What is Double Taxation?
Double taxation refers to the income tax which is imposed twice on the same earned income, asset or finance transaction by the same or multiple jurisdictions; It usually occurs when the same income is taxed both at corporate as well as at the individual level.
In simple words, when we pay income tax twice on the same source of earned income, asset or financial transaction, then this taxation principle is known as Double Taxation. This taxation principle may be applied at both corporate and personal levels. Again when there is international trade then this taxation is applied in two different countries.
For example, corporate profits when earned are taxed as corporate tax and then taxed again as personal income when it is distributed as dividend among the stockholders. Also in the case of an owner of an organization, who is also the employee of that organization, gets taxed when he receives the salary. Again if he receives the dividend from the company being a shareholder, he needs to pay tax on his personal tax.
Double Taxation in Corporations (S Corp and C Corp)
- The principle of Taxation affects the C corporations where business profits are taxed both at corporate and personal levels.
- Double taxation in corporations must pay income tax at a corporate rate even before distributing the profits to the shareholders. Then the profits shared between the shareholders as the dividend is taxed again at the recipient’s individual rate. Thus the corporate profits are taxed twice. Taxation in corporations is not affected by the Taxation principle, a corporation that passes through earnings directly to the shareholders without going via the intermediate step of paying dividends.
- It is generally accepted as a negative element of the tax system and the tax authorities try to avoid it in possible situations. This taxation process puts the corporations at a disadvantage when compared to the unincorporated businesses, provides the incentive to corporations to use debt financing instead of equity financing and retain earnings instead of distributing among the shareholders.
- Moreover, if corporate and personal tax systems are integrated then the tax code is simplified to a large extent.
Tax Results when the dividend is given:
How to Avoid Double Taxation?
- For the smaller corporations, most of the major shareholders are employees of the firm and thus the earnings are distributed among the shareholders as wages and fringe benefits for how to avoid double taxation. Although the employee is liable to pay tax on their income the corporate deducts the wage and benefits paid as expenses of the company and thus avoids paying corporate tax on that amount.
- In the case of small businesses, the entire amount is distributed to the employee or owner’s account and thus nothing is left which can be subjected to corporate tax. In situations where income is left with the business, it is done so for financing future growth of the company. Though this amount comes under corporate tax these tax rates are usually lower than the rate paid by individuals.
- Large companies whose shareholders are not their employees and the earnings or corporate profits cannot be distributed as wage or fringe benefits are often able to avoid double taxation. These employees can be shown as the tax consultant, as payments to consultants come under tax-deductible business expenses and not dividends. The shareholder in this situation still has to pay tax on his compensation.
- It is also an option to add the shareholders to the payroll as members of the board of directors of the company. There are tax-exempt investors such as pension funds and charities which are significant shareholders in large corporations. These groups have the tax-exempt status which helps them in avoiding paying taxes on the corporate dividends received.
International Double Taxation Principle
International businesses often face issues of taxation principles. Their income gets taxed in the country where it is earned and then this income is again taxed when it is sent back to the business’ home country. In many cases, the total tax rate becomes so high making pursuing international business an impossible and expensive venture. To avoid these kinds of situations countries all over the world have made hundreds of double taxation treaties just to avoid taxation which is based on models given by the Organization for Economic Cooperation and Development (OECD). Mentioned in the double taxation treaty by signatory nations are the limits of their taxation of international business to help in trade between two countries and to avoid taxation twice.
This taxation has always been a topic of debate, as a lot of corporations find it unfair to pay taxes twice on the same income. One of the ways to avoid this is to stop paying dividends and retain the additional profits as retained earnings. Growth companies do not pay dividends as they do not have ample surplus funds after spending on expansion. Mature companies generally pay the dividend as they don’t have a lot of requirements of funds for expansion. But these days more and more mature organizations are going to share buybacks instead of paying dividends. In this way, they are in one hand rewarding the shareholders and on the other hand, are sparred from getting double taxed.
Double Taxation Video
This has been a guide to what is Double Taxation and its meaning? Here we discuss how double taxation works in Corporations along with practical examples and how to avoid it. You may learn more about accounting from the following articles –