Citizenship-Based Taxation: Who’s Tried It & Why the US Can’t Quit (2024)

Dateline: Kuala Lumpur, Malaysia

The tax reform talks that occurred in October of 2017 had a lot of folks hoping for a long-overdue change to the United States’ basis of taxation.

For the first time in almost a century, politicians were seriously talking about the nation’s system of citizenship-based taxation and – for the first time in over a century and a half – they were actually considering changing that system and adopting a residence-based system instead.

While I had my concerns about how the change would affect the tax situation of US citizens living abroad, the general sentiment was that moving away from citizenship-based taxation would have been a step in the right direction.

However, the solution the US government came up with instead (and signed into law December 22, 2017) was not a move in the right direction at all but a clear step back, especially for US expats.

Not only did lawmakers fail to eliminate citizenship-based taxation but they managed to throw numerous people under the bus – including small and medium business owners operating overseas – in an attempt to get big businesses like Facebook, Apple, and Google to repatriate their overseas profits.

Many hopes were crushed. But, to be honest, if you were hanging all your hopes on systemic reform, that is your real problem. I see too many people putting false hope in promises of reform during election campaigns and legislative debate.

It’s just wishful thinking.

I can’t tell you how many people have asked me over the years if the changes politicians are promising at the moment will make America a place where they’ll be “treated best.” I don’t peddle doom and gloom, so I’m not going to tell them that there is absolutely NO possibility of favorable change actually taking place, but I am also a man of action and I am not content to sit by and wait for someone else to determine my future for me – let alone a group of politicians.

If you’re still hanging on to the hope that your government will get its act together and change things for the best, I find it helpful to examine the history of citizenship-based taxation in the United States to get a better perspective of why the country has had such a hard time quitting the addictive behavior.

The History of US Citizenship-Based Taxation

Some would argue that the practice of citizenship-based taxation is too deeply entrenched in the history of the United States for the nation to ever give it up. Despite being the only country in the world that fully follows the draconian system (Eritrea taxes its diaspora, but only at a flat rate of 2%), it would seem that the US is too set in its ways to really care.

Civil War Roots

The practice of citizenship-based taxation in the US dates back to 1861 when the United States was struggling to raise revenue for its Civil War. Congress argued that American citizens living outside the country were avoiding their duties to the US in a time of need. They determined that these citizens could make up for their lack of civic engagement by paying a higher rate of tax on their US-source income.

Thus, the first federal income tax legislation ever put into place in the United States automatically put individuals living abroad at a disadvantage. The first version enacted in 1861 and 1862 appeared to be more of a territorial tax system instead of a worldwide one, but the negative sentiment towards citizens who chose to live overseas was present from the start.

A few short years later, the law was reformed and citizenship-based taxation of nonresidents on their worldwide income as we understand it today went into effect. Beginning in 1864, instead of paying a higher rate, all nonresident citizens paid the same rates as resident citizens; however, they were now required to pay taxes on their worldwide income and not just their US-sourced earnings.

For the next 60 years, the rationale for maintaining citizenship-based taxation in the United States was founded on the notion of duty and community membership that originated from the Civil War (although no other “community” on the planet required the same of its members).

Cook v. Tait

Eventually, the fundamental problems of citizenship-based taxation became apparent to many US citizens and, in 1918, the US government implemented a foreign tax credit to eliminate the issue of double taxation and to assuage concerns from American corporations operating overseas that they were losing their competitive advantage by paying too much in taxes.

However, as the tax scholar Montana Cabezas argued in 2016, the tax credit was merely a patch to cover up the problem, not a cure. This was one reason George Cook chose to attest the taxation of his foreign-source income not long after in 1922 in what became the 1924 Supreme Court Case Cook v. Tait.

Cook had lived in Mexico for over 20 years and no longer had ties with the United States; he felt it was unconstitutional for the US to tax him on income that was not sourced in the United States. But the court decided against him and ruled that citizenship-based taxation was constitutional.

The Supreme Court’s justification, however, was no longer about Mr. Cook’s duties to his country but about the “inherent benefits” that came with being a US citizen.

What those inherent benefits were exactly was unclear, but since citizens living abroad could not vote until 1975 (some 50+ years later), those benefits certainly did not include the right to vote (i.e., the right of representation).

And I’ve already made my case against the whole “You have the right to use our embassy and consular services!” argument.

The only slightly justifiable reason Cabezas could find in the Supreme Court rationale about “inherent rights” was the “right of return” – the ability to return to the United States and participate in the American economic and social community. However, the US government has never publicly claimed this rationale as the reason for its continued use of citizenship-based taxation.

Whatever their claim, not long after Cook v. Tait the US government tried to patch up the problem once again, this time introducing the Foreign Earned Income Exclusion (FEIE). Since then, any discussion about the taxation of nonresident US persons has centered around the FEIE and the available foreign tax credits.

