Taxation of foreign-source income: territorial, worldwide, and citizenship-based system

TAXATION OF FOREIGN-SOURCE INCOME—TERRITORIAL, WORLDWIDE, AND CITIZENSHIP-BASED SYSTEMS constitutes a fundamental taxonomy of approaches employed by sovereign states to delineate the scope and methodology of taxing income derived from international sources. These systems define the jurisdictional boundaries within which states may assert taxing authority over income realized by their residents or nationals beyond territorial borders, thereby establishing the relationship between the source country and the country of residence. Three principal systems merit identification: territorial taxation (circumscribing fiscal jurisdiction to domestically-sourced income), worldwide taxation (encompassing the global income of residents), and citizenship-based taxation (predicating tax liability upon nationality irrespective of domicile).

Legal Nature and Fundamental Distinctions

The system for taxing foreign-source income manifests a state’s exercise of tax sovereignty and reflects its conception of nexus—the connection justifying the imposition of tax. Traditional international law recognizes two foundational categories of nexus: personal nexus (taxation of residents or nationals regardless of income source) and territorial nexus (taxation of domestically-sourced income regardless of the taxpayer’s residence). The coexistence of these two forms of nexus engenders an inherent conflict of tax jurisdictions and the prospect of juridical double taxation, wherein identical income faces levy by two or more states (check out: tax advisory).

The territorial tax system (territorial taxation, source-based taxation) operates upon the principle that a state shall tax exclusively income arising from sources situated within its territorial boundaries, without regard to whether the taxpayer constitutes a resident, national, or non-resident. Foreign-source income earned by residents generally remains exempt from taxation in the country of residence, save where such income is remitted to that jurisdiction—a characteristic feature of certain territorial system variants. This approach proves typical of jurisdictions serving as financial and commercial centers that seek to attract international capital and talent through elimination of taxation on foreign-source income.

The worldwide income system (worldwide taxation, residence-based taxation) requires tax residents to report for taxation the entirety of their income irrespective of geographic source—both domestic and foreign-source income alike. This system rests upon the principle that a resident benefiting from legal protection, public infrastructure, and state services should contribute to governmental financing proportionate to total economic resources, regardless of where such resources are generated. The worldwide system predominates among OECD member states and most jurisdictions with sophisticated tax regimes, though it typically operates in conjunction with mechanisms designed to prevent double taxation, such as the foreign tax credit or the exemption method.

Citizenship-based taxation (citizenship-based taxation) represents the rarest and most controversial model, wherein tax liability flows from the mere fact of possessing state nationality, independent of actual domicile, income source, or time spent outside the country. This system derives from the concept of a permanent bond between citizen and state conferring nationality, thereby justifying the right to tax the citizen’s worldwide income even absent any continuing benefit from state services or presence within its territory.

Historical Genesis

The roots of contemporary systems for taxing foreign-source income extend to antiquity, when city-states and empires imposed taxes primarily on a territorial basis—levying charges on land ownership, commercial transactions within defined territory, and border customs duties. In ancient Rome, the tax system operated predominantly on territorial principles, focusing on the tributum (land tax) and various indirect taxes on commercial transactions. The concept of taxing personal income regardless of source remained either unknown or administratively impracticable given the technological and communication capabilities of the era.

During the medieval period, European kingdoms and principalities taxed principally real property, tangible assets, and commercial privileges within their territorial boundaries. The concept of tax residence as a basis for taxing worldwide income proved alien to the feudal socioeconomic system, wherein taxes attached primarily to land ownership and the taxpayer’s estate status rather than to general income or movable wealth.

Modern income tax systems began taking shape in the nineteenth century concurrent with the development of nation-states, the centralization of fiscal authority, and mounting budgetary demands associated with industrialization, urbanization, and expansion of state apparatus. Great Britain introduced the first modern income tax in 1799 as a temporary measure to finance the Napoleonic Wars, subsequently reinstating it permanently in 1842. The British system from its inception embraced the concept of residence as the foundation for taxing worldwide income, though it incorporated territorial elements for certain income categories.

