What it means
Tax systems generally take one of two approaches. A territorial system taxes only income earned inside the country, while a worldwide system taxes residents on everything they earn, wherever it comes from.
Many countries use a mix of the two. Under a worldwide system, a person or company must report foreign salaries, rental income, interest, dividends and business profits on the home tax return.
For a company, this includes profits earned by foreign branches and, depending on the rules, certain income of foreign subsidiaries. The obvious danger is double taxation, where both the country of source and the home country tax the same income.
Two main tools reduce it. A foreign tax credit lets the taxpayer deduct foreign tax paid from the home country tax, while tax treaties between countries allocate taxing rights and often lower withholding rates.
The foreign tax credit is normally limited so that it cannot cancel the home tax on domestic income. The limit is the home tax on total income multiplied by the share of income that is foreign, and any unused credit may be carried to other years under the local rules.
For businesses expanding abroad, the worldwide approach has practical effects. It increases reporting, requires translation of foreign accounts into the home currency and means that profits kept overseas may still be taxed at home, so tax planning and transfer pricing become central.
Individuals who move abroad can also be affected. Citizens of the United States remain subject to its tax rules wherever they live, and they often claim credits or exclusions to limit the cost.
In practice
Real-world examples
Example 1
A US consultant spends a year working for a client in Singapore and pays tax there on her fees. She still reports the income on her US return as part of her worldwide income. A foreign tax credit prevents her paying the full tax twice.
Example 2
A manufacturer with a subsidiary in Mexico must include certain foreign profits in its home tax calculation. The finance team prepares a schedule showing the profits by country and the foreign tax paid on each. It uses the schedule to claim foreign tax credits.
Example 3
A retired person living in Spain receives dividends from a company in her home country and rent from a flat abroad. Her tax residence in Spain means Spain taxes her on both, while her home country may tax the dividends at source. A tax treaty decides how the two countries share the taxing rights.
Think of it
Think of worldwide income like a personal household budget. Even if you earn a salary from your main job, pick up weekend work, and receive rental income from a holiday cottage, your family total budget counts all sources together, no matter which pocket the money goes into.
Formula
Calculation
Foreign tax credit limit = Home tax on total income x (Foreign income / Total income)
Net home tax = Home tax on total income - Foreign tax credit allowed
A taxpayer earns $150,000 from domestic work and $30,000 of rental income from a property abroad, on which $6,000 of foreign tax is paid. Worldwide income = 150,000 + 30,000 = $180,000. Assume, for illustration, a flat home tax rate of 20%, so home tax on worldwide income = 180,000 x 20% = $36,000. Credit limit = 36,000 x (30,000 / 180,000) = 36,000 x 1/6 = $6,000. The foreign tax paid of $6,000 is equal to the limit, so the credit allowed = $6,000. Net home tax = 36,000 - 6,000 = $30,000.Case study
Seen in the real world
Atlas Bridge Engineering is an illustrative, fictional design firm based in the United States, with a small office in Brazil. In one year the firm earned $4,000,000 in the United States and $1,000,000 in Brazil, on which it paid $230,000 of foreign tax.
Worldwide income was 4,000,000 + 1,000,000 = $5,000,000. At an assumed flat home rate of 21%, home tax on worldwide income was 5,000,000 x 21% = $1,050,000, and the credit limit was 1,050,000 x (1,000,000 / 5,000,000) = $210,000.
The foreign tax of $230,000 exceeded the limit by $20,000, so only $210,000 could be claimed this year and the unused $20,000 was available to carry to other years under the rules. In the illustrative sequel, the tax team reviewed whether its Brazilian pricing was setting profit at a level that triggered more foreign tax than needed.
Watch out
Common mistakes
- Assuming income earned and taxed abroad can be left off the home tax return, when worldwide taxation requires it to be reported.
- Claiming a foreign tax credit larger than the limit, which can lead to disallowed amounts and penalties.
- Ignoring currency translation, when foreign income must be converted into the home currency using an acceptable rate.
Questions
People also ask
Which countries tax residents on worldwide income?
Many do, including the United States, which also taxes its citizens abroad, while some use a mainly territorial system that taxes only domestic income.
How is double taxation avoided?
Usually through foreign tax credits, exemptions for certain foreign income and tax treaties between countries.
Does worldwide income apply to companies as well as individuals?
Yes, in countries with a worldwide system, companies are taxed on profits wherever earned, subject to rules on credits and on foreign subsidiaries.