How to Avoid Double Taxation and Legally Reduce Tax Obligations?

The leadership of any company or corporation that conducts national or international business and generates income believes that they pay too much in taxes. Company owners often share this sentiment, especially if the country has a progressive tax scale where higher incomes are subject to higher rates. Business people who operate enterprises understand that paying taxes is inevitable, and the use of illegal patterns of tax evasion threatens severe consequences. But what to do if the issue of double taxation arises when the same income appears in the declarations twice? And how do companies avoid double taxation?

This issue arises much more frequently than it may seem. Furthermore, double taxation can occur both in conducting domestic, national business and in commercial activities abroad. Even in offshore jurisdictions, which are initially considered to be tax-free, a company/corporation may end up taxed twice. Are there any effective methods and ways to combat such a problem? Our experts will tell you about legal methods to avoid double taxation.

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What is double taxation?

Any activity that generates income requires payment of taxes. In civilized countries, this statement requires no proof. Of course, we can argue about excessive taxes on businesses, the fact that a company or corporation is sometimes forced to conduct commercial activities at a loss and that government spending is too high and irrational. However, everyone is obligated to pay taxes.

The issue of corporate double taxation arises when taxes on the same income must be paid twice. A typical (but not the only possible) example is a company or corporation paying dividends to shareholders. The legal entity must first pay corporate tax, after which the shareholders (effectively co-owners of the company) again pay tax on the same income but in their personal declarations. This issue typically arises at the end of the financial year and does not concern international/transnational business.

One more double taxation example describes a typical situation where a legal entity engages in commercial operations abroad in a jurisdiction that is not considered an offshore zone for all formal and factual purposes. In this case, tax obligations for the same income may arise for the company or corporation both in the country where the business is conducted and in the jurisdiction where it is a tax resident. Double taxation in this pattern goes beyond national borders, leaving fewer simple ways to combat it.

Not all companies or corporations encounter such issues. For each case, there are specific methods of counteraction, but in some cases, double taxation may have to be accepted due to a combination of factors. It can be challenging to assess the situation independently and understand the actual ways to tackle the problem, especially without sufficient experience in legal tax optimization. Therefore, the best solution for avoiding double taxation is to turn to experienced professionals and develop a plan to reduce the tax burden.

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What is double taxation for corporations and companies doing national business?

The corporation double taxation issue is primarily relevant for large structures that pay dividends to their shareholders. It does not arise in all countries or for all legal forms of organizations. Therefore, it is essential to determine whether a specific business is subject to double taxation and whether this problem can be resolved. The second condition requires a mandatory consideration of the tax legislation peculiarities in a particular country. General advice and recommendations are of little use and may not produce the desired effect. Therefore, when discussing national (domestic) double taxation, the example of the United States should be kept in mind, where the problem is particularly acute.

However, in the USA, double taxation refers to only C-class corporations and those LLCs that have chosen the corresponding tax format. The fact is that C-corporations are taxed as separate legal entity. This does not exempt the shareholders from personal fiscal obligations, which results in dual taxation. The combination of these two factors determines the difficulties faced by business owners structured as a C-class entity.

Organizational and legal forms of doing business in the United States that are typically not double taxed include:

• sole proprietors
•  partnerships
• S-Class corporations
•  Limited Liability Companies (LLCs).

The latter may choose the C-Class taxation format, but this decision is voluntary. In many cases, the benefits of such a move outweigh the potential drawbacks of paying corporate double tax. However, a final decision on the organizational and legal form of doing business should only be made after a careful analysis of all relevant factors.

How does double taxation work technically? A C-Class company or corporation is a separate legal entity distinct from its shareholders. The actual payment of taxes is made at the end of the financial year and is calculated based on the profits earned during that period.

In addition to paying taxes to the government, the company or corporation has to settle with its shareholders. If dividends are distributed, the structure owners must also pay taxes (the amount is calculated based on the dividends received). But in both cases, taxes are effectively being paid on the same income (the profits of the company or corporation for the financial year).

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What are the 3 modes of eliminating double taxation for small businesses?

Effective methods of combating double taxation exist but cannot be called easy to apply. It is extremely important to understand that reducing or not paying taxes on legitimate grounds can only be done at the corporate level. The portion of income that was paid to shareholders in the form of dividends is not subject to change. Therefore, it is possible to combat double taxation of a company or corporation if the profit was not distributed.

