Double Taxation

Definition of Double Taxation

Double taxation occurs when the same income is subject to tax twice– either in the hands of two different taxable parties in the same country (called Economic Double Taxation) or in the hands of the same taxable party across two taxable jurisdictions or countries (called Juridical Double Taxation).

Explanation

With increasing globalization, it is common for an entity or individual to earn money in a country different from its country of residence. This is because tax laws of a country would require income earned within the bounds of the nation to be taxed in that country, as well as income earned elsewhere but belonging to the residents of the country, to be taxed in the hands of the residents. This could often lead to the income being taxed twice – in the country of origin (where the income arose) and in the country of residence.

It could also occur when corporates are required to pay taxes on their profits, a portion of which can also be taxed in the hands of the shareholders as dividend income.

How Does It Work?

• Economic Double Taxation: Corporations must pay taxes based on their earnings for the period. Entities often distribute a portion of their profits to their shareholders as dividends. For the shareholders, the compensation received from their investments in such corporations is income earned. Hence, they would be required to pay personal income tax on the same. This essentially leads to taxes being paid by the company and the individual shareholder on the same amount, i.e., the company’s earnings are paid out as dividends.
• Juridical Double Taxation: This kind of double taxation occurs when the country of origin and the country of residence taxable entities. In the case of a company headquartered in the United States of America with its operations spread across the United Kingdom, for example, the company’s arm in the UK would be earning profits in the UK, which would be repatriated to the company’s home country – the USA. As a result, the UK arm would be required to pay taxes on its earnings in the UK. While the profits repatriated to the USA might also be taxed as per US taxation laws, leading to the profits being taxed twice – in the UK and the USA.

Example of Double Taxation

Different examples are mentioned below:

Economic Double Taxation

Juridical Double Taxation

In the above example, considering Corporation ‘A’ paid the dollar equivalent of $200,000 as taxes in the UK and is liable to pay taxes of $250,000 in the US on the repatriated profits (without considering any double taxation benefits), tax regulations or DTA between the two nations may provide for either of the following options (indicative only; not reflective of actual tax provisions) –

• Income Exempt: Repatriated profits may be exempt from tax in the US. Accordingly, the corporation would have no tax liability on the profits repatriated to the US.
• Tax Credit: Corporation ‘A’ may be allowed a tax credit of $200,000 (that is, the amount of tax paid in the UK on the same profits). As a result, the company’s tax liability on the repatriated profits may reduce to $50,000 as opposed to $250,000 had the income been fully taxed without the benefit of a tax credit.
• Concessional Tax Rate: Repatriated profits may be taxed at a lower rate than the rate applicable to other corporation earnings, resulting in tax liability lower than $250,000.

Double Taxation Agreement

To avoid Juridical Double Taxation, various countries have entered into treaties, often based on guidance provided by the Organization for Economic Cooperation and Development, to prevent it. These agreements, called Double Taxation Agreements (DTA), are structured to avoid double taxation on the international earnings of taxable entities and allow for a better exchange of information between the countries to foster better trade relations between nations and prevent tax evasion.

Some of the common ways in which DTAs may provide relief from it are as follows –

• Allow income from another country to be exempt from tax in the country of residence so long as the tax is paid in the country of origin.
• They are taxing the income in both countries and providing tax credits in the country of residence to the extent of taxes paid in the country of origin.
• We are allowing for lower or concessional rates of taxes in either of the taxing countries.

DTAs may contain different methods of claiming tax relief for different types of income.

How to Avoid Double Taxation?

Tax laws usually prevent double economic taxation through lower tax rates or tax credits. For example, qualified dividends in the US are taxed at lower tax rates in the hands of the individual taxpayer than the rate that would be ordinarily paid on other regular income of the individual.

In the case of Juridical Double Taxation, income from a foreign country may be exempt in case taxed in the country of origin, or the country of residence may allow for tax credits on international income, or in some cases, tax at concessional rates, in line with any Double Taxation Agreement between the countries.

Advantages

Some of the advantages are mentioned below:

Benefits to the Tax Payers

DTAs help reduce the tax burden that they would otherwise incur on account of double taxation by any of the following means (as provided for in the DTA) on their international income:

• Foreign-source income is exempt
• Foreign-source income is taxed at concessional rates
• Tax credits or refunds of tax paid in the other country

Benefits to the nations involved in the DTA

• Promotes better trade and investment relations between the nations
• Allows for more transparency in the flow of transactions between the nations
• Better information sharing between nations can help prevent or detect tax evasion.

Conclusion

It refers to the taxation of the same income twice, leading to higher-than-normal taxes levied on the same income on a macro level. Tax regulations and DTA allow for lower tax rates and tax credits to provide for double taxation. DTAs thus help provide relief from Juridical Double Taxation and allow for better trade relations and information sharing between countries.

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