Citizenship-Based Taxation: Who’s Tried it and Why the US Can’t Quit

The tax reform talks that happened a few years ago had a lot of folks hoping for a long-overdue change to the United States’ basis of taxation.

For the first time in almost a century, politicians were seriously considering changing the nation’s citizenship-based taxation system to a residence-based one.

While we had our concerns about how the change would affect the tax situation of US citizens living abroad, the general sentiment was that moving away from citizenship-based taxation would have been a step in the right direction.

However, the solution the US government devised instead (and signed into law on December 22, 2017) was not a move in the right direction but a clear step back, especially for US expats.

Not only did lawmakers fail to eliminate citizenship-based taxation, but they managed to throw numerous people under the bus – including small- and medium-sized business owners operating overseas – in an attempt to get big businesses like Facebook, Apple and Google to repatriate their overseas profits.

Many hopes were crushed. But, to be honest, if you were hanging all your hopes on systemic reform, that’s your real problem. Too many people have put false hope in promises of reform during election campaigns and legislative debates.

It’s just wishful thinking.

Many people have asked us over the years if the changes politicians are promising at the moment will make America a place where they’ll be ‘treated best’. 

We don’t peddle doom and gloom, so it’s not that there is absolutely NO possibility of favourable change actually taking place. But why be content to sit by and wait for someone else to determine your future – let alone a group of politicians?

Suppose you’re still hanging on to the hope that your government will get its act together and change things for the better. 

In that case, it’s helpful to examine the history of citizenship-based taxation in the United States to get a better perspective of why the country has had such a hard time quitting addictive behaviour.

The History of US Citizenship-Based Taxation

The deep historical roots of citizenship-based taxation in the United States arguably make it almost impossible to abandon.

Despite being the only country in the world that fully follows this draconian system (Eritrea taxes its diaspora, but only at a flat rate of 2%), it would seem that the US is too set in its ways to care.

Civil War Roots

The practice of citizenship-based taxation in the US dates back to 1861 when the United States was struggling to raise revenue for its Civil War. 

Congress argued that American citizens living outside the country were avoiding their duties to the US in a time of need. They determined that these citizens could make up for their lack of civic engagement by paying a higher tax rate on their US-source income.

Thus, the first federal income tax legislation ever put into place in the United States automatically put individuals living abroad at a disadvantage. 

The first version enacted in 1861 and 1862 appeared to be more of a territorial tax system instead of a worldwide one, but the negative sentiment towards citizens who chose to live overseas was present from the start. 

In the wake of this negative sentiment, the law was reformed again in 1864, and citizenship-based taxation of non-residents on their worldwide income as we understand it today came into effect. 

For the next 60 years, the rationale for maintaining citizenship-based taxation rested on the Civil War-era concept of duty and community membership, despite no other nation imposing similar requirements on its citizens abroad.

Cook versus Tait

Eventually, the fundamental problems of citizenship-based taxation became apparent to many US citizens. 

So, in 1918, the US government implemented a foreign tax credit to eliminate the issue of double taxation and to assuage concerns from American corporations operating overseas that they were losing their competitive advantage by paying too much in taxes.

However, as the tax scholar Montana Cabezas argued in 2016, the tax credit was merely a patch to cover up the problem, not a cure. 

This was one reason George Cook chose to challenge the taxation of his foreign-source income not long after in 1922 in what became the 1924 Supreme Court Case Cook vs. Tait.

Having lived in Mexico for over 20 years with no remaining ties to the United States, Cook argued that taxing his non-US sourced income was unconstitutional. 

However, the court upheld the constitutionality of citizenship-based taxation. In its ruling, the Supreme Court shifted the justification away from Cook’s duties to his country to the ‘inherent benefits’ that came with being a US citizen.

What those inherent benefits were exactly was unclear, but since citizens living abroad could not vote until 1975 (some 50+ years later), those benefits certainly didn’t include the right to vote (i.e., the right of representation).

And here’s a strong case against the whole ‘you have the right to use our embassy and consular services!’ argument.

The only slightly justifiable reason Cabezas could find in the Supreme Court rationale about ‘inherent rights’ was the ‘right of return’ – the ability to return to the United States and participate in the American economic and social community. However, the US government has never publicly claimed this rationale as the reason for its continued use of citizenship-based taxation.

Despite the ruling in Cook vs. Tait, the US government attempted another fix, introducing the Foreign Earned Income Exclusion (FEIE). 

Since then, any discussion about the taxation of non-resident US persons has centred around the FEIE and the available foreign tax credits.

Nothing more has been said about abandoning citizenship-based taxation.

Until the fall of 2017.

