Many large foundations and universities are investing billions of dollars in overseas companies as a way to avoid facing large tax bills on hedge-fund income, nonprofit tax experts told Congressional lawmakers at a hearing today.
Foundations urged Congress to change the tax system so that nonprofit endowments would no longer face any incentive to place large investments in so-called “offshore blockers.” Nonprofit endowments are taxed just as for-profit businesses if they invest in a type of fund that uses a lot of debt to increase returns so they use so-called blocker companies overseas to convert taxable profit from hedge funds into dividends, which are not taxed.
“I don’t know of any foundation that wants to invest in offshore blocker corporations,” Janne G. Gallagher, vice president and general counsel of the Council on Foundations, told the House Ways and Means Committee today. “But current law is such that foundations that elect to invest in hedge funds would not be prudent stewards of their assets if they did not use these corporations to block the application of a tax that we believe Congress never intended to apply to this form of investment.”
The House Ways and Means Committee, which has jurisdiction over federal tax policy, held the hearing to discuss several controversial elements of the current tax code. Much of the hearing focused on issues such as the alternative minimum tax, which affects individuals, and on the tax laws that govern investment fund managers.
But part of the hearing was also centered on the use of offshore companies by nonprofit endowments and other large investors in hedge funds.
Hedge-fund returns are taxable even to nonprofit endowments if the funds use debt to increase the size of their returns. To avoid paying, many large endowments invest in hedge funds that are organized in offshore tax havens, like the Cayman Islands.
In recent months, some lawmakers have become increasingly alarmed by the growth of offshore investments and have said they want to change the rules that govern the tax treatment of hedge funds invested overseas.
For example, members of the Senate Finance Committee told reporters in May that they are considering introducing legislation that would change the tax structure for offshore investments in debt-financed hedge funds.
Any changes in the law could influence the investment strategies and returns for endowments at foundations, universities, and other institutions with big endowments. A recent Chronicle survey of endowments at 268 nonprofit groups found that among organizations with endowments greater than $1-billion, hedge funds account for a median of 18 percent of their portfolios. At the wealthiest colleges and universities, the median investment in hedge funds is 20 percent of their portfolios, according to the survey.
The Council on Foundations, a Washington organization that represents about 2,000 grant makers nationwide, calls the use of such corporations a necessary evil that can be avoided if Congress rewrote a longstanding rule that taxes income generated through debt-financed investments.
That sentiment was echoed at the hearing by Suzanne Ross McDowell, a Washington tax lawyer who previously worked on nonprofit issues at the Treasury Department.
“If Congress amends the unrelated debt-financed rules as suggested, tax-exempt investors will no longer be forced to invest offshore and use blocker entities to avoid the unrelated debt-financed income rules on legitimate investments,” Ms. McDowell said. “Further, the current disparate treatment between direct borrowing and leverage, and between different types of tax-exempt investors, will be eliminated.”