Report: Hedge funds escaped billions in taxes

Two large banks used a complex financial scheme to help 13 hedge funds avoid paying billions of dollars in taxes and evade federal borrowing limits on brokerage accounts over a 15-year period, according to the findings of a Senate subcommittee investigation.

Deutsche Bank and Barclays Bank sold "basket options" to the hedge funds that allowed the funds to report trading profits as long-term capital gains for tax purposes, even though 97% of the assets were held for less than six months, the Senate Permanent Subcommittee on Investigations said.

Also, the trades were made in the banks' accounts so that the hedge funds would not be subject to leverage limits that prevent banks from lending more than $2 for every dollar put up by the hedge funds, according to its report. The funds, however, controlled all assets, executed all the trades and reaped the profits, the subcommittee said.

From 1998 to 2013, its report said, the banks sold 199 basket options to hedge funds to conduct more than $100 billion in trades. One fund, Renaissance Technologies, earned about $34 billion in profits and avoided paying $6.8 billion in taxes through the financial legerdemain, the report said.

The subcommittee's findings focused on two hedge funds — Renaissance and George Weiss Associates — because it said they were involved in the single-largest volumes of trades.

"Ordinary Americans have shouldered the tax burden these hedge funds shrugged off," said Sen. Carl Levin, D-Mich, chairman of the subcommittee. "The same ordinary Americans would pay another price if the reckless borrowing outside of federal safeguards would blow up."

Deutsche Bank said in a statement: "The options offered by Deutsche Bank which were discussed in the Committee's report were at all times fully compliant with applicable laws, regulations and guidance. Moreover, they were a niche offering to a small number of clients over a discrete period of time which we completely ceased offering in 2010. We fully cooperated with the Committee throughout its investigation."

Barclays said in a statement that it "has been fully compliant with the law, has cooperated with the committee and looks forward to continuing that cooperation at the hearing. "

In a statement, Renaissance spokesman Jonathan Gasthalter said: "We believe that the tax treatment for the option transactions being reviewed by the (subcommittee) is appropriate under current law. These options provide Renaissance with substantial business benefits regardless of their duration. The IRS already has been reviewing these option transactions for over six years, and Renaissance has cooperated fully with both reviews."

George Weiss Associates said it terminated its basket options in May 2010 "because of increasing market volatility." It added, "basket options are lawful financial instruments often used to obtain leverage."

The basket options will be the subject of a subcommittee hearing Tuesday morning.

According to the subcommittee's findings, Deutsche Bank began selling the basket options in 1998 and Barclays started offering them in 2002. By exercising the option, a hedge fund would either make or lose money based on the results of millions of trades over many months. Since they often waited more than a year to exercise the option, the hedge funds treated the profits as long-term gains.

The subcommittee, however, says the option was simply an artifice and the funds made an average 26 million to 36 million trades during the year, holding many positions for only seconds. As a result, the trades should have been part of a normal brokerage account, and the funds should have been paying an ordinary income tax rate for short-term gains, which is as high as 39% instead of a 15% or 20% rate for long-term capital gains.

In 2010, the Internal Revenue Service issued a memorandum that said basket options with constantly changing assets were not true options and investors must recognize the gains or losses when they occurred rather than when an option was exercised.

At that time, Barclays continued offering new options for two years, the Senate report said. Deutsche Bank stopped offering new options but continued to administer existing ones.

In 2012, the IRS notified Renaissance that it would not allow basket option profits from trades lasting less than 12 months to be treated as long-term capital gains and sought additional taxes from the company, the report said. Renaissance submitted a letter opposing the finding and the matter is now awaiting an appeal.

By conducting trades in the banks' accounts, the banks were able to provide the hedge funds as much as $20 in loans for each dollar put up by the funds, according to the report. While the hedge funds controlled all of the trades, the banks contend they were simply acting as investment advisers, the subcommittee said.

The subcommittee said the banks also profited from the scheme, with Deutsche Bank earning $570 million in financing, trading and other fees and Barclays taking in $655 million.

The subcommittee says the IRS should audit hedge funds that used basket options from Deutsche Bank or Barclays and collect unpaid taxes. Regulators also should step up their scrutiny of these transactions.

The Treasury Department and the IRS also should simplify the rules so that regulators don't have to notify potentially thousands of a hedge fund's partners to conduct an audit, the subcommittee said.