Source and residence

There are 195 countries[1], and you probably pay most of them no income tax. Why?

A typical taxing jurisdiction (such as a country—but also a subnational political entity such as a province or a U.S. state) will invoke two concepts to establish the base of income to which its tax applies:

  • Source of income: is the income from a source within jurisdiction X?
  • Residence of the recipient: did the income go to a resident of jurisdiction X?

Let us begin with the principle that jurisdiction X will tax all income, and only that income, for which the answer to either of these questions is “yes”:

domestic source incometaxedtaxed
foreign source incometaxednot taxed

Here are some inferences which can be divined from the source–residence matrix and the various ways we can slice it:

  • Income with no connection whatsoever to jurisdiction X (either by source or residence) escapes taxation by X. This accords with common sense, and with the practical barriers X’s government would face in attempting to enforce a tax on such income.
  • For a resident, the source of income is irrelevant to its inclusion in the taxable base. In other words: residents are taxed on worldwide income. (The source of income may be relevant to a resident in other ways, such as for the computation of certain credits or deductions.)

    Conversely: for a non-resident, the source of income determines its taxability. The non-resident is taxed only on income from domestic sources.
  • Where income is domestic-source, residence is irrelevant to its inclusion in the taxable base. (It may be relevant to other questions, such as the rate of tax imposed.)

    Conversely: where income is foreign-source, the taxpayer’s residence determines its taxability. Only a resident is taxed on such income.

It is also apparent that double taxation arises when a resident of X has income from a source within Y. Both jurisdictions will tax the same income: one by reason of residence, and the other by reason of source.

Typically, this is resolved by a credit: X (the jurisdiction of residence) allows its tax on that income to be reduced (but not below zero) by the tax paid to Y (the source jurisdiction). This gives Y the “first crack” at taxing the income, but lets X capture the residual amount, if X would otherwise impose a higher effective rate of tax than Y.

If this all sounds grossly oversimplified, it is. The reader may notice that I have invoked the concepts of source and residency without yet giving them any precise definition. Some of the thorniest challenges lie in that sharpening. I have also pretended that all jurisdictions are alike in their rules, which is far from true.

But this principle of taxation by source and residence, even armed with only the intuitive understanding that those words convey in ordinary use, forms a scaffolding for our exploration of income taxation in an international setting, on which exceptions and qualifications can be hung.

In fact it is remarkable how consistently the nations of the developed world have implemented personal income taxation based on some flavor of the source–residence model[2]EY Worldwide Personal Tax and Immigration Guide 2019-20. It finds expression not only in the tax laws of the U.S. and Canada but also across the U.K., Germany, France, Spain, Italy, Australia, China, Japan, South Korea, India, Russia, and Brazil (collectively representing 75% of world GDP[3]IMF WEO database Oct 2019).

Notable divergences:

  • Some jurisdictions, such as Singapore and Hong Kong, ignore or deemphasize residence, and tax only or mainly by source.
  • Others, such as the Cayman Islands and the United Arab Emirates, have no personal income tax at all.
  • The tax law of the United States gives a unique consideration to citizenship status: non-resident U.S. citizens are taxed as if resident. I will explore this further in future posts.

The policy objectives served by a source–residence model are evident from the “neutralities” it ensures. If residents are not taxed on foreign income, they have a strong incentive to move their investments abroad. And foreign entities enjoy an unfair competitive advantage if they can derive untaxed income from domestic sources.[4]See Larkins, Ernest R., International Applications of U.S. Income Tax Law (Wiley, 2004), 3-7 on capital export and import neutrality.

But a more cynical explanation of the model is that it is simply the widest possible net that tax law could cast and realistically collect. It is the result one would expect if a government, like a space-filling gas, tends to tax anything it can get its hands on.

2 EY Worldwide Personal Tax and Immigration Guide 2019-20
3 IMF WEO database Oct 2019
4 See Larkins, Ernest R., International Applications of U.S. Income Tax Law (Wiley, 2004), 3-7 on capital export and import neutrality.

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