Unfortunately, the original reason the US couldn’t quit citizenship-based taxation was the same reason it failed to do so once again in December 2017.

Why the US Can’t Quit Citizenship-Based Taxation

Since the 1860s when citizenship-based taxation began in the United States, there has been little discussion about the rationale for the practice among politicians. 

This is largely due to its disproportionate impact on a politically marginalised group: expats (whose voting rights are often hampered) and former US residents (who typically lose voting privileges). 

It’s not a widely-known law, even among many expats who assumed they would no longer need to pay taxes once they left the country. 

The IRS has even admitted that it does a poor job of informing its overseas citizens of their continuing tax obligations. Although, it continues to insist on applying ‘disproportionately high penalties for non-compliance’.

Even without the penalties, Cabeza notes that, for expats just over the border in Canada, estimated ‘accounting costs to file a basic offshore income tax return, even when one does not owe any tax to the United States, easily reach the thousands of dollars’.

The two rationales the United States has given in the past to support its use of citizenship-based taxation no longer hold up. 

The changing relationship between citizens and the state in a globalised society, where people are moving overseas more than ever, conflicts with the first rationale put forth in the 1860s of duty and community. 

And the argument about ‘inherent benefits’ has largely gone out the window since the Foreign Account Tax Compliance Act (FATCA) made US citizenship more of a liability than a benefit.

While the debate on citizenship-based taxation continues amongst expats and advocates, it seems to have faded from the political agenda in Washington. They got their win and they don’t care much about getting you yours.

Six Countries that Have Tried Citizenship-Based Taxation

The United States’ long history of using citizenship-based taxation is no excuse for its continued use, but it’s the excuse they’re making. 

Unfortunately, this pattern can be seen in more areas than just the US, such as the basis for taxation, as the United States is more than happy to sit on its laurels.

A country like that is a country unwilling to change and, therefore, progress. If you follow our five magic words, you know that this is NOT the kind of country where you want to be.

Historically, several countries have experimented with citizenship-based taxation, only to abandon it upon recognising its inherent flaws. 

Interestingly, many of these countries implemented this system under oppressive regimes, discarding it during periods of reform.

In contrast to the US, other nations have acknowledged the inherent injustices of citizenship-based taxation and abandoned it, often in conjunction with broader political reforms.

These six countries used to tax their citizens on their worldwide income, regardless of where they lived or earned their money.

 1. Mexico

Similar to Spain, Mexico taxes its resident citizens who relocate to tax havens like the Bahamas or Monaco for five years after their departure. However, in all other cases, Mexican citizens can freely leave the country and relinquish their tax obligations.

That wasn’t always the case. 

For several years leading up to 1981, Mexico experimented with a citizenship-based taxation system similar to the one used by their neighbour to the north. It required all Mexicans to pay taxes no matter where they lived, subject to any tax treaties.

This shift to a residence-based taxation system likely stemmed from logistical challenges and a growing recognition of the inherent fairness issues associated with citizenship-based taxation.

You can read more about how to get Mexican residence and citizenship here.

2. Romania

Romania previously taxed its citizens on their worldwide income regardless of their residence. However, sometime between 1933 and 1954, they abandoned the practice. 

The 1933 law establishing income tax states that ‘the taxable income will include all the gains realised in the country or abroad’ for Romanian citizens wherever they reside.

Conversely, a 1954 law enacted by the Soviet Socialist Republic of Romania omitted any explicit mention of citizenship-based taxation. Instead, a list of occupations is given of those individuals who must pay income tax on income earned within the territory.

Today, Romania applies a flat personal income tax rate of 10% to all Romanian tax residents on their worldwide income, except for salaried income for work performed and received abroad. 

Similar to Mexico, individuals who move to a country that doesn’t have a tax treaty in place with Romania remain taxable on their worldwide income for the next three years.

Once those three years are up, they’ll only have to pay on income sourced in Romania.

Read more about Romanian residence and citizenship here.

3. Bulgaria

Article I of Bulgaria’s 1950 tax law stated that all Bulgarian citizens were required to pay income taxes on their worldwide income regardless of their domicile and residence.  

The article was repealed in 1995, and beginning in 1996, Bulgaria abandoned the practice of citizenship-based taxation and began taxing its occupants’ worldwide income on the basis of residence within the country.

Their reason for doing so is unclear, but the repeal came at a time of great economic reform in Bulgaria following the collapse of the Soviet Union. 

This suggests that the change may have been motivated by a desire to align with international tax norms, attract foreign investment‌ or simplify tax administration.

Today, Bulgaria has one of the best tax rates in the EU at a flat rate of 10% for both individuals and corporations. If you’re looking to plant business flags in the EU and want to keep your taxes low, Bulgaria is definitely a worthy contender.

