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.