A pivotal moment in the history of foreign-source income taxation occurred when the United States adopted citizenship-based taxation during the Civil War. In 1861, Congress enacted the Revenue Act imposing an income tax that—in contrast to European systems—established tax liability not merely for residents but also for American citizens residing abroad, albeit initially only on income from American sources. This extraordinary innovation found political justification as an expression of disapprobation toward affluent persons who had emigrated abroad to avoid involvement in the civil conflict and military service obligations. Though this tax lapsed in 1872 following the war’s conclusion, it was revived in 1913 after ratification of the Sixteenth Amendment to the Constitution, which unambiguously conferred upon Congress authority to levy income taxes without apportionment among the states.

The constitutionality of taxing citizens worldwide received judicial imprimatur from the United States Supreme Court in the landmark decision Cook v. Tait, 265 U.S. 47 (1924). The case involved an American citizen domiciled in Mexico who challenged the federal government’s authority to tax income from Mexican real property. The Supreme Court unanimously held that Congress possessed constitutional authority to tax the income of American citizens regardless of the source of such income or the taxpayer’s place of residence, reasoning that a permanent bond exists between citizen and state, and that citizens derive benefits from the mere fact of possessing citizenship. Cook v. Tait became the cornerstone of the modern American citizenship-based taxation system and continues to be regularly cited by the Internal Revenue Service and federal courts as precedent confirming the system’s legality.

Following World War I, the League of Nations undertook the first systematic efforts toward international coordination of tax systems and elimination of double taxation. During the 1920s and 1930s, League of Nations experts developed a series of model tax conventions, including the Mexico Model Convention (1943) favoring the residence principle and the London Model Convention (1946) favoring the source principle. These two competing models reflected the fundamental conflict of interests between capital-exporting countries (preferring residence-based taxation, which permits them to tax their residents’ foreign investments) and capital-importing countries (preferring source-based taxation, which permits them to tax foreign investors’ income from local sources).

After World War II and the establishment of the Organisation for Economic Co-operation and Development (OECD) in 1961, that organization assumed the League of Nations’ role in standardizing international tax law. The OECD published its first Model Tax Convention on Income and on Capital in 1963, which became the international template for negotiating bilateral double taxation treaties. The OECD Model has been systematically updated and presently forms the foundation for the network of more than 3,000 bilateral tax treaties in force worldwide. The OECD Model generally favors the residence system with circumscribed source-country rights to impose withholding taxes on specified categories of passive income (dividends, interest, royalties).

In the postwar period, many European countries initially employed worldwide systems taxing residents on global income, following the British model. However, beginning in the 1950s, some states experimented with territorial taxation elements as a means of stimulating international expansion by domestic enterprises and attracting foreign investment. Great Britain introduced in 1957 a preferential territorial system for overseas trade corporations, exempting undistributed profits from foreign trade, though this system underwent multiple modifications in subsequent decades.

A watershed reform occurred when Great Britain comprehensively transitioned to a territorial system for corporations in 2009 through introduction of foreign branch profits exemption and dividend exemption. This reform was motivated by concerns that the British worldwide system encouraged enterprises to relocate headquarters to territorial jurisdictions and to artificially retain foreign profits without repatriation to Great Britain. Subsequently, numerous OECD countries, including Japan, New Zealand, and several European states, adopted analogous reforms, creating modified territorial systems for corporate income while preserving worldwide systems for individuals.

The most significant twenty-first century reform was the American Tax Cuts and Jobs Act (TCJA), enacted in December 2017. TCJA fundamentally transformed the American corporate tax system from worldwide to modified territorial, introducing a participation exemption for foreign dividends received by American parent corporations from foreign subsidiaries. Concurrently, the legislation reduced the corporate tax rate from 35% to 21% and imposed a one-time deemed repatriation tax at 15.5% on accumulated foreign earnings held in liquid form and 8% on earnings invested in illiquid assets. Despite transitioning to a territorial system for corporations, TCJA preserved anti-avoidance provisions, including taxation of Global Intangible Low-Taxed Income (GILTI) and a deduction for Foreign-Derived Intangible Income (FDII). Critically, the reform excluded individuals—American citizens and residents remain subject to worldwide taxation under citizenship-based taxation principles.

