DALLAS, TX--(Marketwired - Jul 29, 2014) - This week, the Senate's Permanent Subcommittee on Investigations held a hearing to question leaders of major banks and hedge funds about an alleged tax avoidance strategy. According to the Senate's report, these entities have used basket options to skirt billions in federal income tax. The hearing comes on the heels of several high-profile tax avoidance scandals involving Deutsche Bank and Barclays. Some financial experts predict a wave of conservative investment options as hedge funds and major banks endure tight government scrutiny.
At Tuesday's Senate committee hearing, representatives of Renaissance Technologies LLC, Deutsche Bank, and Barclays Bank contested that their use of basket options was not intended as a tax avoidance strategy. The committee presented compelling evidence to the contrary, citing Renaissance Technologies' estimated $6.8 billion tax savings.
Senator Carl Levin, who chaired the committee investigation, said that basket options help banks establish an elaborate "fiction." When banks sell a basket option to a hedge fund, the bank remains the legal owner of the stocks in the basket option. The outcome is that hedge funds can rapidly conduct trades, accruing profits that are typically considered short-term capital gains. However, since the hedge fund is not considered the legal owner of the stocks in question, it simply owes tax on the long-term capital gains of its basket option.
"The difference in tax rate between short-term and long-term capital gains is about 20 percent," says attorney Joe Garza, who provides tax planning services to high net worth individuals in the U.S. and abroad. "That difference is what allowed Renaissance Technologies to add $6.8 billion in tax savings to its $34 billion in total trade profits." Demand for basket options is also what generated about $1.1 billion for Barclays and Deutsche Bank over the last 15 years.
Garza says banks like Barclays are reaching the end of an era. "Barclays has left a trail of scandals over the few years, ranging from the Libor rigging scandal to its manipulation of gold prices. Policy makers are scrutinizing the actions of big banks. They're ready to crack down wherever they can."
The Senate subcommittee that conducted the recent hearing does not have the power to impose penalties. But changes could still be eminent for major financial institutions. The subcommittee's primary function is to recommend changes to the law. Garza predicts that under its influence, hedge funds will look a lot different by the end of the decade (to learn more about hedge funds, watch Garza's presentation above). "Policy makers will want to tighten up the language surrounding stock ownership and long-term capital gains. Their goal will be to prevent financial institutions from playing with those definitions. In the meantime, regulators will be watching the banks like hawks."
At the Senate subcommittee hearing, Senator John McCain asserted that "Americans are tired of seeing Wall Street firms playing by a set of rules other than those applying to ordinary citizens." According to the Wall Street Journal, the rules are lightly enforced for hedge funds, simply because auditing a partnership is such a massive undertaking. That's another area where Garza expects to see change.
"The IRS today lacks man power. But a commitment to regulation means it will have to bolster its forces," he explains. "As the IRS grows more vigilant, fewer risks will be taken on Wall Street, and investors will be offered more traditional ways to maximize their profits."
Joe Garza is a tax and estate planning attorney and the senior partner at Garza & Harris. His firm provides tax and estate planning, asset protection, and business succession services to over 2,000 clients around the globe.