Probe: Hedge funds, banks used ‘fictions’ to skirt capital gains taxes

Banks and hedge funds worked together to create an “alternative universe” where professional investors could skirt billions of dollars in taxes, according to a new Senate investigation released Monday.

{mosads}Sen. Carl Levin (D-Mich.), one of the report’s authors, said the accounts set up between hedge funds, such as Renaissance Technologies and banks such as Deutsche and Barclays, were “a series of fictions” that made it seem like the banks were trading a collection of stocks.

Instead, Levin’s report says, the hedge funds were making trades that were organized in a way that allowed Renaissance to cash in after a year and pay the lower tax rate on long-term capital gains.

Renaissance alone might have saved some $6.8 billion in taxes because of the so-called “basket options” they secured from Deutsche and Barclays between 2000 and 2013, and on profits of more than $34 billion, the report said.

Levin said it’s tough to know how widespread those sorts of arrangements were because the IRS audits only a fraction of the U.S.’s large partnerships.

“It’s a lot of money, even by Washington standards,” said Levin, whose Permanent Subcommittee on Investigations will question executives from Renaissance, Barclays and Deutsche on Tuesday.

Levin completed the report with the subcommittee’s top Republican, Sen. John McCain (Ariz.). It delves into a number of areas that Levin has focused on during his tenure with the investigations gavel, including corporate tax avoidance, and high frequency stock trading and complex financial instruments.

The Democrat stopped short of saying that any of the activities that allowed Renaissance to lower its tax bills were illegal, and said it appears the banks stopped offering them after the IRS started to question the financial arrangements.

Renaissance, whose co-chief executive will testify Tuesday, says the set-up was legal. The hedge fund has been fighting with the IRS for years over the basket options, with the tax agency seeking to wring more taxes out of Renaissance for certain tax years.

“These options provide Renaissance with substantial business benefits regardless of their duration,” a spokesman for the hedge fund said Monday.

“The IRS already has been reviewing these option transactions for over six years, and Renaissance has cooperated fully with both reviews.”

Levin’s report doesn’t accuse Deutsche and Barclays themselves of any tax avoidance but insists the two banks knew they were offering hedge funds a questionable product, even before the IRS started raising questions in 2010.

Combined, the two banks raked in well over $1 billion in fees for administering the accounts.

Deutsche Bank and Barclays said in separate statements Monday that the arrangements they offered were legal and that they had cooperated fully with the Investigations subcommittee.

The options discussed in Monday’s report, Deutsche added in its statement, “were a niche offering to a small number of clients over a discrete period of time which we completely ceased offering in 2010.”

Deutsche offered the basket option to 13 hedge funds between 1998 and 2013, while Barclays sold the option only to Renaissance, the Senate report found.

In all, those offerings added up to more than $100 billion in trades, and tens of billions in profits. Renaissance itself accounted for roughly 40 percent of the basket options purchased from Deutsche or Barclays during that 15-year span. The Senate report also discusses another hedge fund, George Weiss Associates, that took less advantage of the accounts.

The trades that occurred in those accounts were essentially the same as the trading hedge funds did with their own brokerage accounts, the Senate report says. The difference, Levin said Monday, was the “sort of alternative universe” the hedge funds and banks created that helped lower Renaissance’s tax bill.

In general, the banks would open an account that had a basket option — a group of securities cobbled together, much like the products that contributed to the 2008 financial crisis.

But while the account was in the banks’ name, the hedge fund did all the heavy lifting, when it came to managing the stocks involved.

The Senate report says hedge funds made millions of trades within the basket options set up by the banks. In all, 97 percent of the assets involved in those trades had been held for less than six months.

But because the banks technically owned the broader collection of assets, those trades were not subject to the higher tax rate for short-term capital gains — which was 35 percent for most of that 15-year span, and now stands close to 40 percent.

Instead, hedge funds would generally wait to cash in their option with the banks after a year, at which point they got to pay the lower rate for long-term capital gains.

That rate was lowered to 15 percent under President George W. Bush, before being hiked back to 20 percent in the “fiscal-cliff” deal.

The set-up also allowed banks to skirt a loan limit for stock trading, giving hedge funds a higher amount of leverage that Renaissance now points to as a legitimate business reason for the accounts.

In 2010, the IRS issued a legal memorandum that essentially said investors couldn’t pay the lower capital gains rate on the accounts set up by Deutsche and Barclays.

According to the report, Barclays continued to sell the options to Renaissance for an additional two years, while Deutsche stopped setting up the accounts. Now, both banks offer those options with an expiration date of less than a year, forcing investors to pay the higher tax rate. 

Still, Levin said Monday that the IRS should be more aggressive in auditing the hedge funds that took part in the basket options. The Government Accountability Office said this year that 99 percent of the tax returns filed by large partnerships like hedge funds haven’t been audited — a far lower percentage than large corporations.

In fact, Levin said that the IRS’s actions, and their continuing fight with Renaissance, underscored that a range of agencies needed to more fight back more forcefully against these sorts of issues.

Levin said Monday that the Treasury Department should also issue more strident warnings against these sorts of deals, and that regulators should take a deeper look at the increased leverage that could pose risks to the broader financial systems. Lawmakers could also remove some of the obstacles the IRS faces in auditing hedge funds, the report added.

“To say they have not moved swiftly is an understatement,” Levin said about the IRS’s review of Renaissance. “They need to move on this.”