Citizenship-Based Taxation vs Residence-Based Taxation

Compare Citizenship-Based & Residence-Based Taxation

While the majority of countries across the globe utilize a Residence-Based Taxation model, the United States Tax System is one of the only countries that utilize the Citizenship-Based Taxation model. The two different tax systems can have very disparate tax results, depending on where the taxpayer resides and the source of the taxpayer’s income. Unfortunately, many non-residents who become US persons by either becoming a Lawful Permanent Resident or by meeting the Substantial Presence Test test are blindsided by the tax implications of being a US person under a Citizenship-Based Taxation model. Let’s go through the basics of comparing the difference between a Citizenship-Based Taxation model and a Residence-Based Taxation model.

Citizenship-Based Taxation (CBT)

The idea behind the Citizenship-Based Taxation model is the concept that a person is subject to tax on the income of the country they are a citizen of, whether or not they reside in the country — and whether or not the income they generate is sourced in that country. In other words, a taxpayer is forced to pay tax simply for the benefit of being a citizen of that country. The United States is one of only two countries that practices this type of tax system. Take for example a US Taxpayer who lives abroad. If the US Citizen abroad resides in a foreign country and earns all of their money from foreign sources, is it really fair for the United States to have the power to tax that individual — upwards of 37% — simply because they have US Citizen status? Making matters worse, is that even though it is referred to as citizen-based taxation, in fact, it refers to US persons and not just US citizens – which is why foreign nationals who are considered US residents can get swept up into the definition of CBT.  But, if a taxpayer has paid taxes overseas on foreign income then they can usually claim a foreign tax credit. Likewise, if the taxpayer resides overseas sufficient to meet either the bonafide residence test or physical presence test, then they should qualify for the foreign earned income exclusion –– which allows them to exclude upwards of 108,000 of annual income from US tax liability — along with a housing exclusion –– and married couples can each claim FEIE.

Residence-Based Taxation (RBT)

With Residence-Based Taxation, the idea is that unless a person is a resident of that country — they are not taxed on their worldwide income. For example, Taxpayer is a citizen of Foreign Country 1 but not a resident of country 1. He earns some interest income from foreign country 1 because he still has some bank accounts in that country — but he lives in Foreign Country 2 — and earns nearly all of his income in foreign country 2. Under the Residence-Based Taxation model, the taxpayer is not subject to worldwide income from Foreign Country one, because he is not a resident of Foreign Country 1. Taxpayer will still pay tax on the interest that was generated in foreign country 1 — and the tax rates may vary (based on whether Taxpayer is a resident or nonresident of that country) — but Foreign Country 1 does not collect income that the taxpayer earned while residing in Foreign Country 2 for income generated in Foreign Country 2.

Avoiding Citizenship-Based Taxation (CBT)

In order for US persons to avoid Citizenship-Based Taxation, they must either formally expatriate or make a treaty election, if applicable ––  noting that there are various pitfalls and landmines in making a foreign resident treaty election — especially if the taxpayer is already considered a long-term resident.

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