This week the Senate Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs (Subcommittee), in conjunction with the Subcommittee’s hearing on July 22, 2014, released a report on hedge funds’ use of financial derivatives considered abusive. In its report styled “Abuse of Structured Financial Products: Misusing Basket Options to Avoid Taxes and Leverage Limits,” the Subcommittee recommends that the Internal Revenue Service (IRS), the Financial Stability Oversight Council (Council) and other federal financial regulators take steps to examine complex financial arrangements that are perceived to facilitate the underreporting of taxes and inflict untoward risks upon the U.S. financial system. Specifically, the report focuses upon certain basket option structures sold by financial firms that ostensibly allow their hedge fund clients to circumvent federal taxes, by recasting short-term capital gains as long-term capital gains, and avoid otherwise applicable leverage limitations. The Subcommittee examined basket option contracts used by 13 hedge funds to conduct more than $100 billion in securities trades, focusing upon two of the funds as case studies.

The Subcommittee’s recommendations include:

• The IRS should audit the hedge funds purchasing these basket option products and determine additional taxes owed.
• Federal financial regulators should, in an effort to end bank involvement with abusive tax structures, intensify their efforts and actions to penalize bank participation in tax-motivated transactions.
• The Council, together with other agencies, should establish new reporting and data collection mechanisms to analyze the use of derivatives and structured financial products that facilitate circumvention of federal leverage limits.
• The federal statutes and regulations regarding the audits of large partnerships, like hedge funds, should be revised.

The Basket Options

The basket options that are the subject of the Subcommittee’s report and the July 22 hearing are synthetic derivatives linked to underlying portfolios of assets that, in the Subcommittee’s view, are the functional equivalent of a prime brokerage account. While the Subcommittee casts a wide net, referring generally to derivatives that have been used by taxpayers to lower their taxes by taking advantage of “economic imperfections in the tax law,” the derivatives that are the subject of the report were designed and issued by the sponsoring banks as options to be held by hedge funds. In these arrangements, the hedge fund client purchased an “option” from the bank, the economics of which were tied to the performance of a basket of assets (or “reference portfolio”) to be held in a designated trading account. The reference portfolio was funded in part by the hedge fund’s premium paid for the option and by leverage financing provided by the bank. The trading account was opened in the name of the bank and operated as the bank’s own proprietary trading account. The bank, however, appointed a representative of the hedge fund-client to serve as the investment adviser and to exercise control over the securities purchased and sold in the trading account. In other words, the hedge fund, as the option holder, was the party that controlled the trading strategy, the timing of trades, and the designation of assets selected for the reference portfolio. Later, generally more than one year after entering into the option, the hedge fund would choose to exercise the option, which was cash settled and provided a return based upon the performance of the basket of assets.

From the perspectives of the banks and their hedge fund clients, the options served as synthetic derivatives linked to portfolios of assets that did not involve the hedge funds’ direct ownership and trading of assets. In other words, under each option contract, the bank was regarded as the owner of the assets in the designated trading account. At the hearing, representatives of select financial institutions provided testimony that these structured arrangements had been fully vetted both in internal review processes, as well as by outside advisers.

The Perceived Abuses

The Subcommittee found two perceived “fictions” in these circumstances that led to tax and regulatory abuses. The first fiction was that the bank, rather than the hedge fund, owned the assets in the reference portfolio and that the hedge fund purchased merely an option, the economic performance of which was tied to the performance of assets in the bank’s proprietary account. The second fiction was that the hedge fund was regarded as having held an asset for a period of longer than one year, thus deriving long-term capital gains tax treatment, where the asset trading in the account was conducted on a short-term basis.

In the Subcommittee’s view, the option functioned as little more than a “fictional derivative” that facilitated the hedge fund’s treating short-term capital gains as long-term capital gains. Interestingly, while the Subcommittee suggests that this treatment confers upon hedge fund investors an improper tax benefit, those likely most affected are the fund sponsors entitled to carried interest, as the predominant portion of most hedge funds’ capital – though perhaps not that of the hedge funds at issue in the report – comes from non-U.S. investors and U.S. investors generally exempt from federal income tax.

The Subcommittee also found that the options enabled the participating hedge funds to trade on a leverage ratio of as much as 20:1, which exceeded the lower federal leverage limits under Regulation T that would apply if purchasing securities directly through a prime brokerage account. The Subcommittee somewhat ominously expressed its apparent frustration that “[a]lthough federal financial regulators have long been aware that derivative and structured products, including basket options, are being used to circumvent federal leverage limits, they have taken little or no action to limit those practices and enforce the statutory limits on purchasing securities with borrowed funds.” In his opening statement at the hearing on these investment structures, Sen. Carl Levin also alluded to over-leveraged arrangements as “reckless behavior that puts the stability of the financial system – and by extension, the U.S. economy – at risk.”

In light of those perceived tax and leverage abuses, the report calls upon federal regulatory agencies to take action. As to tax enforcement, the report specifically notes that the IRS’ audit coverage of large partnerships is “poor.” The call for more audit resources to be applied to partnership audits was repeated at the hearing, where Subcommittee members called on the IRS to step-up its efforts to audit hedge funds and other large partnerships.

Tax Enforcement Issues

In informal advice in 2010, the IRS concluded that a contract very similar to one of the contracts examined in depth in the Subcommittee report “does not function like an option, and should not be treated as such.” IRS AM 2010-005. The IRS also concluded that the hedge fund should be treated as the owner of the securities in the basket. Given that tax ownership can be a very fact-intensive issue and that the IRS’ position regarding this type of transaction has not been tested in the courts, the Subcommittee report offers up various common law doctrines, such as the substance over form and step transaction doctrines, as additional bases upon which the IRS should challenge these transactions. The IRS, though, may find it difficult to rely upon those common law doctrines, which normally are invoked to recharacterize transactions structured in a certain manner solely to avoid taxes. Here, the option transactions afforded the hedge funds the use of leverage not otherwise available, which allowed the funds to realize incrementally larger profits. Further, any IRS challenge to these transactions engaged in by hedge funds (regarded as partnerships for federal tax purposes) would likely be governed by the so-called TEFRA audit provisions in the Internal Revenue Code. Those rules are often beneficial to the IRS, but they are extremely intricate and would likely further complicate any IRS challenge.

Wrap-Up

Given the increased scrutiny of complex financial structures, financial institutions selling, and hedge funds (including their sponsors) using, basket options or other synthetic derivatives must remain vigilant to the tax positions taken and to related disclosure and accounting considerations.