Nothing more has been said about abandoning citizenship-based taxation.

Until the fall of 2017.

But the reason the US couldn’t quit citizenship-based taxation in the past is the same reason it failed to do so once again in December 2017.

Why the US Can’t Quit Citizenship-Based Taxation

Since the 1860s when citizenship-based taxation began in the United States, there has been little discussion about the rationale for the practice among politicians. In large part, this is because it affects a small minority that does not have a political voice – expats (who can vote at a cost) and green card holders who no longer live in the US (and who cannot vote).

It is not a widely-known law, even among many expats who assumed they would no longer need to pay taxes once they left the country. The IRS has even admitted that it does a poor job of informing its overseas citizens of their continuing tax obligations… although it continues to insist on applying “disproportionately high penalties for non-compliance.”1

Even without the penalties, Cabeza cites that, for expats just over the border in Canada, estimated “accounting costs to file a basic offshore income tax return, even when one does not owe any tax to the United States, easily reach the thousands of dollars.”

The two rationales the United States has given in the past to support its use of citizenship-based taxation no longer hold up. The changing relationship between citizens and the state in a globalized society where people are moving overseas more than ever conflicts with the first rationale put forth in the 1860s of duty and community. And the argument about “inherent benefits” has largely gone out the window since FATCA has made US citizenship more of a liability than a benefit.

But while you and I may continue discussing citizenship-based taxation, Congress and the President are done talking about it. They got their win and they don’t care much about getting you yours.

6 Countries That Have Tried Citizenship-Based Taxation

The United States’ long history of using citizenship-based taxation is no excuse for its continued use, but it’s the excuse they’re making. Unfortunately, this is a pattern that can be seen in more areas than just the US basis for taxation as the United States is more than happy to sit on its laurels.

A country like that is a country unwilling to change and, therefore, progress. If you follow my five magic words, you know that this is NOT the kind of country where you want to be.

Other countries in the past have experimented with citizenship-based taxation – some for much longer periods than others – and all chose to abandon the practice when they realized its flaws. Curious enough, a majority of the countries practiced citizenship-based taxation while under oppressive governments and abandoned the system during a period of reform.

So, while the US is comfortable sticking with a tax system that was born of its Civil War more than 150 years ago, other countries recognized the injustices in the system and eventually abandoned the practice along with the oppressive governments that implemented them.

These six countries used to tax their citizens on their worldwide income, regardless of where they lived or earned their money:

1. Mexico

Mexico is one of several countries that taxes its resident citizens who move to a tax haven like the Bahamas or Monaco for three years after their departure. (My guess is they borrowed this from Spain, which does the same thing.) Otherwise, Mexican citizens are free to leave Mexico at any time and be relieved from local taxes.

That wasn’t always the case, however. For several years leading up to 1981, Mexico experimented with a citizenship-based taxation system similar to the one used by their neighbor to the north. It required all Mexicans to pay taxes no matter where they lived, subject to any tax treaties.

Even today, Mexico’s enforcement of many laws is rather lax, so I imagine that logistics, as well as fairness, played a role in the change. Mexico now uses residence as their basis for taxation.

To read more about how to get Mexican residency and citizenship click here.

2.Romania

Romania previously taxed its citizens on their worldwide income regardless of their residence. However, sometime between 1933 and 1954, they abandoned the practice. The 1933 law establishing income tax states that “the taxable income will include all the gains realized in the country or abroad” for Romanian citizens wherever they reside.

The law laid out in 1954 by the Soviet Socialist Republic of Romania, on the other hand, makes no direct statement about taxation being based on citizenship. Instead, a list of occupations is given of those individuals who must pay income tax on income earned within the territory.

Today, Romania applies a flat personal income tax rate of 16% to all Romanian tax residents on their worldwide income, except for salaried income for work performed and received abroad. Similar to Mexico, individuals who move to a country that does not have a tax treaty in place with Romania remain taxable on their worldwide income for the next three years. Once those three years are up, they will only have to pay on income sourced in Romania.

To read more about Romanian residency and citizenship, click here.

3. Bulgaria

Under Article I of Bulgaria’s 1950 tax law, it stated that all Bulgarian citizens were required to pay income taxes on their worldwide income regardless of their domicile and residence. The article was repealed in 1995 and, beginning in 1996, Bulgaria abandoned the practice of citizenship-based taxation and began taxing its occupants’ worldwide income on the basis of residence within the country.

Their reason for doing so is unclear, but the repeal came at a time of great economic reform in Bulgaria following the collapse of the Soviet Union.

Today, Bulgaria has one of the best tax rates in the EU at a flat rate of 10% for both individuals and corporations. If you are looking to plant business flags in the EU and want to keep your taxes low, Bulgaria is definitely worth your consideration.

