Double Taxation and its Avoidance Mechanism | UGC NET Commerce Preparation Course PDF Download

Companies, associations, and individuals are all responsible for paying taxes. They must report their earnings and determine their tax liabilities. This process generates revenue for the government to fund infrastructure and development projects. All entities must adhere to tax laws to ensure they file and pay taxes correctly. Failure to meet these obligations can result in fines or penalties. The taxation system has various contentious aspects, one of which is double taxation in India. Understanding double taxation can be beneficial for both businesses and individuals.

What is Double Taxation?

Double taxation refers to the scenario where income is taxed twice, typically at both the personal and business levels. This concept involves taxing the same income source twice, which can apply to both companies and individuals.

• Double Taxation: The calculation of double taxation occurs on an income source at both personal and business levels. This means that income earned by a business is taxed as both the company's earnings and the individual shareholders' money.
• Causes of Double Taxation: The reasons behind double taxation are rooted in tax laws. There are advocates and critics of this practice.
• Advantages and Disadvantages of Double Taxation: Double taxation has its pros and cons. While it ensures taxation for affluent individuals, it also brings about complexities.
• Double Taxation Example: An instance of double taxation could occur when a company owner is also a shareholder. In such a case, the owner must pay taxes on the business income as well as on any dividends received, resulting in double taxation on the same income.
• Double Taxation in India: The Income Tax Act in India addresses double taxation issues. Relief from double taxation is provided through tax agreements with other countries, and Sections 90 and 91 offer Indian citizens protection against double taxation.

Causes of Double Taxation

• Ownership Stake Leading to Double Taxation: When an individual holds an ownership stake, such as being both an owner and a shareholder, they might face double taxation. This occurs when taxes are paid on both business earnings and dividends.
• Company Structure Impact: The type of company structure influences double taxation. For instance, a sole proprietorship or a limited liability company typically does not incur double taxes.
• Lack of International Agreements: Double taxation can arise when there are no agreements between countries to prevent it. Individuals earning income in a foreign country may face double taxation if there are no mechanisms in place to avoid it.

Types of Double Taxation

The issue of double taxation manifests in companies and across different nations, often resulting in individuals paying more taxes and consequently receiving less income than anticipated. Understanding the various types of double taxation is crucial for clarity:

Corporate Double Taxation

Corporate double taxation arises due to the legal separation of a company from its shareholders. The income generated by the company is distinct from that earned by its shareholders, thereby perpetuating a system of double taxation.
A company is considered a separate legal entity, meaning its earnings are distinct from those of its shareholders. This leads to the issue of double taxation within corporations.
First, companies pay taxes on their profits after deducting expenses, with taxable income being subject to the applicable tax rates. After this, companies can distribute dividends to their shareholders. However, when shareholders receive dividends, they are required to pay taxes on this income as well. Since the dividends come from income that has already been taxed at the corporate level, both the company and its shareholders face double taxation, reducing the overall income for both.
Proponents of double taxation argue that because the company and shareholders are distinct entities, and dividends represent personal income, this system is fair. On the other hand, critics contend that since a company's profits ultimately belong to its shareholders, taxing both the company's earnings and the shareholders' dividends is unfair.
Therefore, companies must consider double taxation when calculating their tax obligations, as this ensures an accurate assessment of their financial standing.

Problems of Double Taxation 

• Reduced After-Tax Returns: Double taxation lowers the returns for investors as corporate profits face taxation at the corporate level first, and then dividends are taxed at the individual level, potentially discouraging investment in corporations.
• Distortion of Investment Decisions: Double taxation can skew investment choices, pushing corporations towards debt financing over equity financing due to tax deductibility differences, influencing how companies structure their capital.
• Inequity Among Business Structures: Various business structures face differing tax levels, leading to disparities. Double taxation can create unfair advantages for certain structures, impacting competition.
• Complexity in Tax Planning: Managing double taxation adds complexity to tax planning, prompting companies and individuals to employ intricate strategies to mitigate its effects, resulting in increased administrative burdens and compliance costs.

Impacts of Double Taxation

• Lower Corporate Savings and Investment: Double taxation may dissuade corporations from retaining earnings for reinvestment, potentially reducing corporate savings and long-term investment in projects.
• Impact on Small Businesses: Small businesses, especially those structured as pass-through entities, could be disproportionately affected by double taxation, hindering their ability to compete with larger taxed-at-entity-level corporations.
• Reduced Competitiveness in Global Markets: In a globalized economy, double taxation can decrease the competitiveness of businesses internationally, giving foreign corporations in low-tax jurisdictions a comparative advantage.
• Shareholder Tax Burden: Shareholders bear the weight of both corporate and individual taxes on dividends, reducing available income for personal use or reinvestment, impacting investors' overall wealth and financial well-being.

Other Consequences of Double Taxation

• Risk of Tax Arbitrage: The presence of double taxation may create opportunities for tax arbitrage, where individuals and corporations exploit loopholes or engage in complex financial transactions to minimize their tax obligations.
• Reduced Incentives for Equity Investment: Double taxation can lessen the appeal of equity investments compared to other options like debt instruments, potentially affecting the efficiency and liquidity of capital markets.

