< Index for December 99 Issues  > <  Index for International Living  > < Subscribe to International Living >

The United States is the only major industrialized country that claims the right to tax its citizens and permanent residents on their worldwide income regardless of where they live. Yet moving overseas can limit…and even eliminate…the taxes you owe in the United States - if you choose your new home wisely. You have three options: a country with a “double-taxation” treaty that works in your favor, tax expatriation, or foreign residency.

The countries themselves fall into three categories: industrialized countries like Canada, France, or Germany; undeveloped countries like Mexico, Nicaragua, and Honduras; and tax-haven countries like Bermuda, Panama, and Belize. 

No “double-taxation”
If a “double-taxation treaty” exists between the United States and the country in which a U.S. citizen resides, then the tax treaty supersedes the Internal Revenue Code (IRC) and the language of the treaty governs.  As a general rule, tax treaties allow you to offset foreign tax paid against what your federal tax liability would have been. 

Who do you owe?
That means that if your foreign taxes are higher than your U.S. federal tax, no U.S. tax is due.  If your foreign taxes are lower, the difference will generally still be due Uncle Sam, unless the Section 911 exemption for physical-presence tests is met. (See page 5.)  While a tax treaty does ensure that you do not pay taxes twice, it also ensures that you pay taxes in the country that has the higher tax rate. 
In every other industrialized country except New Zealand, the top bracket for taxpayers is higher than that in the United States. No additional taxes would be due Uncle Sam if you lived and worked in these countries and paid taxes there.

The second method for escaping taxation is expatriation; when you renounce your U.S. citizenship. Although considered by many tax scholars as the ultimate plan for tax avoidance, very few people are willing to take such a drastic step. Over the past decade, the number of expatriates (not all of whom can be considered “tax expatriates”) has ranged from about 300 to a few thousand per year. In other words, while there is academic interest in it, expatriation is not a common solution for Americans.

Becoming a resident of another country
The third way to reduce or eliminate taxes while living abroad is centered around Section 911 of the tax code, which ties your tax obligation to the number of days you’re actually in the United States.  (We examined this provision thoroughly in last month’s issue.) I repeat it here because, though it requires you to gain foreign residency, you are not obliged to renounce your citizenship. 

Tax treaties with foreign countries (or even taxes due in other countries for that matter) are irrelevant. This is an important distinction, as you’ll see below when we examine tax havens. As a general rule, you can spend only 30 days in the United States the first year that you move abroad and 120 days per year thereafter to qualify for Section 911.

“Source-of-income rules” 
While the United States imposes taxes based on a “citizenship” model, most countries impose them by following one of three other models; a “source-of-income rules” model, a “territorial-basis” model, or a “residency” model. In the end, your foreign taxation may be the same in the three models, but it’s important to understand the subtle differences between them when you’re moving abroad. These differences, ultimately, determine whether you pay more taxes, less taxes, or no taxes at all.

The “source-of-income rules” model is generally the one that the United States (when taxing non-citizens), Japan, Mexico, and a number of our trading partners use. The rule focuses on the location of where the income was derived. If a Japanese trading company sold a U.S. truck in Mexico, all three countries would agree that the profit would be taxed primarily in Mexico if there was a “permanent establishment” in Mexico and possibly also in Japan under the “residency” test below if there was no permanent establishment in Mexico. 

The U.S. involvement, however, is only that the vehicle is an object of U.S. production and has no bearing on either the source of the profit (i.e., Mexico) or residency of the company earning the profit (i.e., Japan). Likewise, a U.S. national living in Mexico whose source of income is from the United States would not be subject to Mexican income tax.  If that same person worked in Mexico, however he would be subject to Mexican tax under the “source-of-income rules test” and also to U.S. tax under the “citizenship test.”  He would then have to use the U.S.-Mexico tax treaty to keep from paying taxes twice. (He would, however, pay the higher of the two tax rates under the treaty.)

Conversely, if that person operated a company incorporated in another jurisdiction (such as neighboring Belize) and sold U.S. vehicles to Japan, who could then tax the transaction?  The profit was “earned” in Japan, but if there is no permanent establishment by the Belize company in Japan, Japan will not try to tax the profits, except for sales taxes paid by the end user.  The United States and Mexico have no relation to the sale itself or to the Belizean company and will not try to tax the company.  The ultimate income to the U.S. person in Mexico would not be taxed by Mexico, due to the source rules, but it would ultimately be taxed to the U.S. person living in Mexico under the catchall “citizenship test.” 

