“There are two generally recognized bases for any country's jurisdiction to tax income: (1) jurisdiction over the recipient of the income, and (2) jurisdiction over the activity which produces the income (i.e., the source of the income). Thus, a country may tax the worldwide income of persons subject to its jurisdiction or it may tax income earned within its borders, or it may tax both.”

The Joint Committee on Taxation, U.S. Taxation Of Foreign Source Income: Deferral And The Foreign Tax Credits: Prepared For The Use Of The Committee On Ways and Means, September 27, 1975

With investing and employment opportunities becoming increasingly global, determining the right tax jurisdiction is often a challenge. Paying taxes on income to the wrong country can be a costly mistake. Income sourcing rules help sort out the right tax jurisdiction. In fact, these rules are integral to the U.S. taxation of international income. They are critical for both U.S. persons as well as non-U.S. persons with foreign income as they help determine the portion of income attributable to U.S. and to overseas.

A non-resident alien is subject to taxes only on U.S. source income. Therefore, for non-U.S. persons, these rules help limit the scope of income subject to U.S. taxation.

S, a non-U.S. person, had total worldwide income of $100,000. However, her U.S. source income was only $15,000. Because of the sourcing rules, S is subject to U.S. taxes for only $15,000, i.e., only on the income sourced to U.S.  

U.S. persons are subject to U.S. tax on their worldwide income whether the income is sourced to U.S. or to a foreign country.  Therefore it is easy to wonder whether the sourcing rules are important to them. However these rules are vital to U.S. persons for they help determine credits and deductions available to offset their U.S. tax liability such as the foreign tax credit.

T has total worldwide income of $300,000. He paid $20,000 in taxes to a foreign country for interest earned.  T can take foreign tax credit for the taxes paid.  However, for T to compute his credit, he needs to figure out his foreign income based on the sourcing of income rules.
 
The premise of U.S. foreign tax credit is that foreign governments have the right, and therefore, are the primary jurisdiction to tax income earned outside the U.S.  However, the U.S. retains residual right to tax the income earned outside the U.S.  By allowing the foreign tax credit, the U.S. reduces or limits the impact of double-taxation.

Disclaimer: Every individual’s tax situation is different and tax situations change over time. This article is intended to give general information to enable the reader to discuss their situation with a tax adviser.  It is not intended to be tax or legal advice and should not be construed as such.

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