CBO Report Cites Higher Ed Arbitrage

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WASHINGTON — Congress could save billions of dollars by prohibiting tax-exempt colleges and universities from earning arbitrage indirectly through endowments that are invested at higher interest rates than what they are paying on their tax-exempt bonds, the Congressional Budget Office concluded in a report.

The report, released late Friday, raises questions about whether schools should be able to borrow on a tax-exempt basis “when they have money in the bank,” said Sen. Charles Grassley, R-Iowa, the ranking minority member of the Senate Finance Committee who commissioned it.

“Does the expense of debt service take money away from ­student aid or academic service?” he asked in response to the report. “Do bond issuances occur even as universities raise tuition and build investment assets? These are further questions to explore.”

Grassley’s focus on this issue comes as federal lawmakers are struggling to find revenue to pay for programs under “pay-go” rules requiring any new spending provisions be offset with equivalent revenue raisers.

For example, key members of Congress and the Obama adminisitration want to make the Build America Bond program permanent. But House Ways and Means Committee chairman Sander Levin, D-Mich., has said that proposal is so costly, the program may have to be temporarily extended.

Historically Congress has had no trouble limiting the tax-exempt borrowing of nonprofit colleges and universities. Under the 1986 Tax Reform Act, nonprofit, 501(c)(3) universities could not be the beneficiary of more than $150 million of outstanding tax-exempt bonds. However, Congress repealed that limit in 1997, leading to several years of higher issuance with an all-time high of $18.6 billion in 2008, according to Thomson Reuters.

Nonprofit universities, like all other tax-exempt borrowers, are restricted from earning arbitrage by investing bond proceeds at a significantly higher interest rate than the one on the bonds. However, the CBO report concludes that the tax law currently does not prevent borrowers from “engaging in what is essentially indirect tax arbitrage.”

Indirect arbitrage, according to the CBO, is when a borrower earns interest on investment assets not directly financed with bond proceeds at an interest rate higher than the one on its tax-exempt bonds. If the issuer holds onto those investments and instead sells tax-exempt bonds to pay for capital expenditures for a project, it is effectively using tax-exempt proceeds to invest in higher-yielding securities, the CBO said.

If Congress wants to broaden the definition of arbitrage to take into account all of the investment assets of nonprofit borrowers, significantly more bond deals done by schools would face arbitrage restrictions, according to the CBO.

In an analysis of tax-exempt bonds sold by 251 nonprofit colleges and universities in 2003, the CBO found that about 90% of institutions would be characterized as profiting from arbitrage if the definition was broadened to include their investments. If those institutions were permitted to set aside a year of operating expenses in a reserve fund that would not be limited by arbitrage, roughly 44% would be characterized as profiting from arbitrage.

If the definition of arbitrage was expanded, nonprofits would likely respond by reducing their issuance of tax-exempt bonds, which in turn would save the federal government money, the CBO said. It cited the Joint Tax Committee’s estimate that the federal government would forgo about $5.5 billion in tax revenue by allowing higher education institutions to borrow on a tax-exempt basis.

Charles Samuels, a lawyer with Mintz Levin Cohn Ferris Glovsky & Popeo PC and counsel to the National Association of Health and Educational Facilities Finance Authorities, said that while broadening arbitrage restrictions might add revenue to federal coffers, it would hurt the higher education system.

“If Congress decreases support for higher education, it will save some on short-term revenues, but will undermine national higher ed goals,” he said. Samuels added that the report failed to account for the benefits the nonprofit college and university system provides, and how those might be adversely affected by more rigorous arbitrage restrictions.

“What’s the consequence on the quality of higher education?” he asked. The report “doesn’t take into account the implications of its actions. ... I don’t think it really advances the policy debate very much.”

Samuels argued that while a school’s endowment might have investments earning at a higher rate than interest costs, it should not be directly compared with the school’s interest costs on debt. “They aren’t related,” he said. “The fact is tax-exempt bonds can’t be used for the same purposes as endowments.”

The CBO report marks the latest federal survey of the tax-exempt higher education system.

In January, roughly 40 colleges and universities, including Harvard University and the University of Texas, were selected for audits by the Internal Revenue Service. Those audits came on the heels of 400 compliance questionnaires the IRS sent to colleges and universities nationwide in October 2008. Among other things, the questionnaires asked schools how they invested and used endowment funds. The IRS is expected to issue a report on the responses this year.

The report also marks the latest of a series of inquiries Grassley has made into the merits of tax-exempt organizations and particularly higher education. He commissioned another CBO report in April 2007 to look into high-profile sports programs run by nonprofit schools.

That report, issued in May 2009, said lawmakers should consider banning the use of tax-exempt bonds to finance sports facilities if they fear the programs are becoming too commercial.

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