What is a Territorial Tax System and How to Use One to Pay Zero Tax?

You would be wrong to think that you must move to a country with a headline 0% tax rate, such as the UAE or Vanuatu, to minimise your taxes. 

The truth is that many other countries around the world will allow you to structure your tax affairs internationally and pay no or low taxes. 

For a variety of reasons, zero-tax countries will only suit some. Whether because they’re too expensive, too remote or because there is little genuine economic activity in them, tax havens are only sometimes the best places to live full-time. 

However, for those it suits, living in a territorial tax country could offer your ideal lifestyle while eliminating your tax burden at the same time.

When you add it all up, moving to a territorial tax country can protect most of your income, give you a place to call home (even if it’s not all the time) and let you enjoy the benefits of travel.

So, how does it all work? 

In this article, we’ll explore all aspects of territorial tax, the mistakes to avoid and the best places to get the benefits. 

Nomad Capitalist is a turnkey solution for offshore tax planning, dual citizenship, asset protection and global diversification. You can find out more here.

Understanding Global Tax Systems

When formulating your global tax strategy, it’s first important to understand the basics of how each system works and the basis for taxation, whether citizenship or residence: 

• Citizenship-based taxation: As the name implies, if you’re a citizen of a country that uses this tax system, no matter where you live or work around the globe, you must file and pay taxes at home. The only way to avoid doing so is by renouncing your citizenship. The United States and Eritrea are the only two countries that currently use this system. 

• Residential tax: One of the easiest to understand and widely employed tax systems, residential tax means that if you live in a country, you will pay tax there. If you don’t live there, you don’t. 

Each country has their own defined method to differentiate between tax and non-tax residents. Generally, if a person lives in a country for more than 183 days, give or take, there is a basis for taxation. Most developed countries swing in favour of taxing worldwide income and exempting overseas citizens. 

With that in mind, countries usually implement one of four tax systems: 

• Worldwide tax
• Territorial tax
• Zero tax
• Countries with special exemptions.

Worldwide Tax

In contrast to a territorial tax system, a global or worldwide tax system requires individuals or businesses to pay taxes on all income they generate, regardless of where they conduct business. 

Territorial Tax 

Territorial taxation means that individuals and businesses are only taxed on income earned within a specific country and not on income earned from foreign sources. In other words, any income earned outside of the country is not subject to taxation in that country. 

Zero Tax 

That’s right, there are a relatively small number of countries where you pay absolutely no taxes. As a tax resident, you will pay no income or capital gains tax in countries like the Cayman Islands, the British Virgin Islands, the Bahamas, Vanuatu and Monaco.

Special Exemptions

Of course, there are exemptions on offer, and many nations now offer special tax regimes. These are often implemented to attract foreign investors. 

For example, lump-sum and flat-tax options, like those provided in Italy, are sometimes offered by countries to attract entrepreneurs, investors and high-net-worth individuals. Italy, options are sometimes offered by countries to attract entrepreneurs, investors, and high-net-worth individuals.

How Does Territorial Taxation Work?

If you have a job within your territorial tax residency country, your salary is taxed and, if you invest in real estate locally, that income is taxed. 

But, if you have a foreign company or income and investments, those won’t be taxed. 

Therefore, if you earn money worldwide, as is often the case with seven- and eight-figure entrepreneurs and investors, finding and living in a territorial tax country can effectively minimise your tax burden and even reduce it to zero.

Key Features of a Territorial Tax System

While every country’s tax system has its own unique rules, most territorial tax countries operate with the following features:

• Domestic focus: Taxes are levied only on income earned within the country.
  
• Exemption for foreign income: Income earned by companies or individuals abroad is excluded from taxation. This can reduce the complexity of tax compliance for multinational corporations.
  
• Reduced double taxation: Because foreign income is generally exempt, companies avoid being taxed twice – once in the foreign country and again in the home country.
  
