Excerpt from Report to the Congress on the Sales Source Rules

Countries generally tax both the income that arises within their borders (source-based taxation) and the income earned by their residents, whether arising within or without their borders (residence based taxation). When a country (the residence country) asserts its jurisdiction to tax an item of income because it is paid to one of the country's residents, and another country (the source country) asserts its jurisdiction to tax that item of income because it considers the income to arise within its borders, double taxation of the income may result. Generally, countries act to avoid double taxation of international income because double taxation is believed to be inequitable and economically inefficient. A country either may exempt its residents from tax on income arising outside its borders, or it may grant its residents a credit, as the United States does, for income taxes paid to another country on income that it considers to arise outside its borders.

Rules for determining the source of income (source rules) play an important role in allocating taxing jurisdiction between countries. A country's source rules determine whether income arises within its jurisdiction and therefore is subject to tax on a source basis. When a country is the residence country, its source rules determine whether it should consider income as arising outside its borders and therefore allow its residents to claim a credit for income taxes paid to a foreign country with respect to that income (or, if it has an exemption system, exempt that income from tax). When two countries' source rules are not harmonious, double taxation may result, or an item of income may be taxed by neither country.

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