IRS makes a distinction between excluded, exempt and re-sourced (by treaty) income. Others might know what the difference is but it's taken me a long time to come to grips with it. I'm passing it along in case it's of use and/or to see if others find it right or wrong.
-Excluded income is foreign wages
-Exempt income is US social security benefits (by virtue of the treaty and form 8333)
-Re-sourced - the treaty allows certain items (US pension distributions, US interest) to be taxed by the residence country (UK). Use another form 8333. It allows you to treat income from/sourced in the US as if it were from/sourced in the UK. That's the re-sourcing (re-characterizing)
What's the difference between these three? Here's my analysis -
Re-sourced income is first included on your 1040, eg, lines 15 and 16, 'pensions and IRA distributions'. This becomes part of your taxable income, and hence is figured into your tax liabiality. Then by virtue of taking a treaty position, you can re-source it, and claim it as UK income on form 1116, and take a tax credit for it.
Excluded income is first included on your 1040 on line 1, 'wages', then on line 21, 'other income' it's excluded/subtracted, using Form 2555. Thus it doesn't form part of your taxable income or your tax liability. Thus no foreign tax credit.
Exempt - you state your Social Security benefits on line 20a. Then on line 20b, 'Taxable Amount', you put 0. ie, it's exempt from US tax. So it isn't included in your taxable income or your US tax liability. Thus no foreign tax credit.
So each one is treated differently vis a vis putting on form 1040, forming part of your US taxable income, and calculating your subsequent tax liability. It has a certain logic.
I'm not too good at this but a chart might look something like this:
_________________________________________________ _______________
counted as | forms part of | you can take a
txbleincome | tax liability | foreign tax credit
_________________________|__________________|____________________
re-sourced X | x | x
_________________________|__________________|____________________
excluded x | |
_________________________|__________________|_____________________
exempt | |
_________________________|__________________|_____________________
