Just when you thought corporate tax obligations couldn’t get any more complicated – there’s also the chance your business could be subject to double taxation. Essentially, this means you’re taxed not just once, but twice, on the same income.
While C Corp owners know all about double taxation, it’s also applicable for international businesses. During international trade and investments, your income could be taxed by both countries.
But don’t panic! In this blog, we take a deep dive into international double taxation to help you navigate the complexities and mitigate the risks.
Understanding Double Taxation
In the context of international business, double taxation happens when income from multinational entities is taxed twice. The US is one of the few countries that taxes citizens on their worldwide income, so no matter where it is earned, you’ll need to pay the relevant taxes to the IRS. However, if the country you receive income from also levies taxes against this revenue, you’ll effectively be taxed again on the same revenue. As such, this is an important aspect to consider when it comes to your tax planning strategy.
However, as many business owners know, double taxation is also possible at a domestic level. This mainly affects C Corporations, which are taxed at an entity level, as well as at a shareholder level, because the two are considered legally separate entities.
At the corporate level, C Corp profits are taxed at a set rate of 21%, no matter their annual earnings. Then, once post-tax profits are distributed to shareholders as dividends, they are subject to personal income tax.
Your business could also be subject to double taxation if it operates across US states. Different states have different business climates, tax consequences and federal filing requirements. State tax apportionment rules will determine whether your income should be taxed by different states, according to your nexus.
The impact of double taxation on businesses
Double taxation increases your tax burden, reducing your net income and profitability, and possibly causing issues with cash flow. As such, it can lead to an increase of prices for goods and services, as it can be difficult to compete with foreign businesses that don’t face the same tax liability.
Moreover, double taxation presents numerous compliance challenges, and may affect your investment decisions.
Altogether, this unfortunately discourages many businesses from growing internationally.
A tax pro can help you ensure that your business is doing everything it can to mitigate the burden of double taxation.
Double Taxation in International Business Operations
To truly understand the significance of double taxation, it’s important to know exactly what kind of income can be taxed twice. This includes:
- Business profits: If you have subsidiaries or branches in foreign countries, their profits can be taxed in the host country and in the US.
- Dividends: When your business distributes dividends to shareholders, these can be subject to taxation in the country where the corporation is based as well as where the shareholders reside.
- Interest: Any interest earned on foreign investments can be taxed in the country where they are held, as well as in the US.
- Royalties: If your company receives payments for the use of intellectual property, like patents or trademarks, this may be taxed internationally and locally.
- Capital gains: When your company sells an asset like stock or real estate and makes a profit, the capital gains can be taxed in the country in which they are made and in the US.
- Employment income: If you have staff working abroad, their salaries and benefits might be subject to double taxation.
It’s also important to consider exactly why your income is subject to double taxation.
Causes of double taxation in international transactions
There are several reasons for double taxation. In a nutshell, it boils down to the overlapping tax systems of different countries.
As mentioned above, the US taxes all income from citizens, regardless of where they live or where the money was generated. This is known as resident-based taxation, in which as long as you’re considered a US resident or citizen, your income is subject to federal taxation.
But not all countries have the same rules. Others have source-based taxation. Here, only money that is generated within a country’s borders is taxed, no matter where the resident lives.
This means that US businesses operating in countries with sourced-based taxation will pay income tax to the IRS, as well as the source country.
Different countries also have various ways of determining tax residency. As such, it’s possible to be considered a resident of multiple countries at the same time.
Also, there may be different rules governing what is considered taxable income. For instance, the IRS considers ordinary dividends ordinary income, while qualified dividends are subject to capital gains tax.
Because of these differences, many countries try to limit double taxation through treaties.
Prevention of Double Taxation through Tax Treaties
Tax treaties are contracts between countries dictating how multinational companies pay taxes. They differ depending on the jurisdictions involved, but must adhere to guidelines established by the Organization for Economic Cooperation and Development (OECD).
The US currently has over 60 treaties with other countries. They allow for tax credits, exemptions, or reduced tax rates on various types of income. Also known as double taxation agreements (DTAs), treaties seek to encourage cross-border trade and investment between countries.
How tax treaties work
There are two main ways that tax treaties work. The first is known as the exemption method. For example, some countries like The Cayman Islands exempt citizens from paying taxes, no matter where the income is generated (although they might still have to pay taxes in the countries where the money was generated). Such countries are often called tax havens, as they are attractive for businesses or individuals who want to lower their tax liability.
The second method is through tax credits. In this case, a country allows a credit for taxes paid to it.
Some tax treaties also allow for a reduction in withholding taxes.
Because of these benefits, treaties have anti-abuse provisions to prevent taxpayers from exploiting the benefits for tax evasion.
Tax Credits for International Business Income
As mentioned above, there are a number of tax credits available to reduce the burden of double taxation.
The primary credit applicable in this scenario is the Foreign Tax Credit. This basically allows you to offset the taxes paid to a foreign government against your domestic tax liability. Essentially, this means that you can take a dollar-for-dollar credit or reduction on the taxes you pay in another country, and use that on your US income tax.
Exclusions
Another option is through exclusions or deductions. For example, the Foreign-Earned Income Tax Exclusion (FEIE) allows you to exclude part of your foreign-earned income when filing your US taxes. This amount is adjusted annually for inflation, but for the 2023 tax year, it covers up to $120,000. Note that passive income like interest, dividends, and pensions are not eligible for FEIE.
It’s also possible to exclude foreign housing. For US citizens living abroad, the IRS allows you to deduct certain housing expenses from your tax payments. Generally, you can exclude up to 14%. However, there are limitations.
Firstly, the IRS considers some cities to be more expensive than others. As such, residing in these cities can mean a higher exclusion amount. Secondly, this exclusion mainly covers expenses like rent, occupancy taxes, and some utilities. There are also ‘tests’ to see whether you qualify.
- The physical presence test requirements are that you spend more than 330 full days in one or more foreign countries during a 12-month period.
- The bona fide residence test requirements include that you need to live in a foreign country for an entire calendar year, with no plans of returning for the foreseeable future.
Note that making use of credits and exclusions can significantly impact your tax reporting.
Compliance and Reporting Requirements
When it comes to double taxation, you must adhere to tax reporting requirements. Noncompliance can come with hefty penalties, including large fines with high interest rates.
And the first step here is proper record-keeping. When your documents are up to date and in order, tax filings are so much easier.
You must report all foreign income. After all, under the Foreign Account Tax Compliance Act (FACTA), the IRS can easily track any foreign-earned income.
It’s also important to keep track of exactly what forms to fill in for each tax jurisdiction. For example, if you have a foreign branch generating income, this is reported on your normal tax return. If the branch is a separate entity or a subsidiary, you’ll also need to complete Form 5471. And if you make use of a foreign tax credit, you’ll need to fill in Form 1118.
If you are ever in doubt, tax professionals like our team of dedicated CPAs can help you navigate tax reporting with ease.
If you need help navigating double taxation for international transactions, schedule a Discovery Call with one of our CPAs.
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