Company Shareholder Taxation::
Under the classical or separate system of taxation, the company’s profits are taxed without any distinction between distributed and undistributed profits. The after-tax profits are taxed again in the hands of the shareholders (corporate or individual) when paid as dividends. As a result, the same profits are taxed twice: first at the corporate level and again when distributed to the ultimate shareholder.
Similar economic double taxation arises when capital gains tax is levied on the sale of shares, as the value of the shares is based on post- tax earnings. Foreign dividends are often subjected to a third layer of juridical taxation when the source State applies a dividend withholding tax.
The economic double taxation encourages investors to prefer debt to equity as well as use branch or hybrid structures. It creates an incentive to retain earnings and avoid dividend payments.
Different tax treatment between dividends and capital gains, although economically equivalent, leads to a preference for capital gains. For example, it promotes tax planning through payments of dividends as capital gains (e.g. share buyback).
On cross-border transactions few countries tax capital gains at source under their domestic tax law (Exceptions: Australia, Brazil and India). Tax treaties also provide for full exemption (OECD MC) or taxation only on substantial holdings (UN MC) for capital gains.
Many countries relieve the economic double taxation on domestic dividends partly or fully by various methods of company shareholder taxation at either the corporate or shareholder level, or at both levels.
These company shareholder tax systems include:
Corporate relief systems:
(i) Dividend deduction or credit approach:
The dividend payment is treated as a tax- deductible expense of the paying company. (Example: Isle of Man). Alternatively, the tax withheld on the dividend payments is creditable against the corporate tax payable (Example: Guernsey).
(ii) Split rate method:
The distributed income is taxed at a lower rate than retained income. The company is subject to a higher corporate tax and it receives a credit for the tax differential when the dividends are paid. (Example: Germany – pre 2001).
(iii) Dividend exemption system:
The company pays a higher tax on the distributed profits than on retained income due to an additional corporate tax which is payable when the dividends are declared. There is no withholding tax, and the income is tax-free in the hands of the shareholders. (Examples: India, South Africa).
Corporate relief systems are not widely used. India has adopted the dividend exemption system. The company pays an additional corporate tax as dividend distribution tax when it makes a dividend distribution.
This tax is not levied on retained profits. The dividends are tax-free in the hands of the shareholders. A similar system exists in South Africa, where the latter tax is termed as Secondary Tax on Companies.
Estonia applies a tax only on distributed profits, including transactions considered as hidden profits distributions; there is no tax levied on retained profits or earnings, or on the shareholders.
Shareholder relief systems:
(i) Imputation or tax credit systems (“dividend credit”):
The company is subject to corporate tax, but relief is granted at the shareholder level. The shareholders receive either (a) a full imputation credit based on the underlying tax paid by the distributing company, or (b) a partial imputation as a dividend tax credit, regardless of the corporate tax paid.
(ii) Shareholder relief under the classical system (“dividend relief”):
These systems follow the classical system but provide partial or full dividend relief to the shareholder. The dividends received are either fully tax-exempt (“dividend exemption”), or subject to partial tax-exemption relief (“partial exclusion”). The relief may also be given as a dividend received deduction.
Imputation system is still used for domestic dividends in several countries. However, the number has declined in recent years, (see Section 5.2 below). Very few countries today follow a pure classical system. Most countries have adopted the classical system and modified it to provide dividend relief.
Under the dividend exemption regime, tax is levied at the corporate level only (“single tax”); there is no tax liability on shareholders. The alternative systems for partial dividend exemption include half inclusion, flat rate and final withholding systems. The half inclusion system generally grants a 50% dividend-received exemption to non-corporate shareholders.
Flat-rate systems give shareholder relief through a reduced dividend tax rate. Several countries levy a reduced final withholding tax on dividends paid to shareholders. This final withholding system may entail an extra tax burden for foreign investors unless relief is given in their home country.
Many countries provide relief for domestic inter-company dividends. Relief is usually given by a full or partial exemption or dividend received deduction. While some of them exempt all inter-company dividends, many of them grant such relief only to direct investment (e.g. substantial shareholdings) under their domestic participation exemption rules.
Economic double taxation on cross-border inter-corporate dividends is relieved in many countries through tax exemption provided they meet certain qualifying participation requirements. Several jurisdictions have extended their domestic participation exemption rules to include foreign dividends.
Similar benefits are also granted in the EU Member States under the EC Parent-Subsidiary Directive on qualifying direct investments. They supplement the exemption or indirect foreign tax credits, which are granted on qualifying foreign dividends by many countries under their domestic law or tax treaties.
Besides source tax on corporate income and residence tax on dividends, a third level of taxation arises due to withholding tax on dividends paid to nonresidents.