How Does Double Taxation Works: The Complete Guide

If you are a business owner, entrepreneur or freelancer, it is important to understand what double taxation is. While it is not every business that is double taxed, understanding how it works and the conditions that could warrant being double taxed is necessary.

Double taxation simply implies being taxed on a source of income twice. C corporations are the most popular business structure known to be double taxed. Aside from that there are other instances in which double taxation could be applied on an income. So let’s take a look at what it entails and how it works.

What is Double Taxation?

Double taxation occurs when a source of income is being taxed twice. It is a tax principle that involves paying an income tax both at a corporate level and individual level.

Double Taxation can also occur in international trade or businesses when an income is taxed twice from two different countries.

C corporations, unlike other business structures, experience double taxation. This is so because C corporations aren't treated as pass-through entities when it comes to tax. They are therefore taxed at the corporate level and at an individual level which then results in double taxation.

When corporations make profits, they pay tax for the business. Shareholders are then paid from this profit as a dividend. At the individual stage, the dividend is also taxed.

C corporations and other Business Structures.

As earlier mentioned, C corp is one business structure mostly associated with double taxation. This is so because of the dividend they receive unlike other business types and more so they are taxed as a corporate body. While Limited companies can also be taxed as a corporation, they have the chance to choose to be taxed as a pass-through entity.

Other business structures like sole proprietorship, partnerships, and limited liability partnerships are all taxed at an individual level. This means they are treated as pass-through entities for tax payments. As such the tax payment is passed down to the individual shareholders rather than the business itself. More so, they don't pay tax at a corporate level making it feasible for them to avoid being double taxed. So if your business is a Limited company, LLP, Partnership or Sole Proprietorship, you are probably not going to be double taxed.

How Does Double Taxation Work

In an actual sense, double taxation can occur in two instances. These are when a corporate body is taxed twice, known as corporate double taxation and when taxes are applied on an income by two countries known as international double taxation.

1. Corporate Double Taxation

If you are a shareholder in a C corporation and your dividend is taxed after the business profits have been taxed at a corporate level, then we say a corporate double taxation has occurred. As such the earning of the corporation is being taxed twice. Firstly it was taxed on the profits made by the business and secondly, it was taxed individually on the dividends provided to the shareholders.

This type of double taxation is common in several countries including the UK. There have been a lot of arguments for and against corporate double taxation. Proponents who are against corporate double tax say shareholders are the owners of the corporation to which the corporate tax is applied. So when tax is being paid by the corporation and again by the shareholders, it simply connotes that the same income source is taxed twice.

However, proponents who are for this tax principle are of the opinion that C corp is recognized as a separate legal entity when it comes to taxes and as such must be taxed distinctly from their owners or shareholders. So when the corporate body and individual shareholders are taxed, it is just and fair enough.

2. International Double Taxation

International double taxation occurs when a multinational company or an individual income is taxed by two different nations. So if a multinational company resides in a foreign company, it can be taxed by the country in which the company is situated and the home country of the company.

On the other hand, a foreign income earned by an individual in a foreign nation can also be taxed twice. Also if an individual resides in their home country but earns income from another nation, it can be taxed twice.

In most cases, International Double Taxation result when trading or business transactions involves two nations. The business transactions could be done by companies or by individuals who render their service to another nation. As such International double taxation isn't easily avoidable when you do business outside of your home country.

Despite these, there are still some measures that help ensure that international double taxation is reduced to the barest. We will look at that in the later part of this article.

How to Avoid Corporate Double Taxation

Here are some of the ways you can avoid or remove double corporate taxation.

1. Pass-through taxation

Pass-through taxation is applied to business structures like sole proprietorships, limited companies, LLP and S corp. All of these business structures only have their personal income taxed and not the business itself thereby preventing double taxation. To avoid double taxation as a corporation, one way to go about it is to change your business structure to one of those that are treated as pass-through entities. As such, only the individual's earnings will be taxed and not the corporate income.

2. Substitute dividends with Salaries

Instead of having dividends distributed to the shareholders, you can offer a higher salary to the shareholders. Salaries can be taxed at a personal rate which can be included in the deduction expenses of the corporation.

3. Law Enforcement

Ultimately there should be some forms of legislation mitigating against double taxation. There should be tax-free dividends as this would encourage investors to invest and reinvest more into the corporation.

4. Retain Earnings

When dividends are paid, then taxes are applied to them. In situations where dividend payments are removed, then there aren't tax payments for it. This could be particularly useful to corporations that are at the growing stage.

5. Split the Income

Profits derived from the corporation can also be split into two. One can withdraw some of the profit from the corporation while you leave some others. With that, you can be able to avoid double taxation by not meeting up with the tax bracket and thus will not be expected to pay an individual income tax.

