Governments and international organizations are working very hard to tax your income no matter where you earn your money. Indeed, the US already has a Citizenship Tax system which means simply being an American citizen will have you paying taxes no matter where you live in the world. The only other country that does this is Eritrea, a nation well known for its human rights violations.
As an expat (or aspiring expat), you should move to a different country or territory to minimize your tax bill. My clients also look for more safety, better education, homeschooling-friendly places, and more. But in any case, all these goals require money, so living in a territory where you can keep the fruits of your labour is the best solution.
In today’s article, you will learn about what a territorial tax system is, how it works, and its pros and cons, and we will examine examples of countries with this kind of system.
In the territorial taxation system, you are only taxed on income earned within the border
WHAT IS A TERRITORIAL TAX SYSTEM?
The principle of territoriality governs a territorial tax system. In other words, due to this principle, a country or territory only taxes the income earned within its borders regardless of the nationality or residence of the taxpayer. Supposing this system was implemented this way if you worked in a particular country, you would only be taxed in that country and not anywhere else.
In contrast, a worldwide tax system taxes income its residents earn regardless of where it was generated. Consequently, if a country resident’s income comes from a foreign source, that income is still subject to taxation in the country he resides. For example, if you live in the US and your income source comes from Canada, you pay taxes on that income.
Adopting a territorial tax system has numerous implications for businesses and individuals. And as an expat, this is what interests you the most.
First, this system simplifies tax compliance for businesses, especially multinational corporations. The worldwide tax narrative is pushing to tax the income of corporations with a global operation. A territorial tax system allows companies to pay taxes on revenue generated within a specific country or territory. Not only does a company benefit from simple tax compliance, but it also avoids the need to file taxes in multiple jurisdictions, which is time-consuming and expensive.
Second, a territorial tax system can encourage foreign investment in a country. If a government only taxes the income generated within its borders, it can boost its economic growth and create more jobs while providing an attractive investment environment for foreign countries.
It is worth noting that there exist two types of territorial tax systems. On the one hand, a fully territorial tax system exempts all foreign-sourced dividend and capital gains income. On the other hand, a partially territorial tax system exempts only a particular share of foreign-sourced capital gains and dividends or exempts foreign-sourced dividend income but includes foreign capital gains income (or vice versa).
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For example, a country might have a 15% corporate tax on domestic income plus a 10% tax on foreign income
HOW DOES A TERRITORIAL TAX SYSTEM WORK?
A territorial tax system works by splitting income into domestic and foreign income. Domestic revenue is generated within the country, whereas foreign income is generated outside the country. A territorial tax system only requires the taxpayer to pay taxes on domestic income.
For an individual taxpayer, domestic income is generated from employment, self-employment, and investments within the country’s borders. Foreign income is the same, except it is generated outside the country.
In contrast, a business’ domestic income refers to the income generated from sales, services, investments and other economic activities within the country’s borders. If all that economic activity’s income is generated outside the country, it is considered foreign income.
The tax liability is determined by the tax rate based on the income generated within the country. This tax rate varies from country to country and depends on the type of income and the country's tax laws. In any case, the tax rate solely applies to revenue generated within the country, not income generated out of the country.
Many countries with territorial systems require individuals and companies to report all income earned, regardless of origin, to ensure tax is not evaded by moving operations or investments out of the country. The tax rate of domestic income and foreign income can vary. For example, a country might have a corporate tax of 15% for domestic income but a 10% tax rate for foreign income. This promotes the internationalization of companies while the country gets tax revenue.
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Foreign companies are encouraged to invest in the country and national companies to expand internationally, generating more jobs
PROS OF A TERRITORIAL TAX SYSTEM
There are many advantages that the territorial tax system has, particularly for digital nomads and expats. Some of the benefits that this system brings are:
ATTRACTING FOREIGN INVESTMENT
A country can create a tax environment encouraging foreign companies to invest and expand their operations there. This can lead to economic growth and job creation. The quintessential example is Singapore, which went from poverty to prosperity in little time thanks to this openness.
SIMPLIFIED TAX SYSTEM
A country can eliminate the need for complex tax treaties and policies to tell which country must tax the income generated outside its borders. Thus, a company can more easily comply with tax regulations and reduce compliance costs.
PREVENTING DOUBLE TAXATION
This system can prevent double taxation by taxing only the income earned within its borders. In contrast, multiple countries can tax a business on the same income under a worldwide tax system.
PROMOTING ECONOMIC GROWTH
Foreign companies are encouraged to invest in the country, and domestic companies to expand internationally. As a result, this increases the country's economic output and creates more jobs.
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Domestic companies may end up paying higher taxes than foreign companies that earn income within the country
CONS OF A TERRITORIAL TAX SYSTEM
Despite the many advantages of the territorial tax system, some disadvantages must be considered. Let's get to know a little more about these disadvantages.
DISINCENTIVIZING DOMESTIC INVESTMENT
If a company can earn income in a country with a territorial tax system and then transfer that income to another country with a lower tax rate, it has less incentive to invest in the domestic economy. Consider all the fast fashion brands that produce their clothes in countries like Turkey, Bangladesh and South East Asian countries.
UNEQUAL TREATMENT OF DOMESTIC AND FOREIGN COMPANIES
Domestic companies might be subject to a higher tax rate than foreign companies earning income within the country’s borders.
ENCOURAGING PROFIT SHIFTING
A company might shift profits to countries with lower tax rates. In other words, it generates income within country X and then transfers it to country Y with a lower tax rate to reduce its tax burden. Country X can lose tax revenue due to its territorial tax system.
A territorial tax system can effectively promote economic growth and present good opportunities for expats with online income
Many countries and regions have implemented territorial tax systems, including Singapore, Hong Kong, Ireland, and Estonia. These countries have been prosperous in attracting foreign investment and promoting economic growth. A territorial tax system can effectively promote economic growth and attract foreign investment, and country’s that have present plenty of opportunities for expats, particularly those with online income.