An Ultimate Question: How Does Double Taxation Work?

Avoid double taxation for your company. Know how double taxation works.
Double Taxation

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Before We Start…

Are you a business owner? Or are you thinking of becoming one? Or are you just some curious fellow who wants to know about business and explore their options?

If you answered “yes” to any of these questions, then the complicated part of taxation is not a foreign word to you. You know something about taxes, even if it’s just a little bit. But do you know about “double taxation?”

Taxes are an important way for any country to make money, but it can be a big problem when people or businesses are taxed twice on the same income or assets. So, what exactly is double taxation, and how can people avoid it?

Today, we’ll discuss how complicated double taxation is and how taxpayers can get around it with relief measures and agreements. We will explore the main ideas and learn about tax relief, treaties, and agreements to avoid double taxation. Stay with us.

What Is Double Taxation?

As the name suggests, double taxation means that the same income or earnings are taxed twice at different levels. This taxation principle can be applied to both corporations and individuals. Also, when there is international trade, this tax is applied in two different countries.

For example, when a company makes a profit, the profit is taxed as a corporate tax. When that profit is divided among the stockholders as dividends, it is taxed again as personal income.

A person who owns an entity must pay tax on their income. Also, if the owner is a shareholder and gets a dividend from the company, the tax is taken from the owner’s personal income. 

Double Taxation
What Is Double Taxation?

How Does Double Taxation Work?

Because corporations are seen as separate legal entities from their shareholders, they are often taxed twice. As a result, corporations pay taxes on their annual earnings, just like people do. When corporations pay out dividends to shareholders, those dividend payments incur income-tax liabilities for the shareholders who receive them, even though the earnings that provided the cash to pay the dividends were already taxed at the corporate level.

Unintended consequences of tax legislation often include double taxation. It’s usually seen as a bad part of a tax system, so tax authorities try to avoid double taxation whenever possible.

Most tax systems try to have an integrated system where income earned by a corporation and paid out as dividends and income earned directly by an individual is, in the end, taxed at the same rate. This is done by using different tax rates and tax credits. In the U.S., for example, dividends that meet certain criteria can be called “qualified.” This means their tax rate is either 0%, 15%, or 20%, depending on the person’s tax bracket. As of 2022, the corporate tax rate is 21%.

Types of Double Taxation Are…

When a person or business is taxed twice on the same income or asset by two different tax authorities, this is known as double taxation. There are two types of double taxation. Both types of double taxation can be hard on your finances and make you less likely to invest or do business. Many countries have made tax treaties and agreements to help people and stop or reduce double taxation. This is done to lessen the effects of double taxation. These treaties usually include provisions for tax credits, exemptions, or deductions to help taxpayers.

The two primary types of double taxation are given below. Take a look-

Double Taxation Corporation

For corporate taxation, when a business makes a profit and an income, the tax is based on its total income as a business unit. After taxes are removed, the rest of the money is given to the shareholders. The shareholders are also taxed on the share profits they get on a personal level. This is how double taxation occurs for a corporation.

Only C-corporations have to pay double tax when it comes to corporate taxation. This is because S-corporations are like partnerships in that they make it easy for partners to split profits and are only taxed as individuals, not as businesses.

Similarly, Limited Liability Companies (LLCs) and sole proprietorships don’t have to pay taxes twice because they are pass-through entities. In these businesses, profits go through the owners and co-owners as individuals, so they only have to pay taxes on a personal level.

International Double Taxation

International double taxation occurs when you are considered a resident of two different countries for tax purposes. As a result, you have to pay taxes on your income in both countries, even though it’s the same money.

Double taxation is a common issue for international businesses. There may be taxes on income in both the country where it is earned and the country where the business is based. In some cases, the total tax rate is so high that doing international business becomes prohibitively expensive.

To avoid these problems, countries worldwide have signed hundreds of treaties to avoid double taxation, many of which are based on models developed by the Organization for Economic Cooperation and Development (OECD). One of these kinds of treaties is called the Double Taxation Avoidance Agreement, or DTAA.

In these treaties, the signatories agree to limit how much they tax their international businesses so that they can trade more with each other and avoid being taxed twice.

This type of double taxation is also called “jurisdictional double taxation.”

Double Taxation Avoidance Agreement

The DTAA or Double Taxation Avoidance Agreement is an agreement to avoid double taxation. This tax agreement between two countries helps taxpayers avoid paying income tax twice on the same income, asset, or financial transaction in two countries.

DTAA attempts to avoid double taxation by creating a mechanism for allocating taxing authority between the two countries.

A DTAA allows a person or business to receive lower tax rates or be exempt from paying taxes in one of the countries. It also helps remove tax barriers, encourage trade and investment across borders, and stop people from avoiding or evading taxes. The terms and conditions of a DTAA can vary depending on the agreement between the two countries.

Double Taxation Example

Let’s look at the following examples to understand better what double taxation is-

Example- 1 (Corporate Or Economic Double Taxation)

In 2022, a company called BG made a profit of $500 million. As a corporation, it was subjected to a 21% tax in the first place. The rest of the money was split among the company’s three shareholders. Then, each individual was taxed at 37% on each share of profit or dividend. This is how corporations are taxed.

Example- 2 (International Or Legal Double Taxation)

Imagine a scenario: Jessica is a successful businesswoman. She earns income in Canada and is also considered a tax resident in Australia. Now, both countries may claim the right to tax her that income. And this can result in Jessica being taxed twice on the same income, leading to financial burden and unfairness.

Who Is Liable for Double Taxation?

Individuals, businesses, and corporations that earn income or profits in more than one country may be subject to double taxation. Individuals may face double taxation if they work in one country but live in another or if they have income from investments in another country. Businesses operating in more than one country or earning income from sales in another country may be subject to double taxation. Companies with shareholders living in another country may also be subject to double taxation. 