Option #1. Abandoning C-Corp business structuring

How to avoid C-Corp double taxation? As paradoxical as it may sound, the simplest method would be to abandon this way of structuring a business. The main advantage of this method is reliability. If, instead of a C-Corp, practically any other corporate format is chosen when registering a business, the issue of double taxation ceases to be relevant. It should be noted that C-Corp has many undeniable advantages in conducting business. Moreover, the legal separation of shareholders in many cases can be regarded as a positive argument. However, if the income from running the business is planned to be distributed in the form of dividends, C-Corp is unlikely to be considered as the main option.

What type of ownership avoids double taxation? Here are possible alternative options for registering a new business that allow double taxation relief (using the example of the United States; similar formats are provided for in corporate legislation of other countries):

• Sole proprietorship. For entrepreneurs seeking growth and development, this format is not promising. However, a sole proprietorship is a pretty acceptable form for small and medium-sized businesses where expansion is not a top priority.
• Partnership. This is a pass-through format for conducting business, which does not involve double taxation. Income arising from commercial activities is transferred to each partner, who pays taxes as an individual.
• S-Corporation. The taxation model for such a legal entity is similar to that adopted for a partnership. Therefore, taxes are paid by owners (organizers) as individuals.
•  LLC with one member. The tax rules are the same as for a partnership. The business owner, thanks to the pass-through principle, is subject to taxation as an individual. At their request, an LLC can be registered as a corporation. In this case, the issue of double taxation will arise, but additional opportunities for growth and development can compensate for this conditional disadvantage.
• LLC with multiple members. The taxation situation is generally analogous to that of the option with a single member.

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! Attention! When choosing the organizational and legal form of a business in countries with corporate legislation similar to the US one, it is not advisable to make a decision based solely on the desire to avoid double taxation. It is essential to consider all available factors and remember that for a business registered with the prospect of further development, the C-Class format is often more preferable.

Option #2. Transferring a company/corporation’s income to retained earnings

If all income is directed towards the development of the business without distributing dividends to shareholders, double taxation issues can be avoided. This approach is acceptable and logical during the early stages of a company/corporation’s commercial activity. However, as the business grows, shareholders may not agree with the continued expectation and demand a return on their investment through dividend payments.

Option #3: Converting shareholders to employees

This pattern of avoiding double taxation for corporation is based on the idea that the company’s staff is paid a salary from taxable income. This type of expenditure is subject to tax deductions on legal grounds, significantly reducing double taxation’s negative effect. While not universal, this option is entirely legal and, in some instances, can provide substantial savings.

Choosing the organizational and legal form for conducting business, if the priority is legal tax minimization, is an extremely complex task. Opting for the C-Class format, businesses in many countries face the issue of corporations’ double taxation. While legal ways to circumvent it exist, their scope of application is limited, and not every method can be considered universal.

Therefore, if the business is registered with the aim of further scaling, it will either have to accept double taxation or consider opening a company in an alternative jurisdiction. The options for using illegal patterns should not be considered in principle, as this threatens serious legal problems.

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Double Taxation Treaties and international business

When a company operates outside the jurisdiction where it is registered, double taxation is a common problem. For the past 20-30 years, a typical approach widely used has been to relocate the business to an offshore jurisdiction where either no taxes need to be paid, or they are very low.

While this method still works, it has largely lost its popularity because the use of offshore entities for aggressive tax planning has become much more challenging and sometimes even illegal. Therefore, if a company wants to avoid double taxation, the only real option is to rely on Double Tax Treaties (DTTs).

The essence of the international business taxation issue is roughly equivalent to the case where a company/corporation conducts national business. In the second case, double taxation means that tax on the same income was paid by both the company (at the corporate level) and its shareholders (individuals). With an international business format, tax on the same income in certain situations will have to be paid in both the country of the company’s registration and the owner’s tax residency.

The double taxation issue is not entirely ignored at the government level. A typical method of fighting it, which does not depend in any way on the company itself, is to use the opportunities provided by bilateral Double Taxation Treaties. In some cases, they allow for the complete exclusion of extra taxes, but more often, the company receives a significant but not 100% deduction.

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DTTs drawbacks that negatively impact their effectiveness in combating double taxation:

• Extra tax payments are not always fully compensated, so companies may still face some additional tax burden.
• DTTs are usually signed between two countries, which means there is always a risk that the activity of a company engaged in international business is not regulated by them.
• DTTs typically do not apply to offshore companies or have limited applicability.
• Each jurisdiction, even if it has signed a DTT, may have its own rules for calculating and deducting foreign taxes.
• The benefits provided by DTTs are usually one-sided.
• Effective use of DTTs to combat double taxation requires taking into account many individual factors specific to each case (such as residency status).

