The term ‘Double Taxation’ is used to define a situation wherein a corporation is taxed twice on the earnings from the same source. This is so because a corporation’s earnings i.e. its profits are taxed at a corporate level and when these earnings are distributed to the shareholders and owners in the form of dividends, they are taxed again. Hence, a system of double taxation exists.
This system of double taxation is only present in corporations and LLCs that are treated as corporations. Other forms of business structures do not subsist double taxation. The main cause of this problem of double taxation is the ownership interest a person has in a corporation. However, this problem can be prevented by some methods such as forming a business structure where double taxation in non-existent or entering into a Double Taxation Avoidance Agreement. Also, there are certain reliefs available under the Income Tax Act, 1961.
A Corporation is taxed by the Government on its earnings (profits) and the owners or shareholders also pay taxes on their earnings (dividends) that they get from the corporation hence Double Taxation occurs. When an individual or a corporation has to pay income tax twice on the same source of income, it is referred to as double taxation. It means that the income is charged on both the levels i.e. corporate and personal. In a corporation, the owner is like an employee who gets paid in the form of a salary, and this income of the owner is taxed at a personal income tax rate. If the owner is also a shareholder, then he will be taxed on his dividends at the personal income tax rate. Double taxation can also occur when a citizen is employed in another country and hence two different countries tax the same source of income.
It is important to note that not all business structures are subject to double taxation. Corporations and Limited Liability Companies (LLCs) treated as corporations are double-taxed as they are considered as separate entities. On the other hand, S-corporations can simply avoid double taxation as they have the availability of ‘pass-through taxation’. Pass-through taxation means that these S-corporations can ‘pass-through’ their taxes to the owners or individuals, thus the income is only taxed once.
Working of Double Taxation
Double Taxation is in existence only because corporations are considered as a ‘separate legal entity’ from their owners or shareholders. The term separate legal entity means that the owners or shareholders are separate from the corporations and they cannot take the corporation’s capital for their personal use. They can only use the income or dividend that is given to them out of the profits. The corporations pay income-tax, at a corporate level, on their annual earnings and when the dividends are paid out to shareholders from the same earnings, they are also taxed as they create income-tax liabilities. However, retained earnings of the corporation are not taxed until they are paid out to shareholders as dividends.
This notion of double taxation creates an ‘unintended consequence’ of tax legislation. Generally, tax authorities try to avoid double taxation as it is often seen as a negative component of the tax system. The use of varying tax rates and tax credits is adopted by most tax systems to have a system where a corporation’s earnings and the dividends paid out to shareholders are taxed at the same rate. There are many questions raised on the fairness of double taxation. Some critics think that it is unfair to tax the dividends while advocates argue that if the dividends are not separately taxed, then the shareholder’s income will be the only income that is not taxed.
Business Structures and Double Taxation
It is very crucial to choose an appropriate business structure as it impacts the overall mechanism of the business. The type of business structure or organization determines the taxation on the earnings of that business structure and its shareholders. Business structures that do not impose heavy tax liabilities are always preferable. Following are some of the business structures with different tax liabilities at a corporate level and personal level:-
· C- Corporations
Business structures formed as a separate legal entity are termed as C-Corporations. The tax liability in these types of organizations is on the corporate as well as personal level. The profit earnings of the corporation are taxed at the corporate income tax rate and the dividends given to shareholders are also taxed. Hence, C-corporations face double taxation.
· S- Corporations
The corporations that have to meet Internal Revenue System requirements are termed as S- Corporations and are treated as a partnership. S-corporations need not have to pay taxes at a corporate level and in its place, they have a ‘pass-through’ system which means that any profit or loss can be passed through to the owners and the shareholders. Hence, these corporations do not have to face double taxation and are taxed only once at a personal level.
· Limited Liability Company (LLC)
In an LLC, personal liabilities and the liabilities of the business are separated. They are considered as partnerships until and unless they are treated as corporations. LLCs can be taxed at a personal level hence the owners can enjoy no tax liability. Owners are protected from tax liability in these types of organizations as there is no double taxation on the worldwide earnings. The personal liability of owners is limited in LLC so they are not required to pay their debts.
· Sole Proprietorship
A business structure that is owned and controlled by a single person is known as a Sole Proprietorship form of business structure. This is the most common type of business structure and as there is only one owner, the organization is not a separate legal entity. Sole Proprietorship is also saved from the double taxation as both business and personal expenses are considered as one single expense by the owner of the sole proprietorship.
A Partnership form of business structure exists when the organization is owned and controlled by two or more persons. It is similar to a sole proprietorship. Partnership business structures can avoid double taxation as the owner and corporation are not considered as a separate legal entity and hence are taxed at the personal level. All the earnings of the partnership business structure are ‘passed-through’ to the partners and in turn, they are liable to pay the income tax.
