What Is Tax Arbitrage?
Tax arbitrage refers to a strategy or practice where individuals or corporations profit from the ways different kinds of capital gains, income, and financial transactions are treated for tax purposes.
Tax code complexities offer opportunities for individuals or corporations to look for legal loopholes or organize their financial transactions to reduce their tax burden.
How Does Tax Arbitrage Work?
Tax arbitrage works with any transactions that are intended to create a profit based on tax rates, tax systems, and tax treatments. There are different ways in which individuals and corporations can look to legally pay the least amount of taxes.
Tax Arbitrage Example
One example is when corporations recognize their expenses in a high tax location (such as a different state or country) at the same time recognizing their income in a low tax region. This minimizes the amount of tax paid by maximizing deductions.
Another example of tax-loss harvesting, when an individual sells a security with an unrealized loss in order to offset other realized gains. This transaction can be used to offset any of the investor’s capital gains.
Corporations or individuals can profit from the price differences due to different tax systems where they’re trading securities. A common example is purchasing a security in one country, selling it for a profit in another where an investor is not subject to taxes.
Is Tax Arbitrage Legal?
Tax arbitrage is legal because you’re not breaking the law to take advantage of these inefficiencies in the system. You are playing by the rules when you participate in tax arbitrage.
However, there is a fine line between that and tax evasion, where an individual or corporation is purposely evading payment of the actual amount of tax owed. That’s why it’s important to ensure that you’re engaging in practices that are legal.
Making sure you’re updated on the most current tax systems and laws is key because lawmakers can change or modify them at any time. Consulting a tax professional is a good idea to ensure your tax strategy continues to be legal.
Why Is Tax Arbitrage Used by Investors?
Investors use tax arbitrage much as corporations do -- to take advantage of tax-free (or deferred) profits. The incentive is to leverage differences to reduce tax liability and keep more of their investment earnings.