Bulgaria is also on our list of the best citizenship by investment programs in 2018.

4. Vietnam

Vietnam only abandoned citizenship-based taxation a decade ago. The Vietnamese government passed a personal income tax law in 2007 that went into effect September 1, 2009. The new law removed citizenship as the basis for taxation and replaced it with a residence-based system.

This, of course, came at a time when communist-run Vietnam had been making great efforts to loosen state controls and open up its economy. I doubt that it is mere coincidence that they gave up the more oppressive basis for taxation during this time of overall reform.

Under the new law, the definition of tax resident was expanded to include permanent residents and anyone who resides in Vietnam for more than 183 days per year. This is important to note since Vietnam is becoming a popular place for many Nomads looking for a cheaper cost of living. Vietnam is a great place to visit, but don’t stick around too long or you may be liable to pay the flat rate of 20% applied to non-residents.

5. The Philippines

Today, the Philippines implements a hybrid tax system that taxes Filipino citizens under a residential tax system, and non-citizen residents based on a territorial tax system. That means that Filipinos living in their home country must pay tax on all income they earn from anywhere in the world, while a US citizen with aPhilippines residence permitwould pay online on his (likely zero) Philippine-sourced income.

Basically, that means that the country’s large diaspora can earn money overseas without worrying about taxes in the Philippines, adding a layer of good tax strategy to those Filipinos who go to work in Dubai or Qatar.

However, up until the late 1990’s, the government of the Philippines imposed a modified income tax code on its expat workers that required them to pay taxes at reduced rates. At the time, income tax brackets started at a meager 1% and went up to a rather healthy 35% for residents.

Meanwhile, a special set of tax brackets for non-residents went from 1% to 3% and required citizens living overseas to pay up. While it was unfair, a 3% tax doesn’t sound that bad when you get to live in azero-tax country. Ultimately, the Philippines nixed the tax in their 1997 budget.

6. Myanmar

The most recent reformer on this list, Myanmar used to tax the worldwide income of its citizens who lived and earned money overseas at a flat rate of 10%. However, as Myanmar has made efforts to reform following the end of the military rule that lasted half a century, they abandoned the more oppressive parts of citizenship-based taxation.

The new law was passed in 2011 and became effective in 2012. It excludes all salaried income earned by citizens living and working overseas from taxation. This is the greatest source of income for most of Myanmar’s citizens living abroad. And, while Myanmar technically still taxes all other types of foreign income, the tax is no longer enforced by Myanmar’s embassies and consulates.

Partial Citizenship-Based Taxation

The United States has the world’s most complicated tax code. To make things worse, it is one that US citizens cannot escape no matter where they live. While every other country on the planet takes a more reasonable approach to the taxation of their non-resident citizens, there are a few countries that like to dabble in citizenship-based taxation in special situations.

Many of these countries follow the same rule Mexico uses by taxing their citizens for a set period of time after leaving the country unless they can prove they have not moved to a tax haven and that they are paying a similar amount in taxes as if they still lived in their home country. These countries include:

• Mexico (3 years)
• Portugal (5 years)
• Spain (5 years)

After living abroad for the set period of time, these countries no longer consider their citizens as tax residents. However, there is no set period of time that removes the tax resident status for French citizens who move to Monaco or Italian citizens who move to any tax haven.

Other countries require their citizens to prove that they no longer have any ties to the country before they can become exempt from worldwide taxation. This can often be done by showing proof of another nationality or by residing in a country that has a tax treaty with their home country. These countries include:

• Finland (3 years)
• Hungary
• Sweden (5 years for both citizens and foreigners who lived there for at least 10 years)

Turkey taxes its citizens who work abroad for the Turkish government or for Turkish companies unless their income has already been taxed by the country where it was earned. And, as mentioned, Myanmar technically still taxes all foreign income except salary but does not enforce the law.

China has also begun experimenting with citizenship-based taxation as it grows in power in an effort to reach more of its billionaire citizens who are moving offshore.

The Bottom Line

To date, no other country that has tried citizenship-based taxation has stuck with it. Many do not have the administrative capacity to enforce it, but others have chosen to discard it in times of reform when they were focusing on building stronger laws, more just governments, and more open economies.

The United States, on the other hand, has the power to enforce citizenship-based taxation and has little motivation to attempt the kind of drastic change that has enabled most other countries to abandon the practice.

You may be tempted to look at the list of countries that have made it out of the addictive grip of citizenship-based and hope that the United States will one day quit the system as well, but I caution such wishful thinking.

If you’re ready to be done with citizenship-based taxation and you’re not willing to sit around and wait for the US to change of its own accord, my suggestion would be to take care of what you can actually control: your citizenship.