Governments tax corporate income twice, through corporate income tax and individual tax on dividends. Companies may withhold profits to avoid double taxation, but governments combat this with a tax on accumulated profits. The tax comes into effect when a company has excess liquidity without justification, and the threshold and tax rates vary by jurisdiction. Companies must evaluate the best course of action to minimize tax liability for themselves and shareholders.
A tax on accumulated profits is an assessment of income tax on business savings that exceed a certain threshold. Governments expect companies to distribute the majority of profits to shareholders in the form of dividends, which allows the government to tax dividend distributions at the shareholder level. When a company withholds its profits instead of distributing them as dividends, it cuts off government-expected tax revenues. In cases where a company accumulates an amount above a certain threshold, the government imposes a special tax on accumulated profits to compensate for the income it does not receive through dividend distributions.
The corporate income tax structure has a feature commonly referred to as double taxation. Governments actually tax corporate income twice. A company files a tax return each year and pays tax on its net income at the corporate rate. It then distributes a portion of that net income, or profits, to shareholders as dividends. The government re-taxes this money individually because shareholders have to pay taxes on dividends received when filing individual tax returns.
Corporations and shareholders are always looking for ways to avoid double taxation and reduce their overall tax burden. One of the mechanisms companies began using to minimize their tax liability was to withhold profits instead of distributing them as dividends. This would increase the liquidity of the company and typically have a positive effect on the share price. The shareholders could then sell their shares and make a profit that way. They would have to pay capital gains tax on the sale, but the capital gains tax rate is normally much lower than the valuation on dividends.
To combat this practice, governments have instituted the tax on accumulated profits. This tax comes into effect when a company has excess liquidity on hand that it cannot justify based on an anticipated need. For example, a company is allowed to hoard cash if it expects to have to pay a substantial litigation settlement in the near future, but it can’t hoard cash simply to allow its shareholders to avoid paying taxes on dividends. Once the company coffers exceed a threshold set by the tax code in its jurisdiction without proper justification, it has to pay accumulated profit tax on the amount.
There may still be cases where a company chooses to pay tax on accumulated profits rather than allow shareholders to be taxed on dividends. The tax code changes periodically in each jurisdiction. The tax rates that apply to dividends, capital gains and accumulated profits are fluid and the right course to take to minimize the tax liability for the company and its shareholders needs to be evaluated on an ongoing basis.
Smart Asset.
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