U.S. Examines Derivatives Structures Used for Tax Avoidance

The U.S. Senate Permanent Subcommittee on Investigations has accused Barclays and Deutsche Bank, along with at least 13 hedge funds, of misusing basket options in order to save approximately $6 billion in taxes over the course of 2000-2013, and these firms also used these options to avoid leverage limits.
By Jake Safane(2147484770)
The U.S. Senate Permanent Subcommittee on Investigations has accused Barclays and Deutsche Bank, along with at least 13 hedge funds, of misusing basket options in order to save approximately $6 billion in taxes over the course of 2000-2013, and these firms also used these options to avoid leverage limits.

The chairman of the subcommittee, Senator Carl Levin (D-Michigan), and ranking minority member Senator John McCain (R-Arizona) issued a report on the matter, prior to testimony last week from Barclays and Deutsche Bank. In the report, the senators outline how from 1998-2013, these banks sold 199 basket options to hedge funds, which used the options conduct over $100 billion in securities trades, most of which were short-term transactions.

However, says the report, the banks and hedge funds used the option structure to open proprietary trading accounts in the names of the banks in order to seem as though the banks owned the account assets and had control over them, even though the hedge funds had control by way of the bank appointing the general partner of the hedge fund client to act as the investment advisor for the account holding the underlying 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,” says the report.

After a year, the hedge funds would then often exercise the options and claimed the trading profits were eligible for the lower tax rate that comes with long-term capital gains. Yet funds executed an average of 26 to 39 million trades per year, sometimes holding positions for only seconds, says the report.

In addition to avoiding taxes, the report alleges that the banks and hedge funds avoided federal leverage limits through this account structure. If hedge funds traded in a normal brokerage account, they would have been subject to a leverage limit of half the amount of holdings. Yet because the option accounts were in the name of the banks, it seemed as though the banks were transferring their own money into their own proprietary trading accounts, rather than lending to hedge funds, says the report. As a result, hedge funds were able to add significantly more leverage.

In their testimony, Barclays and Deutsche Bank affirmed that they acted appropriately legally, in part because the IRS only issued an opinion in 2010 prohibiting the use of basket options to claim long-term capital gains.

“Although the IRS issued generic legal advice in 2010, it is my understanding that this type of legal advice does not set out official rulings or positions of the IRS and may not be referenced in other documents as precedent,” said Marty Malloy, managing director and head of Barclays’ European Prime Services, in his testimony to the subcommittee. “Since the issuance of the advice, the IRS has issued no further guidance or decision on these transactions.”

Going forward, the subcommittee issued the following four recommendations:

1) The U.S. Treasury, IRS, and Congress need to make it clear that derivatives alone cannot lower tax liability, and to achieve this, tax regulations providing special benefits to derivatives, such as the U.S. source rule for swaps, whereby the source is determined by the residence of the taxpayer, should be revised or eliminated.

2) The Financial Stability Oversight Council (FSOC), working with the Office of Financial Research (OFR) and other federal agencies, should establish new reporting and data collection mechanisms to conduct an in-depth analysis of the extent of leverage in the U.S. financial system, the ways in which financial firms bypass federal margin rules and leverage limits, and the extent to which highly leveraged financial instruments and arrangements may create risk. Along with this analysis, Congress and the relevant agencies should look closely at how derivatives are used to circumvent accounting, tax, or regulatory rules, and look at what steps should be taken to prevent these uses, particularly as it applies to financial risk.

3) The U.S. should reform the Tax Equity and Fiscal Responsibility Act (TEFRA) to make it easier to audit larger partnerships. One possible amendment to TEFRA would be to allow the IRS, in the case of large partnerships, to notify the partnership itself regarding an audit and to rely on that partnership to notify the individual partners it deems appropriate.

4) Federal financial regulators and agencies need to intensify their warnings, scrutiny and legal actions against bank participation in tax-motivated transactions.

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