As published in the Winter Park/Maitland Observer, Thursday Jan. 3, 2012 Edition Offers... Read More »
Academia Benefits from Illegal Tax Arbitrage
ar·bi·trage (är
b
-träzh
) n. - the purchase of securities on one market for immediate resale on another market in order to profit from a price discrepancy.
- American Heritage Dictionary, Fourth Edition -
The CBO has issued a report titled Tax Arbitrage by Colleges and Universities alleging that tax exempt colleges are engaging in a form of indirect tax arbitrage (emphasis added):
The law explicitly prohibits the use of tax-bond proceeds for the purchase of investment assets, a practice known as tax arbitrage; however, issuers of tax bonds may use the proceeds for the purchase of operating assets while they simultaneously hold investment assets that provide a higher rate of return.
To the extent that colleges and universities earn an untaxed return on investments that exceeds the interest they pay on tax debt, they are benefiting from a form of indirect tax arbitrage.
The law allows a tax-exempt college to raise the capital it needs in order to conduct research and expand facilities through the issuance of tax-free bonds. But if a college already has invested capital on which it is earning a rate of return that exceeds the bond rate, it doesn’t need to issue tax-exempt bonds at taxpayer expense to raise capital. It already has the capital.
The only reason a not-for-profit college or university would want to retain it’s invested funds while raising taxpayer-subsidized capital is to benefit from the spread on the interest earned on those funds and the amount of interest it has to pay on the tax-free bonds. In other words, to make a profit.
The CBO report makes no overt recommendation, but the clear implication is that colleges and universities should be forced to exhaust their invested, liquid funds before they are permitted to float a taxpayer-subsidized bond issue.
As part of its stated effort to close the tax gap, the Obama administration should agressively pursue tax-exempt organizations that abuse the rules at taxpayer expense.
(Hat Tip: Shirl Kennedy, Docuticker)
It is too bad this article is headlined by a false and inflammatory title. If the rules / laws allow colleges and universities to obtain tax-exempt financing and at the same time not have to use up their endowments and reserves, then they are not “abusing the rules at taxpayer expense” and they are not illegal. The CBO article does not state that it is illegal; it tries to point out a potential unintended consequence of the tax-advantaged rules that are allowed for tax-exempt institutions.
There are in actuality other reasons for a 501(c)3 higher education institution to retain its endowment and reserve funds, including: donor stipulations on restricted gifts require it; educational operations can improve by increased investment and therefore better achieve the educational mission; unexpected financial events can be absorbed via reserves; tuition and fees are subsidized (i.e., kept lower) by the revenue directed to operations, and others.
If arbitrage rules were extended to all schools to cover this so-called indirect tax arbitrage, the tax-exempt financing market for this sector would disappear as no institution would want to limit the ability of its endowment funds to provide the returns needed for short-term and long-term needs. This would not end financing but it would signficantly impact the financial health of the sector and therefore further burden the other revenue-generating aspects of the organization, not the least of which are the tuition-paying students and their parents.
I’m sure the overall point of the CBO’s report is well understood by others within the non-profit sector. A more reasoned approach would be to cap accessibility to tax-exempt financing based on some specified ratio of debt to unrestricted net assets, and/or some similar measure of financial flexibility. This would impact the most financially well-off institutions — those most able to absorb the negative operational impact of such a rule change.
Erik,
Thanks for visiting and thanks for your comment.
You say that my headline is false and inflammatory. I am willing to admit that it’s inflammatory, but it is clearly not false.
The CBO considers tax arbitrage to be illegal. In fact, the whole point of its report is that the practice by colleges and universities of earning an untaxed return on investments that exceeds the interest they pay on tax debt is against the rules. Against the rules, to me, means “illegal.”
I think you would do better to criticize the CBO’s characterization of the practice of tax arbitrage rather than quibble about my publication of that characterization.