• Dividends from foreign subsidiaries: In many territorial systems, dividends from foreign subsidiaries are not taxed when repatriated, or they are taxed at reduced rates.

If you structure your affairs carefully, you can use these tax jurisdictions to great advantage.

Pros and Cons of a Territorial Tax System

A territorial tax system may seem pretty straightforward, but there’s a lot to consider when becoming a tax resident in one of these countries. 

Advantages of a Territorial Tax System

• Competitiveness: These systems encourage businesses to operate globally without the fear of being taxed heavily.
  
• Simplicity: Territorial taxes reduce the administrative burden associated with tracking and reporting worldwide income.
  
• Avoids deterrents to repatriation: Companies are less likely to hoard profits abroad, as repatriating earnings doesn’t trigger any extra tax.
  
• Potential to pay zero tax: When your affairs are properly structured, you can use territorial systems to eliminate or vastly reduce your tax obligations. We’ll cover this in more detail below. 

Disadvantages of a Territorial Tax System

Managing money can be tricky: In territorial tax systems, you’ll generally need to have a bank account in a foreign country. Bringing money into the country can also be difficult, sometimes sparking certain tax triggers even if it’s foreign-sourced.

Complex rules: Many people move to territorial tax systems, thinking they will be exempt from paying taxes when, in reality, they are not. You need to carefully understand all of the rules involved before you make the move.

Using Territorial Tax to Pay Zero Tax

With a properly structured approach, you can, in some cases, reduce your tax burden significantly, potentially as low as 0% on your worldwide income. However, this requires careful planning and a solid understanding of the rules.

There’s a common misconception that as long as your income is earned overseas, you can live and work in almost any country, and it won’t be taxed. 

That is only sometimes true. 

Many countries will tax income if it’s earned locally or remitted into the country, treating it like a salary. This is because they consider the income to have been sourced domestically if the work was performed there.

Similarly, other countries have policies that may subject your income to taxation even if it flows through a foreign corporation. It’s essential to confirm whether your work or income qualifies for tax exemptions under local laws. 

Simply running income through an offshore entity doesn’t guarantee that you’ll avoid local taxes.

Some believe that incorporating an offshore company is either overly simple or impossibly complex. Others think they must relocate to a tax-free country to minimise taxes. 

Neither assumption is entirely true. 

Many territorial tax countries offer opportunities to lower taxes on foreign income without requiring you to move to a completely tax-free jurisdiction.

In territorial tax systems, domestic income is taxed like anywhere else. However, income sourced from outside the country is often tax-exempt. 

A critical factor for anyone seeking the advantages of an international lifestyle – both for tax purposes and overall quality of life – is deciding where to establish residency.

By becoming a tax resident of a territorial tax country, you can often avoid taxes on your worldwide income. 

On top of this, some countries have specific rules about remitting funds, so it’s often wise to keep your main banking outside the country to maintain compliance and minimise complications.

Ultimately, this approach enables you to strategically choose where to live, work, invest and incorporate, ensuring that you gain the best tax advantages while enjoying a lifestyle that aligns with your goals. 

By focusing on jurisdictions that treat you best, you can maximise both financial and personal benefits.

This allows you to choose places, as part of a strategy, to invest, live, work, hire and incorporate where you will gain the best tax advantages by going where you’re treated best.

As part of your Nomad strategy, you can rely on a territorial tax country to give you significant benefits in setting up your affairs. This can involve:

• Basing your company in a 0% location
• Living in a place that does not tax foreign income
• Owning real estate in a place where it’s lightly taxed
• Opening bank accounts in places where your interest isn’t taxed
• Buying your stocks in a country that won’t tax them. 

If you get these things sorted appropriately, you can save a lot of money. 

Territorial Tax System Countries

Many countries offer territorial tax systems, even some typically known for high taxes.  These systems can effectively reduce your tax liability to zero on foreign-sourced income.

Some of the most popular examples of territorial tax countries we recommend are:

• Malaysia
• Singapore
• Thailand
• Georgia 
• Panama
• Nicaragua
• Costa Rica.

