Residency vs tax residency vs citizenship are three concepts that digital nomads mix up all the time. Therefore, I decided you outline what each concept means and why the difference matters.
Residency vs Tax Residency vs Citizenship: Differences in Short
Residency and citizenship on the one hand are concepts that have to do with immigration. Tax residency on the other hand is a concept that springs from tax laws.
The three concepts have some elements in common and do interlink with each other. However, it’s important that you understand why they are different. This will allow you to have a proper understanding of different structures and how to optimize your tax setup.
What is Residency and How is it Established?
Your residency is the place where your are living or where you have the right to live, where you have your residence. However, it mostly refers to the place where you have your official address or legal address.
For a lot of people, their country of residency will be the same as the country of which they are a citizen. Let’s say you are German and at the same time also have your official address still in Germany then you will have your residence there.
However, your residency should not necessarily align with your citizenship. If you are, for example, German you can easily go and live in Bulgaria and have your residency there. You will still be a German citizen but a Bulgarian resident.
In principle, you will only have one main residency, the place where you have your main official address. On the contrary, you could have different nationalities at the same time. Yet, some countries don’t allow you to have more than one nationality.
Nevertheless, this doesn’t mean that you can’t have multiple residence permits. A country can grant you a residence permit which allow you to live in the country. However, some residence permits come with the condition that you need to spend a certain amount of time within the country to keep them active.
What is Tax Residency and How is it Established?
A common mistake is to mix up residence and tax residence.
Your tax residence is the place where you qualify as a tax resident and pay your personal income taxes.
How you obtain tax residency will depend on the country in question. Some countries will purely look at the days you spend in the country (days test) while other will rather focus if you have any significant connections to the country.
So, your tax residency and where you have your residence won’t necessarily be the same place. Nevertheless, in practice they will often align.
An example of a situation when your residence and tax residence don’t align would be in the following case.
You have your residence in the country that only deems you a tax resident if you spend 183 days there and you don’t actually spend that much time in the country. As a consequence, you will have your residence in that place but not your tax residence.
On the contrary, you could also be deemed to be a tax resident by the local tax authorities in a country where you don’t have your residence. For example, because you spend a lot of time in that country while your official address is still in another country.
This could potentially lead to you being a tax resident in different countries which could lead to double taxation.
For this reason, countries have double tax treaties in place in order to resolve which country can tax which income. Yet, not all countries have double tax treaties with each other so be careful with this.
What is Citizenship and How is it Established?
Citizenship refers to the country you are a citizen of. Or, in other words, from which country you hold a passport and the nationality.
Citizenship is important as it will determine where you can easily travel or even settle yourself.
For example, if you hold citizenship of a country of the Schengen Area you can freely move around in all the countries of the Schengen Area without the need for a visa.
Moreover, you can even settle in any of these countries without the need for a visa.
Yet, you will need to register yourself with the local authorities if you plan on staying longer than three months but that is basically just a formality.
Most people will obtain their citizenship upon their birth. This could be the case when they are born in a particular country of by getting the citizenship of their parents.
However, many people still obtain a new citizenship later in life. This is mostly through citizenship by descent or citizenship by investment.
In the first case, you go through your ancestors to see if they were a citizen of a certain country and if that country offers you the opportunity to obtain citizenship in that way. Italy is an example of a country that offers citizenship by descent.
In the case of citizenship by investment, you can get a passport by investing in a certain country or making a donation. Turkey is an example of a country where you can obtain citizenship by investment when buying real estate.
Residency-Based Taxation vs Citizenship-Based Taxation
When we talk about residency vs tax residency vs citizenship we also need to have a closer look at the different ways that countries approach taxation.
Most of the countries in the world apply residency-based taxation.
That means that they will only tax you if you have a connection with their country. Basically, you become a tax resident of that country if you have your residency in the country and/or spend a certain amount of time in the country.
Therefore, you always have the option to break your ties with that country. Consequently, you can rather easily escape paying taxes in that particular country if you organize your life around it.
Yet, there is one important country that has a different approach to taxation and that is the US.
The United States apply citizenship-based taxation.
This means that as long as you are a US citizen, you will have to file for taxes in the US. It doesn’t even matter whether or not you ever set any foot in the US. It literally happens to people who were born in the US and obtain US citizenship but never spend any significant time there. They still need to file taxes in the US.
The only solution to solve this problem is to renounce your US citizenship. That means you give up your US citizenship and hand in your passport. Obviously this is only an option for people who have another passport.
Therefore, it’s much harder to put yourself out of the scope of the citizenship-based taxation.
Nevertheless, the US offer some mechanisms to limit the actual taxes that you have to pay. The two best mechanisms are the Foreign Earned Income Exclusion on the one hand and the Foreign Tax Credit on the other hand.
How to Reduce Your Taxes Effectively
The concepts of residence vs tax residence vs citizenship are a lot of time intermingled. However, you can see why it is important to distinguish them.
If you want to further increase your tax knowledge in order to optimize your tax setup you can have a look at the Tax Masterclass for Digital Nomads.