If, however, the U.S. person qualifies for the 911 exemption, if he structures his profits to an offshore trust rather than to himself, or if he pays it to another foreign person or entity, he can ultimately defer or escape taxation on the transaction altogether. 

A “territorial basis” for taxation
The next method of taxation is the “territorial basis” model. This model focuses squarely on whether income is derived from within the country’s territorial boundaries. Individuals and companies located in countries like Panama, Costa Rica, Singapore, Hong Kong, and Venezuela are fully taxed on their activities (and earnings) inside the country’s territory but not on any “foreign-source income.” These countries act as tax havens to the extent that activities from inside the country are geared toward earning money outside the country. Imagine the tremendous increase in U.S. exports and global competitiveness if the U.S. government refrained from taxing activities of U.S. corporations and individuals who were carrying on business outside the territorial limits of the United States.

The “residency  test”
The third method of taxation is the “residency test.”  Most of our European trading partners, as well as countries that have grown out of colonial relationships with them use this taxation model.
This test focuses on the “residency” of the person or company earning the income and does not look at the source of the income. For example, a Canadian living and doing business in Canada is subject to tax on his worldwide income, much as is an American living and doing business in the United States. Unlike the American system, however, which focuses on “citizenship,” the Canadian system focuses on “residency.” The Canadian can drastically alter his tax situation by simply moving outside of Canada, since the move will change his residency. 

That is why many Canadian, British, and other Europeans have a much greater ability to use tax havens.  Once their corporations or they themselves are no longer “resident” in their home countries, they are no longer subject to burdensome taxation associated with such residency.  To achieve the same outcome, the U.S. national would have to expatriate (give up his citizenship) while his Canadian and European counterparts can keep their citizenship intact and simply move abroad.

Tax havens reduce tax burden
The final group of countries involves the 40-or-so tax-haven countries. This category can be further divided in two.  In the first group are “true” tax havens, such as the Cayman Islands, which imposes no income, corporate, or estate taxes of any kind. Most tax havens fall into the second category, however. They establish special types of companies or accounts for foreigners, who are not taxed, but tax their own people. This group includes Belize, Panama, Bermuda, and Hong Kong. 

Surprising to most people, the United States also fits into this category. The United States does not impose capital-gains tax on foreigners, nor does it tax their U.S. treasuries or impose other government obligations.  So a German can have a brokerage account in the United States, trade freely, and receive interest income without paying a penny of U.S. tax.

Consider the taxes before you move
These categories overlap in many areas and can be complex, but don’t ignore them. To accept a job assignment working in Germany with a 10 percent raise may not seem such a rosy deal if the job subjects you to higher taxes and higher costs of living, which can more than wipe out the increase. On the other hand, a lower-paying job in South Africa with lower costs of living, together with the advantages of tax exemptions, may be quite appealing.

Americans retiring to Mexico on a fixed budget have known this for decades. The same Social Security or retirement payment will go much further South of the Border. And since the source of the income is still the United States, Mexico imposes no additional tax. 

Far too few Americans abroad consider their tax situations until after their tax obligations begin to come due. By then it is usually too late to act, and they find themselves not in control but just reacting to the situation. If your income abroad will approach or exceed the 911 exemption (currently $72,000), consider getting professional international tax advice. A little pre-move planning can reduce or even eliminate both your U.S. and your foreign tax exposure, allowing you to keep more francs, pesos, guilders, and dollars in your pocket to enjoy your international lifestyle.

Joel Nagel is an international attorney and managing partner of Nagel & Goldstein, a law firm with offices in Pittsburgh, Washington, D.C., and Miami, Florida. Mr. Nagel is a frequent writer and speaker on international legal topics for International Living. He welcomes reader feedback at (412)263-2707 or NagGol@aol.com.

                           Lowest Rate          Top Rate

Australia          21%             48%
Denmark       50%  68%
France           5%                 50%
Germany     19%              53%
Ireland                  24%              46%
Italy                      10%              50%
Japan      10%              50%
New Zealand  24%              33%
UK                       25%              40%
U.S.                         15%              39%
 
 

Bermuda           0%
Belize                0%
Cayman Islands*     0%
Channel Islands *        0%
Isle of Man *            0%
Barbados **          1% to 2 %
Vanuatu *            0%
Bahamas **           0%
B.V.I. **             0%
Anguilla *           0%
Nevis **             0%
Hong King            0%
Panama               0%
Gibraltar  *             0%

*  “Exempted Companies” 
**  “International Business Corporations” (IBC) no tax on “foreign-source incomes”