In conversations of citizenship-based taxation, the topic of discussion typically revolves around one country – the United States. There’s an argument that citizenship-based taxation is so deeply ingrained into the fabric of US history that the nation may find it difficult to let go of this practice.
But let’s go back a few steps: What is citizenship-based taxation? What are the tax implications for tax residents obligated to pay it? This article will uncover the historical origins of citizenship-based taxation, its continued existence, and the impact on tax residents subject to citizenship-based taxes.
By delving into the roots of this taxation system and understanding its current relevance, we aim to provide a comprehensive overview of its consequences for individuals and the broader economic landscape. We’ll also provide guidance on changing your tax residency and how a new citizenship and jurisdiction can alleviate a heavy tax burden.
Here’s what we cover below:
- What is citizenship based taxation
- The story of citizenship based taxation in the US
- Countries with citizenship based taxation, and more
What is citizenship-based taxation?
Citizenship-based taxation refers to the process by which a nation taxes its citizens irrespective of their status as residents. Often referred to as CBT, is a more stringent form of taxation, wherein individuals are liable to pay taxes based on their citizenship, regardless of whether they currently reside in their home country or generate income from foreign sources.
Under this system, individuals are obligated to report their worldwide income to the tax authorities of their home country and pay taxes accordingly. This approach contrasts with Residence-Based Taxation (RBT), where taxation is primarily determined by an individual’s place of residence or domicile rather than citizenship.
The Implications of Citizenship-Based Taxation
Citizenship-based taxation (CBT) can have several implications for individuals, especially for expatriates or citizens living abroad. Some of these implications include:
Double Taxation: One of the significant concerns with CBT is the potential for double taxation. Under CBT, citizens are required to pay taxes on their worldwide income to their home country, regardless of where the income is earned. This means that citizens living abroad may be subject to taxation both in their country of residence and their home country.
Complexity: Managing tax affairs under a CBT system can be complex and burdensome, particularly for individuals with financial assets or income sources in multiple countries. Compliance with tax laws and reporting requirements of both the home country and the country of residence can be challenging and may require professional assistance.
Reporting Requirements: Citizens living abroad are often required to file tax returns and report their global income to their home country’s tax authorities. This may involve additional paperwork, disclosure of foreign financial accounts, and adherence to specific reporting deadlines.
Foreign Bank Account Reporting: Under CBT, citizens may be required to report their foreign bank accounts and financial assets to their home country’s tax authorities. Failure to comply with these reporting requirements can result in penalties and potential legal consequences.
Limited Access to Financial Services: Some citizens living abroad may face difficulties in accessing certain financial services or investment opportunities due to compliance issues related to CBT. Financial institutions may be reluctant to provide services to individuals subject to complex tax reporting requirements.
How the Civil War Sparked Citizen-Based Taxation
The introduction of citizenship-based taxation in the US can be pinpointed to 1861 when the US grappled with the financial demands of the Civil War. According to the US Congress, Americans living abroad were failing to fulfill their civic duties to the United States during a time of need. Congress concluded that these American citizens could compensate for their limited civic involvement by paying higher tax rates on their US-source income.
As a result, the country’s first federal income tax legislation immediately placed Americans living abroad at a disadvantage. The initial versions enacted in 1861 and 1862 seemed to lean towards a territorial taxation system rather than worldwide taxation. Yet, the underlying disapproval of citizens living abroad was evident from the outset.
In just a few short years, the law underwent reform, and the system of citizenship-based taxation on non-residents’ worldwide income, as we know it today, was set into motion. Beginning in 1864, non-resident citizens no longer paid higher rates; they paid the same rates as resident citizens. However, they were now obligated to pay taxes on their US and foreign-source income.
Why does citizenship-based taxation still exist in the US?
For the 60 years post the introduction of citizenship-based taxation, the justification for upholding it in the United States rested on the idea of duty and belonging to a community, which had its roots in the aftermath of the Civil War (despite no other global community imposing such a requirement on its members).
Since US citizenship-based taxation began over a century ago, little discussion has been had about its rationale among politicians, primarily due to its effect on a small minority of Americans who lacked a political voice.
This law is not widely known, and even expats who anticipate being exempt from taxes upon leaving the country may be unaware of it. The IRS has acknowledged its shortcomings in adequately informing Americans abroad about their ongoing responsibility to file federal tax returns. Yet, it maintains its stance on imposing ‘disproportionately high penalties for non-compliance.’
While the rationale to impose citizenship-based taxation in the US is no longer as compelling, additional reasons like preventing tax evasion continue to be cited as justifications for its continuation. Critics argue that these concerns could be addressed through alternative means, such as strengthening enforcement measures or implementing stricter reporting requirements for citizens living abroad.
Nevertheless, despite growing pushback, changing a deeply ingrained tax system can be a complex and politically sensitive process, and there may be resistance from US officials to initiate reform.
Why can't the US quit citizenship-based taxation?
