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The Tax Prophet Newsletter   Issue # 51 July, 2007

REDUCE TAXES!
CHECK OUT THE TAX PROPHET'S Action Guides


In This Issue:
Introduction
Offshore Investments
How it Works
Whose Involved
Conclusion


A Major Tax Loophole for
Tax Exempt Entities


Introduction

Yale University is generally not known for engaging in suspect offshore investments, but its investment in foreign hedge and private equity funds in 2005 produced income of approximately $150 million, tax-free!

Consider that if the same hedge funds were located in the U.S., much of that income would be taxable at a rate as high as 35% federal, it is clear that many non-profits are escaping millions in taxes through the use of this massive loophole.

Offshore Investments

The Senate Permanent Subcommittee on Investigations ("Subcommittee"), which has been investigating the use of offshore hedge and private equity funds by nonprofits estimates the total tax revenue loss stemming from all forms of investments in suspect tax shelters and use of offshore companies is more than $100 billion annually.

According to Subcommittee chairman Carl Levin, "A key concern is whether tax-exempt use of offshore corporations to invest in hedge funds is accelerating the shifting of U.S. assets offshore to avoid U.S. taxes."


How it Works

Universities, pension funds, and foundations generally pay no tax on investment income, though they are required to pay "unrelated business income tax" when they receive profits from debt-financed investing, which can run as high as 35% federal. Because most hedge and private equity funds use debt financing, they typically produce taxable unrelated business income for their nonprofit investors.

To avoid this result, the funds set up special purpose "blocker" companies (offshore subsidiaries) in tax havens (such as the British Virgin Islands or the Cayman Islands) that convert profits into dividends, since nonprofits do not pay taxes on dividend income.

Consequently, these funds have set up blocker companies for nonprofits, pension funds and other tax-exempt entities to invest in and thereby escape U.S. taxes on their debt-financed income.
Note: Nothing of substance within the fund has changed. The fund still engages in the same type of investments using debt financing, except the nonprofit's share of income is now labeled "dividends," which, the nonprofits argue, permits them to avoid billions in US. taxes each year.


Whose Involved

The Subcommittee has established that the endowments of many universities, including Harvard, Yale and Stanford, as well as major foundations, use this dubious technique.

For instance, approximately 33% of the Rockefeller Foundation's investments involve hedge funds and private equity funds, some of which are offshore. In 2006, the tax bite on the income generated by its $3.7 billion endowment will be paltry $7.0 million.


Conclusion

Given the enormous amount of money escaping U.S. taxation through questionable offshore companies, look for Congress to attack this loophole as unfair and unjust; however, do not underestimate the power of the pro-offshore investment lobby to block legislation.

After all, those benefiting from this tax dodge have endowments running into the tens of billions of dollars.




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All contents copyright 2007 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet is a registered trademark of Robert L. Sommers.