3 territorial taxation traps that you should be aware of to avoid surprises

A term which you will often come across in our articles is territorial taxation. Territorial taxation is one of the 6 tax systems that exist in the world. This type of taxation, unlike (universal) residence taxation, does not require us to be taxed on all our worldwide income, but applies a principle of territoriality that exempts foreign income from taxation. In other words, when we are tax residents in a territorial taxation country, we only pay tax on domestic income.

However, territorial taxation works differently in every country. The idea that foreign income is not taxed seems simple, but is subject to very different interpretations depending on the country.

For example, in some cases, foreign income is considered national income when the value has been generated in the country, even if the clients live in other countries.

Therefore, the only way to remain tax-free with a company located in a territorial taxation that applies this form of territorial taxation would be to use shell companies, which, although registered there, do not actually carry out any activity in the country (similar to what is done with American LLCs to avoid paying taxes).

One of the main aspects that we need to take into account is the separation of the principle of territoriality between individuals and commercial companies. While certain countries have a territorial taxation system for both (Panama would be an example), there are also others that only apply it to companies (like Morocco) or for individuals (as in the case of Georgia). You have to be very careful not to fall into a tax trap. The aim of this article is to summarise the main exceptions regarding territorial taxation to avoid making mistakes that could end up being very expensive (although, of course, if you want to avoid serious mistakes, the best thing to do before setting off is to book a Denationalize.me consultation).

Territorial taxation on legal individuals

The main difference of the territoriality principle is the distinction between physical and moral people (companies) like commercial companies or foundations. In many countries, territorial taxation only applies on one of the two levels, while the other are governed by the principle of universal taxation. Making a mistake here can end up being very costly.

Of course, there are also countries where territorial taxation applies on both a business and personal level. For example, these include several Latin American countries that are well known to our blog readers, such as Panama, Nicaragua, Costa Rica, Guatemala and Bolivia.

On the other hand, countries such as Georgia, for example, only exempts foreign income of individuals from taxation. The situation is similar in most Asian countries with territorial taxation, such as Thailand, Malaysia and the Philippines. This is also the case in Paraguay now. In all these cases, the best option is to set up your business abroad (in countries like the Emirates, Romania, Panama, Cyprus…) or through a partnership in the USA, Canada or the UK.

The American LLCs, the British LLCs or the Canadian LP, are not taxed in the country where they are located (United States, UK or Canada) as long as no work is done there and they do not have domestic clients (except in the case of American LLCs, where it does not matter if you have domestic clients). These partnerships are fiscally transparent companies, which means that the owners have to pay taxes where they are tax resident. Given that you would be a resident in a country where foreign income is not taxed, you would have the perfect combination. Practically all countries with territorial taxation on a personal level work well with partnerships.

Finally, there are other countries that have taken the other route. Instead of not taxing personal foreign income, they offer tax-free foreign income to their companies. This is the case in countries such as Hong Kong, Singapore and Morocco. Individuals are subject to tax on global income, but the income received through their local companies from abroad can be tax-free. In these cases, you have to pay attention to the place from where the added value of the foreign income was generated.

If the service is produces or carried out domestically, the usual corporate income tax applies. On the other hand, if the work is done outside of the country and the client is foreign too, the income would be tax-free.

Another interesting territory in this context is Gibraltar. This little British jurisdiction on the southern tip of Spain allows you to start a local company (even if you are not a resident there) that is not taxed on foreign income.

Neighbouring North African countries also have similar regulations. Few people know that Morocco, Algeria and Tunisia are tax havens on a corporate level. While in these three countries taxpayers are taxed as individuals on their worldwide income, all foreign income on a corporate level is tax-free. Nevertheless, we should not forget that the bureaucracy required to set up a company in any of these three countries tends to be very high, and therefore is not a great option unless you have good contacts there.

Finally, there is still a variety of exemptions to the application of territorial taxation. One example is Uruguay where territorial taxation is unlimited at company level, but limited when private residency is involved. There, foreign dividends are taxed up to 12.5%, unless the country where the company originates has already applied an (equal or lower) withholding tax.

 

On the contrary, in Moldova, as an individual, income received from abroad tends to be tax-free, whereas income received by local companies is not.

In Thailand, foreign income from individuals is not taxed as long as it is not transferred to Thailand in the same year in which the earnings are made. In other words, you have to wait a year before being able to use your money in Thailand. On the other hand, if you have a Thai company, the principle of universal income taxation applies.

These are only a few of the 50 more countries worldwide where you can easily manage to pay little or no tax.

