If you want to legally reduce your tax amount, it is essential to understand the taxation policies of different countries for their citizens and residents to develop a more suitable tax optimization strategy for yourself.
The following article will introduce the basics of four different tax systems worldwide and how to reasonably arrange tax planning under these different systems.
Table of Contents
Legally Reducing the Tax Burden
Both U.S. and U.K. passports are in the top tier of global passport rankings, offering visa-free access to hundreds of countries worldwide. However, from what we understand, many U.S. citizens consider renouncing their citizenship, while British citizens generally do not have this thought.
The reason for this difference is simple: the tax system. The United States implements a citizenship-based tax system, meaning U.S. citizens must pay taxes on their worldwide income. To escape this stringent tax system, some American citizens consider renouncing their citizenship. In contrast, the United Kingdom has a residency-based tax system. As a British citizen, if you do not meet the criteria for being a tax resident, you do not need to pay taxes to the U.K. government.
Due to the different tax policies of the two countries, U.S. citizens who wish to legally reduce their tax burden are more likely to seriously consider renouncing their citizenship than British citizens. This is because British citizens can legally avoid taxes by moving abroad and becoming non-tax residents of the U.K., whereas U.S. citizens cannot escape their tax obligations to the U.S. government no matter where they live.
4 Types of Tax Systems Around the World
Currently, there are four different types of tax systems implemented by countries around the world—citizenship-based taxation, residency-based taxation, territorial taxation, and zero-tax systems.
To properly plan for global taxation, it is necessary to understand how these four types of tax systems are specifically implemented, and what tax regulations citizens, residents, or frequent visitors must follow in countries with different tax systems. In response to these issues, the following text will cover:
- How different tax systems operate.
- Countries that implement different tax systems.
- Exemption policies under different tax systems.
- The impact of different tax systems on non-citizens.
Finally, we will summarize how to develop a rough global tax strategy. As developed countries are gradually tightening tax policies for the wealthy and business owners, proper tax planning is necessary.
Citizenship-Based Taxation
Under a citizenship-based tax system, all citizens of a country must pay taxes on their worldwide income. This means that if your country implements this type of tax system, you will still need to pay a certain amount of tax each year, even if you do not reside in your home country.
There are two branches of this type of tax system. One involves levying a flat tax on all global income, while the other involves taxing different types of income separately, depending on the source of the income and individual circumstances.
However, in either case, and despite some differences in specific tax provisions between countries, citizens of countries implementing this type of tax system must report their income details to their home country and fulfill their tax obligations annually, unless they renounce their citizenship.
Globally, countries that implement citizenship-based taxation are relatively few, but because the United States practices this system, its influence is enormous worldwide.
Furthermore, countries with citizenship-based taxation are not limited to taxing only their citizens, so non-citizens who meet certain requirements may also be subject to taxation under this system.
Countries with Citizenship-Based Taxation
There are only two countries in the world that implement this system—Eritrea and the United States.
Eritrea is a small, war-torn African nation located near Djibouti and Ethiopia. It has consistently received low ratings on issues of personal freedom, press freedom, and human rights. Many Eritreans leave their homeland to avoid indefinite military conscription.
Consequently, Eritrea imposes a 2% flat tax on the worldwide income of all its citizens.
However, Eritrea faces difficulties in enforcing this system. Due to its very low standing in the global financial system, it can only compel its citizens abroad to fulfill their tax obligations by refusing to renew their passports.
In contrast, the United States is a developed country, the world’s largest economy, and possesses significant enforcement power. So, why do these two vastly different countries implement the same type of tax system?
The U.S. citizenship-based tax system has been in place for over a century, and the U.S. government currently seems reluctant to reform it.
The U.S. Congress considered abolishing this system when drafting the 2017 tax reform bill, but the final outcome was the complete opposite. U.S. citizens living abroad are required to pay taxes on their global income, even in countries with which the U.S. has tax treaties.
There are some exemptions for active and business income, but none for passive income.
Compared to Eritrea, the United States can more easily implement its citizenship-based tax system because the U.S. government has the capability to quickly identify overseas citizens who evade taxes. For overseas citizens who owe more than $50,000 in taxes, the IRS even has the authority to revoke their passports.
Therefore, if you are a U.S. citizen, you are required to pay a certain amount of tax on your income, regardless of where you live.
Exemption Policies Under Citizenship-Based Taxation
Although citizenship-based taxation is quite strict, the United States offers some exemptions for its overseas citizens.
The Foreign Earned Income Exclusion (FEIE) allows eligible individuals to exclude a certain amount from their U.S. income tax. Additionally, in some cases, an exclusion for foreign housing costs may be available.
However, the basic premise of the FEIE is that a U.S. citizen must reside abroad for a sufficient period to qualify, and the income exclusion is limited to a certain amount.
U.S. citizens can also use offshore companies to legally reduce their tax burden. However, they are still required to pay taxes on investments and other forms of passive income.
Due to the complexity of U.S. tax exemption policies, it is advisable to consult a tax professional if you wish to apply for the FEIE or create an offshore company.
