Taxing the Tax-Exempt


Gunnison this morning picks up on a startling

article by Bloomberg’s Ryan Donmoyer, in which not only is it mooted that

hedge-fund managers should pay income tax on their income – something

which has been in

the air for a while, and which is perfectly sensible – but also that

tax-exempt foundations, such as the $30 billion Harvard endowment, should pay

income tax as well, on at least part of their income.

The point at issue is something known to tax lawyers as "unrelated business

income tax," which is essentially a tax on leverage. As I understand it,

if a non-profit endowment takes a billion dollars of its own money and buys

a stock which pays a high dividend, then that dividend income is tax-free. If

the same endowment leverages its billion dollars by buying options on the stock

rather than the underlying stock itself, the gain it makes on those options

is also tax-free. But if the endowment borrows the billion dollars from a bank

before buying the stock, then the income is taxable.

It doesn’t make any sense, frankly, to single out "debt-financed investing"

for taxation in these days of extreme financial sophistication and embedded

leverage. Virtually any debt-financed investment can be structured, for a fee,

as a derivative instrument instead, so endowments could get around this rule

even if offshore "blocker" companies were outlawed.

And it’s worth noting that the rule affects much more than just hedge-fund

investments. Big university endowments are essentially hedge funds themselves,

albeit with much lower fees: they leverage themselves quite happily either before

or instead of investing in hedge funds. So even pulling out of hedge funds entirely

wouldn’t solve their problem.

This entry was posted in hedge funds, taxes. Bookmark the permalink.