How do US tax treaties handle differences in income classification between countries? (Capital gains vs ordinary income)

The general rule is that the US applies its own tax laws and classifications to your income, regardless of how a foreign country treats it. This is known as the "savings clause" that appears in most US tax treaties. When you file your US tax return, you'll need to report this income according to US tax rules - so if it's ordinary income under US tax law, you report it as ordinary income. However, you can claim a foreign tax credit for taxes paid to Country B on that same income, even if Country B classified it differently. The foreign tax credit is generally limited to the amount of US tax you would owe on that foreign income. So if Country B's capital gains rate is lower than the US ordinary income rate, you'll likely need to pay the difference to the US. Some treaties have specific provisions for certain types of income, so it's worth checking the specific treaty between the US and Country B. The IRS Publication 901 (U.S. Tax Treaties) might be helpful, or the actual text of the treaty available on the IRS website.

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One important point no one has mentioned yet is the "saving clause" in most US tax treaties. This clause basically preserves the US right to tax its citizens and residents as if the treaty didn't exist in many cases. Because of this, US citizens often can't use many treaty benefits that would reduce US tax. There are exceptions to the saving clause, but they're specific and limited. This is why the US might still fully tax your income according to US rules regardless of how the foreign country treats it. Check Article 1 of your specific treaty to see the saving clause and its exceptions. This could completely change your tax situation.

I'm shocked nobody mentioned Form 8833 (Treaty-Based Return Position Disclosure). If you're taking any position on your US tax return based on a treaty that differs from how the income would normally be treated under US tax law, you MUST file this form. Failing to file Form 8833 when required can result in a $1,000 penalty ($10,000 for corporations). This is especially important if you're claiming that a treaty overrides how the US would normally classify your income.