Basics of taxation
Table of contents
- Types of taxes
- Types of income
- Tax base
- Legal structure
- Taxable income
- Legal residency vs. tax residency
- Individual residency
- Corporate residency
- Double taxation
- Hybrid mismatch
- Tax avoidance vs. tax evasion
Types of taxes
Based on the origin
- Territorial tax
- only local-sourced income is taxed (ex: employment, business, rental income, etc. earned locally)
- foreign-sourced income is exempt (ex: dividends, interest, rental income, etc. from abroad)
- ex: Panama, Costa Rica, Georgia, Thailand, Philippines, Singapore, Hong Kong, Malaysia, etc.
- Residence-based tax
- worldwide income from all sources, local and foreign, is taxed
- ex: most of the world including Americas, Europe, Asia, etc. with a few exceptions
- Citizenship-based tax
- worldwide income of both resident and non-resident citizens is taxed
- ex: US (including green card holders), Eritrea, Myanmar, Tajikistan, Hungary
- Remittance-based tax
- certain income is not taxed until remitted in the country (or not taxed at all if remitted after X year/s)
- ex: Gibraltar, Singapore, Malta, UK, Thailand
- Non-domiciled tax
- special tax regime for non-domiciled residents (usually to defer taxes)
- ex: Cyprus, Malta, UK, Ireland, etc.
List of countries by their tax system on Wikipedia
Based on the tax rate
- Zero tax
- no tax or 0% tax is levied
- ex: UAE, Qatar, BVI, Cayman Islands, Vanuatu, Monaco, Bermuda, etc.
- Flat tax
- fixed-rate tax that doesn't vary based on income
- ex: Bulgaria, Romania, Georgia, Hungary, etc.
- Progressive tax
- variable tax based on tax brackets; imposes higher burden on higher-income earners
- ex: US, Canada, Australia, UK, France, Germany, Sweden, etc.
- Lump-sum tax
- fixed sum (ex: EUR 100k) is paid annually on foreign income; works best for HNWIs
- ex: Italy, Greece, Switzerland, Malta, etc.
- Tax holidays/exemptions
- special tax programs often for 3/5/10 years to attract workers, entrepreneurs, investors, etc.
- ex: Uruguay, Peru, Spain, etc.
List of countries by their headline tax rates on Wikipedia
Based on the type of income
- Income tax
- Personal income tax (PIT): paid by individuals on employment and other income (dividends, interest, etc.)
- Corporate income tax (CIT): paid by corporations on profit (i.e. revenue after expenses, salaries, debts, etc. but before dividends)
- Capital gains tax (CGT): paid on the sale of assets (investments, property, currencies, crypto, metals, etc.)
- Dividend tax: paid by individuals that received dividends from a corp (or withheld by corp when distributing dividends)
- Interest tax: paid on interest accrued in bank accounts, bonds, CDs, etc.
- Royalty tax: paid by property owners on royalty income (payments for use of copyright, patent, trademark, etc.)
- Payroll (social security) tax: paid by both employees and employers, as well as self-employed, to fund pensions, healthcare, unemployment, disability, parental leave, etc.
- Sales tax/GST/VAT: paid by both consumers and producers when buying products and services
- Property tax: paid by real estate owners
- Import tax/duty/tariff: paid on goods and resources imported from other countries
- Stamp duty: paid on documents, licenses, cards, checks, receipts, etc.
- Excise tax: paid by consumers on certain goods (ex: tobacco, alcohol, fuel, air tickets, luxury items)
- Sin tax: paid on products deemed harmful (ex: tobacco, alcohol, fast food, soft drinks, etc.)
- Energy tax: paid by consumers and/or producers of fuels, oil, gas, etc.
- Carbon tax: paid by producers of carbon-based fuels (coal, oil, gas)
- Estate/death tax: paid on the transfer of assets (investments, property, etc.) of a deceased person (either by will or intestacy)
- Inheritance tax: paid by beneficiaries (recipients, heirs) of the estate of a deceased person
- Transfer tax: paid on transfer of title to property from one person to another
- Gift tax: paid on money or property that one person gives to another
- Wealth tax: paid by high or ultra-high net worth individuals on their assets (investments, property, etc.)
- Exit/departure tax: paid by expatriates on their assets when becoming a tax non-resident of their country
- Solidarity tax: paid by higher-income earners to support low and middle-income households
- User fees: paid for admission to parks, museums, also toll fees for roads and bridges
- Withholding tax: paid by a non-resident individual/company on income sourced locally (ex: divs, interest, rent, etc.)
Based on geography
- Federal: levied by the federal government
- State/provincial: levied by the state (ex: US), province (ex: Canada), region (ex: Italy), etc.
- Municipal/local: levied by the county (ex: US), city (ex: LA), district, etc.
