What is double taxation: How it works & ways to avoid it

Double taxation is one term that often becomes a cause for concern for those who live or do business abroad.

Dоublе tахаtiоn can have significant implications for both individuals and businesses, particularly those operating across international borders.

In this article, we will delve into what dоublе tахаtiоn is, how it works, and look into strategies which can help you avoid it altogether — or reduce the taxable amount at least.

Key takeaways

• Dоublе tахаtiоn occurs when the sаmе inсоme is tахеd twice, at corporate, personal or cross-country level.
• International tax treaties, the Foreign Earned Income Exclusion (FEIE), and Foreign Tax Credits (FTC) can help reduce dоublе tахаtiоn.
• US expats must report their worldwide income, but credits and exclusions can bring the taxes down significantly.
• Choosing an S-Corp, partnership, or sole proprietorship can help business owners avoid corporate dоublе tахаtiоn.

What is dоublе tахаtiоn?

Dоublе tахаtiоn is simply what the name implies: income, whether corporate or personal, is taxed in two countries. It can happen when individuals work and live abroad — but are still obliged to pay US taxes — or when businesses pay taxes from their earnings and their shareholders for dividends they receive. We’ll look at both examples in detail anon.

How double taxation works

There are two scenarios when dоublе tахаtiоn might kick in.

1. Corporate income being taxed twice. First a corporation pays income tax on its earnings, then its shareholders pay income tax on their dividends, which are paid out of the corporation's after-tax earnings.
2. Personal income being taxed twice. This could happen when a taxpayer is a citizen of one country, but lives and earns his income in another. This is particularly relevant for expats.

International double taxation

International dоublе tахаtiоn can happen on a personal level — or on a business level.

Business level covers two aspects:

• Taxes are levied on dividends paid to shareholders (we’ve already detailed this concept above)
• Income received from sales of goods and/or services is taxed both in the country of origin and in the country where these are sold

Personal level is much more straightforward. The dividends situation aside (dividends are considered a type of personal income), there is a more commonplace matter of being a citizen of the US but living and working in another country.

According to US tax law, American citizens are taxed on their worldwide income, regardless of where they live or earn said income.

This leaves American expats exposed to dоublе tахаtiоn – once by the country where they earn their income, and again by the United States.

However there are mechanisms in place to prevent this kind of dоublе tахаtiоn. Tax treaties between countries, the Foreign Earned Income Exclusion (FEIE), and the Foreign Tax Credit (we’ll cover them all in detail below).

Dоublе tахаtiоn examples

To better understand the concept of dоublе tахаtiоn, let's take a look at a few examples:

Example 1: Corporate dоublе tахаtiоn

A corporation in the United States earns $1 million in profits. It pays a corporate income tax on these profits.

Then, when the after-tax profits are distributed to shareholders as dividends, the shareholders must also pay personal income tax on these dividends.

Example 2. International dоublе tахаtiоn

An American expatriate living in Germany earns income from a job in Germany. They pay income tax on this income to the German government.

However, based on US tax law, expats must also report their worldwide income to the IRS, potentially leading to dоublе tахаtiоn.

Example 3: Investment income from a foreign source

Consider an American expatriate living in France who receives investment income, such as dividends or interest, from US-based stocks.

The US taxes this investment income because it’s sourced from the US, while France also taxes it since the individual is considered a tax resident in France. Without planning or claiming available credits, this income could be taxed twice, by both the US and France.

To avoid dоublе tахаtiоn, the expat can claim the Foreign Tax Credit (FTC) on their US return for the taxes paid to France or apply the US-France tax treaty provisions, if applicable.

Business entities and dоublе tахаtiоn

When it comes to business entities, dоublе tахаtiоn primarily affects C corporations, often referred to as C-Corps.

This is due to the fact that C corporations are legally considered separate entities from their owners, who are the shareholders.

This separation leads to a two-tier taxation system.

First tier

The first tier of taxation occurs at the corporate level. When a C corporation generates profits, these earnings are taxed according to the prevailing corporate tax rate.

As of the current tax year, this rate stands at 21%, and it applies irrespective of the corporation's annual earnings.

Second tier

The second tier of taxation comes into play when these after-tax profits are distributed to shareholders in the form of dividends.

At this stage, the dividends are subjected to personal income tax, which varies based on the shareholder's federal income tax bracket.

This bracket is determined by several factors, including the shareholder's filing status (single, head of household, married filing jointly, or married filing separately) and the total amount of dividends received.

Exclusions

However, not all business entities are subject to double taxation.

S corporations, partnerships, and sole proprietorships, for example, are classified as "pass-through" entities.

In these business structures, the income earned by the business is not taxed at the corporate level. Instead, it "passes through" to the owners, who then report it on their personal income tax returns.

This pass-through mechanism allows these types of businesses to avoid the dоublе tахаtiоn experienced by C corporations.

Debate on fairness of dоublе tахаtiоn

The fairness of dоublе tахаtiоn is a subject of ongoing debate, particularly regarding passive income like dividends. Critics argue that it’s unfair to tax shareholders on dividends since this income was already taxed at the corporate level.

For US expats, this can be especially burdensome, as dividends earned abroad may be taxed in both the foreign country and the US, despite being the result of the same income stream.

On the other hand, proponents of double taxation argue that without taxes on dividends, high-net-worth individuals could potentially avoid taxes altogether by relying primarily on investment income instead of earned income.

For expats, these varying perspectives on double taxation highlight the importance of utilizing available credits and exclusions to reduce the impact of dоublе tахаtiоn, whether on dividends or other income types.

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Need help to avoid dоublе tахаtiоn?

Remember that every individual's tax situation is unique, and the information provided here is general in nature.

It's always a good idea to consult with a tax pro who is familiar with the tax rules of both the US and the foreign country where you are living or doing business.