4. Vietnam

In 2007, Vietnam enacted a personal income tax law, effective, that shifted from citizenship-based taxation to a residence-based system.

This, of course, came at a time when communist-run Vietnam was making great efforts to loosen state controls and open up its economy. It’s unlikely to be a mere coincidence that it gave up the more oppressive basis for taxation during this time of overall reform.

The new law broadened the definition of tax resident to include permanent residents and those residing in Vietnam for over 183 days per year. 

This has implications for digital nomads and long-term visitors, who may become liable for the 20% flat-tax rate applied to non-residents. However, enforcement of this has been lax.

5. The Philippines

The Philippines currently employs a hybrid tax system. 

Filipino citizens are taxed on their worldwide income under a residential system, while non-citizen residents are taxed only on Philippine-sourced income under a territorial system. 

In essence, it means a Filipino citizen residing in the Philippines pays taxes on all income, regardless of source, whereas a foreign citizen with a Philippine residence permit would only pay taxes on income earned within the Philippines.

Basically, that means that the country’s large diaspora can earn money overseas without worrying about taxes in the Philippines. This adds a layer of good tax strategy for Filipinos who go to work in Dubai or Qatar.

However, up until the late 1990s, the government of the Philippines imposed a modified income tax code on its expat workers that required them to pay taxes at reduced rates. At the time, income tax brackets started at a meagre 1% and went up to a rather healthy 35% for residents.

Meanwhile, a special set of tax brackets for non-residents went from 1% to 3% and required citizens living overseas to pay up. 

Although this system was ultimately deemed unfair and was eliminated in the 1997 budget, the low tax rates offered a degree of appeal for those residing in tax havens.

6. Myanmar

The most recent reformer on this list, Myanmar, used to tax the worldwide income of its citizens who lived and earned money overseas at a flat rate of 10%. 

Following the end of its half-century military rule, Myanmar initiated reforms that led to the abandonment of the more oppressive aspects of citizenship-based taxation.

The new law was passed in 2011 and became effective in 2012. It excludes all salaried income earned by citizens living and working overseas from taxation. This is the greatest source of income for most of Myanmar’s citizens living abroad. 

While the law technically still applies to other types of foreign income, it’s no longer enforced by Myanmar’s embassies and consulates.

Partial Citizenship-Based Taxation

The United States has the world’s most complicated tax code. To make things worse, US citizens cannot escape it no matter where they live. 

While every other country on the planet takes a more reasonable approach to the taxation of their non-resident citizens, there are a few countries that like to dabble in citizenship-based taxation in special situations.

Many of these countries follow the same rule Mexico uses by taxing their citizens for a set period of time after leaving the country unless they can prove they have not moved to a tax haven and that they’re paying a similar amount in taxes as if they still lived in their home country. 

These countries include:

• Mexico (five years)
• Spain (four years).

After living abroad for a set period of time, these countries no longer consider their citizens as tax residents. However, no set period of time removes the tax resident status for French citizens who move to Monaco or Italian citizens who move to any tax haven.

Other countries require their citizens to prove that they no longer have any ties to the country before they can become exempt from worldwide taxation.

This can often be done by showing proof of another nationality or by residing in a country that has a tax treaty with their home country. 

These countries include:

• Finland (three years)
• Hungary
• Sweden (five years for both citizens and foreigners who have lived there for at least 10 years).

Turkey taxes citizens working abroad for the Turkish government or Turkish companies unless their income is taxed in the country where it’s earned. As previously mentioned, Myanmar technically retains a tax on non-salary foreign income but does not enforce it.

China has also begun experimenting with citizenship-based taxation as it grows in power in an effort to reach more of its billionaire citizens who are moving offshore.

Citizenship-Based Taxation: FAQs

Citizenship-Based Taxation – the Bottom Line

To date, no other country that has tried citizenship-based taxation has stuck with it.

 Many do not have the administrative capacity to enforce it, but others have chosen to discard it in times of reform when they were focusing on building stronger laws, more just governments and more open economies.

The United States, on the other hand, has the power to enforce citizenship-based taxation and has little motivation to attempt the kind of drastic change that has enabled most other countries to abandon the practice.

You may be tempted to look at the list of countries that have made it out of the addictive grip of citizenship-based and hope that the United States will one day quit the system, too, but that is wishful thinking.

If you’re ready to be done with citizenship-based taxation and you’re not willing to sit around and wait for the US to change of its own accord, the best move would be to take care of what you can actually control: your citizenship.

At Nomad Capitalist, we’ve helped 2,000+ high-net-worth individuals to ‘go where they’re treated best’, whether that’s by relocating their families, moving their business offshore or securing a second citizenship.