Under this citizenship-based tax system, U.S. citizens are still required to report their income to the government and fulfill their tax obligations annually.
How Citizenship-Based Taxation Affects Non-Citizens
The name might suggest that countries implementing this system only tax their citizens, but this is not the case in the United States. Non-U.S. citizens may also be required to pay taxes to the U.S. government after meeting certain residency conditions.
According to the Substantial Presence Test (SPT), a non-U.S. citizen will be considered a U.S. tax resident if they have been present in the U.S. for a certain period over the past three years. Like its citizenship-based tax system, the tax system for non-U.S. citizens is also very complex. Therefore, foreign citizens residing in the U.S. for long periods should pay close attention to these regulations to avoid becoming U.S. taxpayers.
Residency-Based Taxation
Residency-based taxation is a more common and simpler tax system. In its most basic form, if you live in the country, you pay taxes; if you leave the country, you don’t.
Countries that adopt a residency-based tax system usually have clear criteria for determining whether a person is a tax resident. In many countries, the standard for becoming a tax resident is quite simple: if you live in the country for more than about 180 days, you are required to pay taxes.
However, in the era of digital nomads, the requirements for tax residency have changed somewhat. Some countries have raised the bar for tax residency, adding other conditions besides a certain length of stay, such as having a valid driver’s license or owning property. In some countries, tax residents are even eligible to vote.
In most cases, residency-based taxation is not as simple as “you don’t have to pay taxes once you leave the country,” but the criteria for becoming a non-tax resident are clear and easy to manage. As long as you meet the standard, you can become a non-resident.
Among all types of tax systems, residency-based taxation has the lowest barrier to understanding because the line between tax residents and non-tax residents is very clear.
Countries with Residency-Based Taxation
Most developed countries implement a residency-based tax system because, under this system, the government can still tax the worldwide income of its own citizens, but its overseas citizens can enjoy exemptions.
Countries with residency-based taxation include Japan, Mexico, Canada, the United Kingdom, Australia, New Zealand, and most of the European Union. Some countries in Africa, Asia, and South America also implement similar systems.
Exemption Policies Under Residency-Based Taxation
The best way to avoid taxation under a residency-based system is to become a non-resident. However, achieving non-tax resident status is easier said than done.
One of the most common misconceptions about becoming a non-tax resident is that you can avoid tax obligations by staying in the country for less than 183 days. This is true for most tourists, but if you have already become a tax resident or have a local residence, getting rid of tax obligations can be slightly more complicated.
In most developed countries, transitioning from a tax resident to a non-tax resident is relatively complex because governments want to collect as much tax as possible.
For example, in the United Kingdom, getting rid of tax residency status requires meeting many specific requirements, which vary depending on factors like your U.K. tax record for the past three years and your place of employment. For most people, understanding and following the corresponding requirements can be difficult.
In addition, there are other exemption policies, which vary by country. Therefore, if you plan to do business or reside long-term in such a country, it’s best to spend time researching its tax residency requirements and related policies first.
Impact of Residency-Based Taxation on Non-Citizens
Residency-based taxation is relatively straightforward, but as a non-citizen, it’s necessary to act with caution. For example, if you plan to invest in real estate in Cambodia and spend a significant amount of time there looking for the ideal property. Due to various circumstances, if your stay in Cambodia exceeds 182 days, you will become a Cambodian tax resident. Therefore, as a non-citizen traveling to a country with a residency-based tax system, it’s necessary to research the specific terms of that country’s tax system to ensure you don’t inadvertently become a tax resident.
Territorial Taxation
Territorial taxation is perhaps the most friendly tax system for investment nomads, of course, ignoring zero-tax countries.
Unlike a residency-based tax system, which taxes the worldwide income of tax residents, a territorial tax system only taxes income earned by residents within that country.
For example, many residents of Singapore are wealthy expatriates who hold substantial foreign investments. Because these investments are located outside of Singapore, the Singaporean government does not tax this investment income.
Simply put, if you live in a country with a territorial tax system but do not earn income within that country, you do not need to pay income tax.
Countries with Territorial Taxation
Territorial taxation is one of the more common tax systems, implemented by many countries including Hong Kong, Singapore, and Malaysia.
Exemption Policies Under Territorial Taxation
Like residency-based taxation, territorial taxation has clear standards for defining taxable and non-taxable income. Essentially, if you earn income in a country with a territorial tax system, you must pay tax on that income.
Territorial taxation is easy to understand in most cases, but it can become more complicated when it comes to offshore companies.
Suppose you live in a country with a territorial tax system but are employed by an overseas company, and your salary is paid into an overseas account. On the surface, your income is not earned in your country of residence, so you might think you don’t have to pay taxes. However, the reality is that you live and work in this country. Although the money is not directly deposited into a bank account in that country, the act of generating income through work actually occurs in this country, so you may still end up having to pay taxes.
