Regulatory & Jurisdictional Arbitrage

by Irving Rivera on August 20, 2012 · 1 comment

Jurisdictional Arbitrage

When it comes to information arbitrage the only legal way to take advantage of this market inefficiency is by understanding the difference between regulatory and jurisdictional arbitrage. In today’s post I will explain how you can too profit from this investing tactic.

What is Regulatory Arbitrage?

Regulatory arbitrage, also known as reg-arb, is when investors use the government’s laws in their favor. Reg-arb happen when corporations try to undermine their regulator authority by redefining and reclassifying different business activities in order to take advantage of a more flexible and favorable treatment. Take for example the financial crisis of 2008 when Wall Street investment banks decided to become regular bank holding companies in order to be able to access the FED discount window. However, when a simple commercial reclassification is not enough to bypass the rule of law, corporations then decide to reallocated their actual business address to other countries; practice that is known in the industry as jurisdictional arbitrage.

What is Jurisdictional Arbitrage?

Jurisdictional arbitrage is when intuitions try to take advantage from the discrepancies on the common law between competing territories, countries and cities. This type of arbitrage occurs when corporations build shell companies around the world in order to perform specific business operation that will receive a more favorable treatment just because they are executed on that particular jurisdiction. For example take the case of online gambling which happen to be illegal in the United States, but by just incorporating a company inside a Native American reservation and running the servers from there you bypass the unwelcome regulation creating a brand new industry, call internet betting.

Regulatory & Jurisdictional Arbitrage Applications

Most practical applications of this kind of arbitrage are completely legal since they are based on efficiencies and regulatory loopholes:

    1. Criminal Persecution: extradition agreements for fugitives.
    2. Online Gambling: internet website that allow sports betting.
    3. Banking Regulation: Basel III agreement that redefine the definition of Tier 1 Capital across jurisdictions.
    4. Sales Tax Arbitrage: Amazon buying, Best Buy window shopping.
    5. Tax Arbitrage: the reallocation of business operations to tax heavens.

Case Study Time

Without a doubt the most common and important application of jurisdictional arbitrage is based on taxes and nobody knows how to do this best than Apple Inc. with multinational operations on Nevada, Luxembourg and the British Virgin Islands.

Observe the following report done by The New York Times in how APPL sidesteps billions of dollars in taxes.

Double Irish with a Dutch Sandwich

The Bottom Line

I always believe on tax efficiency and not tax avoidance, which is why we should always remind ourselves about the importance of paying taxes.

Facebook Thoughts
On 2011 $APPL total tax bill was $3.3 billion on revenues of $108 billion and reported profits of $34.2 billion for an effective tax rate of 9.8%. What was your effective tax rate?