Pension Funds and the Public-Private Investment Program

An open letter to Treasury Secretary Timothy Geithner.

Dear Secretary Geithner:

Last week you introduced the world to the Public-Private Investment Program (or P-Pip as it has come to be called), as part of your multi-pronged attack against toxic assets, our banks’ current seeming unwillingness to lend, and the economy's heebie-jeebies. Like all good citizens, irrespective of political party or economic creed (except perhaps Rush Limbaugh), I want your efforts to succeed. In that spirit, I offer a bit of advice to improve the program.

Here it is: Have the IRS and Treasury Department immediately issue an announcement that pension funds and other tax-exempt entities will not suffer any negative tax consequences if they participate in the program. To be more specific, declare (or is it clarify?) that pension funds, 401(k) accounts, Individual Retirement Accounts, charitable endowments, private foundations, and other tax-exempt entities, will not incur Unrelated Business Income Tax (UBIT) from the investment returns they hope to earn through P-Pip.

I know you know what I’m talking about. But let me clarify anyway. Pension funds and other such entities enjoy a valuable tax exemption on their investment income. But there are a few exceptions to that exemption that can nonetheless cause them to incur an income tax, called UBIT. One of these exceptions crops up when a pension fund uses debt financing to purchase its investments. Your Public-Private Investment Program anticipates the use of substantial leverage by its investors, up to 85%. In the absence of some special exception this would cause an investing pension fund to incur tax on 85% of its returns attributable to its P-Pip investment. Even if the leverage is non-recourse. And even if the leverage is incurred inside a partnership of which the pension fund is just a small vote-less partner.

(There's a way leveraged investment partnerships now avoid UBIT by creating off-shore partnerships. But does the U.S. Treasury and the F.D.I.C really want to be seen as creating special purpose entities in off-shore tax havens? I think not.)

Now, there’s nothing per se illegal about a pension fund using leverage and incurring a little bit of UBIT. It might be a reasonable price to pay for a good return. But a lot of pension funds avoid UBIT anyway: It shaves their net return, causes a double tax, requires the filing of an income tax return, even requires them to obtain their own taxpayer identification numbers which they often don’t otherwise have to do. It adversely changes the whole risk-reward calculus.

Most important, you sure don’t want the Treasury Department perceived as playing a game of “Gotcha!” with its tax-exempt citizens. Imagine, on the one hand saying, “Please do your patriotic duty and pick up your fair share of the nation’s toxic trash. Oh, and by the way, we forgot to tell you, Mr. Tax-Exempt Entity, you owe us tax dollars if things work out. Gotcha!”

So removing the threat of UBIT for tax-exempt investors will open up a vast additional market for your P-Pips that would otherwise avoid them. And it would also prevent unsophisticated tax-exempt investors from unwittingly getting caught in a UBIT trap.

An aside: I’m not actually sure there’s a way for the IRS or the Treasury Department to avoid UBIT here. It may be beyond your legal authority, requiring action by Congress. But if the IRS or Treasury purports to issue a special waiver that’s beyond its authority, who’s going to complain? You know what I mean?

Respectfully,
The Two-Legged Stool (a concerned citizen)