The most recent chapter in international taxation history is the OECD/G20 Pillar Two initiative, forming part of the broader Base Erosion and Profit Shifting (BEPS 2.0) project. In October 2021, 136 jurisdictions endorsed a plan establishing a global minimum corporate tax rate of 15% through the Global Anti-Base Erosion Rules (GloBE). This system, which took effect in numerous jurisdictions on January 1, 2024, provides that where a multinational corporation derives income in a jurisdiction with an effective tax rate below 15%, the country of the Ultimate Parent Entity may impose a top-up tax (Income Inclusion Rule, IIR) to supplement taxation to the 15% level. Pillar Two represents a fundamental departure from traditional state tax sovereignty and introduces an element of international coordination compelling a minimum level of corporate taxation independent of individual jurisdictions’ policy choices.

Systems in Jurisdictional Practice

The United States remains the sole major developed country systematically applying citizenship-based taxation to individuals. Every American citizen, regardless of domicile or time spent outside the United States, must file an annual tax return with the Internal Revenue Service and report the entirety of worldwide income. This system extends to holders of so-called green cards (lawful permanent residents), who are treated as tax residents irrespective of actual place of abode.

To mitigate double taxation effects, the American system provides two principal mechanisms. The Foreign Earned Income Exclusion (FEIE) permits qualifying taxpayers to exclude from taxation foreign earned income up to $126,500 for tax year 2024 (an amount annually indexed for inflation), provided they satisfy either the physical presence test (at least 330 days during any twelve-month period spent outside the United States) or the bona fide residence test (actual residence in a foreign country for an entire tax year). The Foreign Tax Credit (FTC) enables crediting of taxes paid abroad directly against United States tax liability, though the credit is limited to the amount of United States tax that would be due on the same income, meaning that where foreign taxation proves lower than American taxation, the taxpayer must remit the differential to the United States Treasury (read more Why US Company Formation Has Become Essential for Global Entrepreneurs).

The American system additionally requires extensive reporting concerning foreign financial assets (find out more about asset management). FBAR (Report of Foreign Bank and Financial Accounts, FinCEN Form 114) mandates reporting of foreign bank accounts where their aggregate value at any point during the tax year exceeded $10,000. The Foreign Account Tax Compliance Act (FATCA) of 2010 imposed upon foreign financial institutions an obligation to identify and report to the IRS accounts belonging to American taxpayers, under threat of a 30% withholding tax on all payments from American sources. FATCA established precedent for the global standard of automatic exchange of tax information (Common Reporting Standard, CRS) introduced by the OECD in 2014, which presently encompasses over 100 jurisdictions.

Great Britain employs a residence-based taxation system governed by the detailed Statutory Residence Test (SRT) introduced in 2013. United Kingdom tax residents face taxation on worldwide income, whereas non-residents are taxed exclusively on income from United Kingdom sources. For corporations, Great Britain has since 2009 applied a territorial system—foreign branch profits and dividends from foreign subsidiaries are generally exempt from United Kingdom corporation tax. Historically, Great Britain maintained special status for persons who were residents but not domiciled (non-domiciled residents, or non-doms), who could elect remittance basis taxation, paying United Kingdom tax solely on income remitted to the United Kingdom. The non-dom regime has been substantially curtailed in recent years, and the British government announced in 2024 its complete abolition and transition to a pure residence system.

