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Tax Arbitrage

Updated April 13, 2021

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. 

Ask an Expert about Tax Arbitrage
At InvestingAnswers, all of our content is verified for accuracy by Rachel Siegel, CFA and our team of certified financial experts. We pride ourselves on quality, research, and transparency, and we value your feedback. Below you'll find answers to some of the most common reader questions about Tax Arbitrage.

What is the Tax Loophole?

A tax loophole is a legal way to take advantage of the tax code to help individuals and corporations save money. There are various loopholes depending on income level. 

What is Risk-Free Arbitrage?

Risk-free arbitrage is where an investor purchases an asset then sells it right away at a higher price to take advantage of price differences in different markets. It's the act of buying an asset and immediately selling the same asset for a higher price. 

Since it’s done in such a short amount of time, in theory, there’s no risk since there’s no rate or return. Instead, the investor makes a profit by selling the asset.

How Are Arbitrage Funds Taxed? 

Arbitrage funds are hedge funds that are set up to profit from arbitrage trading opportunities. They invest in mainly equity, with a bit of debt mixed in. For this reason, these types of funds are also referred to as balanced or hybrid funds. In other words, arbitrage funds are taxed as equity funds since they have mostly equity investments. 

That means if an investor has shares of arbitrage funds for a year or more, profits will be taxed at the capital gains rate which is less than the ordinary income tax rate.

Rachel Siegel, CFA
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Rachel Siegel, CFA is one of the nation's leading experts at ensuring the accuracy of financial and economic text.  Her prestigious background includes over 10 years of experience in creating professional financial certification exams and another 20 years of college-level teaching.

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