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HMRC internal manual

International Manual

Arbitrage: legislation and principles - Introduction: What is tax arbitrage?

What is tax arbitrage?

In the context of cross-border finance, the term arbitrage is used to describe the exploitation by multinational groups of asymmetries between different tax regimes (tax regimes do not always match each other equally), to achieve a reduction in the overall level of tax payable by the group.

For example, tax regimes differ in how they define debt and equity. This presents opportunities to the adept tax planner who will typically seek a tax deduction for interest payable in a given jurisdiction and arrange for the corresponding receipt to arise in a jurisdiction where it will be taxed as something other than interest (perhaps as a dividend or capital proceeds) or not taxed at all (perhaps because it is seen as an intra-entity payment). Examination of the relevant double taxation agreement should show whether any mismatch is legitimate or not.

It is important to stress that arbitrage takes many forms. It may be a simple mismatch in terms of how a particular transaction is characterised in the parties’ respective tax jurisdictions. Or it might involve differing perspectives on the characteristics (e.g. residence status) or identity of the proper person to be taxed or to whom reliefs are due (other corporate law regimes produce entities that we find difficult to recognise). And, just as arbitrage itself can take many forms, so the tax advantage sought may be different from case to case.

If a particular scheme is successful a tax planner may succeed in:

  • obtaining a deduction for interest (or other expenses) where the corresponding receipt will not be taxed, or will effectively not be taxed because of the availability of reliefs (DTR for example)
  • obtaining a double deduction for expenses, most commonly interest, in different jurisdictions
  • claiming loss relief twice in different jurisdictions.

Specific anti-arbitrage rules, applying to both deductions and receipts, were introduced with effect from 16 March 2005 to counter such contrived arrangements to avoid UK tax, and this legislation is at F2A05/S24-31 and F2A05/SCH3. Other specific anti-arbitrage rules are rare, but include the ‘equity note’ legislation at CTA10/S1015 and the group relief restrictions for dual resident companies at CTA10/S109.

Arbitrage transactions that do not offend the general or specific rules of the jurisdictions involved begin to pose problems when the scale of the arbitrage (number of transactions and amounts involved) threatens to create economic distortions. It is clearly undesirable for groups to be unduly influenced towards basing investment decisions not purely on commercial considerations but also on the availability of tax arbitrage opportunities.