Residence and source may be understood as fundamental principles in International Taxations law. Broadly put, the source state is a location where a certain income has its origin while residence state is a location where the person earning the income is resides. Income or profits which result from international activities such as cross-border investment may be taxed where the income is earned (the source country), or where the person who receives it is normally based (the country of residence). 

Residence taxation of income is based on the principle that people and firms should contribute towards the public services provided by the country where they resides, on all their income wherever it comes from. Source taxation is justified by the view that the country which provides the opportunity to generate income or profits should have the right to tax it.

Countries can decide to limit their taxes on income derived from foreign sources. This could be done by completely exempting it from residence taxes, but this could encourage business or investors to go abroad to countries where tax rates are lower than at home. Alternatively, some countries opted to provide credit for foreign taxes paid. So if the source tax rate is lower, the investor would pay the difference in the country of residence; but such a credit means that the income always bears taxes at the higher rate. Different methods impact international investment flows in different ways and in order to resolve this conflict many countries have mutually agreed on taxation treaties.

Fundamentally, the treaties strike a compromise between source and residence taxation. Some rights to tax are given to the source, and the residence country is required to relieve double taxation either by giving a credit for such source taxes paid, or by exempting the relevant income from its taxes. Generally, source jurisdictions retain their right to tax active (business) income, except for short-term activities, but give up some of their right to tax passive (investment) income.

So, the source country has the right to tax the business profits attributable to a branch of a foreign company (defined as a permanent establishment), as well as the profits of a foreign owned company (subsidiary). In exchange, the source country agrees to apply no, or only a low, tax at source (described as a `withholding’ tax) on payments to residents of the other country, such as interest on loans, dividends on shares, or royalties on intellectual property. Thus, the main effect of the tax treaties is to reduce source-based taxation in favor of residence-based taxation of passive income.