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Senate Report details use of basket option by hedge funds to avoid more than $6.8 billion in tax

July 23, 2014

In conjunction with ongoing hearings, the U.S. Senate Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs, has issued a report (Report) detailing how two financial institutions developed structured financial products dealing with basket options and sold them to hedge funds that used them to avoid federal taxes and leverage limits on buying securities with borrowed funds. Most of the profits from these basket options 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. While IRS identified this tactic as abusive in 2010, the Report noted that taxes have yet to be collected on many of the basket option transactions, and the use of the tactic to circumvent federal leverage limits continues.

Background. Deutsche Bank AG and Barclays Bank PLC developed two types of basket options which they sold to hedge funds, including Renaissance Technologies LLC (RenTec) and George Weiss Associates (George Weiss). Starting in ’98, Deutsche Bank sold 96 Managed Account Product Structure (MAPS) with terms greater than one year and with assets with a total initial notional value of about $60 billion. Beginning in 2002, Barclays developed and sold its basket options product, COLT. Barclays sold 31 COLT options with terms greater than one year and with assets with a total initial notional value of about $62 billion. Although the Report did not have the information needed to estimate the total amount of taxes avoided through use of the basket options, looking at data for RenTec, the largest basket option user, it estimated that the basket options resulted in tax avoidance of $6.8 billion.

Most of the basket option contracts were short term transactions, some of which lasted only seconds. However, with respect to basket options that were exercised more than one year after the option was created, the hedge funds holding those options claimed that any short-term trading profits earned within the option period could be recast as long term capital gains for U.S. tax purposes after the option was exercised. The resulting short-term profits—recast as long-term capital gains—were subject to a 20% tax rate (previously 15%) rather than the ordinary income tax rate (currently as high as 39%) that would otherwise apply to investors in hedge funds engaged in daily trading. While the banks styled the trading arrangement as an “option,” in essence, the banks loaned the hedge funds money to finance their trading and allowed them to trade for themselves in highly leveraged positions in the banks’ proprietary accounts and reap the resulting profits. The banks offering the “options” benefited from the financing, trading, and other fees charged to the hedge funds initiating the trades. In the end, the trading conducted by the hedge funds using the basket option accounts was virtually indistinguishable from the trading conducted by hedge funds using their own brokerage accounts, and provided no justification for treating the resulting short-term trading profits as long-term capital gains.

The Report found that the facts indicated that the basket option structures were devised by sophisticated financial firms to allow clients to circumvent federal taxes and leverage limits. The structures rested on two fictions:

(1) that the bank, rather than the hedge fund, owned the assets being traded in the designated option accounts, even though the hedge fund bought and sold the assets, was exposed to all significant risks and rewards, and profited from the trading, with little input from the bank serving as the nominal owner of the assets. In effect, the structure purported to enable the hedge fund to purchase an “option” on its own trading activity, an arrangement that makes no economic sense outside of an effort to bypass federal taxes and leverage limits;

(2) that the profits from the trades controlled by the hedge fund could be treated as long-term capital gains, even for trades lasting seconds. This fiction depended upon the hedge fund claiming that the profits came from exercising the “option” rather than from executing the underlying trades. In fact, the “option” functioned as little more than a fictional derivative, allowing the hedge fund to cast short-term capital gains as long-term gains and authorizing financing at levels otherwise legally barred for a customer’s U.S. brokerage account. Federal “margin rules” were enacted to impose a leverage limit of 2:1 on brokerage accounts opened by U.S. broker-dealers for their customers. In contrast, because the participating banks seemingly lent money to their own accounts, the basket option accounts examined by the Subcommittee provided the hedge fund option holders with leverage ratios as high as 20:1.

In 2010, IRS issued a Generic Legal Advice Memorandum (GLAM) which found that basket options referencing accounts with ever changing assets did not function as true option contracts, and that investors had to recognize the trading gains and losses in the designated accounts when they occurred, rather than at the time the alleged “option” was finally exercised. IRS advised that investors could not use the basket option contracts to justify applying the long-term capital gains tax rate to what were really short-term gains.

