Taxation of Sovereign Wealth Funds

And now for one of your favorite topics: tax law. It sounds like an absolutely painful subject, but in law school I gained a new appreciation of what the IRS does with respect to policies of fairness when I took a class in Income Tax from Miranda Perry Fleischer. For Mrs. Professor Fleischer, her husband Vic, and many other tax profs of their ilk, the underlying policy of the tax code should be that all persons and entities are treated equally. Mr. Professor Fleischer famously ticked off a lot of fund managers when Congress picked up on his suggestion that private equity profits should be taxed at an ordinary income tax rate, and not at the far lower capital gains rate.

Evidently Mr. Professor Fleischer is at it again with a new paper coming out concerning the taxation of sovereign wealth funds (SWF) in the United States. According to Fleischer, "Under current law, Sovereign Wealth Funds are exempt from U.S. tax." So, he proposes that "Congress should consider amending Section 892 of the code to tax these state-owned investments under certain conditions, and the Code should not favor state-owned investors over private foreign investors." But I'm not sure I agree.

I'm all for equal treatment under the tax code. In this instance, however, I think that the principle of equal treatment must be contrasted with the practical effects of imposing tax on sovereign wealth funds, particularly with respect to questions of international relations and economic impact. China in particular takes its sovereignty VERY seriously, mostly because of how much Western powers infringed upon it in the late 1800s and early 20th century. Vic's answer to this question is a good one: let SWFs negotiate a lower rate by treaty. But at a practical level, I don't see the U.S. senate ratifying any treaty of that nature any time soon. So one has to wonder if Congress wouldn't just adopt his more extreme proposal, which is to remove the exemption entirely, treaties be damned. And given the attitude that pervades any hearing concerning China on Capital Hill, I'd say it's not a remote possibility.

The far greater issue, however, is economic impact. It's not too far of a stretch to assume that SWFs would probably take some of their money to countries that retain taxation exemptions, and go bargain-hunting in those locales, if Fleischer's proposal became reality. In my view, this would be bad for the U.S. economy because we need SWF money to provide credit and liquidity in the U.S. market. In fact, section 892 may currently serve as the thread by which the American economy currently hangs.