Tax Arbitrage Explained

4 mins read
by Angel One

Arbitrage is a broad term that’s used to refer to a practice or a strategy wherein individuals or companies take advantage of any existing economic, financial, or regulatory systems loopholes. Depending on the means and the end, arbitrage can be of different kinds. There’s regulatory arbitrage, there’s merger arbitrage, and there’s tax arbitrage. This last kind of arbitrage is what we’ll be looking at today.

And to understand it better, let’s begin at the basics.

What is tax arbitrage?

Tax arbitrage is the process of using the differences in how transactions are treated for tax purposes to earn profits, or, in some cases, to reduce the burden of taxation. The tax laws that govern different countries, including India, are often very complex and intricately structured. But when you read between the lines, it’s possible to identify many incentives that individuals and companies like to take advantage of.

Tax arbitrage can be practiced by using the laws prevalent in one country alone, or it could be practiced by making use of the incentives in international tax laws. The latter is particularly useful for international transactions.

Understanding tax arbitrage

When you take a closer look at the tax systems in India and abroad, you’ll notice that the laws are not created equally. There are differences in tax rates in the laws of the same country, and there are differences in the tax systems of any two countries in the world. Even with regard to how income and expenses are treated for the purpose of tax, there are subtle differences that come into play. Individuals and companies have, over the years, found many ways to use these points of difference to their advantage, so they can pay the least amount of tax and reduce their tax burden.

Depending on the kind of system or regulation used to benefit from, tax arbitrage can be any one of the following kinds.

  • Tax arbitrage based on tax systems
  • Tax arbitrage based on tax rates
  • Tax arbitrage based on tax treatments

Tax arbitrage examples

To better understand what tax arbitrage is all about, it’s a good idea to look at some tax arbitrage examples. Seeing tax arbitrage in action can make the idea clearer.

One of the most common tax arbitrage examples occurs when businesses tax advantage of different rates of taxes in different regions. This can be within the same country, or it could be on a global scale, across countries. For instance, a company may recognize its income and revenue in a region with lower taxes, while correspondingly recognizing its expenses in a region with higher taxes. This way, the overall tax burden for the business is reduced, because the deductions are maximized while the taxes on its earnings are minimal. This would be an example of arbitrage based on tax systems (if it’s between two countries) or tax rates (if it’s within the same country).

Another common example of how individuals and traders can make use of tax arbitrage is by taking advantage of the differences in how certain incomes are treated in different countries. Take income from cryptocurrency trading, for instance. In some countries like the United States of America, the capital gains from selling cryptocurrencies is taxable. But in other countries like Denmark, Singapore and Germany, this income is not taxable. So, to execute a tax arbitrage and take advantage of this leeway, a cryptocurrency trader can purchase a cryptocurrency at a cheaper price from an American exchange and then transfer those tokens to a crypto exchange in one of the countries that do not tax these gains. Thereafter, by selling the tokens at a higher price, the trader can profit from the transaction without worrying about paying any tax in that tax-haven foreign country.

There is a very thin line between tax arbitrage and tax evasion. To stay on the legal side of things, it’s important that individuals and companies practicing this strategy remain fully aware of the laws they’re taking advantage of. They should also get to know the consequences of breaking any of the tax laws involved and must take care to not engage in any illegal misuse of the tax systems being considered.

Also, with tax systems and tax laws often being modified or changed continuously, it is possible for the lawmakers to quash any particular strategy for tax arbitrage by amending the rules or laws that make it possible in the first place. So, individuals and companies must remain updated about the new changes in the tax rates and laws.