Double Taxation

What is Double Taxation?

It refers to the imposition of taxes on the same income stream, assets, or financial transaction at two different points in time. The latter comes in two forms, namely corporate double taxation, which is the taxation on firms' profits.

When it comes to corporations, the firm is first taxed as a business entity, after which its shareholder’s personal income is also taxed. This takes place since corporations are considered separate legal entities from their shareholders.

Corporations pay their tax obligations on their annual earnings. Now, when the organization pays out dividends to its shareholders, those dividends also have tax liabilities. 

Holders who received dividends must then pay taxes on them, creating double taxation.

It is often avoided to maximize corporate and personal profits.

While the latter is considered to negatively affect a corporation by reducing their savings and investment, a small group argues that the latter is necessary to prevent wealthy individuals from avoiding taxes by paying their salaries through company dividends received from owning stock.

Others argue that since the US corporate income tax rate stands at 39.1%, the highest among the developed countries, it suppresses investment and increases the borrowing of funds by corporations. 

Countries such as Estonia and Australia have taken measures such as integrating their tax code to bypass double taxation.

Categories of Double Taxation

A large number of states have personal income taxes that pay dividends as well. 

This form of taxation (usually at the corporate level) has been at the center of a much-heated debate, especially in the US, where efforts to reduce this form of taxation have vastly been disputed.

It can also prevail at the international level (between countries). This is known as international double taxation, which will be explained further below.

1. Corporate double taxation

In this scenario, corporate earnings are taxed twice at two different points in time on the same stream of income. 

For instance, if a company’s net income is first taxed as corporate tax, and then when this same income is given to shareholders as a dividend, it is again taxed in the form of dividend tax.

Opponents of such a taxation model explain that this practice is unfair to the shareholders of an organization since they are considered the entity's owners. 

From that perspective, it creates a situation whereby corporate taxes is first levied on the entity’s profits and, secondly, taxed on the dividends they receive.

This represents the same income stream being taxed at two different time intervals.

On the other hand, proponents of this taxation argue that the above practice should be maintained since a corporation in the form of a company is considered a separate legal entity from its shareholders (owners). 

This justifies a situation where both corporate earnings and dividends are taxed.

2. International double taxation

Businesses that invest and operate globally are also prone to experience it. This takes place in a situation whereby the profits generated by a foreign company are taxed there and taxed again by the government of their home country. 

For example, if a UK-based company operates in Singapore, it will have to bear tax obligations from the Singaporean government and the UK government. 

Given that this proves to be a deterrent for cross-border investment, many countries have signed mutual treaties and instituted tax credits to limit this practice.

Measures to Avoid Double Corporate Taxation

For their opponents, the good news is that such a practice can be reduced by implementing specific strategies. These include the Double Taxation Avoidance Agreement, Income splitting, legislation, and retaining corporate earnings.

1. Double Taxation Avoidance Agreements (DTAA)

The DTAA is a tax treaty between two or more nations to help taxpayers (investors) eliminate the need to pay double taxes on the same income stream. 

A DTAA holds ground where an individual is a resident of one country but earns income in another.

For example, India currently has DTAA with 80+ countries, namely Australia, Canada, the United Arab Emirates, Mauritius, Singapore, and the United Kingdom. It implies that Indian companies operating in those countries will be exempt from Double Taxation. 

The Double Tax Avoidance Agreement aims at helping a country become an attractive investment destination for foreign companies and wealthy investors by providing relief on dual taxation. 

This relief is given by preventing income earned in a foreign country from the tax being taxed in the resident nation. 

For example, if an individual who is a resident of the United Kingdom is asked to go overseas on deputation and receives payments during that period away from home, the income received may be subject to tax obligations in both the UK and the country he is currently working in. 

The existence of an applicable DTAA can help the individual claim relief when filing a tax return for that particular financial year.

2. Split income

It refers to a strategy whereby the organization owner withdraws from the business profit for supporting their wants and lifestyle and leaves the remaining amount in the company. 

The above practice of income splitting will help to minimize the occurrence of being taxed twice. To simplify the above explanation, we are adopting a way of reducing our gross income, which directly translates into a lower taxable income rate.

3. Retaining Corporate Earnings

Business owners can avoid being taxed twice by reusing their profits rather than distributing them as dividends to shareholders. 

If owners of shares do not receive dividend payments, they cannot be taxed, which implies that taxation only applies to the corporation’s profits.

It must be noted that the above practice should be avoided by corporations who rely on company profit as their only income source.

4. Legislation

Countries must introduce legislation to eliminate the elements of it since it proves to be a deterrent for international investors. If investors can receive their dividends without taxation, they will be encouraged to invest more capital.

Double taxation relief

If an individual or corporation has income or gains from a source in one country in which he is a non-resident, that same income can be prone to suffer tax twice. This is where Relief comes into play, alleviating this double charge on the same source of income.

For instance, the United Kingdom provides three options through the provision of relief from double taxation. Two of them are in the form of a tax credit, and the last one is by way of deduction from the profits of the business.

One of the two forms that provide tax relief via a tax credit is called unilateral relief, provided under UK domestic legislation. In contrast, the other is provided through double tax treaties with other countries.

Moreover, if an individual or Corporation wants to claim double tax relief, they will need to accurately determine what income has been subject to taxation more than once. Nevertheless, this can sometimes be difficult in the real world due to the variations in the tax systems in the countries concerned.

How does tax treaty relief work?

Double tax relief under a double tax treaty is usually given in one of the following ways:

• The country where the income arises neglects all its taxing rights in favor of the country of which the recipient is a resident.

• The country where profits are generated applies a reduced tax rate compared to the usual domestic rate that would apply to non-residents.

• Credit-relief: A scenario in which the income is liable to taxation in both countries, but the country where the beneficiary is a resident grants credit for the foreign tax.

To be eligible for a tax treaty relief, it is compulsory to be resident in one of the countries that is a member of the treaty.

To make it clear, let’s take the example of the United States, which has treaties with several foreign countries. Under those tax reliefs and treaties, residents of foreign countries are taxed at a lower rate or even exempt from US taxes on a certain source of income they receive within the US.

Likewise, residents/ citizens of the US are taxed at a reduced rate and even exempt from foreign taxes on income sources they receive within countries other than the US.

Two types of relief 

Two types of relief from such taxation exist, namely Unilateral relief and bilateral relief, which are applicable for a non-resident who is a resident of one country (say the UK) and operates in another nation (say Singapore).

• Bilateral Relief: When two nations reach an agreement, relief is calculated in light of the two nations' shared understanding. One can provide bilateral alleviation using one of the following strategies. Exemption: In this situation, income is taxed in only one country

• Tax Credit Method: Under this method, while income is taxed in both countries, relief is offered in the nation where the taxpayer is the resident. The country of residence computes tax payables on income sourced from a foreign country under its domestic law.

• Unilateral Relief: In some instances, where there is no DTAA between the country of source and country of residence, the country of residence of the individual or corporation taxpayer may provide tax relief under its domestic tax laws.

Researched and authored by Alvin | LinkedIn

Free Resources 

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Account Balance
• Cash Flow
• EBITDA
• Prime Rate
• Segment Margin