Individuals and families with business and personal interests in more than one country face special estate planning challenges.
- Under source jurisdiction (a.k.a. territorial tax system) a country levies taxes on all income generated within its borders, whether by citizens or foreigners.
- Under residence jurisdiction, the most prevalent type of jurisdiction, a country taxes the income of its residents, whether generated inside or outside the country. In other words, all residents of the country are taxed on their worldwide income. The country does not impose residence jurisdiction on its citizens who are non-residents in the jurisdiction. The U.S. is an exception in that its citizens, regardless of their current place of residence, are taxed on their worldwide income.
- Countries use many different tests to determine residency. They may utilize subjective standards such as personal ties (e.g., family, house) or economic ties (e.g., own a local business) to the country. They may also use objective measures such as the number of days residing within the country’s borders.
- Under source jurisdiction, transfer taxes are levied on assets located within (e.g., real estate) or transferred within a country, whether by citizens or foreigners.
- Under residence jurisdiction, citizens and residents pay transfer taxes, regardless of the worldwide location of the assets.
- In an effort to avoid residence taxation, individuals may renounce their citizenship and move to a less strict jurisdiction. In response, some residence jurisdictions impose an exit tax. The amount is usually based on the gains on assets leaving, as if the individual sold the assets and realized the gains. (This is referred to as a deemed disposition.) The exit tax could include a tax on income earned for a period (called a shadow period) following the expatriation.
Due to overlapping tax systems, two countries may lay claim to the same income and/or assets for tax purposes. In a residence-residence conflict, for example, two countries claim residence for the same individual and hence claim taxing authority over the individual’s world-wide assets and income. Alternatively, two countries could claim authority over the same income in a source-source conflict.
In another possible double taxation scenario, an individual might be subject to residence jurisdiction and receive income on assets in a foreign country with source jurisdiction. This is a residence-source conflict, because the individual’s world-wide assets and income are taxed by the residence jurisdiction, and income generated by the foreign assets is taxed again under the source jurisdiction. In response, some countries have adopted policies that help relieve the double taxation.
The exemption method provides complete relief from double taxation. In the exemption method, the residence country imposes no tax on foreign-source income by providing taxpayers with an exemption, which, in effect, eliminates the residence–source conflict by having only one jurisdiction impose tax. The tax liability under the exemption method is simply the tax imposed at the foreign source, or:
- TExemptionMethod = TSource
The credit method also provides complete relief though not always the lowest total tax bill. In the credit method, the residence country reduces its taxpayers’ domestic tax liability for taxes paid to a foreign country exercising source jurisdiction. The credit is limited to the amount of taxes the taxpayer would pay domestically, which completely eliminates double taxation. Under this method the tax liability equals the greater of the tax liability due in either the residence or source country.
The deduction method provides only partial resolution of the residence-source conflict. Under the deduction method, the individual pays the full tax to the source country and is only allowed to deduct the amount of taxes paid to the source country in calculating total world-wide income.
Tax avoidance is legal. Any tax-paying entity or individual would be expected to minimize the amount of taxes paid through various legal tax-reduction strategies. Tax evasion, on the other hand, is hiding, misrepresenting, or otherwise not recognizing income so as to illegally avoid taxation. To avoid complications related to tax evasion strategies that are ultimately uncovered through global tax treaties, it is important to structure estates as efficiently and legally as possible.