The Ultimate Guide To Territorial Taxation
Misunderstanding Territorial Taxation
Of all the subjects I see written about on the internet, nothing is more convoluted and misrepresented (often dangerously) as territorial taxation.
We’re going to clear those misunderstandings up right now so you can be clear and point others to this resource when they start babbling about something that’s frankly inaccurate and potentially illegal.
What is Territorial Tax?
If you go back to the 3 Pillars of Residency I teach at Offshore Capitalist you’ll recall the first pillar is “the residency of the company”.
This means all of the income of the company or person is subject to the tax rules of whatever jurisdiction it is considered resident.
Recall residency is different from registration, therefore a company could technically be resident in multiple jurisdictions — or none. It always depends on the facts and laws applicable.
This is true everywhere in the world, regardless of the jurisdiction.
However, being subject to the tax rules of a country doesn’t mean you are subject to the taxes of the country in question. It is possible to have a company or individual resident in a jurisdiction and not be taxed by that jurisdiction.
What portion of the income of a company or individual a country chooses to tax is what we call the “taxation basis”.
Most of the world applies worldwide taxation.
Worldwide taxation means all income of the company, no matter where in the world it is sourced, will be taxed in the jurisdiction where the company (or individual) is a tax resident.
Just because a rule isn’t enforced or just because someone doesn’t get caught doesn’t mean what they are doing is legal.
Michael Bruce Rosmer
Now, a quick interjection here.
There's a lot of crap circulating in the media around this point. To be direct and clear with you, you shouldn’t be taking tax lessons from the media.
Media reporters aren’t tax experts.
They often don’t even understand the basics of business, let alone tax — and certainly don’t understand international tax.
I can’t count the number of times I’ve seen it reported in the news (generally when comparing the US to rest of the world) that “most countries only tax local income” or “most countries have territorial tax and the US is one of the few still applying worldwide tax”.
This is total and complete utter crap!
Probably 70-80% of the world’s countries, including every country in Europe (except France and to a certain extent Gibraltar) apply worldwide taxation.
Worldwide taxation is the norm.
I’m not sure where media reports come from, but I see it in articles all the time. I suspect they are confused about the rules surrounding the repatriation of foreign dividends and taxation basis.
(It’s fair to point out treatment of foreign dividends varies, but it’s not the subject of this article.)
Some other countries in the world don’t tax worldwide income.
These countries tax on what’s called a territorial basis meaning “tax is levied only on sources from within the country”.
This accounts for perhaps 20% of the countries in the world.
Then, there are some other countries with either quasi-territorial tax or some form of remittance tax, which we’ll avoid in this article.
The Benefits of Territorial Tax
It’s pretty common to see people forming companies or moving to countries with territorial tax. Some of these include but are not limited to:
- Costa Rica
- Hong Kong
There are also some countries with territorial tax for the business, but not for individuals or vice versa — such as Thailand.
I’ve read some articles where the idiotic and irresponsible statement is made “paying no tax starts with setting up in a country with territorial tax”.
We’ll explore in a moment why this could be a recipe for a big tax bill and fines down the road.
On the surface, it might be true.
If you or your company are resident in a jurisdiction with territorial tax, it’s possible to receive income without paying any tax.
From a tax planning standpoint, this is usually most useful because countries with territorial tax often have extensive tax treaty networks, which countries without tax do not.
So yes... potentially... having a company resident in a jurisdiction with territorial tax, or being resident there yourself, could result in zero or much lower taxation.
However, not necessarily.
The Tricky Part About Territorial Tax
With the basics out of the way, let’s dig into the meat and potatoes of these rules and where people totally miss the mark.
We’ve established territorial taxation means “resident persons are taxed only on income from local sources”.
The problems arise when we start to ask what does “from local sources” mean?
Turns out this is not a simple question to answer.
The answer that’s generally wrong and where most people screw it up is they think “local source income” refers to the location of the customers.
So, the argument is, “well the customers aren’t in the local country, so it’s not local income”.
This is ALMOST NEVER TRUE!
Before we dive into the details let’s pose a series of scenarios:
- Let’s say your company is local, your customers are local, but you and the work being done are taking place outside the country? Is it local income?
- How about if you and the company are local but you’re using a team outside the country to provide services to customers within the country? Is it local income?
- What if the customers are outside the country but you and the team and the company are all local? Is it local income?
- What if you’re lending money from within the country to a debtor outside the country is the interest local?
- What if you’re lending money from outside the country to a debtor inside the country is the interest local?
- Where does the money technically reside anyway? Is it where the bank account is? Is it the balance sheet?
- What if you’re shipping goods from within the country to customers outside of the country? Is it local income?
We could go on and on with scenarios but hopefully, this helps to illuminate the complexity of answering the question.
At this point you might be asking, “ok Michael was is local income?”
The answer, unfortunately, is “there is no answer”.
It’s not as bad as it sounds though.
The reason there is no answer is that not all forms of income are considered sourced the same and not all countries have the same rules.