Types of income
- Gross income: total income before any expenses, deductions, or taxes
- Net income: income after all expenses, deductions, and taxes
For corporations, gross income is also the top line (on the income statement), while net income is the bottom line.
Companies also distinguish revenue and profit which are slightly different:
- Revenue (turnover): gross sales of goods/products
- Profit: net sales i.e. gross sales minus all expenses, debts, costs, etc.
Tax base
Tax base (taxation basis) is the portion of income that is subject to tax.
Individuals pay taxes (PIT and socials) on their gross income minus deductions (ex: personal allowance, pension fund contributions, etc.). Socials use your gross income as the tax base, which is sometimes capped at a multiple of min/avg monthly wages.
Corporations pay taxes (CIT) on their profits (or sometimes a lower rate on revenues). Profits are then distributed to shareholders as dividends (which are then taxed again at the personal level).
Legal structure
Most freelancers and digital nomads will fall into one of the following:
- natural person
- employee: paid a salary by an employer, subject to PIT and socials
- independent contractor: registered as a sole proprietor, bills clients with invoices, also subject to PIT and socials (both employee + employer portion)
- legal entity
- corporation: incorporated business, usually an LLC, pays CIT and socials on salary, distributes dividends
- individual also pays div tax (sometimes, withheld by corp) and/or PIT + socials on salary
- corporation: incorporated business, usually an LLC, pays CIT and socials on salary, distributes dividends
Employees are usually taxed at the higher rates because of the progressive PIT and mandatory socials. They may claim personal allowances and home-office deductions, but those are limited. However, employees enjoy labor rights, health insurance, EI/severance pay, PTO, etc.
Self-employed can pay less PIT by deducting business expenses from gross income, but they also pay higher socials (both employee and employer side). Contractors don't get any benefits or PTO, and they often need to purchase private health and contractors insurance.
Despite tax integration, corporations are often the most tax-efficient because they can pay a reduced small business CIT rate at the corporate level, and a flat dividend tax at the personal level (typically, lower than PIT). As a director/manager, you can decide how much you pay yourself in salary and thus in PIT and socials.
Taxable income
Individuals are taxed based on tax residency and source of income:
- Worldwide-tax country
- A resident individual is taxed on income from all sources, local and foreign
- A non-resident individual is taxed only on local source income
- Territorial-tax country
- Both a resident and a non-resident individual are taxed only on local source income
Similarly, for companies:
- Worldwide-tax country
- A resident company is taxed on income from all sources with possible exemptions on foreign PE (permanent establishment)
- A non-resident company is taxed on income from PE and local sources
- Territorial-tax country
- Both a resident and a non-resident company are taxed on income from PE and local sources
Legal residency vs. tax residency
These terms are commonly confused. Note that they can all be in different countries simultaneously!
- Legal residency
- legal status (privilege) to stay in another country as a foreign citizen
- temporary residency (TR): 1-5 years, foreign students, workers, business partners, etc., may lead to PR
- permanent residency (PR): renewed every 5-10 years, entitles to most rights except voting, may lead to citizenship
- NOTE: legal and tax residency may differ; for example, banks may only ask to declare legal residency and address; sometimes, they may not care about your tax residency (although they do when withholding tax)
- NOTE: residency is a legal condition or fact of living in a country, whereas a residence is the place where you live like your home or street address.
- Tax residency
- being subject to the tax laws of a country (i.e. where you pay taxes)
- usually, you are a tax resident of one country
- unfortunately, you could be a tax resident of two or more countries
- DTTs may or may not be in place to offset double taxation
- in theory, you could be a tax resident of no country (although this complicates banking and investing)
- E-residency
- neither legal nor tax residency; just an online registration for government services
- Domicile
- either where you are a citizen of or where you have been a tax resident of in the last X years
- you may be treated differently as a non-domiciled tax resident vs. domiciled tax resident
- ex: Cyprus, UK, Ireland, Malta, Italy, Greece
- NOTE: separate from legal domicile: your permanent home, place of birth, etc.
- Citizenship
- status of being a citizen of a country (by land, blood, naturalization, etc.)
- some countries allow dual citizenship, others require that you renouce all other citizenships (with the exception when it's acquired by birth, marriage, or investment)
- stateless person: someone not considered a national by any state
Individual residency
Canadians, see tax residency in Canada.
Each jurisdiction has its own rules for tax residency. Some countries apply residency tests (ex: SRT in the UK, substantial presence test in the US, etc.). Tax authorities publish general guidelines that you can read online. The fine print can be found in the tax act(s) and case law. Finally, if a DTT applies, it will override the domestic rules.
Tax residency is a question of fact. The following factors are commonly (but not always) taken into account:
- 183 day rule
- automatically a tax resident if you spend more than 183 days in any 12-month period (barring a DTT or visa terms)
- permanent home
- tax resident if you have your primary residence (dwelling) in the country, even if you spend less than 183 days there
- center of vital interests
- may include personal, economic, familial, social, business, etc. ties
- ex: spouse/common-law partner, dependends, property, job/business, bank accounts, documents/IDs, memberships, etc.
