Tax Arbitrage
whatever the tax question, tax arbitrage is often the answer
Arbitrage is the simultaneous buying and selling of assets or their derivatives to take advantage of differing prices, in, for example, different markets despite a zero level of net investment. Tax arbitrage is the simultaneous use or realization of taxable income and of tax assets, such as tax loss carry-forwards, or tax exempt entities, to lower the effective tax rate.
Tax arbitrage may take advantage of the differing rates between explicit tax and implicit tax. Explicit tax is a tax you pay on your income tax return. Implicit tax is the implied discount given to tax favoured assets due to the fact that the resulting income is tax favoured.
- For a taxpayer in the highest taxable rate category taking a short position in a relatively high tax asset and the matching long position in a relatively lowly taxed asset would be a form of tax arbitrage.
- For a taxpayer with losses carried forward, or other tax attributes implying a very low rate, tax arbitrage would involve taking a short position in a lowly taxed asset and the matching long position in a highly taxed asset.
Given the fact that there is no tax on negative income, that is where a taxpayer loses money the taxpayer bears the full cost of the (negative) income. In such a case tax arbitrage is an essential tool of the entrepreneur and any rational taxpayer in a risky environment.
Tax arbitrage can take advantage of differing forms of ownership.
- For example, holding a highly taxed productive asset in a tax exempt vehicle, such as a life insurance policy or retirement fund, and the corresponding offsetting obligation, for example a loan to acquire such an asset in a highly taxed form would yield tax free gains. Borrowing, for example, one hundred dollars at 10% to invest and achieve a return of 10% in the tax exempt, would create 10 dollars of available interest expense. The increase of wealth in the tax exempt would be an un-taxed dollar, until removed in a taxable manner. Provided the exempt income could be accessed tax free, then tax would have been eliminated through arbitrage.
The Canadian Income Tax Act is replete with provisions that create these investment vehicles, such as Registered Retirement Savings Plans, Life Insurance Rules, Pension Plans as well as detailed provisions regarding how and in which way they can be used and their wealth accessed by the taxpayer. Great financial ingenuity has been expended by both the taxpayers and planners to maximize their after tax returns.
One form of arbitrage is the house shuffle: Anyone owning principal residence real estate can leverage it to create tax deductible interest.
Each year the Tax authorities close up more and more avenues for effective tax arbitrage. While doing so, they usually unwittingly create new arbitrage opportunities. For example they have closed the straddle, widely utilized by some of Canada’s most reputable law firms. However, new strategies are appearing. Read about Tax Arbitrage for the highly taxed taxpayer