Gizane Campos Double taxation is a financial challenge that occurs when the same income is taxed twice, either within a single country or across multiple jurisdictions.
It primarily affects corporations, investors, and individuals earning income abroad, leading to an increased tax burden.
This article explores the concept of double taxation, how it works, and its impact on businesses and individuals. Additionally, it covers how international tax treaties mitigate double taxation, helping taxpayers navigate this complex issue efficiently.
What Is Double Taxation?
Double taxation refers to when tax is levied on the same income twice.
It can either happen at different levels of taxation within a single country or across multiple countries.
It primarily affects corporations and international businesses, leading to a higher tax burden for companies and investors.
How Does Double Taxation Work?
Double taxation can happen in two ways:
- International double taxation: When a person or business earns income in one country and is taxed on that income in another country (i.e. their home country). This means tax is paid on the same foreign income in two separate jurisdictions.
- Corporate double taxation: In some countries, corporations pay taxes on their profits and their shareholders will pay taxes again on dividends received from the profits.
What Are Examples of Double Taxation?
If, for example, a U.S.-based company conducts business in Singapore and earns profits in that country, it may be required to pay taxes to the Singaporean government.
However, the same income may also be taxed by the U.S. government, leading to double taxation.
Another example of double taxation is if a U.S. citizen lives and works in Germany. If they earn an income in the country, they are subject to pay taxes to the German government based on local tax laws.
U.S. citizens pay global income tax, regardless of where they live at the time of being paid. So that same individual will pay taxes in the United States on the income earned in Germany despite already paying taxes abroad.
What Are International Tax Treaties?
International tax treaties are agreements between two or more countries designed to prevent double taxation and promote fair tax treatment for individuals and businesses operating across borders.
These treaties establish rules on how different types of income, such as salaries, dividends, interest, and business profits, should be taxed when earned in one country by a resident of another.
The prevention of double taxation, one of the main purposes of tax treaties, is done by granting tax credits, tax exemptions, or reduced tax rates for certain types of income.
In addition, international tax treaties address issues related to tax evasion by improving transparency and cooperation between tax authorities.
This is because tax treaties often provide for governments to allow for the exchange of tax information, helping to combat fraud and ensuring that people and corporations are complying with tax laws.
Aside from tax treaties, there are other ways to avoid paying taxes legally while still being a productive citizen.
Are you a dual citizen earning a living overseas? Protect your wealth with our guide on dual citizenship taxes
What Are Foreign Tax Credits (FTCs)?
As part of international tax treaties, those who are taxed on worldwide income in their country of tax residence or those who have been taxed in another jurisdiction may be offered tax credits to mitigate potential double taxation.
Tax credits are a reduction provided for similar income taxes paid to other countries. Any amount that is in excess of income tax is usually not included in this reduction.
Some rules that apply to foreign tax credits include:
- Nature of the foreign levy
- Whether the foreign country allows a similar credit
- Whether the two countries have a tax treaty
- Nature of the base on which the levy is imposed (such as deemed profits, property and so on)
- Form in which payments are made (withholding of income, check payments, etc.)
- Political considerations
- Conditions imposed by levying body on taxpayers (information disclosure, etc.)
- Services or property provided by tax levying body or related persons because of the tax
Which Countries Have International Tax Treaties?
There are over 2,600 bilateral tax treaties and more than 300 amending protocols worldwide, totaling approximately 180 jurisdictions.
For instance, the United States has income tax treaties with numerous countries, including Canada, Germany, and Japan. These treaties often reduce or eliminate withholding taxes on dividends, interest, and royalties.
Members of the Organisation for Economic Co-operation and Development (OECD), an intergovernmental organization that facilitates world trade and economic progress, have also established a network of tax treaties.
5 Benefits of Tax Treaties Between Countries
There are various benefits to two countries coming together to agree on a tax treaty, including:
1. Prevention of Double Taxation
As covered above, it helps prevent individuals and businesses alike from being taxed twice on the same income. This eases the financial burden.
2. Promotion of Cross-Border Trade and Investment
Tax treaties create a more favorable environment for international trade and investment by providing clear tax rules and reducing uncertainty.
By limiting excessive taxation, businesses are more willing to expand internationally, leading to increased economic cooperation and growth between countries.
3. Reduced Withholding Taxes on Income
Tax treaties can lower or eliminate withholding taxes on cross-border payments such as dividends, interest, and royalties.
This benefits multinational corporations and investors by allowing them to retain more of their earnings instead of losing a significant portion to foreign tax authorities.
4. Prevention of Tax Evasion and Fraud
Tax treaties allow for and encourage the exchange of tax-related information between governments.
This helps authorities detect tax evasion and ensure compliance with tax laws, making it harder for individuals and companies to hide income in foreign countries.
5. Strengthening Diplomatic and Economic Relationship
Tax treaties foster stronger diplomatic and economic ties between countries by promoting cooperation in tax matters.
These agreements can enhance trust, encourage foreign direct investment, and facilitate smoother financial interactions between nations.
Frequently Asked Questions About Double Taxation
Is double taxation legal?
Yes, double taxation is legal, but many countries recognize that it places a significant financial burden on those at the receiving end, so they put measures in place to mitigate it.
Does the US have double taxation agreements?
Yes, the United States does have double taxation agreements (DTAs) with many countries. The key features of these agreements include:
- Tax reductions or exemptions
- Foreign tax credits
- Residency rules
- Prevention of tax evasion
What is corporate double taxation?
When a company earns a profit in the form of dividends, they pay taxes on its annual profits first. Then, after dividends are paid to stakeholders, they in turn pay a second tax.
What is the impact of double taxation on investments?
When income is taxed both where the investor earns it as well as where the investor resides full-time, it can discourage investment and lead to investors rather putting their money in countries with low-tax jurisdictions.
This can potentially negatively impact government revenue and the country’s economy.