As you can seem it is crucial to know up to what level and in which cases foreign income is exempt from taxation and whether there are any exceptions to be taken into account.

Temporary territorial taxation for fiscal immigrants

Many western countries with high tax rates are also attractive for short-term stays. For example, few people know that you can live tax-free for a certain amount of time in Chile, Australia, New Zealand, China and South Korea. The reason is that, in these countries, the tax exemption of foreign income is linked to the duration of stay in the country. In general, this applies to everyone who is not a citizen and also occasionally to citizens who have lived abroad for a certain period of time.

Immigrants who arrive in Chile and New Zealand are exempt from tax on foreign income for the first three years of their new fiscal residency. They only have to pay taxes on global income starting from their fourth year. In Chile, this can even be extended for another 3 years if requested.

This is interesting because both countries naturalise their immigrants relatively quickly. Both citizenships offer excellent passports and a high level of visa exemption, very similar to Germany. Moreover, both can be obtained virtually with only one year of tax payment (4 years until naturalisation in New Zealand, 5 years in Chile).

Australia also has a very interesting regulation for those who want to explore the country. Even if you stay more than 183 days in the country and in principle become a tax resident, no worldwide income tax liability arises. Those who are working in Australia with a 400, 457 or 482 day work visa will only be taxed for their Australian income (not on their worldwide income).

This also applies to the “Working Holiday Visa”, which is very popular amongst young people, which allows you to live and work in Australia for 2 years (subject to 3 months of agricultural work). Even with permanent residency, foreign income will continue to be exempt from tax.

Another example is the People’s Republic of China. Many foreigners highlight that it is very difficult to obtain a tax identification number. Moreover, they do not tax foreign income in China if they leave the country annually for at least 30 days. It is therefore recommended to take a month’s holiday outside China every year to be tax-free.

While many Asian countries already have a territorial taxation system, others only apply it for the first few years after immigration. Even ultra-modern countries such as Japan and South Korea grant immigrants full freedom on their foreign income for the first 5 years. However, in this case it is also important to take into account the Place of Realisation Principle. In other words, in practice only foreign investment income is tax-free during long-term stays.

Strict vs. permissive territorial taxation: place of performance of work

Although territorial taxation exists on both a personal and business level, it is important to define and delimit foreign and domestic income. This is best understood through the example of Hong Kong, whose tax office income delimitation very transparent.

If you have your tax residency in Hong Kong, you are subject to tax on worldwide income. However, if you start a company there, you will have the chance to receive certain foreign income tax-free. Hong Kong applies the principle of the place of performance of work and use of the good or service. If it is a one-man company with a director in Hong Kong, then the business would normally have to pay tax in Hong Kong, as it would be considered domestic. However, if the director frequently travels abroad to carry out personal consultations or seminars in other countries, the income generated would be exempt from tax because it has been made outside the territory of Hong Kong.

Ultimately, it all depends on the place where the added value of a product or service is generated.

Hong Kong companies have regained their appeal thanks to local online banks such as Neat and Currenxie, who now allow you to easily open a business account. However, business partners have to be very careful not to fall into a tax trap, like the requirement for the Hong Kong company to have sufficient grounds to be recognised in the partners’ country of residence.

 

Normally territorial taxation applies to companies in Hong Kong. If the manager and employees are located outside of Hong Kong, this means that what is established in the city is simply a shell company, work is not carried out there, and, therefore, the company is not subject to tax.

However, contrary to offshore companies that are less regulated, in this case you must establish a monthly accounting system which will be audited at the end of the fiscal year. This audit is carried out for the sole purpose of checking whether the income booked is actually foreign income in accordance with Hong Kong principles (if you need help with incorporating your company in Hong Kong, with accounting or with opening company accounts there, we can put you in contact with our associates in Hong Kong).

In Hong Kong, you can request a so called “offshore status” if you prove that you do not have any type of business relationship within the country. However, this request is quite difficult to complete and, if you are rejected, it will result in a tax penalty on your company’s global income. Therefore, we do not recommend you to use the Hong Kong company with offshore status.

Denationalize.me can help you through its associates to incorporate your company in Hong Kong for approximately 2400 USD.

In regards to using a company in Hong Kong with personal residency in a country with high tax, you will be faced with the problem that your country of residence will not recognise such a foreign company if it does not have sufficient grounds. However, on the other hand, if your company has business substance, Hong Kong will understand that the income is domestic income and we will have to pay tax on it. Since most of the management and value generation is done from Hong Kong, foreign income is treated as domestic income and is subject to the usual corporate income tax rate of 17%, (the first HKD 2,000,000 is only taxed at 8.5%).

