Double taxation is a situation that affects C corporations when business profits are taxed at both the corporate and personal levels. The corporation must pay income tax at the corporate rate before any profits can be paid to shareholders. Then any profits that are distributed to shareholders through dividends are subject to income tax again at the individual rate.
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The corporate profits are subject to income taxes twice. Double taxation does not affect S corporations, which are able to “pass through” earnings directly to shareholders without the intermediate step of paying dividends. In addition, many smaller corporations are able to avoid double taxation by distributing earnings to employee/shareholders as wages. Still, double taxation has long been subject to criticism from accountants, lawyers, and economists. Critics of double taxation would prefer to integrate the corporate and personal tax systems, arguing that taxes should not affect business and investment decisions. They claim that double taxation places corporations at a disadvantage in comparison with unincorporated businesses, influences corporations to use debt financing rather than equity financing (because interest payments can be deducted and dividend payments cannot), and provides incentives for corporations to retain earnings rather than distributing them to shareholders. Furthermore, critics of the current corporate taxation system argue that integration would simplify the tax code significantly. (referenceforbusiness.com) Double taxation arises when an individual or business acquiring income in a foreign country is required to pay taxes on that income in both the foreign country as well as the country of origin. For example, an American company operating in a developing country, in the absence of a tax treaty between the two countries may have to pay a withholding tax to the government of the developing country, as well as corporation tax to the United States government (Howard, 2001, p. 259). The purpose of this paper is to examine the merit of three basic systems, which is exemption system, credit system and deduction system. These systems are dealings with the essence of tax relief from international double taxation. The case between Turkey and Germany is more on exemption and credit system focused in my paper.
Under exemption systems, a taxpayer of a country (the residence country), will not be taxed regardless of where the income is generated, instead, taxpayers are taxed based on the source of their income (the host country), that is, only the country where the income is generated has taxing authority over the income (Stephens, 1998, p.159) With exemption system, it’s encourages resident individual or companies to venture outside their domestic environment and compete with their foreign competitors. Hence it is frequently used term of capital import neutrality. In general, it can be said that a tax exemption system encourages businesses to trade outside their home country, thus accelerating the trends towards globalization and increase of global welfare. Countries that are purely on exemption system are often referred to as “tax havens” because the country does not tax any foreign source income (FSI) earned by individuals or corporations that have that country as their home country (Stephens, 1998). A tax haven is a place where foreigners may receive income or own assets without paying high rates of taxes. Generally speaking, the main characteristic of a tax haven is a very low effective tax rate on foreign income. Major tax havens are the Bahamas, Bermuda, Cayman Islands, Hong Kong, Panama, and Singapore. Most tax havens are developing countries where governments believe that tax haven status would accelerate their rate of economic growth (Howard, 2001, p.256)
The credit system allows tax paid in one state to be used as credit against a taxpayer’s liability in another state. The credit will be in the form of a direct credit or indirect credit (August, 2004, p 732) The philosophy behind a tax credit system is to allow international businesses to operate under the same conditions as domestic enterprises. If a business ventures abroad, it must pay tax on foreign and domestic business income domestically at the same tax rate and tax basis. Foreign tax paid (dividend withholding tax and corporate income tax on the original profits) can be deducted against domestic tax due. This system is also referred as Capital Export Neutral system. Tax-credit systems have been implemented in the United States, OECD countries, and newly industrialized economies in which investment taxes paid to foreign countries can be deducted at home if the home tax rate exceeds the foreign tax rate. AVOIDING DOUBLE TAXATION There are many ways for corporations to avoid double taxation. For many smaller corporations, all of the major shareholders are also employees of the firm. These corporations are able to avoid double taxation by distributing earnings to employees as wages and fringe benefits. Although the individual employees must pay taxes on their income, the corporation is able to deduct the wages and a benefit paid to employees as a business expense, and thus is not required to pay corporate taxes on that amount. For many small businesses, distributions to employee/owners account for all of the corporation’s income, and there is nothing left over that is subject to corporate taxes. In cases where income is left in the business, it is usually retained in order to finance future growth. Although this amount is subject to corporate taxes, these tax rates are usually lower than those paid by individuals. Larger corporations-which are more likely to have shareholders who are not employed by the business and who thus cannot have corporate profits distributed to them in the form of salaries and fringe benefits-are often able to avoid double taxation as well. For example, a non-active shareholder may be called a “consultant,” since payments to consultants are considered tax-deductible business expenses rather than dividends. Of course, the shareholder/consultant must pay taxes on his or her compensation. It is also possible to add shareholders to the payroll as members of the board of directors. Finally, tax-exempt investors such as pension funds and charities are often significant shareholders in large corporations. The tax-exempt status of these groups enables them to avoid paying taxes on corporate dividends received. Background of agreement Avoidance of double taxation between Turkey and Germany has a long story. It goes back to end of 1960’s. For this purpose between the two countries began