The broken flag theory

The flag theory is a highly vivid concept which has been developed more than sixty years ago. It describes the strategic approach of (in the figurative sense) planting flags in different countries to allocate different aspects of taxation, regulations, and economic framework.

A case study "the taxation of digital nomads in thailand"

Thailand's digital nomads and "promads" utilize the four flag theory in a simplified matter. With a passport from Europe, the USA, or other OECD countries, a raw assembled paper offshore company in Hong Kong, BVI, or else, a personal bank account in Singapore, and tax residency in Thailand. The basic idea is to work in Bangkok, Chiang Mai, or on a sunny Thai island on behalf of the offshore company, to use the foreign bank account as intermediate storage for the proceeds, and to utilize Thailand’s beneficial patchy tax system for a virtually tax-free life.

If you start an online business in your high-tax home country and use in all your correspondence and invoices the address of a no-tax offshore company, you will not seriously expect that your local taxation rules allow that the proceeds remain untaxed. The exotic letterhead or the email signature obviously can't move the tax burden offshore abroad. Unfortunately, Thai tax laws are the same and not different. All your Thai online business proceeds are taxable in Thailand.

There are specific advantages of Thai personal income taxation: Limited taxation of foreign income, no taxation of foreign income that is not remitted to Thailand, no CFC (controlled foreign corporation), no taxation at the place of management. Unfortunately, all these benefits of Thailand's tax system can't be efficiently utilized in the typical case of a so-called digital nomad and his/her online business in Thailand.

Traditionally, many foreigners still like playing games with the Thai Revenue Department - and the Labor Department as well. The existence of offshore entities could be hidden, the exchange of tax data still has a low level, the level of enforcement of Thailand's laws was and is low. At least it is helpful to understand the risk profile of such activities and to be ready to evacuate if things get too hot:

The digital nomad business case

Typically, the foreign digital nomad lives in Thailand by holding a yearly retirement visa or a 5 or 10-year Elite Tourist Visa. Under the scheme, he/she registers a company at an offshore jurisdiction (the "company") and serves as the company’s sole director and shareholder while constantly being in Thailand. The company does not have office space, employees, key assets, or business activities outside of Thailand.

The company operates an online business. Substantial supporting activities are done day-to-day by a team of remote workers, e.g. in the Philippines based on a freelance service contract. The company does not have employees, customers, or suppliers in Thailand. The digital nomad just supervises and monitors the overall business. He/she might or may not do marketing, invoicing, and other administrative tasks. From the viewpoint of the digital nomad, everything is as automated as possible, and his/her time input should be reduced to a few hours per week.

The digital nomad does not receive a salary from the company. Instead, dividend distributions are paid out to the digital nomads bank account outside of Thailand. Any bank transfers by the digital nomad from his/her foreign bank account to Thailand are not made in the same year as the dividend payment.

The surprising Thai tax consequences

The dividend payments of the company are subject to regular Thai personal income taxation when the money is paid to the foreign bank account of the digital nomad. A later money transfer to Thailand is not taxable.

The (whole) profits of the company are subject to Thai taxation. As the company's director, the digital nomad is personally liable for the company's tax obligations in Thailand.

Justification of the tax opinion

Unlimited personal income taxation

The digital nomad accomplishes his/her activities in Thailand and, therefore, is subject to Thai taxation. Under Section 41 Revenue Code, as translated into English on the Revenue Department's website, "a taxpayer who … derived assessable income … from business carried on in Thailand, … shall pay tax". This follows international tax standards. It makes no difference whether the assessable income is classified as salary, royalties, dividends, or other. Also, it is not relevant whether the income is generated through 40 work hours per week or by a four hours per week activity.

Timing of the taxation

The income will be taxed at the time when it is paid to the digital nomad. It is not relevant whether the payment is made to a Thai or foreign bank account. Section 41 Revenue Code, as quoted above, ends with "whether such income is paid within or outside Thailand." The payment to a foreign bank account does not protect the DN from the immediate tax burden. Income generated in Thailand is taxed on a worldwide basis. The transfer of the payment amount from abroad to Thailand within the same year or later, is, therefore, not taxable.

Foreign dividends as Thailand-sourced income

The burden is on the taxpayer to prove to which extend his income is foreign-sourced. "Derived" covers earned as well as generated. The dividend payments obtained by the digital nomad from the company base fully on the business activities of the company in Thailand. Therefore, it falls under the wording of the tax regulation.