Only when the employees of the company travel abroad for seminars, consultations, etc, the value creation will take place abroad and the profits will be tax deductible. Therefore, it is worthwhile to establish a company in Hong Kong, especially if it is a shell company. In any other case, you should carefully asses what to do.

This regulation does not only exist in Hong Kong, it also exits in the majority of countries with territorial taxation, in different forms. For example, if a Panamanian lawyer charges a fee for helping you establish residency, he will have to pay tax on it. If, on the other hand, he receives income from a foreign investment, he too will be exempt from tax. Therefore, you should always take into account the place of performance or performance of any service.

When personal service is effected in the territory of the state in question, the result is obvious. However, in the case of products sold virtually or online coaching, the situation gets complicated. According to tax laws of many territorial states, it all depends, for example, on the location of the server of the websites where these digital products are sold. If the server is located outside of the country, the income from the website would be tax-free. The situation is the same for capital gains and dividend income earned through broker accounts in other countries. If the account is located in a third country, the income would be tax-free.

But, what happens if you, as a resident of Paraguay with a local presence, carry out an online coaching session with a Spanish client? This depends heavily on the rules that apply in each country. Although, the service is physically provided in Paraguay, it is a service with a client outside of this country. In general, and particularly when you are foreign, this income will be exempt from tax, for example in Panama and Paraguay. You also have to keep in mind that tax residency per se is only activated after 183 days. Although you can voluntarily file a tax return after spending a few days in your new residence, you are not obliged to do so.

Some countries, like Hong Kong and Singapur, examine each case more closely. Each case must be assessed independently according to its place of enforcement and realisation. The Hong Kong tax authorities, influenced by court decisions over the years, examine the following factors:

Treatment of the facts

Not only does the source of the profits matter, but also the nature of the income and the transactions associated with them. There is not always a hypothetical universal applicable framework.

Business activity

The aim is to see how and where the taxpayer generates his income. It is always a question of generating a concrete value for a specific income. This income must be assigned to a specific person in the company whether they are employed in Hong Kong or outside Hong Kong.

Occasional or preparatory activities

The relevant activity should be seen in the context of the other activities. It is purely about the added value of certain income, and not about other activities related to its realisation (preparatory or occasional).

Effective management

The place where the company is managed from is only one of the various factors to be considered. However, in general, this is not decisive, given that management often only deals with administrative tasks rather than value generation.

Gross transaction income

Domestic and foreign profits should be considered in the broader context of total earnings.

Global branches

The fact that a branch outside Hong Kong normally respects the Territoriality Principle does not imply that all Hong Kong companies without an overseas presence are automatically subject to tax. However, if the offices, managers and employees are located exclusively in Hong Kong, you can, in principle, request a worldwide tax liability.

Conclusion

To conclude, you can say that, everything that happens inside Hong Kong is subject to tax in Hong Kong. This includes income from rent and sales from real-state in Hong Kong, the sale of shares and other assets through a Hong Kong stock exchange or licensing fees on rights or patents registered or used in Hong Kong.

Normally, services are only subject to tax if both the client and the service provider are physically located in Hong Kong. If the service provider is located in Hong Kong but the client is abroad, it would be very important to determine the type of service. When, for example, the servers are operated remotely and they are not located in Hong Kong, this service is exempt from tax. In principle, and in agreement with the principle of territoriality, online consultations are also exempt from tax, as long as the other business activities are not solely directed towards a full on-site consultation. Regarding the payment of commissions, it all depends on the place where the payer carries out his activity.

In the world of e-commerce in Hong Kong, the important thing is not where you sell products; it is where they are manufactured. Products manufactured in Hong Kong are also taxed on their sales. However, if the products are send from the People’s Republic of China and meet the requirements, they are exempt from tax. If, however, in addition to the Hong Kong companies, we expand our headquarters in China, you must make contracts accordingly. In this case, it is common to tax 50% of the profits in Hong Kong, while the rest remains tax-free.

If in doubt, you should ask for the opinion of the local tax office, as well as a local specialist tax advisor, as some cases may be difficult to resolve. This “Advance Ruling” can be applied for in Hong Kong.

You will find more information about the principle of territory in Hong Kong on their tax office website.

Territorial taxation is therefore a very interesting model of tax planning for both companies and individuals, but it should be approached with caution. Income from abroad is not always exempt from taxation, but is subject to certain conditions depending on the country.

If you want us to help you on your particular case, you can book a consultation here.