Double Taxation: How Does It Work and How to Avoid It?

Double taxation is a principle of taxation that refers to income tax paid twice on the same source of income. Find out how to avoid it.

International businesses often face double taxation, which is an inevitable fallout of our increasingly interconnected global economy.

It’s a nightmare scenario. Getting taxed twice eats away at your profits and discourages international trade. The question is, how can global exporters avoid it?

This article at a glance

Double taxation refers to the imposition of taxes on the same income, assets or financial transaction at two different points in time. There are two types of double taxation — corporate and international. Only C corporations face double taxation at the corporate level. Businesspeople can avoid it if they pay in salaries, not dividends. Retain their corporate earnings. And split their income.

What is double taxation?

Double taxation is exactly what it says on the tin: being taxed twice. It refers to income tax or corporate tax being paid twice on the same source of income.

Will your company face double taxation issues?

There are many corporate business structures that businesspeople can choose from, from sole proprietorships to LLCs.

A sole proprietorship, an LLC (Limited Liability Company) or an S corporation will probably not bring you any double taxation issues. However, those running what’s classified as a C corporation will need to watch out for double taxation.

C corporations are recognised as separate tax-paying entities. This means that your business is liable for business taxes.

In a nutshell:

1. C corporations pay corporate income tax on profits

2. Corporations pay shareholders dividends from the after-tax income

3. Shareholders pay personal income taxes on the dividends they receive

You might wonder where the double taxation occurs. It happens when you, as the owner or shareholder, take a salary from your C corporation’s corporate earnings.

Let’s say you own a C corporation and you face taxation twice — first, on the company’s corporate earnings, and second, on the dividends or salary that you earn from your business.

Example:

Tom is the owner of ABC company. The company made $ 200,000 in profit this year.

Corporate tax rate = 20%*

How much will Tom need to pay as corporate taxes? 20% on $ 200,000 = $ 40,000.

After-tax dividends to be split amongst shareholders and Tom: $ 200,000 — $ 40,000 = $ 160,000.

Let’s say Tom holds 40% of the shares of ABC company, he’ll need to pay personal income taxes on the dividend or salary he receives.

Amount Tom earns: 40% of $ 160,000 = $ 64,000.

Personal income tax Tom has to pay based on a tax rate of 10%*: 10% of $ 64,000 = $ 6,400.

Therefore, the total taxes Tom has to pay for both corporate and personal adds up to: $ 40,000 + $ 6,400 = $ 46,400.

*Rates are fictional. You should refer to your country’s tax rates for all examples.

At first glance, this might appear as a small amount — but the tax Tom has to pay is more than 23% of his company’s total revenue for the year.

How double taxation works in international trade

The second type of double taxation is when the same income is taxed by two different countries, which is also referred to as international double taxation.

Double taxation can also be legal, which means that two countries would consider a single person as a tax resident. Therefore, taxes on income are imposed by one country, after the same income has already been taxed by another country. However, many countries have signed treaties to prevent this form of double taxation from occurring to foreign corporations.

Is there a way to save on being taxed twice, so that you can maximise your earnings?

How to avoid double taxation

C corporations are the only businesses affected by double taxation. You can ensure that business profits are only taxed once by organising your business as a ‘pass-through' or ‘flow-through' entity. Some examples of business entities that can adopt this strategy are:

• Sole proprietorships
• Limited liability companies (LLCs)
• Partnerships
• S corporations

By doing so, your profits go directly to you. Your profits will not be taxed at the corporate level and then again at the personal level. So, you will only pay taxes once, at the personal rate, instead of having to pay at both the corporate and personal levels.

Note that this strategy can only be adopted if your business is not a C corporation. Owners of C corporations can follow the below methods instead.

1. Skip the dividends, and pay salaries instead

If your business is a C corporation, you might want to consider not giving out dividends to shareholders. Instead, you can offer them a higher salary to compensate for the dividends. Salaries can be taxed at the personal rate, and in turn, you can file it under a deductible expense for your corporation. This cannot be done with dividends, as they are not considered deductible expenses.

2. Retain corporate earnings

There’s another benefit to not declaring dividends too. If you do not distribute profits as dividends to shareholders, they are not taxed on them. This means that the retained profits of your company are only taxed at the corporate rate.

3. Split your income

As the owner of a business, you can withdraw from the corporate profit and leave the rest of the profits in the corporation. This way, you can minimise double taxation by not hitting the progressive tax brackets, and will not be liable to pay personal tax on your income.

What about international businesses?

Can international businesses avoid double taxation? It sounds difficult, especially since doing business internationally involves two or more countries for every manufacturing and production process. Here’s how you can avoid double taxation as an international merchant.

Double Taxation Agreements (DTAs)

Double taxation agreements (DTAs) are in place to encourage international trade. DTAs are agreements signed between two countries to prevent territorial double taxation of the same income in two different countries.

The DTA establishes regulations of how income made through cross-border transactions are handled. DTAs vary with different countries, so be sure to check whether there is a DTA signed between the two countries you plan to transact between. This will exempt tax in your home country or the country where your income is generated, depending on the conditions of the DTA signed.

A simple search on Google will bring up the countries that have DTAs with your home country. For example, a search for countries that have signed DTAs with Singapore brought me to this list of DTAs, Limited DTAs and EOI Arrangements.

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There’s a lot to look out for when selling overseas. Saving on taxes and knowing how to avoid double taxation can help your company retain more profits. Apart from tax savings, knowing how to stay clear of high forex exchange rates can also boost your company’s profits.

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