The three international tax systems used by countries are the territorial system, the worldwide system, and the exclusion system. The reality is most countries use a hybrid system that is a combination of the different systems. Currently, the United States employs a worldwide system, but it certainly uses aspects of the other two systems as well. Discussion of a move to a territorial system in the United States has been picking up with members of the House Ways and Means Committee, Mitt Romney, and Newt Gingrich all proposing the change. Since many countries use the territorial system and momentum is growing for a change in the United States, I thought it would be useful to describe the fundamental differences between the territorial system and the worldwide system.
Under a pure territorial system, a country only taxes the income that is earned in that particular country. For example, if a taxpayer lives in country X, but works in country Y, country X will not tax the income earned in country Y. A pure territorial system is not realistic though because a taxpayer can avoid taxes in a country by simply moving his income to a foreign country. For this reason, countries using a version of the territorial system exempt most types of income from foreign sources, but do tax certain types of foreign source income, such as passive income or income earned in certain low-tax or no-tax jurisdictions.
Under this system, a domestic taxpayer’s worldwide income, regardless of source, is subject to taxation by the country of residence. For example, if a citizen of the United States earns half her income in the United States and the other half in a foreign country, all of her income is subject to taxation in the United States. The worldwide system standing alone would subject a taxpayer to double taxation, since a taxpayer’s foreign source income is subject to taxation in the foreign country where it was earned while the foreign source income is also subject to taxation in the taxpayer’s country of residence. In order to mitigate this international double taxation, the country of residence grants domestic taxpayers a credit for foreign income taxes paid.