talks in 1968. After long negotiations and interviews both parties prepared a draft agreement on 19.10.1968. This text is signed by two authorized representatives of the Government; the finalized draft is ratified by the parliaments of both countries and after that a long time period had to pass in order to put this agreement into action. Unfortunately from 1968 until 1985 the agreement couldn’t come up to reality. The final agreement was signed in Bonn (Former capital of West Germany) on 16.14.1985. Unfortunately no real explanation was given for the delay to finalize the agreement from any of the parties. Legal formality The agreement between Turkey and Germany is the avoidance of double taxation taxes on income and wealth. This has become the fourth agreement Turkey has ever done with another country. As It is mentioned the final agreement was reached in 1985 but the ratifications took around four years for the parliaments to agree. January 1.st 1990 is the milestone of this agreement where it came to exercise. As mentioned on the last paragraph of the agreement, the texts were written in Turkish, German and in English languages to avoid misunderstandings by the translation between Turkish and German. If the disagreement cannot be solved than English version shall prevail. Taxes covered subject of the agreement According to OECD model tax treaties the agreement of avoidance of double taxation between Turkey and Germany includes the following taxes. In Turkey; Income tax Corporation tax In Germany; Income tax Corporation tax Wealth tax Trade tax Some other topics covered tax agreement Bilateral agreements to prevent double taxation is not only about to prevent double taxation issues. Such as the OECD’s Model, in such agreements, exchange of information, Nondiscrimination, Mutual agreement procedure, administrative support also helps to prevent tax evasion. When we take a look at the agreement of avoidance of double taxation between Turkey and Germany we can see some parts regarding to tax evasion; Article: 24- Equal treatment Article :25- Mutual agreement Article: 26- Exchange of information Article: 27- Diplomatic and consular privileges Terminologies used in the agreement To understand what actually the agreement is about and how the subjects are determined we need to follow some terminologies in order to understand where we can put the stones. The term Person: Means any individual and any corporation. “Company ” refers to all kinds of legal entity for tax purposes as a legal entity or person means any traded. Legal head: This statement of the Turkish Commercial Law, or Law of the German financial means within the context of legal settlement. Competent authority: Means the Minister of Finance of Republic of Turkey and the Federal Republic of Germany. Fiscal domicile: The concept in general, under the laws of the contracting states of one or the other, place of residence (settlement), home, legal center, business center, the tax liability due to any other criterion of a similar nature refers to places that can be established. Permanent establishment: Some examples of places within the coverage, place of management, branch, office, factory, workshop, mine, oil or natural gas wells in excess of six months as a listed building site, but the remaining places are also out of order. Taxation agreement with the relevant provisions Since the agreement is very long and expaling each of them will require a lot of explanation and many pages I will try to mention some points of the agreement which are relevant to my topic. Below I will give the name and the articles of some part of the agreement and write them what article includes which element. The parts including the articles about the taxation are found between the articles 6-21. Article 6: Matter of real estate income. Article 7: Matter of commercial profits. Article 8: Navigation, air and land transport. Articles 9&10: Substance-dependent enterprises dividends matter. Article 11: Material interest. Article 12: Article grid operating charges royalties. Article 13: Material increase in value of capital gains. Article 14: Item self-employment activities. Article 15: Substance-dependent activities. Article 16: Managers payments. Article 17: Artists and athletes. Article 18: Substance pensions. Article 19: Matter of public servants. Article 20: Teachers and students with substance. Article 21: Provisions of the taxation of other income is divided into substance. Article 22: Taxation of wealth. The most important of all is the article 23. This articles tales the basis of OECD model of agreement and removes the basis of double taxation between two countries. This article shows the tow model to remove double taxation. These methods are 23/A the ‘Exemption method’ and 23/B ‘Credit method’. These two methods are closely related to each other. “At the first stage, each country chooses between the exemption and the credit method (as prescribed by the OECD model treaty) and at the second stage, each country sets nationally optimal non-discriminatory capital tax rates. It is shown that in the subgame perfect equilibrium both countries choose the exemption method. Mutual application of the exemption method is also shown to yield the highest welfare for each country. While the tax export effect generally induces both countries to choose inefficiently high tax rates, this effect is weakest when both countries exempt foreign earned profits from domestic taxation.” (springerlink.com) Major problems faced with Germany during double taxation For the Turkish citizens been living in Germany for many years the German government was questioning the source of their incomes that they have in Turkey. German citizens have residency in Turkey and get their pensions from Germany had a problem. Turkey had the right to tax them but because of internal issues the Turkish domestic laws leave the income tax to be written as a income. The German side was asking to write them as tax. But the problem could not be solved. Germany is a big fair and exhibition country. Turkish companies apply to many of those during the years. To keep the business alive the federal government was giving participants the right to tax non-refundable. For EU members this procedure still continues but for the Turkish companies this refund option is not available anymore. The German tax authorities wanted to access the bank accounts in Turkey of Turkish citizens living in Germany. The branch of Turkish national bank in Germany was ridden with police force and all documents were seized by the federal forces. This action was not welcomed in the Turkish side.
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