Tax arbitrage, defined as the use of simultaneous complimentary financial positions producing tax efficiency, are illustrated both theoretically and practically. Due to tax law constraints, practical examples are mixed forms of deferral, income shifting and true tax arbitrage.
- A taxpayer earns 100,000 from salary in a form that is fully taxable, that is as an individual.
- A taxpayer borrows at a rate of 8% to invest in an income producing activity. The interest of which is a deduction to the taxpayer and income to the lender.
- The taxpayer then invests the cash in a favourably taxed investment, an asset that is tax exempt that produces an identical 8 % return. This produces an increase of wealth of 8% yearly.
The taxpayer would have to take a position of 1,250,000 to offset 100,000 of income at 8%.
Of course in the real world, tax law generally prohibits the deduction of interest for investments in tax exempt vehicles. Risk is a factor that determines returns that may be masked by the fact that, due to for example depreciation, returns may be non taxable. However as a principle, the above example illustrates tax arbitrage at work.
We set out below a “real world” example. We caution that it is really a mix of tax arbitrage and tax deferral.
A real world example:
Taxpayer- earning 100,000 of income in highly taxable form.
Short Position: Cash
Long Position: Real Estate in the form of a REIT that returns capital quickly as part of its yield.
Goal: Lower the effective rate, through arbitrage, of the 100,000 of income received in highly taxable form.
At an 8 % rate of return on capital, 1,900,000 borrowed at 8% will cost 152,000 per year. Assume the REIT yields 8 %, of which 66 2/3% could be return of capital. Numerous Canadian REITs have this profile. This would yield a distribution of 152,000, taxable income of 51,000, and tax free income (because it is return of capital, but it is a cash distribution ) of 101,000. As the 152,000 borrowing cost is available to shelter the 51,000 income, in fact the entire 152,000 income is tax free. In addition the taxpayer has an additional tax shield of 101,000 from the position. It remains tax free until such time as the distributions of capital from the REIT exceed the cost of the unit. Over the long term, the full amount received from the liquidation of the REIT position when the income becomes taxable (that is to say when the capital returned exceeds the original cost of the unit) will be taxable at capital gains rates.
This would achieve our goal of arbitrating the rate of the income from marginal rates of 53 per cent, for example, if it was ontario sourced income, to deferred capital gain rates, that is 50 % of the income rate, payable when the position was liquidated or 12 and half years out (i.e. when the return of capital exceed the capital cost at 8 %). In other words the income tax payable on 100,000 dollars could be deferred for 12.5 years, absent market frictions, tax law changes and liquidity issues.
There are a variety of financial products that utilize the same strategy with life insurance, known as “leveraged life insurance”. Finance and Tax professionals have become so adept at reworking their products when the taxing authorities changes the law and its administrative application that the taxing authority in Canada has taken the highly unusual position of announcing it would make tax law changes in the area of leverage life insurance – when it found abuses -retroactively. This is draconian and highly unusual.
Of course the above example is extreme and rather academic; the principal though, could with other strategic tax directions, lead to substantial long term efficiencies.