Definition
Double taxation takes place when the same income or financial transaction is taxed two times. This commonly occurs in a corporate context where profits are recognized and taxed at the corporate level before any distributions, such as dividends, are paid to shareholders. Following that, shareholders are taxed again on the dividends they receive, leading to the same income being taxed both corporately and individually.
Examples
1. Corporate to Shareholder: A corporation earns $25,000 in net income. It pays a $5,000 corporate income tax, reducing its net earnings to $20,000. If the corporation decides to distribute the remaining earnings as dividends, the shareholders receiving these dividends would then pay taxes on the $20,000. If the shareholder tax is $8,000, the same income has thus been taxed twice — once at the corporate level ($5,000) and once at the shareholder level ($8,000).
2. International Double Taxation: A U.S-based company operates in the United Kingdom and earns substantial income there. The UK taxes the company’s earnings, and the U.S. also taxes these profits when they are repatriated. This means that the company’s profits are being taxed in the UK and then again in the U.S.
Frequently Asked Questions (FAQs)
Q1: Why does double taxation occur? A1: Double taxation occurs primarily because corporations are considered legal entities separate from their owners (shareholders). Due to this separation, profits are taxed once at the corporate level and again at the shareholder level when distributed.
Q2: Can double taxation be avoided? A2: Yes, double taxation can be minimized or avoided through various strategies, such as forming an S corporation, which allows profits to pass through directly to shareholders’ tax returns and avoiding taxation at the corporate level. Additionally, tax treaties between countries can help mitigate international double taxation.
Q3: What is the main drawback of double taxation? A3: The main drawback of double taxation is that it reduces the overall returns available to shareholders, thereby potentially discouraging investment in corporate equity and leading to economic inefficiencies.
Q4: Do all countries practice double taxation? A4: No, the approach to corporate taxation varies by country. Some countries have integrated systems that alleviate double taxation, either by providing shareholders with tax credits or by exempting dividends from further taxation under certain conditions.
Q5: What is the role of tax treaties in reducing double taxation? A5: Tax treaties between countries are agreements aimed at preventing double taxation of the same income by assigning taxing rights to one jurisdiction over the other, providing tax credits, or exemptions to alleviate the tax burden.
Related Terms with Definitions
1. Corporate Tax: A tax imposed on the profits earned by corporations, it represents the first level of double taxation when those profits are distributed as dividends.
2. Dividend Tax: A tax levied on shareholders who receive dividend payments. This represents the second level of double taxation.
3. Pass-Through Entities: Business entities like S corporations or partnerships where income is passed directly to owners or shareholders, and only taxed once at the individual level, thus avoiding double taxation.
4. Tax Credit: A tax incentive that allows taxpayers to subtract certain amounts from their total tax owed, often used in tax treaties to alleviate the effect of double taxation.
5. Tax Treaty: An agreement between two or more countries to resolve issues related to double taxation, ensuring income is not taxed by more than one jurisdiction.
Online Resources
- IRS Guidance on Corporate Income Taxes: IRS - Corporate Income Tax Guide.
- OECD on Double Taxation Conventions: OECD - Double Taxation.
- E-CPA Knowledge Center on Business Taxation: CPA - Business Taxes.
References
- Internal Revenue Service (IRS): Corporate Income Tax
- Organization for Economic Co-operation and Development (OECD): Model Tax Convention.
Suggested Books for Further Studies
- “Tax Savvy for Small Business” by Frederick W. Daily
- “J.K. Lasser’s Your Income Tax Professional Edition” by J.K. Lasser Institute
- “Principles of Corporate Taxation” by Douglas A. Kahn and Jeffrey H. Kahn
- “International Taxation in a Nutshell” by Richard L. Doernberg
- “Federal Income Tax: Code and Regulations–Selected Sections” by Martin B. Dickinson
