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

Up to one-third of the money invested in hedge funds comes from tax-exempt entities. However, the tax law prevents tax-exempt entities from investing directly or indirectly with borrowed money. This limitation prevents tax-exempt entities from investing in U.S. hedge funds, and instead forces them to invest through tax havens. Tax-exempt entities are not the only investors using tax havens, however. U.S. taxpayers use tax havens to shave an estimated $40 billion to $70 billion off of their collective tax bills annually. Congress never intended to force tax-exempts to invest through tax havens; that is an unintended consequence of Congress's shutting down transactions in which taxpayers used tax-exempt entities' exemptions to reduce their own taxes. The avenue Congress chose - the unrelated debt-financed income rules - failed to effectively combat the abuse, however, and today serve primarily to distort the investment decisions of tax-exempt entities. In order to allow Congress to effectively combat the abuse of tax havens, as well as to allow tax-exempt entities to make better investment decisions, the unrelated debt-financed income rules should be repealed and their putative policing of tax-exempt entities' behavior should be replaced by expanding the tax shelter rules. The tax shelter rules would be more effective at preventing abusive behavior and at allowing tax-exempt entities to participate in non-abusive economic transactions