- habitual abode
- dwelling that you habitually return to (ex: from travels) even if you don't live there most of the year
- place of sojourn
- sojourning means staying temporarily (i.e. temporary residence) even for a short time
- nationality/citizenship (ex: US)
For most people leaving western countries, the best course of action is to make a clean break i.e. sever all ties with your home country (sell your home, car, close bank accounts, etc.), and permanently move yourself, your family, and your business to the new country. Alternatively, you could sever all significant ties (like your primary residence) but keep some secondary ties (like your driver's license or private pension fund). If you qualify for treaty relief under a DTT, you could have mixed ties in both countries, but only pay taxes in one based on the tie-breaker rules.
As a non-resident of your home country, if you receive local sourced income, a non-resident withholding tax is automaticaly deducted at the source (see WTH taxes). For some types of income (ex: employment), you may also have to file a non-resident tax return (even though some tax was already withheld).
Corporate residency
The exact rules on how a company is taxed are found in the tax code. A tax treaty, if applicable, will override these rules. While the details vary between countries, tax authorities consider one or more of the following:
- Registration
- If a company is incorporated in a country, it is tax resident there
- Management and control
- If a foreign company is managed in a country, it is tax resident there
- This can include director decisions, senior management, day-to-day management, etc.
- Related: place of effective management (POEM) where strategic decisions are made
- Controlled Foreign Corporation (CFC)
- If a majority shareholder is personally tax resident in a country, their foreign company is also resident there
- "Control" may include voting rights, shareholder value, operations/activities, etc. (see OECD on CFC)
- Permanent establishment (PE)
- If a foreign company has a fixed place of business in a country, it is taxable there
- This can include a branch, an office, a factory, etc.
- Source of income
- If a company generates income in a country, it is attributable and thus taxable there.
- This is determined by economic substance i.e. where the headquarters, offices, employees, etc. are.
- Related: nexus or economic presence (i.e. business activity) in a jurisdiction
In most cases, the place of registration is irrevant for taxes. A foreign company can still be deemed resident if it is managed and controlled onshore, or if its shareholding are individually resident in the country. Likewise, a non-resident company is still taxed on its income from PE and other local source income.
Double taxation
Unfortunately, you could be a tax resident of multiple countries. Luckily though, if those countries have a double taxation treaty (DTT), you may still be deemed a tax resident of one country, but not the other, based on the tie-breaker rules (often found in Article IV). The country you would be deemed a tax resident of is typically the one in which you have your:
- permanent home or
- center of vital interests or
- habitual abode or
- citizenship
If you satisfy one of these tests, you'd qualify for double taxation relief, as the DTT would override (supersede) any local tax laws. If none of the tests apply, the question is settled in court by mutual agreement of the countries.
If there is no DTT in place (often the case for blacklisted or tax haven countries), then you might be subject to double taxation. However, the other country would usually have no tax, very low tax, or territorial tax (where foreign-sourced income is exempt from taxes). In other cases, you may be exempt from tax based on the terms of your visa (ex: digital nomad visa).
If you run your business in a foreign country (as a dependent agent), depending on the type of activities or presence of a fixed place of business, you may constitute permanent establishment. In that case, your business would be taxable on the portion of income that you generated (or is attributable to, based on how much time you spent there) in said country.
Hybrid mismatch
- Differences in tax laws between countries that may be exploited for BEPS and tax avoidance
- Often target discrepancies in tax residency, registration vs. POEM, domicile, etc.
- Ex 1: Double Irish where a company is registered in Ireland but managed from the US
- Ex 2: UK, Cyprus recognize tax domicile, while most countries like Canada don't
- Ex 3: countries like Germany don't require to establish tax residency elsewhere upon exit
Tax avoidance vs. tax evasion
- Tax optimization
- legally and ethically structuring your affairs in a way to owe less in taxes
- tax planning, where arrangements are consistent with the intent of the law
- ex: incorporation if you're self-employed, contributing to retirement funds (for deductions), relocating to another jurisdiction, taking advantage of tax incentives or programs, etc.
- Tax avoidance
- also legal but often unethical, using aggressive or abusive tax planning that pushes the limits of the laws
- ex: complex international tax planning (especially, by multinationals), using tax loopholes, hybrid mismatch, holding or flow-through companies, etc.
- often met with countermeasures, ex: laws/amendments, anti-avoidance rules, blacklisting, CRS, OECD, etc.
- Tax evasion
- illegal, not paying taxes owed, under-reporting income, ignoring laws, has criminal consequences
- ex: claiming non-deductible expenses, providing false information, money laundering, etc.