To really make the most of the territorial tax you need to dig into the local country rules, rather than assuming they are all the same (like a few self-proclaimed experts on the internet do).
Defining Local Source Income
The easiest place to start is with tax treaties and some general definitions.
In most cases, income arising from or attributable to permanent establishments is deemed local source income.
However, be careful because the definition of a permanent establishment (a topic for another article) is a lot broader reaching than you might expect.
A person in the right circumstances can be considered a permanent establishment.
Interest, dividends, and royalties income are considered sourced based on where the payee is located.
In other words, if you loan money to someone then wherever that person is located is deemed to be the source of the income. We’ll dig into some details to clarify.
Not to get you more confused, but dividends are often treated separately so we need to be careful.
Although not necessarily so, rent is also often considered sourced where the customer or use of the property is located. Again, not to make it more complicated, but it very often matters what sort of property you’re talking about (real estate being treated differently from machinery).
Those are the easy ones to understand and you’re generally safe (though I still recommend looking into the specifics for each given country to be sure) assuming:
- Income from permanent establishments is sourced in the location of the permanent establishment especially where a tax treaty is in place
- Interest, Royalties, and Dividends are sourced where the customer is located (varies by residency of payer, location of payer, use of property)
Before going on let’s note an important nuance.
Usually, those types of income are also subject to withholding tax at source, which again can get you into trouble.
We now get into the sale of goods and services, which make up most business.
As a starting point here’s a handy chart provided by the IRS, who do a better job than most at clarifying how they define the source of given income:
Do not make the assumption that because this is how the US applies the definition, other jurisdictions apply it the same.
It is, however, useful because a similar logic frequently applies so it gives us a bit of a potential clarifying piece of data.
Here are two illustrative examples.
Malaysia taxes only income from local sources… but literally, doesn’t define what income from local sources means in their tax law.
Seems really stupid, right?
So, in this case, we are forced to examine their case law to see what’s been ruled in other cases.
The problem is, in many scenarios, there is no available case law. Sometimes legal experts resort to examining Hong Kong and Singapore case law since Malaysia tends to behave in a similar manner.
There is a pretty famous Malaysian case where a Malaysian company lent money to a Dutch company and decided not to pay tax on the interest. It argued that it wasn’t locally sourced — it was sourced in Holland.
The Malaysian tax authority argued the money originating from a Malaysian source and was, therefore, Malaysian source income. It turned out the court ruled in favor of the lender, not the tax authority, but it shows how these matters can be complicated.
Another example not related to territorial tax, but worth observing is China.
Most of the time services are deemed sourced where they are performed, but in China services performed abroad for clients in China are deemed Chinese source income and subject to withholding tax.
Around the world director’s fees and technical service, fees are also often subject to withholding tax.
Common Jurisdiction Examples
Since the most common examples of territorial tax apply to Hong Kong and Panama — let’s look at both of those parts of the world.
Hong Kong applies what they call “the operations test”.
Business people are usually incorrectly advised to form companies in Hong Kong with a view that “it’s only Hong Kong source income that’s taxed and none of my clients are based in Hong Kong”.
The problem is, this isn’t how Hong Kong defines local source income.
In Hong Kong, the definition of local source income is any income arising from operations that take place in Hong Kong — and they’ve become stricter about enforcement over the last few years.
If you’ve got no one present in Hong Kong you probably won’t be taxed in Hong Kong, though you might be taxable elsewhere and might not meet the standards under tax treaties of being tax resident exclusively in Hong Kong.
This brings us to Panama... a source of eternal frustration.
Let’s start with basics.
Just because a rule isn’t enforced or just because someone doesn’t get caught doesn’t mean what they are doing is legal.
There are plenty of cases where people (especially in less developed countries) don’t claim income, don’t pay taxes, etc.
They haven’t gotten caught or in trouble. This doesn’t make what they are doing legal.
Panama has a lot of examples of this.
Panama realizes where their bread is buttered. They realize their international status as a tax haven and as a result are fairly lenient in the application or enforcement of their tax laws — particularly where corporate tax is concerned.
This could easily change and suddenly, in a cash crunch, a lot of companies basing themselves in Panama could be in for an unpleasant surprise.
This includes the application of their corporate residency rules (rarely policed at least in the case of foreigners who have relocated to Panama) and their local source income rules.
Article 694 of the Panamanian Tax Code covers the subject of territoriality and it’s been modified numerous times over the last decade or so.
This territoriality applies to both active and passive income.
The language is somewhat confusing (why do they insist on confusing legalese in these things?) so we’ll keep direct quotes to a minimum and you can look it up yourself if you’re interested.
Obviously, we’re applying the English language in this case, rather than the native Spanish.
The code includes several portions we’ll attempt to cover individually — and in no particular order:
- “Income received by persons not domiciled in Panama as a result of services or actions benefiting persons domiciled in Panama.” The services or actions must be related to the generation of Panamanian-source income or the preservation of capital and the payment made for the services or actions must be registered as a deductible expense by the payer.”
