What’s a good tax residency? (And why it matters)
“Tax residency”, you say?
Wow, this is going to be boring.
I hear you.
But do listen up folks.
A bit of know-how on your basic tax residency rules will get you a long way.
I’d say this is the number one way to legally reduce your taxes as an individual.
You could potentially go from 43% to 10%, or even 1 or 2%.
You can’t do it from your lounge room, sure.
But with some adjustment, some sacrifice, you can drastically adjust how the tax rules apply to you.
You need to be mobile, though, and that’s where we put the “suitcase” into Suitcase Investor…
What’s a tax residency?
I guess the first thing to cover is how governments tax their people.
Generally speaking, for income taxes at least, they look at who is resident in their country.
In other words, who is living, working, and basically treating the place as their home.
It stands to reason these people are consuming public services and should be paying taxes.
This is your tax base as a government.
Many of these people are usually citizens.
And so the analysis is simple for people who are born, live and die in the one country.
So if you are a German citizen and you grew up in Germany, and you never moved, then – no surprises – you are going to be a German tax resident.
You are going to need to file your German income tax return and be assessed for taxation as a tax resident.
You already get this. If you’re from Texas, have always lived in Texas and still live in Texas – you are home turf for the IRS.
But, of course, countries have immigrants and new people arriving.
If you move to Germany or the USA, to start work or to study or retire, then you will at some point become a tax resident of Germany or the USA.
You’ll also stop being a tax resident of the country you moved from.
So if you are a Turkish citizen that moves to Germany: You’ll become a tax resident at some point in your first financial year in Germany. Generally speaking, you’ll also stop being a tax resident of Turkey during this time.
Same deal with moving to the USA.
It gets complicated for you and for governments if you move around during your life.
Most people don’t think twice about this and a change of tax residency is dwarfed by other changes in their life.
It happens unconsciously for them.
It’s automatic too.
However, it doesn’t have to be an uncontrolled event. It can be managed and you can take steps to remove the uncertainty around changes in your tax residency status.
Key point: You can change your tax residency
But let’s back up.
Here’s the opportunity in all this.
From what we’ve said above, you now know it is possible to change your tax residency.
This is a key concept.
And it is the number one way to change how tax rules apply to you.
Once you know you can change, and assume you are willing to change your tax residency, it’s possible to select a country where the tax rules are favorable to you.
And this is where strategy can come in for people who are prepared to be mobile in how they approach business and life.
There’s another key assumption here.
Key point: immigration residency and tax residency are not the same thing
The tax rules determine whether you are a tax resident or not.
The immigration rules determine whether you are a resident for immigration purposes.
Often your “residency” will overlap- so you are both a resident for immigration and tax.
However, it is possible to be an immigration resident and not a tax resident.
For example – you could have a residence card for Panama.
This means you are a resident, right?
You have to look to the tax rules to work out whether you are a tax resident or not.
Panama’s tax law says you need to live in the country for 183 days per year to be a “tax resident”.
Just relying on your immigration visa or temporary residence permit, for example, will not be enough.
This is a good distinction to keep in mind.
It is something folks often get confused.
All this said, your immigration status is important – it gives you the right to live, stay and do certain activities in the new country and often getting a residence permit or visa will be the first step to becoming a tax resident.
But, again, it is not necessarily the same thing and you should plan on these being different steps in your plan.
What am I looking for in a tax residency?
OK, so what am I looking for in a new tax home?
There are a few key points you’ll want to verify:
- what is the rate of basic income tax
- whether worldwide income is taxed (or not)
- whether there is a capital gains tax
What is the basic rate of income tax?
The basic rate of income tax is of course very important.
This is the rate you get taxed on as a resident.
It can vary wildly, from north of 40% in European or OECD countries, to about 10% or even 0%.
The classic example of this is tax on income you earn in employment in the country.
So if you have a job, and it is paying more than x, then you will pay tax at these rates.
While this number is important, it may not be the most important number for you.
This is because you will also want to check out:
- whether foreign income is taxed
- whether there are any tax holidays or special incentive schemes for new residents
- whether the higher rates of tax will apply to your level of income
For example, Portugal has the usual (very high) rates of income tax for a European country.
You are looking at 48%.
But there are ‘tax holidays’, or long-term incentives, that can lower the rate of tax you pay for some time.
Like for years and years sometimes.
This can be quite attractive and enough to get you in and settled.
When your tax holiday expires, you can move on or perhaps you’re interested in staying at that point and have other priorities.
(Or you might have some time to structure your tax affairs, etc.)
The other important what is what are the rates, or thresholds, are how are these likely to apply to you?
Many countries have a progressive tax system.
This means that the first part of your income is taxed at nil rates or lower rates than your income above a certain amount.
For example, and sticking with Portugal, if you earn EUR 18,000 per year you will pay very little actual tax.
But if you are pulling in EUR 150,000 or EUR 1,500,000 it will be a very different picture – depending on whether you have any tax holidays to point to.
Is your worldwide/foreign-sourced income taxable?
Most countries do tax your worldwide income if you are a tax resident.
So (for example) if you a USA, French, Canadian, Australian or UK tax resident – you need to pay tax on both your local income and any foreign income you have.
It all goes in together to make up your tax bill or “assessable income”.
Many of the large, developed countries tax worldwide income.
Note: Some countries- like the USA and Eritrea – tax you on your worldwide income wherever you are, i.e. whether you are tax resident or not. This is terrible but this is the exception.
Most countries will only take a grab at your worldwide income if you are a tax resident.
But get this.