International Double Taxation 

International double taxation occurs when income is taxed in two different countries. This issue commonly affects multinational companies that operate in multiple countries.

Causes of Double Taxation

• When a multinational company operates outside its home country, it can face double taxation. This means that the income generated by a company in a foreign country may be taxed by both the foreign country and the company's home country.
• Individuals conducting business across different nations may also encounter double taxation. They are required to pay taxes on goods both in their home country and in the foreign nation.

Impacts of Double Taxation

• Double taxation can have negative effects on trade. It often leads to higher prices for goods, making them less competitive in the global market.
• Foreign investors may be discouraged from investing in a country due to the burden of increased taxes resulting from double taxation.

Double Taxation Relief

• One way to address international double taxation is through double taxation relief agreements between countries. These agreements establish rules to prevent double taxation, thereby promoting trade and encouraging investment.

Double Taxation Relief Example

Double taxation relief examples include agreements between two countries that outline guidelines for trade, helping to mitigate the issue of double taxation. Such agreements create a more favorable environment for trade and investment.

How Double Taxation Works 

Double taxation is a system that exists in various countries and can impact both companies and individuals. Measures can be taken to mitigate this issue and reduce tax obligations.

Corporate Double Taxation

• Corporate double taxation primarily affects companies.

International Double Taxation

• International double taxation applies to both individuals and corporations.
• For instance, if a company from India establishes operations in Canada, the income generated by both branches may be subject to taxation in both countries.

Example Scenario

• Let's consider a company with branches in India and Canada.
• The Canada branch earns revenue of ₹15,00,000, while the Indian branch generates ₹30,00,000.
• The Canada branch will pay taxes on its revenue, but the Indian headquarters must combine the incomes of both branches for tax calculation.
• The total income of ₹45,00,000 will be subject to taxation for the entire company.

The presence of a double taxation system in international trade can lead to significantly higher tax burdens for businesses, potentially discouraging trade and resulting in revenue loss. Countries can establish double taxation avoidance agreements to provide relief in such situations.

Double Taxation Avoidance Agreements

• Double taxation avoidance agreements, such as examples of bilateral tax treaties, can assist businesses in maximizing their earnings.

It is essential for businesses and countries to understand and navigate double taxation systems to optimize financial outcomes and facilitate international trade.

Avoidance of Double Taxation

Businesses and nations should prevent double taxation to encourage investment, foster economic growth, and boost earnings. This approach also aids in creating a favorable business climate. Explore the following strategies for avoiding double taxation.

• Business Entity: The company can avoid double taxation by choosing not to register as a corporation. Instead, it can opt for structures like sole proprietorship, limited liability company, or partnership. These entities do not face double taxation since they do not pay dividends; profits are shared among the owners.
• Legislation: Countries can prevent double taxation by amending tax laws or introducing new regulations. These changes encourage investment and allow investors to retain more income.
• Personal Income Tax: Some corporations can designate shareholders as employees, helping to avoid double taxation. In this scenario, the salary is taxed based on personal income tax rates.
• Avoiding Dividends: Companies can steer clear of double taxation by refraining from paying dividends to shareholders. This strategy helps save money and allows the retained income to be reinvested in the business, potentially increasing the company's share value.
• Double Taxation Agreement: International double taxation can be avoided through agreements between countries. These agreements establish laws to ensure that the same income is not taxed twice, which can occur when income is taxed in more than one jurisdiction. By preventing double taxation, these agreements help to facilitate trade and contribute to the economies of both nations.

Double Taxation Example

The concept of double taxation can be illustrated with an example:

• Company A, a corporation with three shareholders, earned a profit of ₹10,00,000 in a financial year.
• This profit was initially taxed at a rate of 30% as income tax.
• After the tax was deducted, the remaining profit was distributed among the shareholders.
• Shareholders received this distribution as personal income.
• This personal income was then subjected to income tax based on the individual earnings of each shareholder.
• As a result, the same business earnings were taxed twice within the same year, leading to double taxation.

Difference between Double Taxation Relief and Double Taxation Avoidance 

Here's a table illustrating the variance between double taxation relief and double taxation avoidance:

Advantages and Disadvantages of Double Taxation 

The concept of double taxation carries inherent advantages and disadvantages. Let's delve into them:
Advantages

• Double taxation allows a business to be treated as a distinct entity from its owner.
• It contributes to increased tax revenue for the government.
• Facilitates the development of trade agreements between nations and fosters trade-friendly discussions.
• Enables the taxation of affluent individuals with substantial dividend incomes, thus enhancing equity.

Disadvantages

• Imposes the burden of paying taxes twice on individuals and companies.
• Perception by foreign investors of the country as an expensive business location.
• Can potentially lead to practices of evasion among individuals to circumvent taxes.

Conclusion 

The concept of a double taxation avoidance agreement PDF holds significant importance for nations aiming to position themselves as favorable destinations for trade. Imposing hefty taxes on investors can potentially drive them towards exploring alternative investment avenues, resulting in a decline in foreign investments within the economy. Therefore, it becomes imperative for businesses to implement strategies that mitigate tax burdens, enabling them to allocate these saved funds towards business expansion and providing shareholders with capital gains.