This applies particularly to foreign persons (and not Panamanian persons).
It has numerous consequences. It was also amended with several exceptions in 2015.
Note, under this test if the clients are domiciled in Panama — the income is considered Panamanian source.
Let’s expand beyond this and look at what happens when clients are local.
- “Taxable income is defined as the one produced, from whatever source, within the territory of the Republic of Panama, regardless of place where the income is perceived.”
Note, this is pretty broad or could be.
Certainly, broader than simply having the customers in Panama. Normally, “from whatever source” refers to capital and labor, which is located in Panama.
When you get down to it, this essentially covers all operations in Panama.probably not what you’ve been told and in fact not how many foreigners operate through Panamanian companies, which largely go unenforced.
Probably not what you’ve been told?
Here are some common examples people will say “aren’t taxable because Panama doesn’t tax foreign income” but actually should be included in personal taxable income:
- From personal labor rendered on behalf of another and in an economic employment relationship or legal subordination, in accordance with the Labor Code, such as wages, salaries, overtime payment, daily wages, director fees, gratuities, commissions, pensions, old-age retirement pensions, fees, representation expenses, bonuses, profit participation, productivity premiums, thirteen month bonus, in kind income and subsidies, among others.
- From the exercise of any profession, artistic activities, scientific activities and other services carried out on one’s own belief without an employment relationship.
- From commercial, industrial or financial activities, from mining operations, from construction and from the rendering of public or private services.
- From the employment or investment of capital in any form or nature, such as interest loans, certificates, bonds and private securities, profits or dividends distributed among partners and shareholders.
- From any gain or prize not exempt by law, obtained by luck and chance in activities of entertainment or amusement, operated by persons under private law.
- From any revenue which is received in a compensatory manner, insofar as it is not exempt by law.
- Generally, from any other activity not expressly exempted by the law, or that constitutes a business of production, purchase, sale, trade in, exchange or disposal of property, or derived from the rendering of personal services or generated by a combination of productive factors of capital and labor, or that is expressly taxable by provision of law.
Note, this will include investing, trading, gambling, etc.
Bottom line — there are a lot of foreign people moving to Panama, not paying taxes where they should be.
Oh, and in case you think, “well my company is paying for my house for me” — these along with vehicles, travel, education, and leisure expenses are all expressly noted as something the individual is required to include in their personal gross income.
If you think about it, from the logic perspective, this all makes sense.
Panama, as a country, doesn’t want to not tax its people for selling abroad or for trading on foreign markets.
If this was the case everyone would be aiming to sell to foreign markets and not local markets.
There are several exceptions to this local income — of which we’ll detail two of the big ones:
- Invoice, from an office, established in Panama the sale of merchandises or products for a higher amount of that for which such merchandises or products have been invoiced against the office established in Panama, always that such merchandises or products only move outside.
- Manage, from an office established in Panama, transactions that perfect, consume or have effects abroad.
1 – refers to cases where goods are bought outside of Panama and shipped to clients outside of Panama. In other words, if goods are produced in Panama and shipped to clients abroad or purchased in Panama and sold abroad — this is subject to Panamanian tax along, generally, with foreign sourced goods sold to Panamanian domiciled persons.
2 – refers to when the operations are performed outside of Panama and the only activities in Panama are management duties.
Now, what a lot of people are going to say is something along the lines of “I was told…”
The truth is, a lot of people are taking advantage of easy residency permits in Panama. Forming a company there, living there and working virtually from there and not paying any tax.
Many of these people by law should be paying tax, but Panama isn’t big on cracking down on these situations at the present.
Do not confuse what people are doing and getting away with — and what is actually required by law.
If activities aren’t carried out abroad there’s a good chance they should be taxable domestically. One could make a slim argument around managing ad budgets or something comparable... say in the case of affiliate marketing, but if Panama were to get aggressive (they aren’t at the moment) it’s questionable if this would hold up.
The final country I’ll mention, which is very similar, but arguably more aggressive about enforcement is Costa Rica.
Once again, you’ve got all kinds of people running around saying, “if your customers are foreign you don’t pay local tax”.
This is wrong.
The Costa Rican tax authorities are erratic when examining transactions.
It’s true, like Panama, they aren’t the most diligent about being informed about what’s going on in their country.
However, when they are reviewing transactions, it is important to ensure the activities took place outside of Costa Rica where economic activities are concerned at all.
Hopefully, this has shed some light on a lot of the nonsense surrounding territorial tax and you’ve learned to ask some deeper questions.
It’s worth noting that often you’ve got other taxes — such as withholding taxes — to consider in addition to simply the regular taxes. You should be considering the residency of your company, not just where the company is registered, as it could come bite you in the future.
All of this is on top of the layers of anti-avoidance rules (CFC, transfer pricing, etc.). There is a reason tax planning takes careful consideration and costs a significant amount of money.
If you’re interested in discussing your specific situation, because there is never any one size fits all approach, please feel free to contact me by phone at www.clarity.fm or at www.offshorecapitalist.com.