Last week, a Senate subcommittee held a hearing with representatives from Barclays, Deutsche Bank, and Renaissance Technologies. (You can watch a video of the hearing on the subcommittee’s website.) The goal was to investigate their use of a financial product known as basket options. For the last fifteen years, banks have made huge profits from selling of these basket options to hedge funds. What makes them so valuable? In short, they’ve helped hedge funds save billions in taxes.
“Appropriate Under Current Law”
Representatives at the hearing contested that their use of basket options was not intended as a tax avoidance strategy. A spokesman of Renaissance Technologies, Jonathan Gasthalter, told the subcommittee, “We believe that the tax treatment for the option transactions being reviewed by the PSI is appropriate under current law. These options provide Renaissance with substantial business benefits regardless of their duration.” Renaissance Co-CEO, Peter Brown emphasized that basket options were valuable primarily because they provided a higher level of security to his company’s investments. “On an unlevered basis, our models produce modest returns with very low volatility,” he told the subcommittee.
However, a 93 page report by the Senate’s Permanent Subcommittee on basket options calls the validity of these statements into question. The information presented showed that the arrangement creates the ability for hedge funds to save billions in taxes. In fact, the IRS issued a warning to banks against the sale of basket options; while Deutsche Bank complied with the warning immediately, Barclays continued selling them until last year.
How Basket Options Work
Typically, hedge funds will purchase stocks outright and trade them at their discretion in order to make a profit. In the case of basket options, banks remain the legal owner of a group of stocks, while the hedge fund is said to be merely advising the bank on trades of said stocks. In reality, the hedge fund is conducting rapid trades, sometimes between 26 and 39 million.
So where do the tax savings come in to play? Basket options take advantage of the huge difference between the tax rate on long-term and short-term capital gains. Short-term capital gains are taxed at a rate of up to 44.4% while long-term capital gains are typically taxed at a rate closer to 23.8%. By claiming that hedge funds neither own nor trade a group of stocks, basket options essentially disguise short-term capital gains as long-term ones, thereby lowering the tax rate on their earnings.
The Future of Basket Options, Hedge Funds, and Big Banks
According to the Senate subcommittee that held the recent hearing, basket options allowed Renaissance Technologies to save $6.8 billion in taxes over the last decade and a half. Demand for the financial product helped banks profit as well: Barclay’s and Deutsche Bank are reported to have earned over $1 billion in revenue from basket options.
While the Senate subcommittee does not have the power to impose penalties, its investigation is likely to lead to tightened legislation for banks and hedge funds. Last week’s hearing is just one of many recent moves to close tax loopholes for wealthy investors. If subcommittee members gain the traction that they are hoping for, legislators will place tightening restrictions on hedge funds at the top of their agenda.