tax arbitrage

Case Study Tax arbitrage using low-cost tax-exempt bonds to finance the purchase of higher-yielding taxable securities is prohibited under the tax code and the Department of the Treasury's regulations. For example, a nonprofit hospital or university is prohibited from issuing tax-exempt bonds and using the proceeds to acquire higher-yielding investments or to replace funds that were used directly or indirectly to acquire higher-yielding investments. A nonprofit institution is permitted to issue tax-exempt bonds for financing investments in operating assets, including buildings and equipment. Nonprofit hospitals and universities often accumulate large investment portfolios, courtesy of donors who gain tax benefits by giving money or other assets to the nonprofit institutions. A nonprofit wanting to spend capital funds can skirt the tax arbitrage prohibition by issuing tax-exempt bonds rather than utilizing its portfolio assets to finance buildings and equipment. The portfolio assets remain intact and continue to earn a return higher than the interest paid on the tax-exempt bonds. Using this broad definition of tax arbitrage (utilizing proceeds from tax-exempt bond issues rather than available portfolio assets), the Congressional Budget Office estimated that in 2002 nonprofit hospitals were earning returns from tax arbitrage on almost $11 billion of tax-exempt debt.