What Is Residence Based Taxation and How Does It Work?

Residence-based taxation is a system where a country taxes individuals based on their tax residency, or where they live, rather than their nationality. This approach is the global standard, where tax obligations are tied to the country providing an individual with services and infrastructure. This system contrasts with those that tie tax obligations to citizenship, regardless of where a person lives or earns money.

The Current US System of Citizenship Based Taxation

The United States operates under a system known as citizenship-based taxation (CBT), which is unique among developed nations. Under CBT, all U.S. citizens and green card holders must report their worldwide income to the Internal Revenue Service (IRS) each year, regardless of where they live. This obligation persists even if an individual has resided outside the U.S. for decades and has no U.S.-sourced income.

This system creates compliance responsibilities for Americans living abroad, who must file an annual tax return (Form 1040) and meet foreign asset reporting requirements. They must file a Report of Foreign Bank and Financial Accounts (FBAR) if their foreign financial accounts exceed $10,000 at any point during the year. The Foreign Account Tax Compliance Act (FATCA) also requires filing Form 8938, Statement of Specified Foreign Financial Assets, if assets meet certain thresholds.

To prevent double taxation, individuals can use tools like the Foreign Earned Income Exclusion (FEIE), which allows them to exclude a certain amount of foreign-earned income from U.S. tax. Another tool is the Foreign Tax Credit (FTC), which provides a dollar-for-dollar credit against U.S. tax liability for income taxes paid to a foreign country. While helpful, these tools do not eliminate the underlying filing obligation or complexity. Navigating the rules for the FEIE and FTC can be difficult, and they do not cover all income types, sometimes leaving investment or retirement income exposed to double taxation.

Determining Tax Residency

Under a residence-based tax system, the first step is establishing an individual’s tax residency. Countries use a series of tests, outlined in domestic laws and tax treaties, to make this assessment. These tests identify the country with which an individual has the strongest and most enduring connections.

Physical Presence Test

A straightforward method for determining tax residency is the physical presence test, or the 183-day rule. An individual is considered a tax resident if they are physically present in a country for more than 183 days in a tax year. This test is an objective measure, but as a person could meet the rule in multiple countries, tie-breaker rules are often necessary to assign residency to a single jurisdiction.

Permanent Home Test

The next criterion is the permanent home test, which evaluates where an individual has a permanent home available to them. A permanent home can be owned or rented, as the focus is on the continuous availability of the dwelling, not ownership. For example, if a person rents an apartment year-round in Germany but also owns a summer home in the U.S., tax authorities would evaluate which dwelling constitutes their permanent base.

Center of Vital Interests Test

If the permanent home test is inconclusive, the analysis moves to the center of vital interests test. This test determines where an individual’s personal and economic ties are closer by examining factors such as the location of family and social relationships, primary employment and business interests, and personal assets like bank accounts and investments. For instance, someone whose family and social life are based in Canada would likely have their center of vital interests there, even if they work in the U.S.

Tax Implications Under a Residence Based System

Establishing tax residency determines how an individual is taxed. The system creates a clear division between the taxation of residents and non-residents.

Taxation of Residents

An individual determined to be a tax resident of a country is taxed by that country on their worldwide income. For example, a tax resident of France would report their French salary, rental income from Spain, and dividends from U.S. stocks on their French tax return. To mitigate double taxation on income earned abroad, the country of residence provides a foreign tax credit or an exemption for taxes already paid to another country.

Taxation of Non-Residents

Conversely, a non-resident is only taxed by a country on income sourced from within its borders, known as source-based taxation. A non-resident would file a tax return in that country only to report this specific income. Common examples of source income include:

• Wages for services performed in the country
• Rental income from real estate located in the country
• Royalties for patents or copyrights used in the country
• Gains from the sale of real property located there

Proposed Transition to Residence Based Taxation in the US

Discussions about the U.S. transitioning to a residence-based model have been ongoing for years, driven by advocacy from Americans living abroad. These efforts have resulted in legislative proposals arguing that the current system creates complexity, double taxation, and competitive disadvantages for U.S. citizens working overseas.

A legislative effort, the “Residence-Based Taxation for Americans Abroad Act,” was introduced in late 2024 but expired with the congressional session. This proposal, like past efforts, would allow qualified U.S. citizens living abroad to elect to be taxed only on their U.S.-source income. To qualify, an individual would need to be a tax resident of a foreign country and meet certain presence tests.

These proposals include provisions to prevent tax evasion, such as a “departure tax” for high-net-worth individuals. This would treat their assets as sold at fair market value to capture unrealized gains before they exit the U.S. worldwide tax system. Advocacy groups continue to work with lawmakers to refine these proposals, and while no such bill has passed, the ongoing discussions suggest the challenges of citizenship-based taxation are being considered at the legislative level.