Territorial Tax Systems
Territorial Tax System is a tax system in which only the income earned in the country where the individual is living is taxed. In other words, if a person is living in France, only the income earned by him / her within France will be taxed under the Territorial Tax System. If this person has a great deal of business in say Belgium, the income he / she earns from the business ventures in Belgium will not be taxed. So, to put it simply, income derived from a foreign source, outside the borders of the country where the individual is residing in, is exempt from tax.
In order to fully understand the Territorial Tax System, it should be compared with other tax systems such as the Worldwide Tax System and the Mixed Tax System, found around the world. It should be noted that most territories around the world are neither entirely categorized as a Worldwide Tax System or a Territorial Tax System. While they may lean towards one type of system, most use a mix of both.
Worldwide Tax System
The major feature of a Worldwide Tax System is that residents and entities are taxed on any income that is earned within its borders along with the income that is earned throughout the world. While double taxation can in fact occur, most governments such as the United States reduces the possibility of double taxation to a certain level by having an allowance of a foreign tax credit. It should be noted that the United States predominantly employs a Worldwide Tax System.
If you are a U.S. citizen, resident or entity and your income is earned in another country, once the allowance of a foreign tax credit is exhausted, you will have tax liabilities in the U.S. For instance, citizens and resident aliens who live abroad are taxed on worldwide income. However, they may exclude from their income up to $82,400 of their foreign earnings. After this amount, your income will be taxed by the IRS.
Territorial Tax System
A Territorial Tax System is a system that only taxes income earned within the country’s borders, regardless of the citizenship or residence of the taxpayer. For countries that predominantly use this tax system, any foreign income that is earned outside of its borders is not taxed by the government. These types of systems are usually less complicated because there are no foreign tax credits to worry about and there are no anti-deferral rules. Countries that are considered Territorial Tax Systems include France, Belgium, Hong Kong and the Netherlands. It should be noted that although these countries primarily adopt a Territorial Tax System, there are certain exceptions to stop tax abuse.
The Mixed Tax System
For the most part, all countries have elements of both Territorial and Worldwide Tax Systems in place. While double taxation can exist in many countries around the world, for most residents earning income in another country, the double taxation issues to a certain extent is negligible, especially for low to mid income earners.
Advantages of Territorial Tax Systems
Let us look at some of the advantages of the Territorial Tax System.
- The resident or entity will not be taxed twice.
- Territorially Tax System for the most part, is easier to administer. Worldwide Tax System needs an established bureaucracy to enforce and administer tax laws.
- Following a Worldwide Tax System can be extremely complicated and confusing for tax payers.
- Territorial Tax Systems also are pro free market. They boost the compositeness of U.S. corporations doing business within another country’s borders.
- Worldwide Tax System can sometimes hurt free enterprise by forcing a resident or company operating outside one’s borders pay double taxation. Even with foreign tax allowances, many times the US tax rates are quite high.