Reviewed by Aug 27, 2020| Updated on
Tax arbitrage covers those transactions carried out to gain from the difference or spread made between the tax systems, tax treatments, or tax rates. Under direct taxation, both individuals and corporates find out ways to pay the least tax. In doing so, they may come across various conditions that favour them to do so, whether or not legal.
What is Tax Arbitrage?
Tax arbitrage refers to the arrangement for profiting from the differences arising from various ways the transactions are treated for tax purposes. The complexity of tax laws often gives leeways for incentives which motivate individuals to reconstruct their transactions in the most beneficial way for least tax outflow.
How does Tax Arbitrage work?
A business may recognize revenues in a low tax region while recognizing expenses in a high tax region, thereby taking tax advantage of such an arrangement. It leads to a reduction in the tax bill by claiming maximum deductions. Accordingly, the taxes paid on earnings are minimal. An entity may trade in the securities in such countries or jurisdictions and resort to profit from the price differences on the same security resulting from different tax systems.
An example for the tax arbitrage includes a retail investor purchasing stocks before the ex-dividend date and selling it after that. The price of shares before the ex-dividend date is usually higher when compared to the price on a later date. After the ex-dividend date, the company's stock price reduces to an amount that is more or less equal to the dividend payout. The transactions will lead to a short-term capital loss which in turn can be used to set off any short-term capital profits made by the investor. It will ultimately benefit the investor.
Forms of Tax Arbitrage
There are many more forms of tax arbitrage apart from the above instance. It is clear that some forms of tax arbitrage are allowed under law, whereas the rest are strictly illegal. A thin line exists between the arrangements such as tax evasion and tax avoidance. Therefore, individuals and businesses must consult qualified tax consultants before operating a tax arbitrage transaction. It is presumed that tax arbitrage is extremely popular. Due to its nature, it is difficult to assign exact figures of tax arbitrage being employed.