Barclays and Deutsche Bank helped more than a dozen hedge funds avoid paying more than $6 billion in taxes on securities trades through the use of structured financial products, according to a Senate report due out Tuesday.
The report from the Senate Permanent Subcommittee on Investigations arrives as the Obama administration urges lawmakers to take action to stop American companies from reincorporating overseas in order to lower their tax bills, a practice known as tax inversion.
Multinational corporations have become skilled at exploiting loopholes to shift their tax burden to countries with lower rates and hiding portions of their global profits from taxation. The report shows that a number of firms are also relying on Wall Street banks to execute transactions in a way that allows them to circumvent federal taxes.
“These banks and hedge funds used dubious structured financial products in a giant game of ‘let’s pretend,’ costing the Treasury billions and bypassing safeguards that protect the economy from excessive bank lending for stock speculation,” Sen. Carl Levin (D-Mich.), chairman of the subcommittee, said at a news conference Monday.
At the heart of the report is the use of “basket options,” derivatives with a payoff that is tied to a pool of assets such as stocks, commodities or securities. Deutsche Bank and Barclays sold 199 of these options between 1998 and 2013 to hedge funds, which used them to conduct more than $100 billion in trades, according to the report.
The findings of the investigation will be the subject of a Senate panel hearing Tuesday, where senior executives from Barclays and Deutsche Bank are scheduled to testify.
The subcommittee staff focused on options involving the largest users, Renaissance Technologies (RenTec) and George Weiss Associates. Deutsche Bank and Barclays used the options structure to open accounts for their clients in their own names, creating the illusion that they owned the assets. But in fact, the hedge funds exercised complete control over the assets, executed all the trades and raked in all of the trading profits, according to the report.
The hedge funds exercised the options soon after the one-year mark and claimed that the trading profits were eligible for the 20 percent (previously 15 percent) tax rate that applies to long-term capital gains on assets held for at least a year. The report contends that those options were actually short-term trades that should have been taxed at the ordinary income rate of 39 percent, which would otherwise apply to investors in hedge funds engaged in daily trading.
In one instance, RenTec claimed that it could treat its trading profits as long-term gains, though it executed an average of 26 million to 39 million trades per year and held many positions for a few seconds, according to the report. RenTec spokesman Jonathan Gasthalter said the tax treatment of the options was legal.
“These options provided Renaissance with substantial business benefits regardless of their duration,” he said in an e-mail. “The IRS already has been reviewing these option transactions for over six years, and Renaissance has cooperated fully with both reviews.”
According to the report, the options structure also allowed hedge funds to borrow larger amounts of money to trade and exceed the federal leverage limits. Investors under the average brokerage account are only permitted to borrow $1 for every $2 in the account. But RenTec, in one instance, was able to borrow as much as $17 for every $1 in the account, the report said.
For their part, Deutsche Bank and Barclays pulled in at least $34 billion in revenue from options exercised by their clients after more than one year, according to the report. Investigators say most of those profits came from assets that were held for less than one year but were treated by the hedge funds as having produced long-term capital gains taxable at the lower capital-gains rate.
“These basket option deals were enormously profitable for the banks and hedge funds that used them,” Levin said. “But ordinary Americans have shouldered the tax burden these hedge funds shrugged off. Those same ordinary Americans would pay another price if the reckless borrowing outside of federal safeguards were to blow up.”
A 2010 memo from the Internal Revenue Service raised concerns about the use of basket options to claim long-term capital gains. In the wake of the report, many firms ceased offering the niche product, including Deutsche Bank.
The German bank inherited the product line when it acquired National Westminster Bank in 1998. By the bank’s own estimates, only about 10 clients used the options. Deutsche Bank spokeswoman Renee Calabro said the options “were at all times fully compliant with applicable laws, regulations and guidance.”
Barclays had only one client using basket options. Spokesman Mark Lane also said that his bank has been fully compliant with the law, as did George Weiss spokesman Stephen Labaton.
The Senate subcommittee, led by Sens. Levin and John McCain (R-Ariz.), has investigated multinational corporations, including Apple, Microsoft and Hewlett-Packard, for hiding portions of their global profits from taxation.
A recent report from the Congressional Research Service found that 47 U.S. companies have reincorporated overseas since 2003, nearly double the amount that did in the 20 years prior. The legal loophole has resulted in the loss of billions of dollars in revenue, according to Levin, who introduced a bill to impose a two-year moratorium on tax inversions.
Earlier this month, Treasury Secretary Jack Lew threw his support behind the legislation at a conference in New York hosted by CNBC, calling for “economic patriotism.”