What is double taxation and how to avoid it?

Taxation is a crucial source of revenue for the government. But, in some cases, the profit or income can be taxed twice. Double taxation refers to a situation in which your tax burden increases significantly because of levying taxes at different levels, even when the source of income is one. Let’s understand the meaning and types of double taxation and how you can avoid it.

Double taxation occurs when income is taxed more than once, leading to increased tax burdens. It is categorised into two main types: economic and juridical.

• Economic Double Taxation: This happens when the same income is taxed twice within the same country, typically affecting two different individuals. For example, a business's profits may be taxed, and then those profits might be taxed again when distributed to individuals as dividends.
  
• Juridical Double Taxation: This type occurs when income earned abroad is taxed in both the foreign country and the individual's home country. For instance, an Indian citizen earning income in the U.S. may face taxes in both countries.

Double taxation significantly affects individuals and businesses:

• Businesses: Companies are taxed on their profits, and dividends distributed to shareholders are taxed again at the personal level. If a corporation’s earnings are distributed as dividends, both the corporation and the shareholders incur tax liabilities. Additionally, if a shareholder receives a salary from the corporation, personal income taxes apply.
  
• Individuals: If a business owner draws a salary from the corporation, they are taxed twice—once on corporate profits and once on their salary. This layered taxation can lead to substantial tax liabilities.

To minimise or avoid economic double taxation, consider the following strategies:

1. Retain Corporate Earnings: By keeping profits within the business rather than distributing them as dividends, companies can avoid additional taxes on dividends. This approach is effective if the retained earnings are reinvested in business growth.
   
2. Pay Salaries Instead of Dividends: Distributing earnings as salaries or bonuses, rather than dividends, allows the business to deduct these payments as expenses. Although salaries are taxable to the recipient, this method avoids the double taxation of dividends.
   
3. Income Splitting: Business owners can withdraw a portion of profits for personal use and leave the rest in the business. This strategy reduces both corporate taxable income and personal gross income, minimising the overall tax burden.

To prevent juridical double taxation, utilise the following approaches:

1. Double Tax Avoidance Agreements (DTAA): India has signed DTAAs with numerous countries to avoid paying taxes in both the home and foreign countries. These treaties allow for tax rate reductions or rebates but do not eliminate tax obligations entirely. They provide relief by reducing the tax liability in one of the countries.
   
2. DTAA Annexure: For individuals and entities eligible under DTAAs, using forms such as the DTAA Annexure provided by institutions like HDFC Bank can help in applying for tax rate reductions effectively.

More ways to reduce your taxable income as a self employed individual.

​​​​​​​*Terms and conditions apply. The information provided in this article is generic in nature and for informational purposes only. It is not a substitute for specific advice in your own circumstances. You are recommended to obtain specific professional advice from before you take any/refrain from any action. Tax benefits are subject to changes in tax laws. Please contact your tax consultant for an exact calculation of your tax liabilities.