effectively connected income, or had U.S. source income that was not fully covered by source withholding. Filing is also the way to claim deductions, credits, or treaty benefits. A foreign corporation whose only U.S. income was FDAP fully withheld at source and that did no U.S. business generally does not need to file.18Internal Revenue Service. Instructions for Form 1120-F
Withholding agents carry their own compliance exposure. Intentional disregard of Form 1042-S reporting draws $680 per form for returns due in 2026, with no ceiling, and the IRS uses 10% of the unreported amount instead when that produces a larger figure.19Internal Revenue Service. Information Return Penalties If you are a U.S. business paying dividends, interest, royalties, or rents to a foreign person, the paperwork you collect from that person before you pay determines whether you owe 30%, a treaty rate, or nothing at all.