DATELINE: May 15, 2009, Chicago
Among the interesting developments highlighted at the ABA Tax Section meeting last week was the intersection of alternative investments, the UBIT rules, and college liquidity problems. Over the last decade, many colleges and universities have significantly increased the percentage of their endowments devoted to alternative investments, sometimes referred to as absolute return investments—the two are not necessarily synonymous, but there is probably some overlap. One survey of over 700 colleges and universities reported that the allocation had gone from roughly...
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20% in 2002 to 40% in 2008. See NACUBO, 2008 NACUBO Endowment Survey—Table 19, Average Asset Composition of Total Investment Pool Assets (Jan. 27, 2009); and 2002 NACUBO Endowment Survey—Table 19, Average Asset Composition of Total Investment Pool Assets (Jan. 21, 2003). With the market meltdown last fall, many colleges and universities that pursued the alternative investment strategy now find themselves facing a liquidity squeeze. They need the income from their endowments to help cover operating costs and reduce the impact of the economic downturn on their students, but the value of their endowment portfolios has declined significantly, together with declines in dividend, interest, and capital gains.
Many alternative investments contain lockup provisions, requiring a five-year commitment of funds. Moreover, some of these investments may require staged capital pay-ins. These attributes have added to the liquidity squeeze
During a panel at the Exempt Organizations Committee meeting, we learned that some institutions are considering whether to incur debt to tide them over the economic downturn. That raises a potential problem under the unrelated-debt financed income rules in Section 514 of the Internal Revenue Code. These rules convert otherwise exempt income from investment assets to unrelated business income, which is taxable.
The unrelated-debt financed income rules apply to property (referred to as “debt-financed property”) that is financed with acquisition debt. Section 514(b). Now you might think that these rules would not be a problem in the case of existing endowment assets because those assets were purchased before any new debt is incurred. If, however, you attended the ABA Tax Section meeting, you would know that such simple logic doesn’t carry day when the handy work of Congress is at issue.
Section 514(c) defines acquisition debt as:
with respect to any debt-financed property, the unpaid amount of--
(A) the indebtedness incurred by the organization in acquiring or improving such property;
(B) the indebtedness incurred before the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement; and
(C) the indebtedness incurred after the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement and the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement.
The immediate problem faced by colleges and universities is the foreseeability language in 514(c)(1(C). To better understand the problem, assume that Crimson U purchased an interest in a hedge fund for $100 million in cash. The investment is subject to a five-year lockup. Six months later, the economy craters and Crimson U must raise $20 million to continue operating. Its first option would be dispose of its interest in the hedge fund, but there are at least two problems. First, the investment carries a five-year lock-up so Crimson cannot demand that the hedge fund redeem its interest. Second, if Crimson U found a willing buyer, it would, given current market conditions, only be able to realize $10 million from a sale. After all, nobody wants to buy interests in hedge funds right now.
From a pure investment perspective, Crimson’s best option is to hold its investment while waiting for a recovery in the economy. In the meantime, Crimson U can borrow the $20 million. The tax question: Was the possibility that Crimson U might have to borrow $20 million at the time it purchased the interest in the hedge fund reasonably foreseeable. Crimson would argue that it was not because had the borrowing been reasonably foreseeable, Crimson would never have purchased the interest in the hedge fund.
Regulation Section 1.514(c)(1) addresses the issue of foreseeability, providing:
Whether the incurrence of an indebtedness is reasonably foreseeable depends upon the facts and circumstances of each situation. The fact that an organization did not actually foresee the need for the incurrence of an indebtedness prior to the acquisition or improvement does not necessarily mean that the subsequent incurrence of indebtedness was not reasonably foreseeable.
This language imposes an objective standard rather than a subjective one. In other words, Crimson U’s expectations are not necessarily controlling. The IRS might argue that although Crimson U never expected an economic downturn, that Crimson U's view was unfounded given history and business cycles. Crimson U should have better managed its investment portfolio to assure adequate liquidity in the event of a downturn.
As is typical whenever the unrelated business rules come into play, the EO world and its lawyers now are pounding on the IRS’s door looking for relief. Members of the bar are wondering whether relief can be found in the interest expense allocation rules under Section 163 or other rules in the Code that trace or source income or expenses. Maybe, for example, there is relief to be found in the rules that apply to the deductibility of debt incurred to acquire or carry tax-exempt bonds. See Section 265. If so, the bar would like the IRS to craft release by drawing analogies from those or other tracing regimes.
Several comments at the Exempt Organizations Committee meeting gave the impression that some in the IRS understand the problem and may be willing to listen to creative solutions in an effort to provide relief. We can’t fault good advocacy, but we have to wonder whether twisting the law to provide relief in this situation reaches the right policy result. Nobody ever died from UBIT. They just paid some tax. Should the IRS go out of its way to provide relief when a good dose of UBIT today might cause college and university investment committees to think a little bit longer about the merits of investing such a high percentage of a university endowment in illiquid assets?
In any event, the immediate problem is the foreseeability problem. College and universities also should think about future scenarios as they beg for help to solve the immediate problem. What happens when the crisis ends and colleges and universities go back to making investments. Must they pay off any outstanding debt before making future investments in order to avoid unrelated-debt financed income on those new investments. See Section 514(c)(1)(B). Moreover, this assumes that all investment activity has ceased. That may be true in the case of alternative investments, but what happens once the borrowing takes place and the college or university continues to buy and sell publicly-trades stocks and bonds?
In closing, we agree with many that Section 514 should be repealed. It was inspired long-ago by the Supreme Court’s decision in Clay Brown, 380 U.S. 563 (1965). Section 514's scope is much broader than necessary if its goal was to reverse the Supreme Court’s decision. Nevetheless, until Section 514 is repealed, it is the law.
Internal Revenue Service - Circular 230 Disclosure: As provided for in Treasury regulations, any advice (but none is intended) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.
| THE FOREGOING IS NOT AND SHOULD NOT BE TAKEN AS LEGAL ADVICE. IF LEGAL ADVICE IS REQUIRED, THE NONPROFIT OR OTHER PARTY IN QUESTION SHOULD SEEK THE ADVICE OF QUALIFIED LEGAL COUNSEL.
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