DEFINITION of 'Tax Arbitrage'

Tax arbitrage is the practice of profiting from differences that arise from the ways transactions are treated for tax purposes. The complexity of tax codes often allows for many incentives which drive individuals to restructure their transactions in the most advantageous way in order to pay the least amount of tax.

BREAKING DOWN 'Tax Arbitrage'

Tax arbitrage refers to transactions that are entered into to profit off the spread between tax systems, tax treatments, or tax rates. Both individuals and corporations seek to pay the least tax that they can and do so through many ways.

A business can take advantage of tax systems, for example, by recognizing revenues in a low tax region while recognizing expenses in a high tax region. Such a practice would minimize the tax bill by maximizing deductions while minimizing taxes paid on earnings. An entity may also resort to profit on price differences on the same security resulting from different tax systems in the countries or jurisdictions in which the security is traded. For instance, capital gains on cryptocurrency trading are taxed in the U.S., but are tax-exempt in some countries, including Denmark, Singapore and Germany. A crypto trader can purchase a cryptocurrency trading at a cheaper price from a U.S. exchange, transfer his tokens to a crypto exchange in one of the crypto tax haven countries, sell at a higher price, and not be subject to taxation in the foreign country.

Also, tax arbitrage can occur when a retail or institutional investor purchases a stock before the ex-dividend date and sells after. The price of shares before the ex-dividend date is generally higher than the price after the date. On the ex-dividend date, a company’s stock price decreases by about the same amount of the dividend declared. Buying a stock before and selling it after will lead to a short-term capital loss, which can be used to offset any short-term capital gain earned by the investor. Since short-term gains are taxed as ordinary income, decreasing a gain as much as possible is beneficial to most investors.

A company that uses tax-exempt bonds as a short-term corporate cash management strategy engages in tax arbitrage. The interest paid on these bonds (e.g. municipal bonds) is not taxed by the federal government and, in many cases, state governments. Thus, an entity can buy these bonds, earn more interest on them than savings accounts offer, and sell them after a short period of time without the government taxing its interest income.

There are many more forms of tax arbitrage including borrowing Roth IRA contributions up to a certain limit, buying a home and deducting the mortgage interest expense, borrowing with home equity loan to invest in dividend paying stocks, buying another company with leverage (LBO), etc.

Clearly, some forms of tax arbitrage are legal while others are illegal. A fine line between tax evasion and tax avoidance exists; thus, individuals and businesses should consult with a qualified tax advisor before running a tax arbitrage transaction. It is suspected that tax arbitrage is extremely widespread, but by its nature, it is difficult to give precise figures as to what extent tax arbitrage is employed.

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