(Bloomberg) A Renaissance Technologies LLC hedge fund’s investors probably avoided more than $6 billion in U.S. income taxes over 14 years through transactions with Barclays Plc and Deutsche Bank AG, a Senate committee said.
The hedge fund used contracts with the banks to establish the “fiction” that it wasn’t the owner of thousands of stocks traded each day, said Senator Carl Levin, a Michigan Democrat and chairman of the Permanent Subcommittee on Investigations. The maneuver sought to transform profits from rapid trading into long-term capital gains taxed at a lower rate, he said.
“It meant enormous profit for both the banks and the hedge funds,” Levin told reporters yesterday in Washington. “Ordinary Americans had to shoulder a tax burden of billions of dollars, a burden that was shrugged off by those hedge funds.”
The panel urged the Internal Revenue Service to collect taxes from the fund’s investors at the higher rate that Americans pay on wages and salaries. It said Congress should remove legal obstacles to audits of hedge funds and other large partnerships, whose returns the committee said are rarely questioned.
Executives Testifying
Executives from Renaissance, founded by billionaire mathematician James Simons, are set to testify at a hearing today in Washington about the transactions, as are representatives of Barclays and Deutsche Bank. The report was issued by Levin and Senator John McCain of Arizona, the subcommittee’s top Republican.
“Americans are tired of seeing Wall Street firms playing by a set of rules other than those applying to ordinary citizens,” McCain said at the hearing.
In a statement today, Renaissance said it “is comfortable that its tax treatment of the options is correct under current law” and that it expects to prevail in a dispute with the IRS over the matter. It said its decision to use a product known as basket options wasn’t driven by the tax benefits.
Deutsche Bank in 2010 stopped selling versions of the basket option that had tax-saving features, after the IRS publicly challenged the practice.
Barclays stopped in 2013, although Renaissance is still using three options from the bank that were provided before the policy change, the subcommittee said.
Apple and Caterpillar
Levin’s subcommittee doesn’t have authority to impose penalties, and it often examines business practices with an eye toward recommending changes in law. Recent hearings have focused on tax-avoidance maneuvers by Apple Inc. and Caterpillar Inc.
Renaissance, based in East Setauket, New York, compiled one of the best records in investing history by using advanced mathematics and computer algorithms to identify mispriced securities. Its Medallion fund, open almost exclusively to Renaissance employees, returned more than 35 percent annualized over more than two decades.
The fund manager has created fortunes for its top executives, who are also among Medallion’s biggest investors. Simons’s fortune is estimated at about $15.5 billion, according to the Bloomberg Billionaires Index. He’s a prominent political donor, contributing more than $9 million to Democratic causes in the 2012 election cycle.
The panel’s report focuses on basket options, which a hedge fund would buy from a bank. The value of the option would fluctuate based on the performance of a basket of underlying securities, and the hedge fund manager could buy and sell the stocks in the basket.
Brokerage Account
Economically, the trades were similar to a hedge fund holding the securities in a brokerage account, the subcommittee said.
Because the bank was designated as the legal owner of the underlying stocks, the hedge fund didn’t need to recognize a short-term gain when it sold a security. Instead, it would claim a long-term gain when it exercised the option, typically after more than a year.
Under current law, profits from short-term capital gains are taxed at marginal federal rates of as much as 44.4 percent, compared with a 23.8 percent top rate for long-term gains. For some earlier years, the rates were 35 percent and 15 percent.
Illustrating how rapidly the contents of the “baskets” were shuffled, one option reviewed by the committee had more than 129 million underlying trades in a single year, the subcommittee said. Many of Renaissance’s stock investments lasted mere minutes or seconds, it said.
Trade Suggestions’
The hedge funds that used the options sought to portray their involvement in the trading of the underlying portfolio as mere “suggestions” or “recommendations,” the subcommittee said. The panel said in Renaissance’s case, the trades were ordered by the firm’s computers and automatically executed by its banks, a process that took milliseconds.
The panel said Deutsche Bank and Barclays together sold 199 basket options since 1999, including 127 that had the potential to generate long-term capital gains. The options produced $1.1 billion of revenue for the two banks, according to the report.
