Double taxation occurs when the same income is taxed twice, impacting individuals and businesses. Explore its types, causes, and solutions like DTAs and exemptions.
By Brad Nakase, Attorney
Email | Call (888) 600-8654
Have a quick question? I answered nearly 1500 FAQs.
Because of the way both individual and business income is taxed, there is a possibility of double taxation.
There are two main types of double taxation: corporate double taxation, in which company profits are taxed twice (once on profits and again on dividends), and international double taxation, in which foreign income is taxed twice (once in the country of origin and once in the country of residence) for investors.
Corporate double taxation can be mitigated in a number of ways, including by law, the formation of an organization as a sole proprietorship, parentship, or limited liability company (LLC), the avoidance of dividend payments, and the incorporation of shareholders into the workforce of the companies that their stockholders control.
Double taxation agreements (DTAs) and other trade treaties, as well as relief mechanisms like exemptions and foreign tax credits, can help reduce the impact of international double taxation.
This scenario occurs when the same income is subject to taxation at two distinct levels on corporate earnings. When a business pays taxes on its net income, it is subject to both the corporation tax and the dividend tax. The United States isn’t the only country where corporations face double taxation.
Proponents of a system free of corporate double taxation point out that shareholders pay taxes on their share of a company’s profits, and then they face personal taxes on dividends, which amounts to double taxation on the same income.
Those who want to keep the current system of double taxes on profits and dividends argue that it’s fair since a company’s corporate form creates a distinct legal entity from its owners.
Although multinational corporations and other businesses with operations in more than one country are the primary targets of international double taxation, individuals based in other countries may also be subject to this practice. In some cases, both the nation of origin and the investor’s home country may impose taxes on their overseas income.
Accordingly, double taxation contradicts the tax fairness principle, inhibits cross-border investment by limiting capital movement, and can lead to higher prices for consumers and businesses by increasing the tax burden on investors.
In order to eliminate wasteful and investment-discouragement aspects of double taxation, new legislation is required. For established businesses that do not require substantial funding, allowing investors to receive dividends free of taxes would encourage them to reinvest rather than hoard their money.
Forming a limited liability company (LLC), partnership, or sole proprietorship allows for the adoption of pass-through taxation provisions. In this type of organization, the owner(s) or partners split the earnings equally, hence there are no dividends. Nevertheless, this tactic will only work for smaller businesses.
Avoiding payment of dividends and holding earnings in the firm to encourage growth. Businesses in their early stages or those experiencing rapid expansion might benefit from this approach. A larger product offering and a larger portion of the market depend on it. If a company is well-established, has consistent cash flows, and doesn’t need much capital, its shareholders will likely demand dividend payments.
While shareholders may be able to claim themselves as workers in smaller businesses or as executive directors in bigger ones and get a salary, this income is still subject to personal taxation. Double taxation would not apply.
Establishing tax treaties between nations and legal authorities is the most effective strategy for dealing with the problem of international double taxation. The accords facilitate cooperation and information sharing across various governmental bodies. Their stated goals include the following: the facilitation of international commerce, the elimination of tax evasion, the promotion of tax certainty, and the reduction or elimination of illicit taxing activities.
Double taxation agreements (DTAs) are pacts that two nations sign to avoid or reduce the possibility of territorial double taxes on the same income. The elimination of double taxation is a primary goal of DTAs, as this practice inhibits commerce between countries. Double taxation hinders investment flows and is unproductive in today’s global community.
Countries are encouraged to trade and invest with each other across borders through DTAs. In order to increase trade and remove double taxation, governments often encourage the signing of DTAs when their commerce is increasing and both countries expect it to continue rising. The DTA prevents double taxation by establishing rules and regulations for the treatment of revenue obtained via cross-border transactions.
The investor’s home nation may be required to pay tax under a DTA, but the country of revenue generation may be exempt. Another option is for the investor to pay taxes in the nation where their income is considered to have originated, and then claim a foreign tax credit when they return home.
No matter where the money comes from, taxpayers who use the exemption technique only have to pay taxes in their own nation or jurisdiction. People must pay taxes in the country where they are earning money. To increase trade and corporate globalization, the exemption technique removes obstacles to open commerce and encourages investors to invest across borders in their own nations.
As a result of their low or nonexistent tax rates on foreign earned income by resident firms and people, countries that rely only on the exemption approach are known as tax havens. Those with a lot of money, large companies, and banks looking to avoid paying taxes often go to tax havens.
On the other hand, tax havens are under fire for allegedly assisting corrupt individuals and companies in hiding their money dealings and laundering it. A few examples of tax havens are Cyprus, Bermuda, The Bahamas, and The Cayman Islands.
The foreign tax credit system applies taxes to citizens’ income whatever its source. Under the FTC approach, a resident’s home nation can deduct foreign taxes paid in the country from their domestic tax burden.
You can reduce your tax bill in one nation by paying taxes in another. With this strategy, companies may function properly within the bounds of current tax laws. The FTC is sometimes called the Capital Export Neutral System.
Have a quick question? We answered nearly 2000 FAQs.
See all blogs: Business | Corporate | Employment Law
Most recent blogs:
Contact our attorney.