From the above-mentioned analysis of different business structures, it can be concluded that C-corporations and LLCs (treated as corporations) are the business structures that face double-taxation while business structures such as S-corporations, Sole Proprietorship, Partnerships, and LLCs are the one that doesn’t face the double-taxation system.
The Causes of Double Taxation
Double Taxation occurs when a corporation is taxed twice on the same income. A corporation is taxed on its profit earnings and when these are paid to the owners and shareholders, these earnings, as dividends or personal income, are again taxed. The main cause of double taxation is the ‘ownership interest’ in the corporation. The salaries of the owners and shareholders are taxed even when the earnings are already taxed at the corporate level.
Ownership Interest in a corporation is referred to as the amount or quantity of something that is owned by a person in a corporation. Ownership interest can be measured by the shares, stocks, capital, etc, that is owned by a person and which would indicate how much ownership that person has in the corporation.
In a corporation, an employee’s salary is taxed only once however, the earnings of an individual having ownership interest in the corporation will be taxed again after the taxation of the earnings of a corporation. Another cause of double taxation is how a company chooses to incorporate it. As discussed above, if a company chooses its business structure as S-corporation, Partnership, etc., it can avoid the system of double taxation. Therefore, ownership interests in a corporation and its business structure both can become a cause for double taxation.
Avoiding Double Taxation
The system of double taxation can be avoided in various ways. One possible way to avoid double taxation is to structure your business as a sole proprietorship, a partnership, an s-corporation, or an LLC. It is evident from the above discussion that in these types of corporations, the income is not taxed twice as the corporations and owners are considered as one single entity. In this way, the earnings of the business will pass through to the owners and shareholders. Another way is to make owners and shareholders, employees of the corporation because their salaries are not taxed at the corporate level. A corporation can also opt-out from paying dividends to avoid getting taxed twice.
· Double Taxation Avoidance Agreement (DTAA)
The problem of double taxation can also occur in situations when a person operates his business from other countries which causes overlapping of tax laws and regulations. This problem is often diminished by the tax agreements or treaties between the countries. In India, to protect the taxpayers from paying tax in different countries on the same income, the government has entered into a tax agreement called the Double Taxation Avoidance Agreement (DTAA) with more than sixty countries.
Many countries levy tax based on both the rules that are Source Rule and Residence Rule. The source rule implies that a tax is levied on the country in which the income is originated irrespective of the receiving person’s residence. On the other hand, the residence rule implies that the tax will be levied by that country where the taxpayer resides only. When both these rules are applied, the problem of double taxation occurs, and to prevent this from happening, DTAA comes into play. In India, residential status is vital for income tax considerations. The global income of individuals, who are residents of India, is taxed however, for the non-residents, only Indian income is taxed.
· Relief from Double Taxation
In India, the Income Tax Act, 1961 (as amended by the Finance Act, 2020) has provided for the relief against double taxation under Section 90 and Section 91. Relief from double taxation can be sought either by the Bilateral Relief or the Unilateral Relief.
Under Section 90 of the Income Tax Act, 1961, bilateral relief from the double taxation system is provided. The DTAA is present in this type of relief. Bilateral relief can be pursued in two ways:-
- Exemption method– In this method, if an income is taxed in an outside country, then it will not be taxed again in India thus completely safeguarding the company from double taxation.
- Tax Credit method– In this method, a corporation can ask for a tax credit for the taxation of income in India when it already taxed in the other country. A tax credit means a deduction or reduction in the taxation of the income. This method reduces the tax-liability on the corporation.
Under Section 91 of the Income Tax Act 1961, unilateral relief from double taxation is provided for. It is provided under this section that a corporation will get relief against the double taxation system whether or not there is an existence of DTAA between India and the other country. The relief will only be sought when certain conditions are fulfilled by the individual or the corporation. Those conditions are as follows:
- In the previous year, the corporation or individual should have been a Resident of India.
- The income would be taxed in both countries, India and the other country with which there is no DTAA.
- In the previous year, the income should be accrued and received by the taxpayer outside India
- The tax should be paid by the corporation or individual in the other country itself.
The system of Double Taxation that is present in corporations is both problematic and essential for their functioning. This system is problematic as the income which is earned from the same source is taxed twice at different rates even though it is not practical. However, it is also essential to have a double taxation system otherwise the shareholder’s income would be the only income in the world that is not taxed. Non-Payment of taxes by an individual or a corporation is a federal offence in any country and thus it important that the income is taxed by the government at appropriate rates. However, there is still a need for modification in the rules and regulations regarding this system of double taxation so that it is not unfair to any taxpayer.
Frequently Asked Questions (FAQs)
- What is meant by double taxation of corporate earnings?
- Who all are subject to Double Taxation?
- What causes double taxation?
- How to avoid double taxation?
- What reliefs are available against double taxation in India?