The U.S. Senate Permanent Subcommittee on Investigations held a hearing on tax avoidance by banks and hedge funds working together using basket options.
The concept is pretty simple, and was perfectly legal and commonplace until recently, when the IRS started challenging it.
Banks offer hedge funds basket options whose values fluctuate based on the performance of the underlying securities.
Hedge funds could then buy and sell stocks within the basket without subjecting the transactions to taxation as a short-term gain because it was technically owned by the bank.
The hedge funds only had to pay taxes on long-term gains, if and when they actually exercised their options.
This arrangement makes a huge difference because of the difference in the tax rates for short-term capital gains and long-term gains.
Senator Carl Levin, who chairs the Senate Permanent Subcommittee on Investigations, said in his opening statement that “This structure worked well for the banks, which earned hundreds of millions of dollars in fees. It worked well for the hedge funds, which made billions of dollars in profits. But it didn’t work for average taxpayers, who had to shoulder the tax burden these hedge funds shrugged off with the aid of the banks.”
The hearing was focused on the basket options developed and sold by Deutsche Bank AG and Barclays Bank PLC to more than a dozen hedge funds.
These two banks together sold 199 basket options to hedge funds, which then made use of the arrangement to make more than $100 billion in trades.
One of the hedge funds singled out for attention in the hearing was Renaissance Technologies LLC aka RenTec, which used the basket options to rack up 100,000 trades per day on average, or about 30 million per year.
Around 60 options sold by the two banks to a RenTec fund called the Medallion fund, which generated profits of around $34.2 billion for investors, who saved $6.8 billion in taxes on these profits by avoiding taxes on short-term gains.
RenTec computers would send the order to the bank, which would then execute the trade. RenTec’s investment in a stock would often end in seconds or minutes, and was made to appear as a mere recommendation rather than being an actual trade.
Renaissance claims it was well within the law in doing this, and noted that it was the same as trading securities held by a brokerage.
However, the IRS challenged it and both banks have since discontinued the practice. Renaissance is currently engaged in a dispute with the IRS over the tax treatment of the trades that were conducted from within basket options.
Photo credit – senate.gov