The Tax Man is Coming

Hold on to your wallets. Several tax changes have been bandied about recently aimed at raising revenue under new PAYGO rules adopted by the 110th Congress.

One of them is the focus of a New York Times article, which would eliminate the offshore exemption for Unrelated Business Taxable Income (which is commonly dyslexically called “UBIT”) that nonprofits rely on in making hedge funds investments. The focus for now seems to be on hedge funds, but an attack on UBIT blockers logically could extend to private equity. For a related discussion on the potential impact of the other recent tax proposal (carry as ordinary income) see this recent article by David Toll.

This is a big deal – entire swaths of the hedge fund market could be rendered non-economic by taxing debt-financed returns. Recent reporting on this proposal typically refers to it as a “loophole” or a “tax dodge” and I take issue with that characterization. If you consider the history of UBIT rules and what they were meant to prevent, offshore blockers are not a dodge to rules aimed at taxing debt-financed gains. The tax was enacted in 1950 out of concern over potential “unfair competition” between non-profits and taxable businesses. The debt-financed provisions were aimed originally at real estate, but expanded significantly in 1969 to cover other activities.

I’ve heard an old story before about a Northeast University issuing tax-exempt bonds and investing the proceeds, but that may just be lore. In any case, investing is not the kind of thing at which UBIT was aimed.

This episode ultimately might be a great demonstration of the fallacy of the static forecasting used anytime a legislator wants to boost revenue with increased taxes. After years of don’t tax-and-spend, supply side economics has developed a negative connotation, but the economic history of tax cuts is pretty clear. In fact, federal tax revenues today are soaring thanks to “tax cuts for the rich” (they pay the overwhelming majority of the taxes, after all). Tax policy impacts behavior, and in this case it certainly will have a big impact.

Whatever the esteemed Senators forecast as a revenue increase, they will never get it. The fact is for some funds/strategies, I can’t afford to pay it. The cornerstone of most hedge fund programs today is the multi-strategy fund sector. It’s not uncommon to see gross leverage of a well-hedged fund to reach four or five times equity (although they typically speak in terms of long-side leverage, which is more like two to 2.5x today). It is difficult to see how we could pay 34% on the debt-financed gains of funds like that and still be left with an acceptable return. This is an awfully big insurance premium to pay the Feds for LTCM-like bailouts (which they left Wall Street to underwrite anyway).

The application to funds outside of multi-strategy and leveraged/long-short credit is less obvious to me right now. There’s a no-action letter from the late-1990s that allowed market neutral mutual funds to balloon and that could come into play. The other alternative of course is the creation of swap and/or option structures to produce a (real) “loophole” to changes in the application of UBIT. Either way, the bankers are likely to make far more than the government.