How to Manage International Double Taxation

To manage international double taxation, tax treaties will need to be applied between countries that trade together. These treaties are there for the two jurisdictions to share vital information about tax and taxation practices. Treaties help maintain efficient trading between two countries, reduce or eliminate excessive tax evasion and promote proper tax practices.

To prevent being over-taxed by two countries, many nations are coming together to introduce special tax treaties that will encourage international trading. Some of the forms of the tax treaties are:

1. Double Taxation Agreement (DTA)

A double taxation agreement is a type of agreement signed by two countries to reduce or eliminate double taxation applied to an income by two countries. DTA are there to prevent double taxing an income so that international trading and investment can be encouraged.

When two countries observe that trading and business transactions between them are growing, they introduce DTA to encourage more trading activities and eliminate being double taxed from the two jurisdictions. With this, the two countries share information about their tax practices and payment principles to encourage international traders.

As such the two jurisdictions come up with rules and regulations that will guide how income earned from international trading is treated to avoid double taxation.

2. Double Taxation Exemption Relief

In the exemption relief, the multinational company or individual taxpayer is prevented from paying taxes in their resident country. This means they aren’t taxed by their own country however they have to pay the tax in the country when the income is generated. For the exemption method to work, the resident country must be willing to encourage cross-border investment by removing tax payments so that an income is not double taxed.

Countries that apply the exemption relief are known as tax havens as they apply little to no tax on income that is generated from other jurisdictions.

As such most of these tax haven countries are attracted by multinational corporations and wealthy individuals as they only have to pay little to no tax when they have their corporations and businesses within the tax haven jurisdictions. Examples of tax havens are Cyprus, Bermuda, Bahamas etc.

Benefits of Tax Treaties

Tax treaties are beneficial to individual taxpayers and international companies in the following ways.

1. It helps two countries reach an agreement on how the tax will be applied without double taxing other's income.
2. Double taxation is reduced to the barest minimum, and the use of double tax agreements and exemption relief helps protect individual and business income from being taxed twice.
3. Tax treaties foster global growth and development by encouraging business transactions and investments between two countries.
4. Apart from that, individuals and businesses have the chance to invest more in international businesses since they don’t have to bother about excessive tax payments.

It also encourages individuals to seek jobs and other opportunities from other countries. When an individual knows that the income to be generated from a foreign country is protected from double tax, it boosts their confidence in seeking foreign opportunities.

Should I Consider C Corp for my Business?

While the C corp business structure is popularly known for its double taxation, there are still some factors you would want to consider when deciding on whether to start your business as a C corp or not. It is important to use a C corp business structure if:

1. You are seeking good investors for your business and you wish to sell stock to raise capital for the business.
2. You are considering personal liability protection. C corp offers the strongest personal liability protection.
3. Your business and shareholders can effectively manage or reduce the double taxation associated with the C corp.

While the double taxation of C corp can be managed or avoided, it is important to stay away from the business structure if you feel the double taxation will be a financial burden to the business and shareholders.

Advantages of C Corp Business Structure

C corp business structures offer some advantages that are worth exploring.

1. Limited Liability

When we talk about limited liability protection, the C corp business structure offers the most efficient protection to its owners. As a shareholder in a C corp, your liability doesn’t go beyond the amount you have contributed to the business. With that, your personal assets and belongings are protected from liability.

2. No restrictions on shareholders

Unlike other business structures, there are no restrictions on the number of shareholders that could be part of a C corp. As such the C Corporation can sell as much stock as possible to new shareholders so they can raise capital for the business. Unless the corporation itself sets minimum shareholder requirements, there are no laws restricting the number of shareholders they could have.

3. Corporations are more attractive to investors.

C corp business structures are more attractive to investors than any other business structure. Once a corporation has been formed, it’s easier for it to gain more investors because of the kind of credibility and trust associated with C Corp. Moreover, C corp has the strongest liability protection and this makes it more attractive to investors.

4. Separate entity

C corp is also recognized as a separate legal entity that can sue and be sued in its name. It can enter into a contract, seek funds from investors, and buy properties on its own. It has a separate identity different from its shareholders and so is treated distinctly from them.

Is Double Taxation Legal?

Yes, double taxation is legal. The tax authority across several countries is in charge of determining how tax payments should be carried out and the tax rates. Whether the tax is applied to corporations, shareholders or international businesses, it should be noted that all the regulations guiding tax levied are in accordance with the federal laws.

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Conclusion

Double taxation is a tax principle that is common to C corp business structures and international businesses. While some ways and strategies can be used to manage double taxation, it is important to understand how double taxation works so you can easily identify it when it occurs. Do you have any questions about how Double Taxation Works? Kindly contact one of our experts here for help today.