The Senate Permanent Subcommittee on Investigations released a report today that found that hedge funds have been using basket options to save billion in taxes. And when we say “billions,” the report indicates it’s more like tens of billions, since the paper estimates that the tax reduction achieved at one hedge fund, Renaissance Technologies, operated by the famed James Simons, was $6.8 billion.
Basket options were sold by Wall Street firms, in particular Barclays and Deutsche Bank, as a way to convert what would otherwise have been labor income into capital gains income. The bone of contention is that the IRS wrote a memo in 2010 telling players involved to cut it out, and they didn’t. From the Wall Street Journal:
Hedge funds used a tax avoidance technique offered by Wall Street banks for years to skirt federal leverage trading limits…
Companies involved in the practice have pushed back against the Internal Revenue Service, which warned in a 2010 memo against claiming a tax break based on the use of financial products known as basket options. The companies said use of the products to claim lower long-term capital gains tax treatment for trading activity is legal and doesn’t violate tax rules or leverage limits under current law…
Investigators said two banks, Deutsche Bank AG DBK.XE -1.16% and Barclays Bank PLC, sold 199 basket options to more than a dozen hedge funds, which used them to conduct more than $100 billion in trades.
After the IRS released its 2010 memo, banks wound down the sale of basket options as a way for hedge funds to claim long-term capital gains tax treatment. But some still are selling the structures as a way around federal leverage limits, according to the report.
The Senate has a hearing on Tuesday and will grill two of the hedge funds, Renaissance and another large user identified in the report, George Weiss, along with Deutsche and Barclays. Spokesmen from the two banks piously claimed that everything they did was perfectly kosher. Normally, one would assume that that position would be correct, since the party filing the tax return is the one responsible for the tax positions taken in a tax return. However, the banks were making representations regarding ownership that were critical to the tax position that the hedge funds took:
Investigators believe the basket options maneuver amounts to a “series of fictions,” the biggest being that the banks own the account assets, said Sen. Carl Levin (D., Mich.), the subcommittee chairman. In reality, the account is basically a trading account, investigators say.
Oh, and notice the size of the losses. This $6.8 billion at one fund compares to the Joint Committee on Taxation’s estimate that $19.5 billion in tax revenues will be lost over the next ten years as a result of the pending tax inversion deals, in which companies like Walgreens move their headquarters overseas to lower their taxes. So this issue has the potential to become heated, assuming Congress is successful in creating public interest. Stay tuned.