Some countries may tax foreign income at a lower rate, or they may not tax foreign income at all.
Obviously, if you have a high proportion of foreign income, then this could be very favorable for you.
Putting this together: if you can change your tax residence, then you can potentially change whether you get taxed on your worldwide income or not.
What about capital gains tax?
Capital gains tax is another one to look out for.
This is a tax on an increase in the value of your capital assets over time.
Think stocks, property and the like – if they go up in value, then the increase in value can be subject to tax.
Usually, these gains are taxed at their own rate or taxed as part of your overall income, depending on the type of system in place.
If you have substantial investments, you may prefer a tax system that does not tax capital gains.
Alternatively, you can go with a country that does tax these gains, but does so at a nice low rate.
Things to watch out for
There’s a few things to watch out for when it comes to your tax residency.
- Number one – Time on the ground is pretty important: While the 183-day test isn’t everything (and there are exceptions), if you want to be a tax resident of a place you will normally need to spend some time with your feet on the ground. Particularly if you are just changing tax residencies, time on the ground is an important one and can be the difference between some tax rules you like and some tax rules you like a lot less…
- Make a decision and plan everything around that decision: Your tax residency can change without you realizing it, and can change depending on specific timings. For example, one issue is when the local tax year starts and ends: this can be important for calculating the 183-day test. I’ve seen people make a move and cut across tax reporting years. This can be messy and can involve additional, unexpected amounts you will have to send to the tax man (or lady). It is best if you have worked with your advisers and have closely thought out how your tax residency will change. It can be expensive if it changes without you intending it to, or if it changes a bit earlier or later than you intended it to. See also #5.
- Thinking the 183-day test is all there is: OK, OK – I’ve talked a lot about the 183-day test. It must be important, right? Right on the money there, Steven. But another mistake is thinking that this rule is a magical rule, you know, in the same class as vampires and when they can cross the threshold. While the 183-day test is a big part of most tax systems, it isn’t the only test that tax authorities apply. If they think they can get you, some tax authorities will rule that you are a resident based on your long-term intentions rather than whether you spend 183 days in a specific place. I’ve seen this where people set up in their new tax residence, but keep very solid ties at home and basically visit home every other week. They’re paying the mortgage, keep their kids in school and check regularly that the lawn at home is freshly cut. If the tax authority can say your long-term intentions are to treat your old home as your actual home, then you have a problem for tax purposes and they can treat you as a tax resident based on your long-term intentions, i.e. where you intend your “domicile” to be. This is likely an issue with “paper residencies”.
- “I’ve got no tax residence because I am constantly on the move”, aka Digital Nomad style: This is probably a variation on the point above. It assumes that because you don’t have a permanent home or base, AND don’t spend 183 days in any specific place, then no country to get you for tax purposes. This is a nice idea (and, again, treats the 183-day rule as magic) but doesn’t work in practice. What ends up happening, eventually, is that the country with the strongest claim on you will look you up and raise back taxes on you. This is why, under #2, it’s important to make a decision and actually have a preferred place lined up where you would like to be tax resident. You need an alternative theory. This helps you say: “No, hold on there. Actually I am a tax resident of x or y country and you can see these specific connections I have to x or y country”. Thinking you can get away as “homeless” for tax purposes might work for a while, but what goes up has to eventually come down. It’s likely to breed a dragon. For my two cents, it’s better to be proactive and get the tax rules work for you.
- The internet’s great but… It is still a good idea to run your specific situation past an accountant or lawyer that knows the territory. They will be able to help you avoid some of the pitfalls and hopefully point you in the direction of a plan that could work well based on your individual financial profile or objectives.
A few ‘easy picks’ for you
So let’s look at a few easy picks.
These are places where folks have traditionally found the tax rules favorable.
Let’s start with Panama.
Panama is interesting because, while it does apply income tax, it will not tax you on your income from foreign sources.
This goes for citizens and tax residents.
This is the so-called ‘territorial concept’ of income taxation.
General rates of income tax max out at 25%.
Typically speaking, to be considered a tax resident of Panama, you need to spend at least 183 days in Panama per year.
Hong Kong can be worth a look because it doesn’t have any taxes on capital gains.
Nor does it apply income tax to the foreign income of tax residents.
While the tax system seems in order, you may want to verify whether your comfortable reflagging to Hong Kong given its recent instability.
Singapore is also popular: the headline reason is that it does not tax some foreign income.
So you can be based in Singapore, as a tax resident, and you only need to pay tax on your Singapore-sourced income.
There is some fine print and your foreign income needs to be eligible.
This can be a good deal and is obviously structured as a handy competitor to Hong Kong.
Singapore will treat you as a tax resident if you’re there for 183 days or more in a given tax year.
If you’re in the market for a European country, Montenegro should be on your list to check out.
It’s not Monaco, but it does have low taxes overall.
9% is the base rate of income tax.
Unfortunately, foreign-sourced income is taxable and you would have to factor this in.
The consolation prize is that you won’t be paying Spanish, Portuguese or French-style taxes to live in Europe.
I’ve previously written about Monaco and – fair warning folks – it is not the poor dad option.
It may however make you a richer dad though – with 0% income tax, no tax on foreign-sourced income and no tax on capital gains* – it could be your ideal tax home in Europe.
The bad news is that you will need to put some serious investment into the place: as a start you’ll need to put down 500k in euros to get a residence permit and get yourself into the Monaco property space.
If this is a fit for you, it is a very effective option on taxes.
It’s not exactly an uncomfortable spot either.
Ship and Castle can be your local.
(*) Some of this doesn’t apply if you are a French citizen.