The issue of citizenship-based taxation (CBT) in the United States is complex and deeply rooted in the country’s historical tax laws and international tax policy. Here are some reasons why it’s challenging for the US to abandon CBT:
Revenue Implications: The US relies on its taxation system to fund government programs and services. Transitioning away from CBT could have significant revenue implications, especially if it results in tax revenue losses from Americans living abroad.
International Taxation System: The US has a worldwide taxation system, which means it taxes its citizens on their global income regardless of where they reside. This approach is uncommon among developed nations but has been in place in the US for a long time. Changing this system would require a comprehensive overhaul of the US tax code and international tax treaties.
Tax Enforcement and Compliance: Implementing a residence-based taxation system, where only income earned within the US is taxed, would require robust mechanisms for enforcing tax compliance. It could also potentially lead to tax evasion if not properly regulated.
Political Considerations: Any proposal to change the taxation system, particularly one as significant as moving away from CBT, would face political hurdles. It would require bipartisan support and consensus-building, which can be challenging in a politically polarized environment.
Overall, while there may be arguments for and against citizenship-based taxation, its abolition would require careful consideration of the economic, political, and diplomatic implications, as well as significant legislative and administrative efforts.
Citizenship-Based Taxation: Six Countries that Tried it
The US may appear alone in its citizenship-based taxation system; however, several countries have imposed income tax on non-resident citizens abroad in the past—all of which chose to abolish the practice in favor of residence-based taxation due to its flaws and public outrage.
While the US remains committed to a tax system rooted in its Civil War history over 150 years ago, other nations identified the inequities and subsequently abandoned it along with the authoritarian regimes that enforced it.
Mexico
Mexico is among the countries with a residence-based system, imposing no taxes on their non-resident citizens who relocate abroad to tax havens like the Cayman Islands or Monaco, besides territorial taxation on earnings derived from Mexican sources.
However, it wasn’t always like that. From the late 1970s until 1981, Mexico trailed a citizenship-based taxation system that closely mirrored the one employed in the US. All Mexicans were obligated to pay taxes, irrespective of their place of residence, with consideration to any existing tax treaties.
Romania
Romania had a previous personal income tax law that imposed global income tax on citizens living abroad permanently. The tax system was abandoned sometime between 1933 and 1954. Today, Romania imposes a worldwide taxation system on resident citizens. Furthermore, the country charges one of Europe’s lowest income tax rates, with a flat rate of 10 percent.
Bulgaria
According to Article I of Bulgaria’s 1950 tax law, all Bulgarian citizens were obligated to pay personal income tax on their worldwide income, regardless of whether they lived in Bulgaria or overseas. The legalization was nullified in 1995, and from 1996 onward, the Bulgaria government discontinued its citizenship-based taxation system, opting instead to tax residents based on their worldwide income if they lived in the country.
Vietnam
Vietnam imposed a citizenship-based tax until as recently as 2009. Reform came as the country’s communist leadership made efforts to relax state regulations on finances and open up the economy. With the enactment of a new law in September 2009, the criteria for tax residency were expanded to include permanent residents and individuals residing in Vietnam for over 183 days annually, while non-resident citizens were no longer subject to citizenship-based taxation.
The Philippines
Prior to the late 1990s, the Philippine government implemented a modified income tax code for its non-resident citizens, stipulating that they pay taxes at reduced rates. The tax rate started at one percent, rising to three percent before it was repealed.
The Philippines scrapped citizen-based tax in their 1997 budget. Today, a hybrid taxation system is employed. This means resident Filipinos are obliged to pay tax on their worldwide income, whereas US citizens with Philippines residence permits would be subject to territorial taxation on Philippine-sourced income to eliminate double taxation.
Myanmar
Myanmar, the most recent country on this list to undergo tax reform, once levied a ten percent tax on the worldwide income of its citizens working and residing overseas. However, in light of Myanmar’s recent endeavors towards reform after the half-century-long military rule, they abandoned citizenship-based taxation before military rule resumed in 2021. New legislation that came into effect in 2012 excludes paying taxes on all foreign income citizens living abroad earn.
How Americans Living Abroad Can Reduce Citizenship-Based Taxation
While citizenship-based taxation may be an unfair burden placed on Americans living abroad, there are measures a US citizen can take to reduce or even eliminate the impact of this taxation system and owing the country taxes after moving abroad.
However, it should be emphasized that whether a US citizen can eliminate their citizenship-based tax obligations depends on how much they earn and their individual circumstances.
Claim Foreign Earned Income Exclusion (FEIE): The Foreign Earned Income Exclusion program allows qualifying US citizens living abroad to exclude a certain amount of foreign income on their tax returns from US income tax. As of 2023, the foreign-earned income exclusion threshold is $120,000.
Utilize Foreign Tax Credit (FTC): Some countries have tax treaties with the US to eliminate double taxation on non-resident citizens. If you pay foreign taxes to other countries, the same income is also subject to US income taxes. You can use the Foreign Tax Credit scheme to offset your US income tax liability wherever a tax treaty exists. Thus, preventing double taxation.
