Published on December 9th, 2013 | by Daniel2
The Five Flag Theory
It is not always straightforward how you should organize your financial and personal matters as a digital nomad. Most digital nomads I know (and myself included) are still incorporated in their native country and pay tax there. Which is actually quite at odds with the lives that most digital nomads live. For instance, this year I have lived for less than 3 months in the Netherlands in total, but I pay tax as if I live there full time.
The disadvantages of these current state of affairs are obvious. First, there are the administrative issues, as handling mail, housing costs (if you still own a house there), and paying taxes. And there are opportunity costs. The taxes in most Western countries are sky high compared to what you get back for them as a working individual with a business, and being mostly abroad.
However, as a location independent professional you have a potential advantage that most others do not have: you can live everywhere in the world. But how can you use this to your advantage financially and personally? A while ago I bumped into a useful framework for this, named the “Five Flag theory”. This framework was originally contrived for high level expats or wealthy individuals. But it is actually very practical for the common digital nomad as well. Basically, the Five Flag theory is an arrangement according to which you organize your personal affairs across different countries.
The “Five” flags are:
- Passport (legal citizenship)
- Legal residence
- Business Incorporation
- Asset Base
- Playgrounds (lifestyle)
So, first you split up your personal affairs according to these five factors. Then, you will plant a flag in the most optimal country for the relevant factor. Overall this will optimize your personal finances, legal stability and privacy. And as you may have experienced, being a “tourist” can be sometimes much more convenient than being a local tax payer. Let’s go dig deeper in the five factors and explain in detail.
Factor 1 – Passport
Your passport is the base from which you derive your political and legal legitimacy or security. This is especially important when you travel. In the basic sense, it determines which countries you can enter and on what basis (i.e. visa requirements). This means that if you have a passport from a country with high prestige and credibility these things will be easier. With a good passport, it will also be easier to get things done legally in other countries, so in order to plant your other flags.
However, it is important that your passport is from a country that does not tax its citizens who earn money outside of the country. Passports from most European nations are fine in this regard, but the USA passport is a good example of a detrimental passport, as they will tax their citizens regardless their residence and income patterns.
In short, the best countries to have a passport and legal citizenship from are most developed countries, with the notable exception of the USA. In case you are a US citizen, renouncing your citizenship and getting a passport from another country may be the only recourse. Which is a time-consuming process, but doable.
Factor 2 – Legal Residence
The second base is where you establish you legal residence. This will determine where you pay your personal income tax. For this it can be beneficial to choose a location where the average income tax is low, but also has a stable legal environment. In most cases your legal residence will be in a different location than your passport country.
Good locations to establish your legal residence are Switzerland, Monaco, Malta, British Virgin Islands, Maldives, China, Hong Kong or Singapore. These countries have almost non-existent income tax, especially when you are a foreign resident. Also many countries in Eastern Europe have relatively low income tax. These locations are well established, have sound legal boundaries, and are easy to reach by airplane.
Factor 3 – Business Incorporation
If you want to go for the full five flags and optimize your finances, it will be very beneficial to own a business and to incorporate it in locations where the corporate tax rate is low.
A famous location to incorporate your business is Hong Kong. Besides that corporate tax rate (especially for foreign owners) is low, Hong Kong also has a top notch banking system, which will make it easy to transfer money to and from the country. Setting up a business in Hong Kong costs around $1200. As long as your business income is made outside Hong Kong, you effective corporate tax rate will not be higher than 15%.
Other good locations are Singapore, Bahama’s, Bermuda, Cayman Islands, Malaysia and Switzerland, if you take various tax deductions into account. In case you are an advanced entrepreneur, it can be beneficial to split up your business bases, i.e. do not have all your business incorporated in one country. This will diversify political risk.
Factor 4 – Asset Base
When you have built up some considerable assets, for instance in bank savings or investments, tax on savings and capital interests can become important factors. Again, these taxes in most western nations tend to be sky high. So it makes sense to put your money in locations where they are subject to low tax. These locations can be fully different from where you have your residence or business incorporations, but it would be smart to have them close in the sense that you can reach them easily by plane from your current location.
Famous locations to have your asset base are Switzerland, Liechtenstein, Singapore and Hong Kong. Less known locations are Chili, Panama and Malta. Be aware of political risks and you will do fine. As with business bases, also with regard to your asset locations it can be good to diversify among locations, in order to decrease potential political risk.
Factor 5 – Playgrounds
Probably the most fun flag to think about: where to live your life? This does not have to be in those places where you planted your other flags, although it can efficient to have it be the same place as your legal residence. All in all, this decision is purely based on your personal preferences in lifestyle and what your value. Intellectual connoisseurs will find probably Italy or Japan more interesting, while party persons are more inclined to be in South-East Asia, for instance. For digital nomads, important basic considerations are internet speed, quality of life and attitude to foreigners. You may base your choice also on the consumption tax rate and VAT rate, but when base prices are relatively low this will probably not matter much.
If you are an online entrepreneur, you should possibly also consider the location of your websites, servers and databases as a 6th add-on factor. Some locations will be safer and more secure with regard to your online data than others.
How to achieve the Five Flags
It will probably be hard to achieve the Five Flags in a short time period. It is something which can need a substantive effort and time of planning. However, it can be done and many have done it before you. Be careful and take care of the loose ends when you engage in the process of splitting and optimizing the location of your affairs.
In specific, keep the following in mind:
- Take the professional route. Do not skimp on planting your five flags, but do your due diligence and consult the advice of experienced tax lawyers when in doubt.
- Take advice and consultations in the locations where you want to plant your flag. Do not go for consults in your home base. Most of the time the consultants back home will not have enough experience or knowledge about the subject matter.
- Take your time. The process of planting your flags is time-consuming. Do not try to rush things, also because you do not want to attract attention to yourself too much. Although everything you do is perfectly legal, your home authorities probably do not like it.
- Tick off all the checkboxes for back home. This means, for instance, that you make sure your home tax authorities will unsubscribe and unregister you from your tax liabilities in your native country. Make sure that you have written proof of this, and that your passport country will not have you liable for any future taxes.
- Make sure you are flexible. That means – especially when your start out – sign a short-term lease for your legal residence. Make sure you have short term contracts, and so forth. This way you can test the waters and be flexible in case some unexpected issues or regulations come up.
All in all, I think the Five Flag theory is a very useful framework for arranging your financial and personal affairs. Personally, I have not completed the full circle yet, but I am sure I will engage into it much more closely the coming years, ceteris paribus.