On 7 October 2024 the OECD published a taxation working paper with the title Tax arbitrage through closely held businesses: Implications for OECD tax systems, written by Tom Zawisza, Sarah Perret, Pierce O’Reilly and Antonia Ramm. The working paper looks at incentives for tax arbitrage in OECD countries, examining how OECD tax systems could be encouraging owners of unincorporated businesses, and owner-managers of closely held incorporated businesses, to reduce their tax liabilities through tax arbitrage.
The statistics indicate that tax incentives to incorporate and earn capital income through corporations have increased in the past two decades. The number of incorporated businesses has increased in many OECD countries, partly for tax reasons. Features of the tax systems in many countries in relation to corporate taxation and taxation of dividends, capital gains, gift sand inheritance are providing taxpayers with a strong incentive to retain earnings inside corporations.
The differences in the way different businesses and types of income are treated for tax purposes may be encouraging the owners of closely held businesses to engage in tax arbitrage. They can reduce their tax liabilities by shifting between business forms, exploiting different tax treatment of various types of income, and planning around the timing of income (such as dividend payments). Opportunities for this behaviour may have been increased by recent declines in corporate income tax rates, and by the decreasing costs of business incorporation in some countries. There are also opportunities to exploit the unclear distinction between capital and labour income for business owners.
In a situation where tax arbitrage can allow business owners to reduce their effective tax rates, there may be a negative impact on the progressivity and revenue raising potential of the tax system. Also, the use of tax arbitrage can result in different tax treatment of taxpayers engaged in similar activities with similar income levels, thereby reducing the horizontal equity in the system.
The corporate income tax should limit the extent to which taxpayers can reduce their taxation liabilities by incorporating their business. To reduce incentives for arbitrage, OECD countries must consider the interaction of personal and corporate taxes. The reduction of corporate income tax rates in many countries has increased the risk of tax arbitrage and the resulting erosion of personal income tax revenues through incorporation of businesses. Policymakers need to take into account the ways in which capital income can be received or realised by individuals after it is earned by the corporation, such as dividends, capital gains or wealth transfers between generations.
The authors note that preferential capital gains tax treatment for long-held assets or relief for business asset disposals can increase incentives to incorporate and retain earnings, extracting income in the form of capital gains. Scaling back some of these reliefs could reduce tax arbitrage. Also, taxation of appreciated business assets on death by capital gains tax or inheritance tax could reduce incentives to defer gains. The OECD is currently looking at the role of capital gains taxes and considering the possibility of capital gains on an accrual basis or the imposition of look-back charges (i.e. interest payment on deferred taxes).
Other policies to reduce the scope for business owners to reduce their labour income for tax purposes include a split-rate model that specifies an appropriate allocation between labour and capital income; or rules requiring owners of closely held corporations to pay themselves a “reasonable” or minimum salary.
