You desire to break free from the conventional 9-to-5 routine and experience greater autonomy and adaptability in your life. You’re envisioning yourself engaging in remote work from various places, immersing yourself in unfamiliar cultures, and solely relying on your laptop to generate income.
Isn’t it an extremely challenging way of living?
Before you set off and make travel arrangements, there is an obstacle that must be addressed, which is the main difficulty faced by most digital nomads. This obstacle refers to the taxes that digital nomads have to deal with.
As a digital nomad, it is important to follow the tax laws of both the countries you visit and your own country, as they can differ significantly. Additionally, you will need to consider visa requirements, which may restrict the duration of your stay in a country and the type of work you are allowed to engage in.
Additionally, if you are a US citizen residing and working abroad, you are still obligated to pay taxes to the IRS.
Where Do Digital Nomads Pay Taxes?
To start off, let’s address the most commonly asked question: Are taxes paid by digital nomads?
Yes, digital nomads do pay taxes, but it is indeed one of the major challenges they face during their journey.
The majority of digital nomads often pay taxes in their home country or the country where they spend the most time. Nevertheless, it is not unusual for digital nomads to pay taxes in several countries.
There are multiple reasons why a small percentage of digital nomads do not pay taxes, which include earning an income below the taxable threshold, living in tax-friendly nations, or engaging in tax evasion.
It’s Not That Simple: The Complexities of Taxes for Digital Nomads
The taxation situation for digital nomads is not simple. It is a complicated situation that frequently involves figuring out outdated laws and regulations that haven’t been updated to match the current remote work situation.
In a hypothetical scenario, let’s analyze the sequential steps taken by John, a digital nomad from the UK. He chooses to deregister as a resident in his home country and relocate to Bali for both living and working. His assumption is that this action exempts him from the responsibility of paying taxes in the UK. Nonetheless, it’s important to note that this widely believed notion is predominantly false.
There is a tax residency fallback law that exists in many developed countries, such as the UK. This law states that if someone is not a tax resident in another country, they are treated as a tax resident in their country of citizenship or their previous residency. Therefore, if John does not become a tax resident of another country, he will continue to be considered a UK tax resident for tax purposes.
Digital nomads need to navigate numerous complex tax laws, including the one mentioned above, as each country has its own tax laws and treaties. Understanding these laws and treaties can be overwhelming, but in the following paragraphs, we will attempt to break them down for you.
Digital Nomads and the 3 Tax Systems
It is crucial to first acknowledge that various countries possess distinct tax systems before delving into their intricacies. In essence, there exist three main types of tax systems: residential, citizenship-based, and territorial.
- Residential Tax System: Countries with a residential tax system, tax residents on their worldwide income. The criteria for determining residency can vary, but it’s often based on the amount of time spent in the country.
- Citizenship-Based Tax System: Only two countries, the U.S. and Eritrea, tax based on citizenship. This means that citizens are required to file taxes on their worldwide income, regardless of where they live.
- Territorial Tax System: Countries with a territorial tax system only tax income earned within their borders. This can be advantageous for digital nomads who earn income from foreign sources.
Despite appearing straightforward, terms like residency, domicile, and citizenship often cause significant confusion.
Residency vs Domicile
Although the concepts of residency and domicile may appear similar, they possess separate meanings within tax law.
Residency commonly pertains to the location in which you reside during a specific period. If you reside in multiple countries within a year, you can be considered a resident of each country if you live there for a certain period of time. The specific duration may differ among countries, but it is typically approximately 183 days in a calendar year.
On the contrary, domicile primarily concerns your permanent residence – the location you plan to go back to after being absent. Usually, you can only have one domicile at a given time, typically being the country you view as your lasting home, regardless of your current whereabouts. Your tax responsibilities can be influenced by your domicile, particularly if you maintain substantial connections to that country.
Residency vs Tax Residency
These terms, which are likely to cause confusion, are also seemingly similar but distinct from each other.
Residency pertains to the place of your residence, whereas tax residency concerns the place where you are legally required to fulfill your tax obligations. The criteria for establishing tax residency can extensively differ from one country to another. These criteria may rely on various factors, including the duration of your stay in the country, your employment situation, and the whereabouts of your primary residence.
You could be living in Bali for a year, making you a resident of Bali. However, if you’re a UK citizen and have significant connections to the UK, you may still be regarded as a UK tax resident. Consequently, you are required to disclose your global income to the UK tax authorities, regardless of your residence in Bali.
Tax Residency vs. Citizenship
When considering digital nomad taxes, it is crucial to comprehend the distinction between ‘citizenship’ and ‘tax residency’.
Your citizenship is generally determined by your place of birth or your home country. It is the location that you usually regard as your ‘home’, even if you are presently not residing there.