These are just some examples of where your foreign income, including income from real estate and foreign corporations, isn’t taxed if you become a tax resident. 

If you’re interested, read our list of the 10 best countries with a territorial tax system for more information.

Territorial Tax Restrictions

Just because a country’s tax system is territorial doesn’t mean there aren’t any restrictions.

In some cases, income can be deemed locally sourced if you have a work permit. 

Because you’re judged to be generating income from within the country, it sometimes becomes a balancing act of how much of your company’s revenue is generated by you. 

For example, your salary could be taxed, but maybe the business isn’t. If you’re working as a freelancer for overseas companies, you’re essentially the business, so you may need to be taxed.

These are just two examples, but a lot of different rules come into play. That’s why it’s so important to speak to experts on international taxation to properly structure your affairs.

Exemptions from Territorial Taxation

Countries with territorial tax systems define what is and what isn’t taxable. Every country has its own rules and its own loopholes.

Generally, income earned within a territorial tax country is subject to taxation. However, things get more complex when you work for an offshore company while residing in a territorial tax country.

Suppose you live in a territorial tax country, but your company is based elsewhere and pays you in a bank account in a different country. Technically speaking, in that case, you’re not earning it in the territorial tax country. 

This could lead you to believe that you have no tax exposure. But, because you live and work in that country, you could end up paying taxes since you were physically present while earning the money. 

Another common misconception is that you’re taxed where your customers are located. While this might be true in some cases, it’s generally not the determining factor. 

Tax liability typically depends on your company’s residency and where the work is performed or where permanent establishments exist.

So if you have a company in a territorial tax country, like Panama or Costa Rica, and you’re selling into the European market, they will tax you. 

For example, if your company is in a territorial tax country like Panama or Costa Rica, but you’re selling services into the European market, you likely won’t be taxed in Europe. However, if you’re performing the work in Costa Rica, you’ll probably be taxed there.

There are other exceptions like Singapore, where if you’re sending money from abroad, it will generally not be taxed. 

How we define foreign income is often quite tricky; in the case of pensions, different types of investment income, where the customers are, and where the work is done, you have to pay attention to the details. This is the thing with international taxes – the details matter.

Territorial Tax System: FAQs

Moving to Countries with a Territorial Tax System

There are several ways to reduce taxes by living overseas, from travelling as a nomad to maintaining homes in different places. 

Still, if you have established wealth, you may want to avoid feeling obliged to keep moving constantly. 

So, how do you live in just one place and reduce your taxes?

The best-known option is simply moving to a tax-free country. Now, if you’re from the US, which taxes you wherever you go, you will need additional planning to minimise your taxes at home. 

So, in theory, you can move to Monaco, Dubai or Vanuatu, for example, establish a business there, become a tax resident and pay no taxes. 

As we’ve discussed, that option is only for some. Do you know how you can do it otherwise? 

It depends on what your tax budget is. Paying zero tax is attractive, but from a human lifestyle perspective, you may be willing to pay 10%, especially if you’re paying 50% now.  

It’s sometimes better to consider paying something for what it can offer. 

To do that, you have territorial tax countries like Costa Rica, Panama, Malaysia, Singapore and others where you can go and your foreign-sourced income is not taxed. 

In many of these countries, you’ll have issues around bringing money into the country to live on. 

These countries have moderate taxation, but it’s on a much smaller proportion of your income, and you may pay nothing at all if you’re careful with how you remit money.

Everyone’s situation needs careful planning regarding how you’re sending money to the country, how your business is running, and how you’re personally living. 

Many factors must be analysed, but it is possible to avoid tiny little islands and hot desert countries, live in one place full time and dramatically reduce your tax bill in dozens of unique countries. 

At Nomad Capitalist, we create and implement bespoke, holistic strategies for successful investors and entrepreneurs to legally reduce their tax bills and diversify and protect their assets. If you would like to learn more, please get in touch today.