Companies engage in business to make profits after which they either reinvest back into the company for the purpose of expanding the company, or distribute the profit to the shareholders in terms of dividends. Mostly, this Profit is taxed as corporate income tax, and after the dividends are distributed to the shareholders they are again subjected to individual income taxation. This is what is referred to as double taxation since the same income is subjected to two rounds of taxation. Another form of double taxation is found on inheritance taxation where the owner of the property is expected to have been paying tax on his income. The person who inherits the property, on the other hand, will be required to pay taxes on the same property.
Countries try to avoid double taxation because of its negative effect on the movement of capital, which leads to disinvestment and afterwards low economic development. Most countries therefore use tax conventions; which give taxing rights to countries so that they can have clear understanding on which country should tax the income. For instance, it would be agreed that when the source country taxes the income, the country of residence should not again tax the same income from a particular person. To stress this point Vogel (1997) argues that;
Countries may also encourage people to join small corporations because the employees of these corporations may also be the shareholders of the company, to avoid double taxation these corporations may issue profits inform of wages and fringe benefits to the shareholders. (p.33)
Tax treaties provide tax relief such as; exemption on part or whole income, which the people have earned. There is also tax credit which countries give to the people as a relief to reduce double taxation.
Difference between legal and economic double taxation
Legal double taxation is different from economic double taxation because it is mainly concerned with a particular tax payer; there the income to be taxed and the period when the tax is imposed are identical. This difference is essential as it can enable people to determine whether they are interested in the particular tax payer, or they are concerned with different tax payers; who could have received income inform of transfer payment.
Levying tax on the company’s income and taxing the dividends of shareholders is a form of economic double taxation in which, a company is considered to be a separate entity to the shareholders. The relief on this type of double taxation is the exemption given to some investors, such as charities or pension funds, who are shareholders in the company (Thomas 1994).
Methods used to relieve international double taxation
There are three general methods deployed in relieving international double taxation and they include: tax deduction method, exemption method and credit method. The two methods that OECD treaty approves, for double tax relief, are the exemption method and credit method.
Tax exemption method allows the source country to tax the income of the resident of a given country, and therefore the home country of this particular tax payer will not be expected to tax the same income. The method is generous of the three methods because the tax payer does not part with any deductions on his income once the source country has taxed his income. This method is also much simple to apply and it is cost effective.
Credit method allows the tax payer, who has paid taxes on his foreign income, to pay less domestic tax if the foreign tax is higher than what he is expected to pay in the home country. However, the difference could still be higher and the tax payer may have to part with huge amounts of money for taxes. Deduction method would be preferred especially because deduction will result in reduced income for the tax payer, but this is a good thing since with less income it means that the tax payer will have to pay less tax. Thus, the tax payer will enjoy the reduced tax burden, which he will have to face because the tax liability will be reduced.
Deduction method subjects the tax payers to higher rates of taxation and it offers less relief to tax payers because the combined taxes are high. Moreover, it discourages sourcing income from foreign country since foreign investors are expected to pay more on taxes than those who do business within the country.
The rate of tax applied on the foreign source of income, which the citizens of a given country get, will affect the level of taxes they will be required to pay locally. Credit method enables people, who have earned taxed foreign income, to have a reduction on the local taxes that they will be required to pay if the amount paid for foreign income is higher than the tax liability in the home country. This exemption method is the one which the citizens of the country are excluded from paying tax on foreign source income. The country leaves the foreign country, where the income was earned, to tax the income and therefore, the same income will not be subjected to taxation in the home country. This method encourages the citizens of a country to invest in foreign countries where taxes are lower as compared to the local levels of taxation. In this case the effective rate of interest on the foreign income will determine how people will invest their capital in different countries (Gelband 1997).
Under exemption method, it is important for countries to consider the levels of foreign tax. This is because countries with significant difference in the tax level may experience inequity, and people will invest in countries where the foreign tax on income is lower. In order to avoid this, these countries should try and establish tax structures which are almost similar to those of foreign countries that they do business with. It is therefore relevant for the countries to know the levels of tax levied on foreign income for the purpose of maintaining equity among the countries involved (Arnold 2002).
Implications for financing multinational enterprises
Countries are supposed to exempt incomes, which are positive and not losses so that countries; where the foreign income goes should exempt its citizens from taxation. Normally, only gains or profits are taxed but losses are not taxed, and this means that country A will not grant exemption to ACo since the company made a loss. However, country A will need the figures of the loss which ACo made in its operations in country Y for the purposes of calculating the domestic tax base.
If a country does not take into account the foreign losses, it will be doing a major mistake because it will not be planning its tax base. Any incurred loss therefore should be put into account as it will reflect the true position of the country financially. Losses incurred should be noted in order to be exempted from taxes whenever a country is calculating its taxation each year.
It also matters very much if a country uses exemption method or credit method, and to know which method a country uses, for the sake of calculating income, as well as to reduce chances of double taxation on income. Country A will have to establish how to tax the income for ACo because it has a branch in country X and a subsidiary in country Y. Therefore, if the interest is fully deductible, it posses a challenge to multinational enterprises as taxes are higher on foreign income than in the domestic country; and the profits could be lower in foreign countries (Erasmus 2010).
Prove of Tax paid to foreign government
Tax payment can be proven by producing evidence issued by foreign tax authority after one has paid for the tax (Dailey 1997).
Reference List
Arnold, B., 2002. International Tax Primer. New York: Kluwer Law International.
Dailey, F., 1997. Tax savvy for small business. Berkeley: Nolo Press.
Erasmus, D., 2010. Tax Intelligence: The 7 Habitual Tax Mistakes Made by Companies. New York: Xlibris, Corp.
Thomas, D., 1994. Eliminate the double tax on dividends. Journal of Accountancy, 178, Web.
Vogel, K., 1997. Klaus Vogel on Double Taxation Conventions. 1st ed. New York: Kluwer Law International.