Despite the GLAM, Barclays continued to sell COLT options to RenTec for the next two years. After the GLAM was issued, Deutsche Bank suspended issuing new MAPS basket options, although it continued to administer multiple option accounts already trading assets. Both financial institutions later revised their basket option contract to offer only basket options with terms that lasted less than one year and could not be used to claim long-term capital gains.

Finding of facts. Based on the Subcommittee investigation, the Report made these findings of fact:

  • Between ’98 and 2013, Deutsche Bank AG sold basket option products to 13 hedge funds, while Barclays Bank PLC sold them to one hedge fund, together leading to over $100 billion in securities trades and tens of billions of dollars in profits, most of which came from trades that lasted less than 12 months in duration, but were treated by the hedge funds as producing long-term capital gains. The basket options also produced financing, trading, and other fee revenue for the banks totaling $570 million for Deutsche Bank and $655 million for Barclays.
  • Deutsche Bank AG and Barclays Bank PLC were aware of the questionable tax status of their basket option structures for many years prior to the issuance of the 2010 IRS advisory memorandum, but continued to sell the product.
  • Over a fourteen-year period from ’99 to 2013, RenTec held 60 basket option contracts for more than one year, used them to carry out an investment strategy utilizing hundreds of millions of trades, virtually all of which lasted less than 12 months, and characterized the vast majority of the resulting $34 billion in trading profits as long-term capital gains.
  • Although the investments in the basket option trading accounts were held in the name of the banks, Deutsche Bank and Barclays routinely hired the option holder—i.e., the hedge fund—as the investment adviser for the accounts and ceded control of their accounts to the option holder, which traded the account for its own benefit.
  • Although Deutsche Bank and Barclays claimed the basket option structure was a valid derivative in part because it carried financial risk for the bank, Barclays downplayed that risk both internally and in reports to its U.K. regulator when it benefited the banks’ interests.
  • By opening the basket option accounts in their own names and supplying their own funds to those accounts as financing for the trades controlled by their hedge fund clients, Deutsche Bank and Barclays enabled the hedge funds to attain a leverage ratio of as high as 20:1, despite the much lower federal leverage limit of 2:1 intended to prevent systemic risk.
  • While, in 2010, IRS determined that basket options were being misused and, in 2012, proposed additional tax liability for one hedge fund, the Government Accountability Office determined that 99% of the tax returns filed by large partnerships with assets exceeding $100 million have not been audited by IRS. This extremely low auditing rate may embolden large partnerships such as hedge funds to employ abusive tax structures.
  • Although federal financial regulators have long been aware that derivative and structured financial products, including basket options, are being used to circumvent federal leverage limits, they have taken little or no action to limit those practices and enforce the statutory limits on purchasing securities with borrowed funds.

Report’s recommendations. Based on the Subcommittee investigation and findings of fact, the Report recommended:

1. IRS should audit the hedge funds that used Deutsche Bank or Barclays basket option products, disallow any characterization of profits from trades lasting less than 12 months as long-term capital gains, and collect from those hedge funds any unpaid taxes.
2. To end bank involvement with abusive tax structures, federal financial regulators, as well as Treasury and IRS, should intensify their warnings against, scrutiny of, and legal actions to penalize bank participation in tax-motivated transactions.
3. Treasury and IRS should revamp the Tax Equity and Fiscal Responsibility Act (TEFRA) regs to reduce impediments to audits of large partnerships like hedge funds, and Congress should consider amendments to TEFRA to facilitate those audits.
4. The Financial Stability Oversight Council, working with other agencies, should establish new reporting and data collection mechanisms to enable financial regulators to analyze the use of derivative and structured financial products to circumvent federal leverage limits on purchasing securities with borrowed funds, gauge the systemic risks, and develop preventative measures.
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