Your tax residence country is determined by certain factors such as the number of days you spend in the country, your connections or ‘substance’ there, and other criteria established by the tax laws of the country. In essence, it is the country where you are recognized as a legal resident for tax purposes.
For some digital nomads, their home country and tax residence country can be different, although it is also possible for them to be the same. You may be a citizen of one country, but if you spend a sufficient amount of time in another country (or have sufficient substance there), you may be deemed a tax resident.
Do Digital Nomads Have to Pay Self-Employment Taxes?
Many digital nomads who are self-employed will be responsible for paying the US self-employment tax, which consists of the following:
- 12.4% of your income for Social Security
- 2.9% of your income for Medicare
After adding up all the numbers, the outcome will be 15.3% of your earnings. It is worth noting that the self-employment tax cannot be exempted using the Foreign Earned Income Exclusion (FEIE) or Foreign Tax Credit.
If you reside in certain countries, referred to as having International Social Security agreements or “Totalization Agreements” with the US, you might be able to avoid paying the self-employment tax and only be liable for Social Security taxes pertaining to the foreign country of your residence.
What Tax Forms Do Digital Nomads Need to File—and When Are They Due?
Digital nomads may have to file different tax forms depending on their individual circumstances. It can be overwhelming to keep track of which forms are necessary to file and which ones are not.
To aid in simplifying matters, provided below are a few of the most frequently used tax forms for individuals leading a digital nomad lifestyle.
a) IRS Form 1040: Individual Income Tax Return
The personal tax return, known as IRS Form 1040, is required for almost all US citizens, including digital nomads.
Generally, the deadline to submit Form 1040 is April 15 annually. However, if April 15 falls on a weekend or holiday, the due date may be postponed by a few days. It is important to note that an extension can be requested in such cases.
b) IRS Form 2555: Foreign Earned Income
In order to receive the FEIE and Foreign Housing Exclusion, it is necessary for you to fill out Form 2555 and include it with your Form 1040.
Because the same due date of April 18th applies, this form is always submitted together with Form 1040.
c) IRS Form 1116: Foreign Tax Credit (Individual, Estate, or Trust)
Form 1116 is required for claiming the Foreign Tax Credit and, similarly to Form 2555, must be included with your Form 1040 and filed simultaneously.
d) FinCEN Report 114: Report of Foreign Bank and Financial Accounts (FBAR)
US individuals, including digital nomads, who possess over a total of $10,000 in foreign bank accounts must file an FBAR.
Although this form is submitted separately from Form 1040, it is still due on the same date: April 18th. (Nevertheless, if the deadline is missed, an extension until October 16th, 2023 is automatically granted.)
Regardless of the method chosen, it is necessary to submit this form online and directly send it to the Financial Crimes Enforcement Network (FinCEN), rather than the IRS.
e) IRS Form 8938: Statement of Specified Foreign Financial Assets (FACTA)
Form 8938 must be filed by individuals living abroad, such as expats, digital nomads, or other US persons, who possess foreign assets exceeding a specific threshold.
- For digital nomads filing their taxes individually, that threshold is $200,000 at the end of the tax year or $300,000 at any point during the tax year.
- For digital nomads filing a joint tax return, the threshold is $400,000 at the end of the tax year or $600,000 at any point during the tax year.
When it comes to digital nomads who are not considered to be living abroad, the thresholds for them are significantly lower. Specifically, the thresholds are reduced to a quarter of the amounts mentioned above.
If you cannot meet the requirements of the physical presence test or the bona fide residence test, the IRS will still use the lower thresholds for Form 8938, even if you are living abroad.
Form 8938 is typically not required to include foreign real estate and should be filed along with your Form 1040 by the same due date.
Substance and Its Importance in Determining Tax Residency
The 183-day rule is frequently used as a guideline, but it is not the sole determinant of tax residency. It is merely the surface-level aspect, as the concept of “substance” is pivotal in establishing your tax responsibilities. This factor has the potential to significantly impact your tax obligations, either positively or negatively.
When considering substance, you should ponder on your genuine and important connections or interests in a country. It encompasses more than just being physically present, but rather focuses on the extent of your ties to a particular place. As an example, you could question yourself:
- Do you own property in the country?
- Is your family based there?
- Do you have a local bank account or investments?
- Are you registered with local authorities for utilities, healthcare, or other services?
Your ‘substance’ in a country is influenced by all these factors.
Countries examine the essence because they intend to impose taxes on individuals who are making worthwhile use of their resources and infrastructure.
If you have substantial ties to a country, you could still be considered a tax resident even if you spend less than 183 days there.
On the other hand, it is possible that being present in a country for more than 183 days without any substantial connections or interests does not necessarily qualify you as a tax resident.
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