An investigation by the US Senate has issued a damning report into practices by some hedge fund managers that allowed them to save more than $6 billion in taxes on capital gains.
The report from the Permanent Subcommittee on Investigations said Renaissance Technologies and George Weiss Associates had both used “basket option structures” held by Barclays and Deutsche Bank to place hundreds of thousands of derivatives trades.
The profits from the trades were then cashed as long-term capital gains, which are taxed at a far lower rate than gains made by trades that last less than a year. In fact, the report claimed that “97% of the assets [were] held for less than 6 months”. In total, the structures generated profits of more than $35 billion, “of which at least $34 billion came from options exercised after more than one year”, the report said.
“The facts indicate that the basket option structures examined in this investigation were devised by sophisticated financial firms to allow clients to circumvent federal taxes and leverage limits.”—Permanent Subcommittee on Investigations report.
“Most of those profits came from assets which were held for less than one year but which were treated by the hedge funds holding the options as having produced long-term capital gains taxable at the lower long-term capital gains rate,” it said.
The hedge funds were also said to have used the structures to increase leverage far beyond legal limits: The funds allegedly borrowed using a leverage ratio of as much as 20:1, compared to the US federal limit for brokerage accounts of 2:1.
The subcommittee—which is chaired by Democrat Senator Carl Levin—said in its report: “The facts indicate that the basket option structures examined in this investigation were devised by sophisticated financial firms to allow clients to circumvent federal taxes and leverage limits.”
It added: “These financially engineered products—which relied on high volume trading, leveraged funds, and artificially lowered tax rates to produce their profits—warrant greater attention from federal tax, securities, and banking regulators to prevent their continued misuse.”
A spokesman for Renaissance told the New York Times: “We believe that the tax treatment for the option transactions being reviewed by the [committee] is appropriate under current law.”
Elsewhere in the report, the US’s Internal Revenue Service (IRS) was said to be “failing to audit 99% of the tax returns filed by large partnerships with assets exceeding $100 million” as it “had not kept pace” with the growth of these companies. The subcommittee called for an overhaul of the Tax Equity and Fiscal Responsibility Act to make it easier for the IRS to audit large partnerships.
The subcommittee also called for the IRS to audit hedge funds that used the basket structures and collect any unpaid taxes on short-term gains, and urged financial regulators to clamp down on the creation of such structures.