American vs Foreign Tax Systems - an Overview
Updated: Mar 13
"A person doesn't know how much he has to be thankful for until he has to pay taxes on it." - Anonymous
The US tax system is different compared to most countries. This has been the case since the nineteenth century, however in today’s globally-connected digital age, the difference is felt more keenly, and particularly by expats.
In this article, we’ll explore exactly how America’s tax system differs from other countries.
• What is CBT?
• Why does the US have CBT?
• What systems do other countries have? (with examples)
• What does CBT mean for expats
• The intersection between US and foreign taxation
• Other tax differences between the US and other countries
What is CBT?
The US tax system is fundamentally different compared to most countries because the US taxes citizenship. This type of tax system is known as citizenship-based taxation, or CBT, and it means that all US citizens(as well as Green Card holders) have to file US taxes on their global income, whether they are resident in the US or abroad.
The US doesn’t just tax US citizens though, it also taxes resident non-citizens (known as resident aliens), and income earned in the US by non-resident non-citizens (known as non-resident aliens), so covering all bases.
The only other country in the world that currently has CBT is Eritrea, in East Africa.
Why does the US have CBT?
The origins of CBT in the US date back to the Civil War, when many northern landowners left the country, heading to either Canada or Europe to avoid the fighting. This presented a serious problem for the US government though, as landowners were the primary source of the taxes that funded the northern war effort, so if landowners were no longer resident in the US and so no longer liable to pay US federal taxes, the government would potentially be starved of funds. The solution was struck upon to tax US citizens, including non-residents, to keep the taxes flowing, and CBT was born. It could therefore be said that CBT played an important role in securing the eventual Union victory.
After the war, when the landowners returned, the system was never revoked.
What systems do other countries have?
Most foreign countries have either a residence-based (RBT) or territorial-based (TBT) tax system, or a combination of both.
A residence-based tax system means that the country taxes just those people who reside in the country. Every country has its own definition of qualification for tax residency, but typically if either your main home is in the country, or your main place of work or source of income is in the country, or you spend more than a certain amount of days each year in the country, then you are considered a resident for tax purposes there. Some countries with RBT tax residents on their worldwide income, others on just their income generated in the country.
A territorial-based tax system means just taxing income generated in the country, whether the recipient of the income is resident in the country or not.
The majority of countries have residence based tax systems. Countries with territorial systems include Costa Rica, Panama, Paraguay, Malaysia and Singapore.
What does CBT mean for expats?
If you only ever live in the US, you wouldn’t necessarily know that the US has a citizenship-based tax system, unless you have offshore income.
American expats however are directly affected by CBT, as it means that they have to file US taxes on their income earned abroad as well as any income they receive in the US.
Until recently, most expats didn’t know about this antiquated requirement, and it didn’t matter, as the IRS had no way of knowing about the finances of Americans living abroad and so enforcing CBT for Americans living abroad. In the 21st century however, through a combination of information sources, the US government can access American citizens’ financial details globally, and so enforce CBT for expats.
The information sources include credit card expenditure (if the card issuer is a US company), and bank balances of nearly all banks globally (including foreign banks), as well as foreign tax information due to information exchange agreements and information exchange clauses in tax treaties with foreign governments.
The intersection between US and foreign taxation
If an American lives in a country with residence-based taxation (including most developed countries), then they will have to pay taxes in their country of residence as well as US taxes.
The US has signed tax treaties with around 60 other countries, but rather than exempting expats from filing US taxes, these treaties state that when expats file their US taxes, these treaties state that when US citizen expats file their US taxes, they must still report their world-wide income but then may claim a credit for income taxes paid to the foreign country to alleviate double taxation.
“Tax treaties serve an important purpose for US taxation since they dictate sourcing and which country has the first right of taxation on income. They also provide for treaty resourcing income in order to utilize foreign tax credits. One key example is retirement/pension distributions. Under most US tax treaties, the country of residence at the time of distribution has the first right of taxation on pension distributions, unless otherwise stated in the treaty.” - Shannon Meyer CPA, Aspyr Group
Expats who live in countries which don’t have a tax treaty with the US can also claim foreign tax credits. Tax treaties can be useful for some expats though, as some tax treaties retain the tax benefits of US retirement plans abroad, for example (and vice versa).
So while expats always have to file US taxes, when they file they can claim US tax credits to avoid double taxation. There is another provision called the Foreign Earned Income Exclusion which can also alleviate double taxation, and which is sometimes more beneficial, so always consult a US expat tax professional to ensure you’re filing from abroad in your best interest.
An American living and working for a French company in France will have their income taxes deducted at source, so they may not have to file a French income tax return, if employment is their only source of income. They will however have to file a US tax return to report their French employment income to the IRS. When they file Form 1040, they can also file Form 1116 to claim the Foreign Tax Credit, which will give them US tax credits to avoid double taxation. They may also have to report any foreign-registered financial accounts and assets that they may have.
Other tax differences between the US and other countries
Aside from CBT, US taxation has some other notable differences compared to most foreign countries.
First, the US has relatively low personal income tax rates compared with most European countries (or more specifically, higher thresholds, resulting in lower tax bills).
While in most countries, income tax rates increase for higher income amounts (including the US), some foreign countries have a flat tax, meaning the same personal income tax rate is applied to all income. Examples of countries with a flat rate of income tax include Bolivia, Belize, Romania, Mongolia, Estonia, and Georgia.
Many foreign countries have additional taxes that the US doesn’t, such as wealth taxes in France and Spain for example, and solidarity taxes in Germany.
Some countries have no income taxes meanwhile, such as the Bahamas, Bermuda, the UAE, and the Cayman Islands.
Penalties for not filing taxes are almost always stringent in all countries, so it’s best not to act based on hope or assumptions.
Every country has its own tax rules, and while the US CBT system is different, you shouldn’t make any assumptions or rely on online research about other countries’ tax systems as a substitute for seeking trustworthy expert advice.
If you have any questions, don't hesitate to contact us.
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