Hedge funds used 'dubious' means to bypass tax rules, senators say

http://www.theguardian.com/business/2014/jul/21/barclays-deutsche-bank-tax-rules-report

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More than a dozen hedge funds, with assistance of Barclays and Deutsche Bank, used “dubious” financial products to claim billions in unjustified tax savings and circumvent rules meant to limit risky bets, a Senate subcommittee investigation has found.

The Senate permanent subcommittee on investigations (PSI) released a report on its investigations on Monday, before a hearing on Tuesday. The PSI has been investigating a series of tax avoidance schemes by companies including Apple and Caterpillar.

The PSI called on the Treasury Department to clamp down on the practices its investigation uncovered and for the Internal Revenue Service to audit Barclays and Deutsche Bank.

The 93-page report released by senators Carl Levin and John McCain centers on the use of financial products known as basket options that were sold to hedge funds and used to help reduce taxes on short-term capital gains.

“Over the years, this subcommittee has focused significant time and attention on two important issues: tax avoidance by profitable companies and wealthy individuals, and reckless behavior that threatens the stability of the financial system,” said Levin.

“This investigation brings those two themes together. These banks and hedge funds used dubious structured financial products in a giant game of ‘let’s pretend', costing the Treasury billions and bypassing safeguards that protect the economy from excessive bank lending for stock speculation."

McCain said: “Americans are tired of large financial institutions playing by a different set of rules when it comes to paying taxes. The banks and hedge funds involved in this case used the basket options structure to change the tax treatment of their short-term stock trades, something the average American investor cannot do. Hedge funds cannot be allowed to have an unfair tax advantage over ordinary citizens.”

From 1998 to 2013, Deutsche and Barclays sold 199 basket options to more than a dozen hedge funds which used them to conduct more than $100bn in trades, according to the report. The subcommittee focused on options involving two of the largest basket option users, Renaissance Technology Corp and George Weiss Associates.

Barclays managing director Marty Malloy, Satish Ramakrishna, the managing director at Deutsche Bank Securities, and Peter Brown, the co-chief executive of Renaissance Technologies, are among the witnesses scheduled to testify on Tuesday before the Senate panel.

According to the report, the banks and hedge funds used the option structure to open proprietary trading accounts in the names of the banks and “create the fiction that the banks owned the account assets, when in fact the hedge funds exercised total control over the assets, executed all the trades, and reaped all the trading profits.”

The hedge funds often exercised the options shortly after the one-year mark and claimed the trading profits were eligible for the lower income tax rate that applies to long-term capital gains on assets held for at least a year. The report claims RenTec treated trading profits as long term gains, even though it executed an average of 26 to 39m trades per year and held many positions for mere seconds.

In 2010, the IRS issued an opinion questioning the use of basket options to claim long-term capital gains but it did not change the tax rules. The banks are not commenting ahead of the hearing but are likely to argue that they operated within the law and the current tax code.

The PSI report also accuses the financial institutions of using basket options to evade federal limits introduced after stock market crash of 1929 to protect against the risk of trading securities with borrowed money. That crash, which left banks unable to collect money they had leant, led to the Great Depression.

A normal brokerage account would allow a two-to-one leverage limit – that is, for every $2 in total holdings in the account, $1 could be borrowed from the broker. The basket option gave the appearance that the bank was transferring its own money into its own proprietary trading accounts instead of lending to its hedge-fund clients. The scheme allowed hedge funds to take on “exponentially more debt than leverage limits allow, in one case permitting a leverage ratio of 20-to-1,” according to the report.

“These basket option deals were enormously profitable for the banks and hedge funds that used them,” Levin said. “But ordinary Americans have shouldered the tax burden these hedge funds shrugged off."