A common question that arises amongst expats, is how territorial tax systems might impact the income taxed on an individual or company. Normally, most governments will try to limit the amount of income taxed or provide an offset to monies made while abroad. If you happen to work or reside in a country that employs a territorial tax scheme, the government of that country will only tax monies made in the country. Some countries will employ a hybrid system of the various taxation schemes making use of exclusionary limitations or other methods to bring additional income in to the respective federal treasury.
Why Do Territorial Tax Systems Exist?
More than half of the countries in the world leverage federal income taxes on both individuals and businesses. The system of how the tax is assessed varies significantly with there being no one set method or manner of taxation agreed upon under international law. Due to the large number of variations; however, there is a chance that an expat can find him or herself in the position of being taxed twice on the same income by two different countries!
To address this concern when dealing with income made internationally, most developed (and less-than-developed) countries will provide a discount or break for taxes paid to other countries. Due to the complexity involved when operating in multiple tax jurisdictions, the majority of large companies will employ international tax specialists to ensure they meet the requirements for paying the minimal amount of tax required across these jurisdictions.
In countries which have elected to employ territorial tax systems, the rules are simplified to the point where you only pay tax on income made in the country. France and Hong Kong are two countries that employ a territorial system. A major issue that arises with this taxation scheme; however, is that if the country decides to significantly increase their taxation rate, individuals can avoid paying taxes by moving their income to another country. In the case of France, a number of wealthy individuals moved their income to neighboring Belgium to avoid increased tax rates on the rich put forth by the government in 2012.
How Does Re-characterizing Income Work?
Under any type of taxation system (to include territorial ones), individuals or companies are able to re-characterize income or shift it to different locations to reduce the amount of taxes paid (or avoid them altogether). As a result, many countries have passed (or are working on passing) laws or rules that place limits on the amount of money that can be transferred outside of the tax jurisdiction.
For taxation systems that rely on residency-based systems, taxpayers are able to defer income taxes by transferring funds to related parties who don’t meet the requirements to be taxed by the specific locality. Some countries impose “anti-deferral” rules that limit the amount of funds which can be transferred to avoid paying the required tax for the nation.
What are the Taxation Systems used Throughout the World?
There are generally two types of income tax systems employed world-wide: residential or territorial. As stated, the territorial tax system only taxes the income or money made from sources within the given country. Under the residential model, a resident of a country is taxed on income made across the globe. Non-residents are only taxed on the local income made in the country. A few countries, such as the United States, also tax non-resident citizens on income made world-wide.
In locales where a residential tax scheme is employed, the systems normally use a form of deductions or tax credits for taxes paid while abroad on the foreign income only. Many of these same countries have also signed tax treaties with the various partner nations to help avoid double taxation of their respective expats. Depending on the location, some countries will also permit a deferment of specific foreign income for corporations or corporate income.
How Does Residency Impact Taxation?
If you are from or are working in a country that employs a residential taxation system vice a territorial one, the primary factor to research is the definition of how a resident is determined for tax purposes. The specific definition and impact on the tax paid will vary across country, but typically revolves around the number of days the individual is physically present in the country. For example, in the United States, all citizens are taxed as residents. There are extensive rules governing the residency of “non-residents” or “foreigners” in the country to include the periods physically located in the country (normally uses a three year time-frame), the start and stop dates of the residency period, and exceptions for transiting through the country. Similar rules are applied to residents who work abroad to check qualification for tax credits on monies made while out of the country.
Other countries which employ residential systems use different and many times less complex rules. Switzerland determines residency based on if an individual has a permit to be employed in the country and actually has a job covered by the permit. The United Kingdom (U.K.), on the other hand uses three categories for residency to include: resident, non-resident, and resident but nor ordinarily resident.
Conversely, territorial tax systems will tax one’s local income independent of where the taxpayer claims residency. Since the world-
wide economic crash of the late 2000s; however, many countries have started to employ hybrid territorial and residential taxation systems to help recover lost income from those who transfer monies offshore.
What are the Countries that Tax Nonresident Income?
Just about all countries in the world tax the foreign income of just their residents (if the country has an income tax). At the time of this writing; however, there were two countries in the world that also tax the worldwide income of non-resident citizens of the country: Eritrea and the United States!
In Eritrea, nonresident citizens are leveraged a flat tax of 2% on foreign income (the income tax rate in the country ranges from two to 30%). The method of enforcement in Eritrea is a little harsher than in other countries since the government will deny passports, confiscate assets, deny leaving or entering the country, and even harass family members until taxes are paid. This practice is referred to as the “Eritrean diaspora tax” and has been condemned by the United Nations.
In the United States, both citizens and resident non-citizens or foreigners are taxed on worldwide income. Nonresident foreigners are taxed on local income. If a U.S. citizen resides in another country, he or she may exclude a portion of their foreign income from U.S. taxation as well as take credit for any foreign income tax paid. To do this; however, the individual is required to file a U.S. tax return to claim the credit—even in cases where the person does not have a U.S. tax liability or payment owed. Many times, failing to file taxes while abroad as a U.S. citizen can result in more severe penalties than actually paying any tax owed!.
Other Countries that Tax Based on Citizenship
There are a few other countries that enforce a tax based on citizenship in certain circumstances. These include Finland, France, Hungary, Italy, and Spain.
In Finland, the government will tax citizens who move from the country to an international destination for the first three years after moving. If the person is able to prove to the government that they do not have any ties back to the country prior to the three year period elapsing, then the tax can be relaxed. After three years of absence, citizens of Finland are no longer considered residents of the country for tax purposes only.
