How Countries Define Their Income Tax Borders

June 01, 2015

One unique aspect of the United States’ tax code is that it taxes the income of all its citizens no matter where they live. In recent years, this has caused a lot of headaches for U.S. citizens living abroad, especially since the passage of FATCA. Many believe this is leading U.S. expatriates to renounce their citizenship.

The practice of a country taxing its citizens’ income no matter where they live is actually very rare in the world. The United States is one of just two countries (the other being the African nation of Eritrea) that taxes individuals’ based on their citizenship. Other countries mainly levy their income tax on those who live in the country, ignoring those who live elsewhere.

Throughout the world, there are three general ways a country defines its “tax borders.”

Under a citizen-based tax system, all income earned by citizens, whether they live in the country or not, is taxed in their home country. Even if they move outside of the country and earned all their income in a foreign country, it still is subject to tax in their home country.

Countries with citizen-based taxation (such as the United States) provide a foreign-earned income exemption (in 2015 is was about $100,000). In addition, individuals receive a tax credit equal to the income tax they already paid on their income to a foreign country to prevent double taxation.

Most countries have residence-based income taxes. Under this system, individuals must pay taxes on their worldwide income to the country in which they live, whether they are a citizen or not. If they move out of the country, they no longer have to pay tax to that country on any income they earn outside of that country.

As with the citizen-based tax systems, residence-based systems provide tax credits equal to the income taxes an individual has already paid on their foreign source income.

Some countries have what is called a territorial income tax. This type of tax only taxes the income earned inside the country, regardless of who earns it. Any income earned outside of the country, even by residents or citizens, is exempt from taxation. For the taxation of individuals, this type of system is also uncommon throughout the world.

To see how different types of tax systems impact an individual’s tax bill, let’s look at a couple of examples from the perspective of two taxpayers.

Imagine two citizens of a country (Country A). They both earn $100 dollars. The first person lives in his home country (Country A), but earns $50 dollars from work inside his home country (Country A) and $50 from work in a foreign country (Country B). The second person is also a citizen of country A, but he lives in country B and earns all $100 in country B. Country A has a 20 percent income tax and Country B has a 10 percent income tax.

Citizen-Based

Under citizen-based taxation, all citizens of Country A have to pay tax to Country A on all income they earn throughout the world.

Person 1, who is both a resident and citizen of Country A, is liable for tax on the $50 he earns in the country and the $50 he earns outside of the country. The $50 he earns in the country is taxed directly at 20 percent ($10). In addition, the $50 he earns in Country B is also subject to tax in Country A at 20 percent.

However, Person 1 already had to pay the 10 percent income tax on the $50 he earned in Country B. To prevent double-taxation on the $50 that he earns in Country B, Country A provides a foreign tax credit equal to the $10 tax paid to Country B. Person 1 ends up paying the difference between the two countries’ tax rates ($5) to Country A.

Person 2 is a citizen of Country A, but not a resident, but since Country A has a citizen-based income tax, he is still liable for income tax in Country A on all his income. Person 2 first pays the income tax in Country B of 10 percent on the $100 ($10). Then Person 1 needs to pay the 20 percent tax on the $100 minus the foreign tax credit of 10 percent ($10).

Citizen-Based Taxation

 

Person 1

Person 2

Citizenship

Country A

Country A

Residence

Country A

Country B

Income Location

$50 in Country A, $50 in Country B

$100 in Country B

Taxes Paid to Country A

$15

$10

Taxes Paid to Country B

$5

$10

Total Tax Bill

$20

$20

Note:

Country A has a 20% income tax rate, Country B has a 10% Income Tax Rate

 

Residence-Based

Under residence-based taxation, the residents of Country A need to pay tax on their worldwide income to Country A. Non-residents that do not earn income in Country A do not have to income tax.

For Person 1, the tax situation is the same as it was when Country A had a citizen-based income tax. Person 1 pays the 20 percent income tax on the $50 he earns in Country A ($10) and then needs to pay 10 percent to Country B on the $50 he earns there and an additional 10 percent on his foreign income to Country A ($5).

Person 2 is a citizen of Country A, but not a resident. Thus, Person 2 does not need to pay tax to Country A at all. He only needs to pay the 10 percent income tax to Country B ($10), where he lives and earns all of his income.

Residence-Based Taxation

 

Person 1

Person 2

Citizenship

Country A

Country A

Residence

Country A

Country B

Income Location

$50 in Country A, $50 in Country B

$100 in Country B

Taxes Paid to Country A

$15

$0

Taxes Paid to Country B

$5

$10

Total Tax Bill

$20

$10

Note:

Country A has a 20% income tax rate, Country B has a 10% Income Tax Rate

 

Territorial

Under a territorial system, only the income earned in the country, regardless of who earns the income, is taxed in the country. All income earned outside of the country is exempt from taxation.

For Person 1, this means that only his $50 he earns in Country A is taxed in Country A ($10), even though he is both a resident and a citizen. The income he earns in Country B is only taxed in Country B ($5).

As with the Residence-based income tax system, Person 2 does not need to pay any tax to Country A. He neither earns income in Country A, nor does he live there. He only pays income tax to Country B ($10).

Territorial Taxation

 

Person 1

Person 2

Citizenship

Country A

Country A

Residence

Country A

Country B

Income Location

$50 in Country A, $50 in Country B

$100 in Country B

Taxes Paid to Country A

$10

$0

Taxes Paid to Country B

$5

$10

Total Tax Bill

$15

$10

Note:

Country A has a 20% income tax rate, Country B has a 10% Income Tax Rate

 

The United States is a unique country in regard to how it taxes its citizens. But, that may not be a positive thing. Citizen-based taxation plus the new reporting requirements under FATCA have caused a number of problems for citizens living overseas and may have led to a number of people renouncing their citizenship. Perhaps it is time the U.S. move towards the global norm and tax only residents’ income.

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