Territorial taxation is a form of taxation basis that means when someone is resident in a place, then only what is determined local income is taxed. It doesn’t apply to tax non-residents.
The definition of local income is where it gets tricky, as we will explain. However, what matters is how you, as a high-net-worth entrepreneur or investor, can use territorial tax to reduce your tax burden significantly.
This article will explore all aspects of territorial tax to give you a clear idea of how it works, 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.
Global Tax Systems
When formulating your global tax strategy, it is first important to understand the basics of how each type of taxation 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 countries that use this system.
Residential Tax: One of the easiest to understand and widely employed tax systems, Residential Tax, means that if you live in the country, you will pay tax there, and if you don’t, you won’t. With a defined method to differentiate tax and non-tax residents, if a person lives in a country for more than 183 days, give or take, there is a basis for taxation. Most developed countries favour taxing worldwide income and exempting overseas citizens.
Countries worldwide usually implement one of four tax systems:
- worldwide
- territorial tax
- zero tax
- countries with special exemptions
Worldwide
A global or worldwide tax system differs from a territorial tax system in that an individual or business is taxed on all income generated no matter where they conduct business.
Territorial Tax
Territorial tax means that an individual or business is only taxed on income earned within the country and not foreign source income. So, all the money you make outside the country is not taxed there.
Zero Tax
That’s right, there are a relatively small number of countries where you pay absolutely no tax. 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 always exemptions, and many nations now offer special tax regimes. These are often implemented to attract foreign investors. For example, lump sum tax payment, like that provided in Italy, options are sometimes offered by countries to attract entrepreneurs, investors, and high-net-worth individuals.
How Does Territorial Taxation Work?
A territorial tax system is one where only income derived inside the country is taxed, so if you have a job, your salary is taxed; if you invest in real estate locally, that income is taxed, but if you have a foreign company and investments, those won’t be.
So, 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 minimize your tax burden and even reduce it to zero.
You would be wrong if you thought that you must move to a country with a headline zero-percent tax rate to minimize your taxes, like the UAE or Vanuatu. 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 are too expensive, too remote, or because there is little genuine economic activity, tax haven countries are only sometimes the best places to live full-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 for very long, and you can still enjoy the benefits of travel.
Using a Territorial Tax to Pay Zero Tax
This is potentially a way, if appropriately structured, to pay as little as zero-percent tax on your worldwide affairs by:
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. Some countries will tax money at a relatively high rate, like a salary, that you remit into it if it is deemed they earned it while in that country. Hence, the source of income was in that country, i.e. locally.
Other countries have similar policies, so you must ensure that your work in that country is exempt from income tax, even though it’s running through a foreign corporation. It may not be.
Many people also think it’s easy to incorporate an offshore company and live where they are now, or they think it’s too complicated. Some assume that if they want to pay no tax, they have to move to a country that has no tax. That’s not entirely the case.
In terms of domestic taxes, they function like any other country – the exception is that if your income is sourced from overseas, you won’t pay there. A key question for anyone wishing to enjoy the benefits of an international life, both in terms of tax and lifestyle, is where to become a resident.
So, if you live in a territorial tax country long enough to become a tax resident, you won’t be taxed on your worldwide income. Other countries have rules on remitting money into the country, so it’s advisable to keep your main banking outside.
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 are treated best.
As part of your Nomad strategy, you can rely on the territorial tax country to give you significant benefits in setting up your affairs.
- Having your company in a zero-percent location.
- Living in a place that does not tax foreign income.
- Owning real estate in a place where it is lightly taxed.
- You are opening bank accounts in places where your interest isn’t taxed.
- You are buying your stocks in a country that won’t tax them.
If you get those things sorted appropriately, you can save a lot of money.
Territorial Tax Countries
Examples of recommended territorial tax countries include Malaysia, Singapore, Thailand, the Philippines in Asia, Georgia in Eastern Europe, and Panama, Nicaragua, and Costa Rica in Central America.
These are just some examples of where your foreign 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.
Just because it’s territorial doesn’t mean there aren’t any restrictions; in some cases, it can be deemed a local source 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 taxed. A lot of different rules come into play.
Exemptions from Territorial Taxation
Countries with territorial tax systems define what is and what isn’t taxable. Tax must be paid on income earned in a territorial tax country. However, working for an offshore corporation while residing in a territorial tax country can get more complicated.
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 tax since you were physically present while earning the money.
A common mistake is assuming you are taxed where your customers are; that’s usually different. You are generally not taxed where your customers are. It does depend on the type of income and the type of company, but generally, you are taxed where your company is resident and where the work or permanent establishments are.
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. There are exceptions, but if you’re doing the work in Costa Rica, you’re likely to be taxed in Costa Rica. Often, dividends will be non-taxable. There are exceptions like Singapore, but if you’re sending it from abroad, it will generally not be taxed. But it depends on where the territoriality comes from.
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 tax; the details matter.
Moving to Territorial Tax Countries
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 minimize your taxes at home. So you can move to Monaco, Dubai, or Vanuatu, for example, establish a business there, become a tax resident, and pay no taxes.
As we have 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 foreign-sourced income is not taxed. In many of these countries, you will have issues around bringing money into the country to live on; that money could be taxed, or rules that involve paying tax on your salaries there. 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 in how you’re sending money to the country, how your business is running, and how you’re personally living. Many factors must be analyzed, 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.
