U2 small nuclear (sn)RNA contains a large number of posttranscriptionally modified nucleotides, including a 5' trimethylated guanosine cap, 13 pseudouridines, and 10 2'-O-methylated residues. Using Xenopus oocytes, we demonstrated previously that at least some of these modified nucleotides are essential for biogenesis of a functional snRNP. Here we address the subcellular site of U2 internal modification. Upon injection into the cytoplasm of oocytes, G-capped U2 that is transported to the nucleus becomes modified, whereas A-capped U2 that remains in the cytoplasm is not modified. Furthermore, by injecting U2 RNA into isolated nuclei or enucleated oocytes, we observe that U2 internal modifications occur exclusively in the nucleus. Analysis of the intranuclear localization of fluorescently labeled RNAs shows that injected wild-type U2 becomes localized to nucleoli and Cajal bodies. Both internal modification and nucleolar localization of U2 are dependent on the Sm binding site. An Sm-mutant U2 is targeted only to Cajal bodies. The Sm binding site can be replaced by a nucleolar localization signal derived from small nucleolar RNAs (the box C/D motif), resulting in rescue of internal modification as well as nucleolar localization. Analysis of additional chimeric U2 RNAs reveals a correlation between internal modification and nucleolar localization. Together, our results suggest that U2 internal modification occurs within the nucleolus.