What is a Tax Arbitrage?

Tax arbitrage is the process by which an individual or corporation benefits from a transaction that affords them favorable tax conditions. This can occur from transactions which take place in locations, known as tax shelters, which offer better tax rates than others locations. In addition, tax arbitrage can be achieved by taking advantage of laws that place taxes on different income streams in different ways and allow for some taxes to be deferred or even exempted. Although such arbitrage can be a common way of doing business, some of these practices can be illegal and even hurtful to the economy as a whole.

Various taxes have been levied by countries and municipalities for thousands of years as means of paying for public projects and funding government operations. There is no universal tax code, though, meaning that different rules and laws apply depending upon the location and type of transaction being made or income being earned. Anyone who benefits from these differences, which can often be significant, is considered to be under the broad umbrella of what constitutes tax arbitrage.

The use of tax shelters is a common form of tax arbitrage available to both individuals and companies. If someone can claim that income has occurred in a region with lower tax rates than the one in which he is located, he can benefit from the difference. By the same token, companies sometimes attempt to attach their expenses to particularly high tax rates, since that would allow them to make bigger deductions on tax returns.

In addition, the laws that are attached to the income generated by various assets provide ripe opportunities for tax arbitrage. Such arbitrage can be as simple and commonplace as the practice of individuals making investments into retirement accounts which accumulate tax-free interest. There are also differences in the ways that taxes accumulate on disparate assets, like real estate against stocks, that can be exploited by savvy investors. As a matter of fact, many investment techniques are constructed solely for the purpose of tax avoidance, which can significantly improve return on investment.

One problem with tax arbitrage is that, if everyone undertakes it, then someone eventually must pay for all of the taxes that are avoided or deferred. This can place a great strain on an economy, especially at times when other circumstances are already causing widespread financial pressures. There are also many individuals and corporations who undertake arbitrage in unsavory ways that don't comply with the prevailing tax laws.