The foreign company as a tax shelter

The company is an own taxable entity. It shelters and protects the shareholder from immediate taxation of the profits on the level of the company. Without a dividend distribution or other form of money transfer to the digital nomad, no assessable income is generated and, as a consequence, the taxation can be deferred.

CFC taxation

An offshore company can be misused to avoid dividend payments to its shareholders, this is the so-called ballooning strategy. Under controlled-foreign-company legislation principles, company profits could be taxed at the level of the shareholder, even without any dividend distribution. However, Thailand has no yet such CFC rules. As a consequence, the digital nomad could delay (but not avoid forever) the tax payments for personal income tax purposes by keeping the profits on the Company level and its corporate bank account. This works as long as the Company's profits are not needed to be consummated or invested in Thailand.

Thai tax residency

Taxpayers are classified into "tax resident" and "non-tax-resident". "Tax-resident" means any person residing in Thailand for a period or periods aggregating more than 180 days in any tax (calendar) year. Determining the source of income can be complex and contentious. There is no exact guide that can be applied to every scenario to determine whether an income is domestically sourced or foreign-sourced. It depends on the nature of the income and of the business transactions which give rise to such income.

Generally, the income shall be deemed derived from outside Thailand if the income is attributed directly to activities conducted outside Thailand. For this, it is traditionally decisive where the people, the assets, and the business risks are located. Typically, the digital nomad has due to the length of his/her yearly stay in Thailand the status of a tax resident. However, this is not relevant for income from domestic sources. It makes no difference whether the digital nomad travels a lot or not.

Remittance principle for foreign-sourced income

A tax-resident of Thailand is liable to pay taxes on income from sources in Thailand as well as on the portion of the income from foreign sources that is brought into Thailand in the same calendar year it is received. Under the given scheme, the digital nomad is active in Thailand only. All income is generated in Thailand.

Transfer of the income to Thailand

The digital nomad transfers payments from his/her foreign to his/her Thai bank account in the year following the year the dividends are received. These bank transfers do not generate income for the digital nomad and, therefore, are not taxable. Also, they do not retroactively reclassify foreign dividend payments of the previous years into Thailand-sourced income. As a result, the bank transfers do not result in direct or indirect taxable income under Thai laws. The tax burden arose already by paying to the foreign bank account of the digital nomad.

No Philippine implications

While the digital nomad works in Thailand, certain business tasks are outsourced to freelancers in the Philippines. These freelancers are not employees or officers of the company, and, therefore, they do not create an own taxable permanent establishment in the Philippines. Instead, the company obtains its whole profits in Thailand and it is not possible to allocate a certain percentage of the profits to a Philippine business.

Permanent establishment in Thailand

The fact that all profits are made by the company as an offshore entity, does not exclude these profits from Thai taxation. As a general concept, business activities done abroad, create their own tax entity, known as a permanent establishment. The profits base on work in Thailand and are subject to Thai taxation. Under Section 76 bis Thai Revenue Code,

"For a company … incorporated under foreign laws which has an employee, an agent or a go-­between for carrying on business in Thailand and as a result receives income or profits in Thailand, such company … shall be deemed to be carrying on business in Thailand and the person who acts as an employee, an agent or a go-­between for the business, whether he is an individual or a juristic person, shall be deemed to be the representative of the company … incorporated under foreign laws and shall have the duty and liability to file a tax return and tax payment in accordance with the provisions of this part, with respect to only the above-mentioned income or profits."

Director’s tax liability

As a result, the offshore Company is subject to Thai taxation. It is requested to provide a regular and accurate accounting of its PE profits. By failure of doing so, the overall profit will be deemed to be taxable in Thailand. The Thai Revenue Department will not be in a position to execute their tax assessments against the company abroad. However, the digital nomad is responsible as company’s director to do such tax payments and will, therefore, be held tax liable in Thailand.

No place of management doctrine

Under international tax regulations, a corporation is typically subject to the taxes of the country where it has been established. Depending on the local tax laws, corporate income taxes might also exist in the country where the top management is located and where the main business decisions are made. This place of management doctrine does not apply to the DN's case, because such principles are not implemented in Thailand’s regulatory framework.

Discovery risks in Thailand

The business model of the DN follows a usual scheme. In all these cases, the existence of a foreign company and the circumstances of working for this company are concealed by various means. One variant includes arrangements in which a registered activity is taken up for a BOI-sponsored company, while additional profits are earned for and through an offshore company ("IGLU model"). This has gone well regularly in the past. In times of intensive data exchange, the protection against detection is more and more spotty. In case of detection by the tax authorities, there is the threat of, among other things, an additional payment for the taxes of the last ten years.