In France, citizens who live in Monaco but keep French citizenship continue to pay French tax in accordance with a tax treaty signed between the two countries in 1963. Later in 2009, the French Courts did rule that this law only applies to French citizens who have previously lived in France. If one is a French citizen by birth but has always lived in Monaco with no French income, then he or she does not have to pay French tax. This ruling was later refined to only apply to those who have citizenship of a third country. The matter remains in the courts at the time of this writing, so if it applies to you its recommended to seek professional tax advice before failing to pay any required income taxes!
In Hungary, all nonresident citizens are taxed as residents of the country. The exceptions to this rule are for those who have another nationality or if they live in a country with an active tax treaty with Hungary.
Italian citizens continue to be taxed when moving from the country to tax havens until the point of the person is able to prove they no longer have ties to Italy. Other than this case, the country does not tax foreign income of nonresident citizens.
Spain taxes citizens who move from Spain to a tax haven for the first five years after the person moves. After the time period elapses, the person is no longer considered a resident of the country for tax purposes only. Other than this case, Spain does not tax foreign income of nonresident citizens.
Countries that Have Abolished the Practice of Taxing Foreign Income of Nonresidents
There are several countries that used to tax foreign income of nonresidents. These include: Mexico, the Soviet Union, the Philippines, Vietnam, and Myanmar.
In Mexico, the country used to be in the practice of taxing its citizens based on worldwide income similar to the United States. Effective as of 1981, residence became the only basis for the taxation of income made worldwide.
In the former Soviet Union, citizens were taxed on their worldwide income independent of where the person lived. Once the country dissolved in 1991, none of the succeeding states kept this system. Most have used residence as the basis of taxation or only tax locally made monies.
In the Philippines, the government used to tax foreign income of nonresident citizens at one to three percent rates. The practice was abolished in 1998 with the passing of the countries new revenue code in 1997.
Vietnam also used to tax citizens based on worldwide income. Effective as of 2009, this practice was abolished with new residency rules.
Myanmar also taxed the foreign income of nonresident citizens at a flat rate of 10%. Due to a number of taxation reforms in the country, as of 2012 this practice has been eliminated.
How to Get International Income Excluded
There are a number of countries that have schemes which permit exclusion of income while earned abroad from income tax. For example, the Netherlands, Spain, Luxembourg, and Cyprus have holding company laws that exclude dividends from various foreign subsidiaries of corporations from income tax. Under these systems, tax is leveraged on other types of income such as the royalties or interest paid from the same subsidiaries. There are also various requirements dictating the income exclusion laws to include time of ownership and portion to be able to qualify for the exclusion. In the Netherlands, there is also an exclusion of dividends from some subsidiaries of Netherlands corporations. One must own at least 5% and the subsidiary has to be subject to a minimum level of income tax locally for the benefit to apply.
In other locations such as Singapore and the United States, deferment of tax on foreign income is allowed up to a certain amount. For corporations, income can be deferred until remitted back to the country.
Impact of Tax Treaties
There are a number of tax treaties in place between developed countries to help prevent double taxation on expats income. In many countries this is also known as a “double taxation agreement or tax information exchange agreement (TIEA).” For example, the United States has agreements in place with more than 55 countries, while the United Kingdom has treaties with more than 110 countries and territories. If either party regards the other as a tax haven, tax treaties tend to not exist. These treaties also serve to put in place limits on the amount of tax each country can place on business profits, salaries, and other income. There are also various clauses in place to help break “Ties” for corporations or individuals who meet residency or presence requirements for multiple countries. Most treaties also include clauses for countries to help resolve disputes.
Countries with No Income Tax
The following countries do not have a federal income tax at the time of this writing:
Bahamas, Bahrain, Bermuda, British Virgin Islands, Brunei, Cayman Islands, Kuwait, Maldives, Monaco, Nauru, Oman, Pitcairn Islands, Qatar, Saint Barthelemy, Saint Kitts and Nevis, Somalia,Turks and Caicos Islands, United Arab Emirates, Vanuatu, Vatican City, Wallis and Futuna, and Western Sahara.
Countries with Territorial Tax Systems
The following countries either have a traditional territorial tax system or elements of one at the time of this writing:
Andorra- Territorial taxation, only of nonresidents.
Angola – Territorial taxation.
Anguilla – Territorial taxation.
Bhutan – Territorial taxation.
Botswana – Territorial taxation.
Costa Rica – Territorial taxation.
Cuba – Residential taxation of citizens, territorial taxation of foreigners. Does not tax nonresidents.
Democratic Republic of the Congo – Territorial taxation.
Djibouti – Territorial taxation.
French Polynesia – Territorial taxation.
Georgia – Territorial taxation.
Gibraltar – Territorial taxation.
Guatemala – Territorial taxation.
Hong Kong – Territorial taxation.
Lebanon – Territorial taxation.
Macau – Territorial taxation.
Malawi – Territorial taxation.
Malaysia – Territorial taxation.
Marshall Islands – Territorial taxation.
Micronesia – Territorial taxation.
Namibia – Territorial taxation.
Nicaragua – Territorial taxation.
North Korea – Residential taxation of foreigners, territorial taxation of nonresidents. Does not tax income of resident citizens.Palau – Territorial taxation.
Palestine – Territorial taxation.
Panama – Territorial taxation.
Paraguay – Territorial taxation.
Philippines – Residential taxation of citizens, territorial taxation of foreigners.
Saint Helena – Territorial taxation.
San Mari – Territorial taxation.
Saudi Arabia – Residential taxation of citizens, territorial taxation of foreigners.
Seychelles – Territorial taxation.
Singapore – Territorial taxation.
Somaliland – Territorial taxation.
Syria – Territorial taxation.
Taiwan – Territorial taxation in general, but residential taxation under the alternative minimum tax.
Tokelau – Territorial taxation.
Tuvalu – Territorial taxation.
Zambia – Territorial taxation.
Learn more about taxes for expats.