Senate Committee Questions Hedge Fund, Banks on Basket Options

At a July 22, 2014 hearing held by the Senate Permanent Subcommittee on Investigations, Chairman Carl Levin (D-MI) questioned representatives of the hedge fund Renaissance Technologies LLC and its bankers, Deutsche Bank AG and Barclays PLC, about whether complex financial options were used to reduce the hedge fund's tax bill and enhance leverage. The Senators acknowledged that the transactions had non-tax business purposes and were not done solely for tax purposes. While the Senators questioned the characterization of the transactions for tax purposes, most of the witnesses defended the reported characterization as consistent with the law.

The hearing revolved around a transaction described in a 2010 Generic Legal Advice Memorandum, or "GLAM," where the IRS asserted that such options really reflected beneficial tax ownership of the underlying stock positions reflected in the option and legally owned by the banks, because in part, the General Partner of the Hedge Fund controlled the decision as to which stocks were reflected in the options and controlled when stocks in the account were purchased and sold. Renaissance executives at the hearing acknowledged that the IRS has been looking at the these options for nearly six years, but still has not reached a decision as to the ultimate tax treatment of the options. The banks reportedly still offer such options, but they have been structured to limit their term to one year or less to eliminate any long-term treatment.

Senator Levin and Ranking Member John McCain (R-AZ) also suggested that lack of tax audits of large partnerships contributed to potential tax avoidance. According to James R. White, Director of tax issues for the Government Accountability Office, the IRS audits less than one percent of large partnerships and in the majority of cases an audit results in no change to the reported taxable income of the partnership. Further, White testified that because of complex tax audit rules imposed on partnerships it was very difficult to trace through and impose any tax adjustment on the actual taxpaying partners through tiers of partnerships.

At the conclusion of the hearing, Senator Levin suggested that regulatory agencies, including the SEC and IRS, need to pay more attention to such transactions, that partnership audit procedures should be revised, and perhaps the proposal of House Ways Means Chairman, Dave Camp, to market financial derivatives should be adopted to eliminate the alleged abuse.

See: Abuse of Structured Financial Products: Misusing Basket Options to Avoid Taxes and Leverage Limits (July 22, 2014).