Many nomads don’t understand the difference between worldwide vs territorial tax system. These are two different systems that countries apply to determine which income they take into account to calculate your tax liability.
The Difference Between Worldwide vs Territorial Tax System
The main difference between worldwide vs territorial tax system is the income they tax you on.
In a worldwide tax system you will pay tax on your worldwide income unless you can fall back on some provisions to exclude that income from taxes.
In a territorial tax system you will only pay tax on the income that you earn locally from within that country.
What is a Territorial Tax System?
In a territorial tax system, you only pay tax on local sourced income. You don’t pay tax on income from abroad.
Nevertheless, some countries with a territorial tax system might still tax you on the foreign income if you repatriate the money back into the country.
Furthermore, an important remark in this respect is that you might still need to pay taxes on this income in the country it originates from.
Many digital nomads think that having tax residency in a country with a territorial tax regime is a magical solution to save taxes. Unfortunately, this isn’t always the case.
The reason for this is that they don’t understand the concept of foreign sourced income very well.
Let’s say you own a property abroad and you receive (passive) rental income from it. This income is clearly and actually coming from abroad as the real estate is situated there and as such you create the value abroad.
However, this isn’t necessarily the case for your professional income.
Let’s take the example where you work for a client abroad and he pays you for your services from abroad. Some nomads think this is sufficient to speak from foreign income.
Accordingly, they come to the wrong conclusion that this income isn’t taxable under a territorial tax regime.
The contrary is true. If you perform your services locally in the place you are a tax resident of, this will in most cases not be seen as foreign sourced income. Therefore, you would actually pay tax on it in that country.
The reason is that you create the added value locally and not abroad. The only foreign element is that the payment comes from abroad.
Nevertheless, there are some countries that offer you tax benefits if you bring in money from abroad as a freelancer (e.g. Turkey).
The same can apply if you work for your own foreign company. Here, you also need to take into account the aspect of management and control and the rules on permanent establishments.
What is a Worldwide Tax System?
Most (Western) countries apply the concept of worldwide taxation (1).
This means that you need to declare all your income, irrespective if it originates from within the country or from abroad.
Consequently, you will in principle pay tax on all your income.
However, this could lead to the fact that you pay taxes twice on the same income. One time in the country where your income originates from and one time in the country where you have your tax residence.
Luckily, in practice, this is not always the case. The reason for this is that many countries have so called double tax treaties in place. These double tax treaties determine who can tax the income.
For income from real estate, for example, the double tax treaties state that you pay tax on the rent or capital gains in the country where the real estate is situated.
As a consequence, the country of your tax residence should exempt the income from taxes or give a tax credit for the tax paid abroad.
Yet, sometimes they take this income into account to calculate your tax rate for the other income.
How to Optimize Your Taxes
Understanding between worldwide vs territorial tax system is important if you want to do tax planning as a digital nomad.
Especially regarding territorial taxation there a lot of misunderstandings are out there. So, it is important to have a good understanding about the concept and to know how it applies to your personal situation.
If you are a freelancer selling your time, a territorial tax system will often not change so much from a tax point of view if you are still performing your work from the country.
If you want to learn more about how to save on taxes, I recommend having a look at the Tax Masterclass for Digital Nomads.