Relocate to a low-tax country: This might sound counter-productive if you pay citizenship-based taxes; however, a country like Greece allows holders of a Greece Golden Visa to reduce their taxes through the Greece Non-Dom Tax regime. Eligible Golden Visa holders can reduce their tax liability by paying a $100,000 annual tax fee instead of Greek income tax. By combining the foreign earned income exclusion and foreign tax credits, the level of citizenship-based taxation can be significantly reduced.
The Answer to Citizenship-Based Taxation
The solution to avoiding citizenship-based taxation is straightforward: Obtain citizenship in a foreign country and renounce your citizenship. The answer may sound drastic, but there’s no other way to avoid citizenship-based taxes unless you cut ties with the country imposing it.
Many US taxpayers are under the impression they can avoid United States taxes by transferring their tax residency to a tax haven, low-tax country, or even moving funds to foreign bank accounts; however, this is a misconception, and any effort to do so is futile. Even if you permanently live in a tax haven or low-tax country, you must still report and pay income tax on your worldwide income to the US government.
Legally avoiding citizenship-based taxation requires Americans living abroad to renounce their US citizenship after gaining citizenship in a new country with a residence-based taxation system. The arrival of citizenship by investment programs in countries with friendly tax systems has allowed Americans abroad to comprehensively optimize their tax liability without going through the lengthy naturalization process.
Vanuatu citizenship by investment
Vanuatu’s citizenship by investment program allows US citizens and foreigners worldwide to obtain Vanuatu citizenship by contributing $130,000 to the country’s national development fund. Vanuatu provides the fastest economic citizenship program, with citizenship granted within 60 days of making the required donation.
But why Vanuatu? Well, Vanuatu is not only a foreign country that grants citizenship to investors, but all its citizens benefit from no income taxes. The only taxable income for individuals in Vanuatu is rental income, and corporations pay a small pension contribution.
Find out more about Vanuatu citizenship by investment
Frequently Asked Questions about Citizenship-Based Taxation
Can you be a US citizen and not pay taxes?
The United States employs citizenship-based taxation, in which US citizens who are dual citizens or permanent residents of another country are subject to income taxes on their worldwide income regardless of what jurisdiction they live in. The only way you can be a US citizen and not pay taxes is if you live in a country with a tax treaty with the US and the foreign income you earn is below the threshold provided by foreign tax credits and the foreign earned income exclusion.
Are there any tax treaties that can help mitigate double taxation for US citizens living abroad?
The United States has 68 tax treaties with countries worldwide, including most countries in Europe. For example, as an American living abroad in the UK paying UK tax on your income, you can mitigate double taxation through the foreign earned income exclusion and any foreign tax credits available to Americans living in the UK.
Are there any tax treaties that can help mitigate double taxation for US citizens living abroad?
The United States has 68 tax treaties with countries worldwide, including most countries in Europe. For example, as an American living abroad in the UK paying UK tax on your income, you can mitigate double taxation through the foreign earned income exclusion and any foreign tax credits available to Americans living in the UK.
What is USA residence-based taxation?
Residence-based taxation in the US refers to local taxes. The United States has two types of income taxes—federal and state. State taxation follows a residence-based taxation model, meaning whether you pay state taxes depends on whether you live in a state with income tax or one that is tax-free.
How much tax do non-resident US citizens pay?
Non-resident citizens in the US are subject to federal income tax on their worldwide income, which ranges from 10 to 37 percent. The tax rates for non-resident citizens are generally the same, depending on the type and source of income. Non-resident citizens living in countries with a tax treaty with the US typically pay less income taxes through the foreign earned income exclusion and foreign tax credits.
Do US citizens give up citizenship to avoid taxes?
Some US citizens choose to renounce US citizenship as a means to reduce their tax liabilities. This decision is often driven by a desire to escape the scope of US citizenship-based taxation, which requires US citizens to file federal tax returns and pay taxes on their worldwide income regardless of where they reside.
It should be noted that in addition to citizenship-based taxation, the US has a territorial taxation system, so any income earned from activities in the US would still be subject to US taxes after renouncing citizenship.
What is the meaning of citizen in taxation?
Citizenship-Based Taxation refers to the concept that a person is subject to tax on the income of the country they are a citizen of, whether or not they reside in the country — and whether or not the income they generate is sourced in that country.
Which countries tax you based on citizenship?
Why does the US have citizenship based taxation?
The United States implements citizenship-based taxation primarily to ensure that its citizens contribute to the country’s tax revenue regardless of where they reside, maintaining a connection between citizens and the country’s tax system.
Why do U.S. citizens have to pay taxes when living abroad?
United States employs a Citizenship-based taxation (CBT), in which individuals who are citizens or permanent residents of a country are subject to income tax on their worldwide income regardless of where they live.
Are taxes based on citizenship not place of residency?
There are two taxation systems: residency-based and citizenship-based. Residency-based taxation taxes individuals according to their global residence, while citizenship-based taxation taxes individuals based on their citizenship status.
What is a territorial tax system?
Under the territorial tax system, countries only tax income earned within their geographic boundaries. A few countries that have implemented this model include Costa Rica, Hong Kong, Panama, and Singapore.