Germany applies a classic worldwide system for tax residents, who are taxed on the entirety of worldwide income. German capital companies (Kapitalgesellschaften) are subject to federal corporation tax (Körperschaftsteuer) at 15% plus a solidarity surcharge (Solidaritätszuschlag) of 5.5% of the tax amount, yielding an effective rate of 15.825%, as well as to local trade tax (Gewerbesteuer), the rate of which depends on the municipality and ranges from approximately 8% to over 20%, such that aggregate corporate tax burden in major cities such as Munich or Frankfurt may exceed 30%. Germany maintains an extensive network of double taxation treaties (more than 90 agreements) ensuring mechanisms for avoiding double taxation through either the exemption or credit method.

Hong Kong represents the purest model of a territorial system worldwide. Only income arising in or derived from Hong Kong (Hong Kong-sourced income) is subject to taxation, whereas foreign-source income remains entirely exempt regardless of whether it is remitted to Hong Kong. Corporations pay profits tax at 16.5% (8.25% for small enterprises on the first HK$2 million of profits), and individuals are subject to progressive salaries tax ranging from 2% to 17% or a standard rate of 15%, whichever proves lower. This system renders Hong Kong exceptionally attractive for international capital groups structuring Asian investments through Hong Kong holding companies, which may receive dividends and capital gains from regional investments without taxation (read more about incorporation of companies).

Singapore employs a modified territorial system wherein income arising in or derived from Singapore and foreign-source income received (or deemed received) in Singapore are subject to taxation. However, a substantial portion of foreign-source income benefits from tax exemptions under the Foreign-Sourced Income Exemption (FSIE), which exempts from taxation foreign dividends, foreign branch profits, and income from services rendered abroad, provided certain conditions are satisfied. Singapore applies attractive tax rates—the standard corporate tax rate stands at 17%, and individuals are subject to progressive taxation ranging from 0% to 24% (for income exceeding S$1 million annually).

Malta offers a unique system for non-domiciled residents combining elements of territorial and residence-based taxation. Persons possessing non-dom status in Malta are subject to Maltese taxation only on Malta-source income and on foreign-source income remitted to Malta, whereas foreign-source income retained abroad remains untaxed. Particularly attractive, foreign capital gains are entirely exempt from Maltese tax even when remitted to Malta. The system provides for a minimum annual tax of €5,000 for non-doms earning foreign-source income exceeding €35,000 annually, and a 15% rate on remitted foreign-source income, rendering it highly competitive for high-net-worth individuals and international entrepreneurs (read more about Malta’s Resident Non-Domiciled Status: A Tax Haven in the Heart of Europe).

Poland applies a worldwide system for taxing residents. Individual tax residents of Poland are subject to taxation on the entirety of their income regardless of the location of income sources, under progressive tax rates (12% up to PLN 120,000 annually and 32% on the excess) or under a flat 19% rate for business activity. Non-residents are taxed exclusively on Polish-source income. Poland employs either the proportional credit method or the exemption with progression method to avoid double taxation, depending upon provisions of the applicable double taxation treaty. Poland has concluded treaties with more than 80 countries.

Mechanisms for Preventing Double Taxation

The coexistence of different systems for taxing foreign-source income naturally produces situations wherein identical income may be subject to taxation in two or more jurisdictions—both in the source country (on the basis of territorial nexus) and in the country of residence or citizenship (on the basis of personal nexus). States have developed an array of legal mechanisms designed to eliminate or mitigate this phenomenon.

The foreign tax credit method (credit method) constitutes the most frequently employed mechanism in countries with worldwide systems. The taxpayer is taxed in the country of residence on the entirety of worldwide income but may credit against tax liability the amount of taxes paid abroad on the same income. The tax credit operates as a direct reduction of tax liability (rather than as a deduction from income), rendering it substantially more favorable to the taxpayer. However, the credit is typically limited to the amount of domestic tax that would be due on the same income (foreign tax credit limitation), meaning that where foreign tax exceeds domestic tax, the excess is neither refunded nor available to reduce tax on other income, though in some systems (such as the American system) it may be carried forward to future tax years.