Types of DTTs used to reduce the effect of double taxation

If the initial conditions are clearly understood, and the business is structured with subsequent tax optimization in mind, there should be no significant problems. Double taxation’s impact, if felt, can be effectively compensated without crossing legal boundaries. However, if you act impulsively, a company engaged in international business may face numerous challenges, some of which may be fatal.

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Types of Double Taxation Treaties include:

• Bilateral Treaties – concluded between two countries, these agreements do not affect taxes if business activities extend to other jurisdictions.
• Multilateral Treaties – signed by multiple countries, they operate the same way as bilateral ones but concern many jurisdictions at once. Typical examples are SAARC (South Asian Association for Regional Cooperation) and APAC (Asia-Pacific).
• Tax Information Exchange Agreements (TIAE) – these agreements do not directly reduce the negative impact of double taxation, but indirectly, through the fight against harmful tax practices, their impact is positive.
• Double Taxation Avoidance Agreements (DTAA) – agreements covering certain types of taxes, which allow for partial alleviation of the double taxation negative impact. However, in some cases, they may be useless (for example, if income is not clearly specified in the agreement).
• Comprehensive Agreements for the avoidance of double taxation – the standard and most acceptable option for businesses, suitable for any income without any restrictions.

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How to avoid double taxation on foreign income: methods based on DTAA

Interstate agreements are the only legal way to avoid paying taxes on the same income. While not a perfect and sometimes inapplicable solution, it can achieve a sufficient effect within the legal framework when used effectively. However, if tax treaties are applied without prior planning and understanding of their essence, international businesses may face significant problems.

Exemption method

The company/corporation is granted the opportunity to exempt from taxes (fully or partially) income that has already been taxed in the source country. Details are contained in a standard Double Taxation Avoidance Agreement concluded between two countries.

The standard options are as follows:

• Full Exemption – income that is subject to taxation in the source country is not taken into account when calculating the company’s taxable base in the country of tax residency.
• Progressive Exemption – similar to the previous option, the only difference being that the income is not directly taken into account for taxation in the country of tax residency, but will be used to determine the tax rate.

Credit method

Income received from conducting international business will be taken into account in both countries (included in the taxable base). However, in the jurisdiction of tax residency, the company will have the opportunity to deduct the tax already paid in another country.

The standard options are as follows:

• Full Credit Method – there are no restrictions on tax deduction in the country of residence (tax residency).
• Ordinary Credit Method – only that portion of the tax that was actually paid in the source country and did not exceed the tax rate in the country of residence (deduction of the lesser value) is allowed.

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Basic credit method

This method is intended for cases where the same income received by a company conducting international business is subject to double taxation in the country of registration/tax residency. The first time, the taxpayer is the company itself (a legal entity), and the second time, its shareholders from the dividends received (individuals). The essence of the method is that companies and their shareholders are allowed to deduct taxes (fully or partially) paid in the country where the income was received.

Preferential tax credit method

Credit is provided for the amount of tax in the country of income source that was not actually paid due to special tax incentives or tax holidays.

Methods that allow avoiding double taxation are the only legitimate way not to pay taxes twice on the same income. In the case of domestic business, companies/corporations have several options. They can use any suitable approach or their combination.

However, in the case of international business, the only legal alternative is to use double taxation treaties. Their practical application is associated with several difficulties, and often to achieve the optimal result, companies have to carefully study the specific agreement and adjust their business to it.

It is extremely difficult to independently optimize taxation by eliminating double tax payments for the same income. Therefore, we strongly recommend contacting International Wealth experts and discussing the situation within an individual consultation.

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• Set Up an IBC or an LLC in Belize. Apostille and Professional Officers’ Services
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• Registration of an Offshore Company in Mauritius (GBC I/II)
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• Offshore International Business Corporation (IBC) in the Marshall Islands
• Register an LLC in Nevis
• Company Registration in British Virgin Islands (BVI IBC)
• Register a Panama Corporation with a Corporate Bank Account in Curaçao
• Register a company in the form of LLC or Series LLC in the Marshall Islands remotely

E-mail to contact International Wealth experts – info@offshore-pro.info.