OECD Examines Tax Arbitrage in Closely Held Businesses

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A recent OECD working paper explores the prevalence and incentives for tax arbitrage across its member countries, focusing on how certain tax systems may encourage business owners to minimize their tax burdens. The paper particularly highlights how owners of unincorporated businesses and closely held incorporated businesses are leveraging tax arbitrage strategies.

KEY INSIGHTS ON TAX ARBITRAGE

Tax arbitrage typically involves strategic shifts in business structure, income type, or the timing of income to reduce tax liability. Recent trends, such as declining corporate income tax (CIT) rates, have intensified these incentives. As a result, tax arbitrage could significantly affect both the progressivity of tax systems and potential tax revenue.

The working paper highlights several trends and insights, including:

• Forms of Arbitrage: Business owners may shift between different types of income, such as labor and capital income, or alter the timing of income to minimize taxes.

• Impact of CIT Rates: The decline in corporate income tax rates in many countries has heightened incentives to engage in arbitrage, making corporate structures more attractive for tax purposes.

• Influence on Tax Revenue: Opportunities for tax arbitrage can reduce the overall progressivity of tax systems and impact the collection of tax revenue.

INCENTIVES FOR TAX ARBITRAGE

The paper identifies that certain features of tax systems—especially regarding corporate, dividend, capital gains, and inheritance taxes—provide business owners with strong incentives to retain earnings within corporations. This can allow them to defer or time income receipt in ways that reduce their tax obligations at the personal level. The growing divergence between personal income tax (PIT) and CIT rates has contributed to the rise in incorporated businesses in OECD countries, further enabling these tax-saving strategies.

POLICY MEASURES TO COMBAT ARBITRAGE

To address tax arbitrage, several countries have introduced policies aimed at limiting the discretion business owners have in classifying earnings as capital or labor income. Additionally, restrictions have been placed on the ability to retain earnings within corporations to avoid personal taxation. These measures are designed to improve the equity and efficiency of tax systems by closing loopholes that allow for tax arbitrage.

The paper also emphasizes the need for coordinated reforms in both PIT and CIT policies, as CIT serves as a backstop to prevent income shifting through incorporation. Reducing the incentives for tax arbitrage is crucial for maintaining the progressivity of tax systems and ensuring equitable treatment of taxpayers with similar incomes but different business structures.

IMPLICATIONS FOR POLICY AND TAX SYSTEMS

The OECD paper underscores the importance of considering both the PIT and CIT in any tax reforms, particularly as the differential between these rates plays a central role in facilitating tax arbitrage. The report also notes that any efforts to reduce tax arbitrage should carefully assess the potential effects on savings and investment.

By identifying and addressing tax arbitrage behaviors, OECD countries can strengthen the overall fairness and effectiveness of their tax systems while safeguarding revenue from erosion.

SOURCE/ RECOMMENDED READ: 

• Tax arbitrage through closely held businesses : Implications for OECD tax systems | OECD Taxation Working Papers | OECD iLibrary (oecd-ilibrary.org)