The exemption method entails complete exclusion of foreign-source income from the tax base in the country of residence. This method appears in two variants: full exemption, where foreign-source income is not considered at all in determining tax liability, and exemption with progression, where foreign-source income is considered in determining the tax rate applicable to domestic income but itself remains untaxed. The exemption method is typical of territorial systems and for certain income categories (particularly foreign branch profits or dividends from foreign subsidiaries) in countries employing modified territorial systems.

Bilateral double taxation treaties (bilateral tax treaties, double taxation agreements) constitute the most important instrument of international tax coordination. Most tax treaties are based on the OECD Model Tax Convention or the UN Model Double Taxation Convention (the latter favoring stronger source-country rights and more frequently employed in agreements with developing countries). Treaties allocate taxing rights over different income categories between the residence country and source country, typically providing exclusive taxing rights to one country or limiting withholding tax to a specified maximum level (e.g., 5-15% for dividends, 0-10% for interest, 0-10% for royalties). Treaties also contain a Mutual Agreement Procedure (MAP), which enables taxpayers and tax authorities of two countries to negotiate resolution of interpretive disputes concerning treaty application.

Contemporary Challenges and Prospects

Economic globalization, increasing mobility of capital and talent, and the development of the digital economy pose fundamental challenges to traditional systems for taxing foreign-source income. Multinational corporations exploit mismatches between the tax systems of different states and the gap between territorial and worldwide systems to engage in aggressive tax planning, shifting profits to low-tax jurisdictions while maximizing deductions in high-tax jurisdictions. The OECD BEPS project identified fifteen action areas designed to counter base erosion and profit shifting, including transfer pricing rules, treaty abuse (treaty shopping), and Controlled Foreign Corporation (CFC) rules.

The introduction of a global minimum tax rate of 15% through the Pillar Two mechanism represents the most ambitious attempt at international tax policy coordination in history. However, implementation of this system encounters significant technical and political challenges, including the necessity of adapting domestic legal systems, defining effective tax rates for complex corporate structures, and ensuring consistent application of rules across different jurisdictions. Some countries, particularly those with low tax rates (Ireland, Luxembourg, certain Caribbean jurisdictions), fear loss of competitive advantage derived from attractive tax systems (read more about Luxembourg funds).

For individuals, growing international mobility, the development of remote work, and the emergence of digital nomads challenge traditional concepts of tax residence based on physical presence and center of vital interests. Many countries are introducing special tax regimes for high-net-worth individuals and highly skilled professionals, offering preferential taxation or exemptions as a means of attracting talent and capital. Simultaneously, pressure is mounting for tax transparency through automatic exchange of information (CRS, FATCA), public country-by-country reporting by corporations, and beneficial ownership registers.

The future of international taxation will likely be characterized by continued convergence of national systems under the influence of OECD standards and pressure to eliminate harmful tax competition, while fundamental differences persist reflecting divergent conceptions of tax equity, economic efficiency, and state fiscal sovereignty. The balance among these competing values will determine the shape of future systems for taxing foreign-source income.

Robert Nogacki

Founder and Managing Partner of Skarbiec Law Firm, recognized by Dziennik Gazeta Prawna as one of the best tax advisory firms in Poland (2023, 2024). Legal advisor with 19 years of experience, serving Forbes-listed entrepreneurs and innovative start-ups. One of the most frequently quoted experts on commercial and tax law in the Polish media, regularly publishing in Rzeczpospolita, Gazeta Wyborcza, and Dziennik Gazeta Prawna. Author of the publication “AI Decoding Satoshi Nakamoto. Artificial Intelligence on the Trail of Bitcoin’s Creator” and co-author of the award-winning book “Bezpieczeństwo współczesnej firmy” (Security of a Modern Company). LinkedIn profile: 18 500 followers, 4 million views per year. Awards: 4-time winner of the European Medal, Golden Statuette of the Polish Business Leader, title of “International Tax Planning Law Firm of the Year in Poland.” He specializes in strategic legal consulting, tax planning, and crisis management for business.