Universities’ use of tax-exempt bonds to fund capital projects has come under scrutiny from the federal government, introducing the possibility of increased regulation, but Stanford’s existing practices appear set to continue as normal and will face no additional oversight at the state level for now.
Stanford often finances capital projects by issuing tax-exempt bonds in order to avoid drawing large amounts from the University’s endowment payouts. Odile Disch-Bhadkamkar, the University treasurer, said the practice is a preferable alternative when Stanford cannot cover the costs of construction through donor gifts.
“We typically will issue debt for capital projects when we cannot fundraise,” Disch-Bhadkamkar said.
The use of this practice by non-profit colleges and universities with substantial investment assets — like Stanford, which has the third-largest endowment of any university — has drawn the attention of the Congressional Budget Office (CBO), which is concerned with the possibility of such institutions unfairly benefiting from “indirect” tax arbitrage.
Tax arbitrage, which the CBO defines as “the use of proceeds from lower-cost, tax-exempt bonds to directly finance the purchase of higher-yield securities,” is illegal. The CBO issued a report in April, however, pointing to a legal practice that could merit additional federal scrutiny, stating that “to the extent that colleges and universities can earn untaxed returns on investments that are higher than the interest they pay on tax-exempt debt, they are benefiting from a form of ‘indirect’ tax arbitrage.”
Disch-Bhadkamkar characterized this criticism as part of a larger skepticism toward the size of university endowments and investment holdings. She defended the use of tax-exempt debt to fund capital projects, however, as not only legal, but appropriate, on the grounds that it would not be feasible to take funds from Stanford’s endowment payouts to pay for construction projects. Tapping into endowment payouts might have a detrimental effect on the University’s ability to provide funding for expenses unrelated to capital projects, such as normal University functions of teaching and research. Taking on taxable debt would also strain the resources of Stanford’s endowment payouts, she said.
In addition, if the University were forced to rely more on gifts, Disch-Bhadkamkar said, funding for non-“marquee” incremental capital improvements and maintenance that may not attract named donors could suffer.
Because the report does not describe the practice as illegal and because issuing tax-exempt debt is a desirable option for the University, there is no reason to expect a change in the University’s finance practices in the near-term. That could change if, in a political climate encouraging financial oversight, legislation were introduced that imposed new regulation over practices like “indirect tax arbitrage” — a possibility Disch-Bhadkamkar said she recognizes.
“I think everyone is clearly very aware of the scrutiny and the potential for the review of the current legislation,” Disch-Bhadkamkar said.
Currently, Stanford relies on the California Educational Facilities Authority (CEFA) to issue tax-exempt debt, while the University provides credit for the repayment of the bonds. Joe DeAnda, a spokesman for the California state treasurer’s office, said as long as Stanford meets the standard criteria for issuing debt, additional scrutiny of Stanford’s practices would not occur.
“[The CEFA] exists basically solely to provide private non-profit educational facilities with access to that kind of financing,” DeAnda said.
Stanford’s use of funds obtained through bonds is instead subject to the oversight of the Internal Revenue Service (IRS). Disch-Bhadkamkar said that the University works with the IRS to ensure compliance with their rules.
“They look at the investments to make sure that we’ve actually written, against the bonds, checks to pay for construction,” she said.
Stanford received approval to refinance $900 million in tax-exempt debt in March. The funds were linked to construction of a large number of major capital projects, including the Business School’s Knight Management Center and the Law School’s William H. Neukom Building.
The value of Stanford’s endowment was $12.6 billion in fiscal year 2009.