Harvard, Hedge Funds, and Tax Havens: Reforming the Tax Treatment of Investment Income Earned by Tax-Exempt Entities

Educational endowments, private employer-sponsored pension plans, and other tax-exempt organizations (collectively, “tax-exempt entities”) invest a substantial amount of capital in various sectors of the economy, and tax consequences can determine whether or not a tax-exempt entity, like any other entity, makes a potential investment. Consequently, the tax treatment of investment income earned by tax-exempt entities can affect significantly the manner in which capital is allocated on an economy-wide basis. The current tax system applies different effective rates of tax to income earned by tax-exempt entities from otherwise comparable investments. This inconsistent tax treatment distorts investment decisions made by such entities which, given the amount of capital invested by such entities, can result in a less than optimal allocation of capital. In some contexts, the distortion can be mitigated by tax structuring. However, if Congress were to enact legislation currently proposed as part of the Stop Tax Haven Abuse Act, the ability to engage in this tax structuring would be eliminated. Thus, enactment of the proposed legislation would exacerbate the current distortions without providing any offsetting benefits. In lieu of reforms suggested by Congress, this paper proposes reforms to the manner in which tax-exempt entities are taxed on their investment income. In particular, this paper proposes that a tax-exempt investor would generally not be subject to tax on income earned from an entity whose business decisions are not controlled by the tax-exempt investor. The proposed reforms would result in a better allocation of capital among various investment opportunities. The reforms would not subvert any of the other goals of taxing income earned by tax-exempt entities. Finally, the reforms would modernize the tax rules in a way that takes into account changes to investment portfolios held by tax-exempt entities that have occurred since the rules were enacted