Territorial Tax Systems
A territorial tax system is a tax system that taxes only income that is created within the borders of a specific territory (usually a country).
In order to fully understand a territorial tax system, it should be compared with other tax systems found around the world including the worldwide tax system and the mixed tax system. It should be noted that most territories around the world are neither entirely categorized as a Worldwide tax system or a Territorial tax system. While they may lean towards one type of system, most use a mix of both.
Worldwide Tax System
The major feature of a worldwide tax system is that residents and entities are taxed on any income that is earned within its borders and in addition, income that is earned throughout the world. While double taxation can in fact occur, most governments such as the United States reduces the possibility of double taxation to a certain level through having an allowance of a foreign tax credit. It should be noted that the United States predominantly employs a worldwide tax system.
If you are a US citizen, resident or entity and your income is earned in another country, once the allowance of a foreign tax credit is exhausted you will have tax liabilities in the US. For instance, citizens and resident aliens that live abroad are taxed on worldwide income, however, they may exclude from their income up to $82,400 of their foreign earnings. After this amount your income will be taxed by the IRS.
Territorial Tax System
A territorial tax system is a system that only taxes income within its borders. For countries that predominantly use this tax system, any foreign income that is earned outside of its borders is not taxed by the government. These types of systems are less complicated usually because there are no foreign tax credits to worry about and there is no anti-deferral rules. Countries that are considered Territorial tax systems include France, Belgium, Hong Kong and the Netherlands. It should be noted that although these countries primarily adopt a territorial tax system, there are certain exceptions to stop tax abuses.
The Mixed Tax System
For the most part all countries have elements of both Territorial and Worldwide tax systems in place. While double taxation can exist in many countries around the world, for most residents earning income in another country, the double taxation issues to a certain extent is negligible, especially for low to mid income earners.
Advantages of Territorial Tax Systems
- The Territorial tax system has plenty of positives including the inability of a resident or entity to be taxed twice.
- Territorially tax systems for the most part are easier to administer. Worldwide tax systems require a large bureaucracy to administer and enforce tax laws.
- Following a worldwide tax system can be extremely complicated and confusing for tax payers.
- Territorial tax systems also are pro free market. They boost the compositeness of US corporations doing business within another country's borders.
- Worldwide tax systems usually hurt free enterprise by forcing a resident or company operating outside one's borders to double taxation in many instances. Even with foreign tax allowances, many times the US tax rates are so high, there is very little relief.