How Corporate Dividends are Taxed?
The continuous inflow of capital is vital for any economy to grow in the long run. This inflow of cash is achieved by mobilizing the idle funds to the industrious. This happens when individuals invest their money as equity capital in the companies of the nation. Hence, one of the tasks of the government should be to make equity investments an attractive investment option. This can be done by introducing rules which provide better tax treatment to investors.
At the present moment, investors who invest their money in corporations have to pay excessive amounts of tax. In this article, we will discuss about how corporate dividends are taxed.
Tax on Corporate Dividends
Corporate dividends are probably the only kind of income which face double taxation. This is because the income earned by the corporation first faces corporate taxes. This could be at the federal level and also at the state level. Only after these taxes are paid can the rest of the income be used to pay dividends. Now, when the dividends are paid, taxes once again accrue. This time taxes accrue to the individual. In the United States, the taxpayers have to pay a lower tax rate for certain special types of dividends. In other cases, the dividend income is added to their overall income and taxed at the same rate as other income. Hence, corporate income is taxed at about 25% to 30% twice before it reaches the shareholder. The overall tax rate ends up being closer to 50%.
This high taxation rate creates an unnecessary burden on companies to earn more. For instance, if a company wants to pay a 12% dividend, it needs to earn a pre-tax return of 25%, which is becoming extremely difficult given the current competitive landscape.
Dividends are subject to double taxation not only when they are paid to other individuals, but they are also subject to double taxation when they are paid to other companies. One will be surprised to know the number of intercompany dividend transactions that take place. It is a known fact that a handful of wealthy people control the entire corporate system. However, it is not known that they do so with the help of complex corporate structures. In such structures, one person owns majority shares in a few corporations. These corporations then hold majority shares in other corporations. Such pyramids can have as many as ten to twelve layers.
Hence, if funds have to be transferred to the owner, they have to go through multiple chains of intercompany dividend payments. If the income has to be sent ten layers up, it may be subject to taxation ten times! Hence, double taxation is a useful tool to prevent a handful of wealthy families from controlling large swathes of wealth. Many countries across the world have built-in loopholes in their tax systems. For instance, in Canada, if a dividend is being paid by a company to another company that owns more than a 10% stake in it, then it is considered to be an internal transfer of wealth and is not subject to dividend taxation.
Intercompany dividends are sometimes genuinely paid by one company to its corporate investors. However, in a lot of cases, it is also used as a method for income shifting i.e., shifting money from a high tax region to a lower tax region using dividends. Differentiating between the two types of transactions is impossible, even for the most advanced tax systems.
After the advent of globalization, a lot of companies have foreign investors investing in them. This could actually be foreign investors who are investing money in the firm, or it could be an offshore sister concern of the same firm. Regardless of the case, foreign dividends are highly taxed. Sometimes these dividends can represent triple taxation as well. For instance, corporate income is first taxed in company A. Then when company A pays out the dividend, that is also taxed as the income of company B. Finally, this dividend is further paid out to shareholders, it is then taxed for the third time!
In the United States, dividends to non-residents are taxed at a high rate of 30%. However, this rate is seldom paid by any investors. This is because there are many ways to actually lower this rate. Firstly, the United States has bilateral or multilateral tax treaties with many nations in the world. Hence, based on the agreement, the tax rates are lowered. Also, there are other exceptional cases such as interest-related dividends, which are taxed at a much lower rate.
The bottom line is that there is a considerable complication to paying dividends to shareholders. Firstly, the rates are not favorable, and secondly, the process is complicated and requires the services of specialized personnel. This is the reason that companies that are in their growth phase avoid paying any dividend. For instance, companies like Amazon pay a very little dividend, if any. Instead, they use the money to drive further growth, which then reflects as higher share prices and is paid to investors in the form of capital gain.
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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- History of Corporate Taxation
- Why must corporations be taxed?
- Different Forms of Corporate Taxation
- How Corporate Taxes Impact Corporate Behaviour?
- Is Corporate Tax Progressive?
- The Rise of Flat Tax
- Understanding Tax Terminology: Tax Base
- Understanding Tax Terminology: Tax Rates
- Arguments in Favor of Tax Competition
- Arguments against Tax Competition
- Tax Co-operation: A Primer
- Elasticity of Taxes
- Strategies Used by American Companies for Tax Avoidance
- How Corporate Dividends are Taxed?
- Capital Gains Taxes
- State Corporate Taxes
- A Primer on Tax Deferral
- The Corporate Alternate Minimum Tax
- Sales Tax and Use Tax in the United States
- Why Amazon and Netflix Pay $0 in Corporate Taxes?
- How are Losses Treated in Corporate Tax?