The five flag theory is one of the most popular tax optimization strategies in the offshore community. It’s also one of the most misunderstood. In this article I cover the theory, who can benefit from it and how to implement it.
The theory first appeared in the 80s as a refinement of Harry Schultz’s original three flag theory. It takes advantage of gaps in tax law and essentially allows people to “slip through the cracks” by internationalizing every aspects of their lives. To implement it, an individual has to carefully distribute his life across five different jurisdictions. The first flag is citizenship and has to be planted in a country that has a residential tax system. The second flag is residence and has to be planted in a country that has a territorial tax system. The third flag is business and has to be planted in a country that taxes businesses on a territorial basis. The fourth flag is asset and has to be planted in a stable, well governed tax haven. The fifth flag is the rest of the world where you will spend the majority of your time, moving around on tourist visas.
Here’s an example: John is Canadian and is a legal resident of Malaysia. Canada doesn’t usually tax it’s citizens if they do not reside in Canada because of the assumption that they are taxed in their new country of residence. In this case Canada doesn’t tax John because they assume that Malaysia does. The thing is, Malaysia is a territorial tax country and this means that in most cases only locally sourced income is taxed there. Because John generates all his income through a Hong Kong company, holds all the money in a bank account on the Isle of Man and spend most of his time in Thailand, he doesn’t have to pay any taxes in Malaysia. In effect, John doesn’t have to pay taxes anywhere.
Considering it was first published over thirty years ago, you’d think that by now most governments would have caught up with it and closed all the obvious loopholes that enables it. The thing is, they haven’t. In fact, implementing it has become even easier with the internet and the number of five flag theorist has grown to a record high.
What’s the catch?
It’s the travel part. To really “fly under the radar”, a five flag theorist has to travel continually in order to avoid becoming a tax resident somewhere other than flag two. The traveling doesn’t have to be fast, in fact most countries allow tourists to stay up to 6 months before considering them tax residents. That being said, the constant traveling is still a big deal and may be a no-no for some.
Who can benefit from it?
Anyone whose main source of income is generated in a location independent way can benefit from implementing the theory. The main benefits: much lower tax burden, increased legal protection, better risk management and the ability to access more opportunities. Even American citizens can become five flag theorists although the process is slightly more complicated, requires 330 days every year out of the country and in most cases can’t completely eliminate taxes.
How to get started
The first step is to acquire a new residency and to have your home country recognize it. Panama is a great option and so is Paraguay, Hong Kong, Singapore, Malaysia etc. The second step is to register an offshore business in a territorial taxation country. There are multiple options here but Hong Kong and Singapore are the most popular ones. The third step is to move your assets offshore. There are multiple ways to do this and multiple jurisdictions to choose from. The process depends entirely on your home country and the type of assets. The fourth step is to sever any financial ties you might have outside of the countries chosen for flag 3-4. The last step is to start traveling and enjoy your new life.
Obviously I do not recommend making such a drastic move without first seeking professional advice. There are simply too many mistakes one could make and the tax consequences of such mistakes could be very serious.