The 60 options with tenures of more than a year sold by the two banks to Renaissance’s Medallion Fund generated profits of about $34.2 billion, according to the report. Based on the difference between the short-term and long-term rates, the panel estimated the tax saved on those profits at $6.8 billion.
George Weiss
In addition to Renaissance, about a dozen other hedge funds are known to have used basket options sold by Deutsche Bank, according to the report. Among the biggest users was George Weiss Associates, run by the Hartford, Connecticut, philanthropist George A. Weiss, the report said.
In a statement, George Weiss Associates said its basket options, which it stopped using in 2010, were lawful and were used to increase the amount it could borrow. It said it cooperated with the subcommittee’s investigation.
Another user of Deutsche Bank basket options was SAC Capital Advisors LP, the hedge fund run by billionaire Steven A. Cohen, the report said. Once one of the country’s top hedge funds, SAC stopped managing money for outside investors and changed its name to Point72 Asset Management LP this year after pleading guilty to securities fraud in an unrelated matter.
In a statement, Point72 said it didn’t report income earned from its basket options as long-term capital gains.
Renaissance’s use of basket options originated in an effort in the late 1990s to obtain more borrowed money to bet on stocks than it could get through regular brokerage arrangements, the firm said in a statement today.
Risk Limited
The options also were attractive because they limited the risk of loss to the amount paid for each option, Renaissance said.
“No other investment structure of which we are aware provides both high leverage and loss protection,” Renaissance said.
IRS action on the Renaissance matter is “long overdue,” Levin said yesterday. “To say they haven’t moved swiftly is an understatement.”
Renaissance’s Brown Says Risk Controls Led to Scrutinized Trades
Renaissance Technologies LLC’s desire to limit market risk drove it to use financial products under scrutiny by a U.S. Senate panel for their potential tax benefits, said co-Chief Executive Officer Peter F Brown.
The products also let the hedge fund borrow more money to bet on stocks, Brown said in a prepared statement for a hearing today by the Senate Permanent Subcommittee on Investigations. A report by the subcommittee said the instruments may have helped Renaissance avoid more than $6 billion in taxes.
“The world is littered with financial institutions that failed after putting too much trust in their models,” Brown said in the statement. “We are determined that Renaissance not suffer such a demise. The barrier options we use provide precisely the protection we need.”
The computer-driven trading firm routed more than $34 billion through financial products known as basket or barrier options, subcommittee said. The panel said Renaissance contended the profits from most of the options could be taxed at a preferential lower rate.
Renaissance’s Medallion fund bought the options from Barclays Plc and Deutsche Bank AG over the past 14 years. The options provided Renaissance with profits from a basket of securities owned by the banks. The banks paid Renaissance to manage the securities.
If the options were held for more than a year, Renaissance would pay taxes at the preferential lower rate on long-term capital gains, even when the options’ value was linked to millions of rapid trades in the basket of securities.
Capital Gains
Under current law, profits from short-term capital gains are taxed at marginal federal rates of as much as 44.4 percent, compared with a 23.8 percent top rate for long-term gains. For some earlier years, the rates were 35 percent and 15 percent.
Compared with a prime brokerage account with a bank, the options offered two main benefits, Renaissance said today in a separate statement. It could get more borrowed money, or leverage, from the banks to bet on stocks, Renaissance said, and its losses were limited to the up-front purchase price of the option.
“These go hand in hand, because when trading with leverage, a single mistake can be disastrous for our firm,” Brown said in the statement.
Brown said he learned a lesson in market risk in March 2000, during a stock-market rout driven by the collapse of technology stocks.
More Valuable’
“In a very short period we took very large losses,” he said. “Not having slept for days and being incredibly distraught by the losses, I offered to resign, but my boss at the time rejected my offer, telling me, You are now far more valuable, because you now know never to put your full faith in a model.’”
Renaissance’s Medallion fund, with more than $9 billion under management, uses computer algorithms to identify small discrepancies in markets and profit from them. The fund is open almost exclusively to fund employees.
Renaissance was founded by the mathematician James H. Simons, whose fortune is now estimated by Bloomberg Billionaires Index at about $15.5 billion.
Brown became co-CEO with Robert L. Mercer in 2010 after Simons retired and became non-executive chairman. Before joining the firm in 1993, he was a language-recognition specialist at International Business Machines Corp.