Therefore, in countries with territorial taxation, policies regarding offshore companies are stricter. If you plan to live and earn income in such a country, it is best to stay in contact with a tax professional to ensure you fulfill your tax obligations.
Impact of Territorial Taxation on Non-Citizens
Territorial taxation has a significant impact on non-citizens who work or invest in countries that implement this system. For example, if you own an apartment in Malaysia and rent it out, you need to pay tax on the rental income. Or if you earn a salary in Malaysia, you need to pay tax on that salary.
The biggest advantage of territorial taxation is that you can live long-term in a country with this system without paying any tax, provided your income during your residency does not exceed a certain range. For capital nomads looking for a second home, by reasonably utilizing this system, it is possible to not pay income tax to any country.
Zero-Tax Systems
There are a few countries in the world that charge no taxes at all, with no prerequisites.
As mentioned above, under a territorial tax system, you can achieve zero tax as long as you don’t generate local income. However, under a zero-tax system, there are no prerequisites because the system itself means that no type of income is taxed.
Therefore, it’s not an exaggeration to say that zero-tax countries have the most friendly tax system for investment nomads. But to maximize the benefits of this system, tax planning is also necessary.
Zero-Tax Countries
In zero-tax countries, even as a permanent resident, you do not need to pay any income tax. Zero-tax countries include Caribbean island nations such as The Bahamas and the Cayman Islands, as well as a few small countries like Brunei and Monaco.
Exemption Policies Under Zero-Tax Systems
The term “zero-tax system” seems to contradict the word “exemption.” In fact, countries with zero-tax systems only do not levy income tax, but other types of taxes still exist.
For example, in The Bahamas, neither residents nor citizens need to pay any income tax, but they must pay taxes such as property tax and stamp duty.
Other zero-tax countries also impose similar additional taxes, so do not blindly choose to move to a zero-tax country. Before doing so, please carefully research other tax obligations you might have as a resident or citizen of that country.
How Zero-Tax Systems Affect Non-Citizens
Provided visa conditions permit, non-citizens can live in zero-tax countries and enjoy the benefits of a zero-income-tax system. For many capital nomads, zero income tax is extremely attractive, and long-term residence in such countries can effectively prevent them from becoming tax residents of other countries.
However, there are some other restrictions that override the zero-tax system. For example, French citizens must pay personal income tax to the French government even if they live in Monaco. And for U.S. citizens, they are required to pay a certain amount of personal income tax to the U.S. government, regardless of where they live.
Developing a Sound Tax Strategy
Clarify Your Home Country’s Tax Obligations
First, you need to understand how you, as a citizen, should pay taxes to your home country.
If you are a U.S. citizen, understanding all the details of the citizenship-based tax system will help you avoid double taxation, make reasonable use of various tax exemption policies, and make the wisest decision when debating whether it is necessary to renounce your citizenship.
If you are from Canada, Australia, or another country with a residency-based tax system, the most important thing is to understand the tax residency requirements and how to avoid triggering them. In some cases, you might only need to limit the time you spend in your home country to become a non-tax resident. In other cases, you may need to demonstrate a genuine intention to live abroad long-term, such as by having a stable residence overseas, to meet the requirements for becoming a non-tax resident.
Research the Tax System of Your Second Country of Residence
Next, you need to spend time researching the tax requirements of your second country of residence.
If you plan to live in a zero-tax country, this step is simple because you won’t have to pay any income tax. Given the limited number of zero-tax countries in the world and that most of them are not suitable for conducting global business, moving to a zero-tax country is not very realistic.
Therefore, our recommendation is to reside long-term in a country with a territorial tax system and take appropriate measures to avoid becoming a tax resident there. In such countries, you typically only need to pay tax on income earned within that country. Purchasing property and living permanently in such a country can also be a wise choice.
Establishing a second residence in a country with a residency-based tax system is much riskier. Although it is not difficult to control the time you spend in these countries, buying or long-term leasing property there may make you a tax resident and create tax liabilities. Therefore, our advice is to stay in such countries for a month or two at a time, but do not long-term lease or purchase property, as this could lead to you becoming a local tax resident.
Pay Attention to Investment Taxes
In some countries, the tax rates for investments and other forms of passive income are slightly different from those for active income. On one hand, this can bring certain benefits. For example, under a territorial tax system, foreign investment income is not taxed.
However, you may need to pay taxes to the country where the investment income is generated. Also, consider that in some countries, foreign investment income is taxable. Therefore, without proper planning, you might end up paying taxes to two countries.
For example, suppose a U.S. citizen invests in a foreign company located in a country with a territorial tax system. According to the tax regulations of the country where the company is located, you may need to pay tax on that investment income because it is generated locally. At the same time, according to U.S. tax regulations, you also need to pay taxes to the U.S. government.
Consult a Professional
When living abroad and investing globally, you will inevitably encounter different tax systems. Even with extensive experience in overseas investment, it can be tricky when considering the combination of investment, residency, and other tax issues.
If you have questions about your tax obligations, it is best to consult with professionals to ensure there are no gaps in fulfilling your tax duties.
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