Academic journal article Northwestern University Law Review

Repatriating Tax-Exempt Investments: Tax Havens, Blocker Corporations, and Unrelated Debt-Financed Income

Academic journal article Northwestern University Law Review

Repatriating Tax-Exempt Investments: Tax Havens, Blocker Corporations, and Unrelated Debt-Financed Income

Article excerpt

ABSTRACT-When a tax-exempt entity is both able and willing to lend its exemption to other taxpayers, tax-averse parties line up to take advantage of its largesse (and, in the process, reduce their own tax bill). Congress, eager to prevent such abuse of the exemption, decided that, in some circumstances, it would tax entities that would otherwise be exempt from taxation. In this Article, I show that Congress's response to such "lending" has failed to solve the problem and, in fact, is harmful to the tax system and to tax-exempt entities. To address this problem, this Article proposes a new way to prevent such lending-one that builds upon existing law-in order to combat the abuses perpetrated through tax-exempt entities. Congress should repeal the unrelated debt-financed income rules, which experience has shown are ineffective and harmful. This repeal would end the distortions that tax-exempt entities currently face. At the same time, in order to prevent tax-exempt entities from lending their exemptions to taxpayers, Congress should expand the tax shelter rules to capture these abusive transactions.

INTRODUCTION

When a tax-exempt entity is both able and willing to lend its exemption to other taxpayers, tax-averse parties line up to take advantage of its largess (and, in the process, reduce their own tax bill). Congress, eager to prevent such abuse of the exemption, decided that, in some circumstances, it would tax entities that would otherwise be exempt from taxation. In this Article, I show that Congress's response to such "lending" has failed to solve the problem and, in fact, is harmful to tax-exempt entities. I propose a new way-one that builds upon existing law-to combat the abuses perpetrated through tax-exempt entities.

It was inevitable that taxpayers would exploit the exemption granted to certain charitable entities. The Internal Revenue Code is a patchwork of provisions enacted at different times and for different purposes.1 Congress uses the tax law both to raise revenue2 and for unrelated purposes such as "encouraging particular types of investment, supplying economic relief to targeted groups of taxpayers . . . and regulating the economy, not to mention enhancing the political power of politicians among their constituents."3 Such a broad array of goals inexorably leads to a complex and confusing regime,4 and the tax exemption provides one of the many cracks exploited by savvy taxpayers.5

In the United States, the difference between what taxpayers owe in any given year and what they pay on time-the tax gap-is about $345 billion.6 An estimated $40 billion to $70 billion of that tax gap results from U.S. taxpayers using tax havens to whittle down their tax bills.7 Congress has worked for years to narrow the tax gap.8

In Congress's attempts to narrow the tax gap by preventing taxpayers from hiding their money in tax havens, it has inadvertently pushed taxexempt entities to do the opposite. As a result of the laws enacted to prevent tax-exempt entities from lending their exemption to tax evaders (i.e., the unrelated debt-financed income rules), tax-exempt entities cannot invest in U.S. hedge funds. Instead, tax-exempt entities that want hedge fund returns must invest through corporations organized in tax havens.9 And these investments are far from negligible: as many as one-third of all hedge fund assets may be attributable to tax-exempt investors, including endowments and pension funds.10

Even if the unrelated debt-financed income rules did not force taxexempt entities to shifttheir investments from U.S. to tax haven hedge funds, the rules are bad tax policy, failing to prevent even abusive transactions of the type that they were passed to prevent, while at the same time distorting tax-exempt entities' legitimate economic decisions.

There is a simple solution to the problems that the unrelated debtfinanced income rules present: Congress should repeal them. Tax-exempt entities would no longer face distortions of their investment decisions. …

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