How Does Double Taxation Affect Different Income Sources?

Double taxation can complicate things for you. It can reduce the amount of money you get to keep. Double taxation can have different effects on different types of income. Here are a few examples given below:

  1. Business Income: If you own a business—it could be a store or a company—you may have to pay taxes on your profits both as a business and as an individual. This means that the money the business makes is taxed, and as the owner, you are also taxed on the money you get from the business. That’s double taxation.

  2. Dividends: If you own stocks and get dividends, you may need to pay taxes on both. The company you invest in pays taxes on its profits, and then you have to pay taxes on those profits again when they are given to you as dividends. This means that the same amount of money becomes the subject of double taxation.

  3. Inheritance: If you inherit money or property from a loved one who has died, the person’s estate may have already paid taxes on that wealth. But you might also have to pay taxes on your inheritance when you get it. This means the same money is taxed twice—once at the estate level and again when you inherit it.

Talking to tax professionals or getting expert advice on how double taxation might affect your different income sources is important. They can help you determine what to do and ensure you don’t pay more taxes than you should.

Importance of Understanding Double Taxation for Individuals and Businesses

Understanding double taxation is important for both individuals and businesses. Double taxation is when a person or business pays taxes twice on the same income in two different countries or levels. This can happen when a person or business operates or earns income in multiple countries.

For Individuals

Double taxation can have a big effect on an individual’s finances. It can lower their spending and make it harder to save or invest. Individuals must understand tax laws and treaties between countries to reduce the possibility of double taxation.

For Businesses

Double taxation can harm a company’s profitability and competitiveness. It may increase their tax burden and limit their ability to reinvest or expand internationally. By understanding the rules and regulations about double taxation, businesses can plan their operations and structure their transactions to minimize their tax obligations.

Double Taxation Relief

If a person has income or gains from one country and is a resident of another, that income or gain may be taxed twice. DTR, or Double Tax Relief, is intended to alleviate double taxation on the same source of income or gain. It is a relief to avoid double taxation. Double taxation relief for companies aims to keep taxes from affecting business decisions about expanding overseas.

Double Taxation Relief Mechanisms Available to Individuals and Businesses

There are various tax relief mechanisms available to individuals and businesses. Some of these are given below-

  • Tax Treaties: Countries often make agreements about taxes to avoid double taxation. These treaties set up the rules for how income and profits are taxed when they cross borders. They help by letting people and businesses use tax credits or exemptions from one country to pay less tax in another country.  

  • Foreign Tax Credit: A foreign tax credit can be used to get money back for taxes paid to another country. With this credit, the tax they already paid to the foreign country is deducted from the tax they owe in their home country. It helps avoid double taxation by ensuring that income or profits are not taxed twice.

  • Tax Exemptions: Some countries don’t tax certain types of income or profits made outside of their country. This means that people or businesses do not have to pay taxes on that income or profit in their home country if it has already been taxed in another country.

  • Tax Deductions: Individuals and businesses may be able to deduct costs they paid to make money abroad. These deductions can lower their taxable income and, as a result, the taxes they must pay.

It’s important to remember that these relief mechanisms may be available in different countries in different ways, depending on the tax laws in each country. So, if you want to understand and use these mechanisms well, it’s best to talk to tax experts or get advice from the proper tax authorities.

Double Taxation Treaties

Double Taxation Treaties, or DTTs, are agreements between two countries that keep foreign investors from paying taxes on their income in both countries.

Double Taxation Treaties, or DTTs, are agreements between countries that ensure people don’t get taxed twice on the same income. They make a living, working, and doing business in different countries easier without paying taxes twice.

How to Avoid Double Taxation?

So, we discussed double taxation relief and how to lessen the burden of this legal hassle. But what if we say, you can avoid the double taxation altogether? Shocked? It’s easily possible through some strategies and tricks such as:

  • Tax treaties.
  • Claiming foreign tax credits.
  • Using Foreign Earned Income Exclusion (FEIE).
  • Electing S corporation status.
  • Paying reasonable salaries.
  • Etc.

To learn more, check out our blog on “How to avoid double taxation.

Advantages of Double Taxation

Double taxation doesn’t have only disadvantages. It has many benefits also, and that’s why it’s such a popular system. The advantages of double taxation are given below-

  • Acquisition of Fair Share of Taxes: First and foremost, double taxation ensures businesses pay their fair share of taxes. This means that companies can’t hide their profits in places with low taxes to avoid paying taxes. It also makes it fair for both small businesses and big multinationals since they have to follow the same tax rules.

  • Sharing Resources and the Work of Collecting Taxes: Another benefit of double taxation is that it lets countries share resources and the work of collecting taxes. This makes the system work better and reduces the total cost of collecting taxes.  

  • Stops Tax Evasion and Avoidance: Double taxation also helps stop tax evasion and avoidance since companies are less likely to try to hide their profits if they know they will be taxed twice.

  • Helps the Economy Grow: Last but not least, double taxation can help the economy grow. By getting businesses to put their profits back into new projects, it gives the economy a boost. This can create jobs and spur innovation, benefiting everyone in the long run.

Last Words…

So, we’re at the end of our blog. At first, the idea of double taxation might seem confusing to you, but you should know what it means.

Double taxation means income is taxed twice, once at the corporate level and again at the individual level. Once in the country where you reside, once in the country where your business is being operated.

Even though double taxation might seem unfair, this is how many tax systems worldwide work. Understanding the whole thing can help you deal with the complexity of tax planning and make smart choices.

So, the next time you hear the term “double taxation,” you’ll know exactly what it means and how it could affect your money.

Are you still confused? Book an appointment with our experts and let your confusion melt away.

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