Another Reason to Ditch the Capital Gains Preference–Games Lawyers (and Hedge Funds) Play
by Linda Beale
Another Reason to Ditch the Capital Gains Preference–Games Lawyers (and Hedge Funds) Play
Bloomberg today covers a story about another tax-shelter ploy by hedge fund billionaires to make themselves even richer at the expense of ordinary Americans who will have to pony up more (or be beset by a bigger deficit) when the billionaires don’t pay their fair share of taxes. See Zachary Mider & Jesse Drucker, Simons Strategy to Shield Profit from Taxes draws IRS Attack, Bloomberg (July 1, 2013).
As the article notes, the IRS is challenging a tax-lawyer alchemy for converting ordinary hedging income to preferentially treated capital gain income by using a bank as an accommodation party to a derivative transaction–the bank buys the portfolio that the hedge fund wants to own, the bank then hires the hedge fund to manage the portfolio just as the hedge fund would do if it were the legal owner rather than the beneficial owner (which it probably should be considered under general tax principles, with the result that the hedge fund “manages” the purported bank portfolio by engaging in almost daily trades, as is a hedge fund’s practice, and then the bank purports to sell an option on the portfolio to that very same hedge fund (surprise! 🙂 !) and then the hedge fund exercises that option (quelle surprise!) more than a year after its purchase and claims thereby to have converted its trading gains (ordinary income) into an investment contract gain (Ipreferentially taxed capital gains).
This is the reason that most derivatives are such a financial scam. They are merely an artificial way for banks to make more money than they should by accommodating other parties in practicing banking alchemy–doing artificial stuff that doesn’t do the economy any good, produce any goods, or create economic growth that extends to non-banksters. In fact, it does actual harm by assisting other big financial players (in this case, hedge funds and, in particular, hedge fund employees) in scamming the system for no reason other than to reduce their taxes. Simons and Renaissance employees own nearly all of the fund in this case. Id. This is what we can continue to expect from the “greed is good” and “I got everything by my own merit [HA!] but just let me get by with another scam while also subsidizing me with “too big to fail” bailouts” generation of financial institutions and “shadow” financial insitutions like the hedge funds. Hedge funds aren’t very good for investors (see, e.g., this item showing that hedge funds return less than the S&P 500 on average–considerably less), but they make good money for their managers–especially when they engage in derivatives to turn ordinary income into preferentially taxed capital gain.
Thankfully, the IRS has challenged the scam, utilizing the core tax principle of “substance over form”. See the November 2010 Chief Counsel Memorandum noting that the contract does not function like an option and since it provides the benefits and burdens of ownership to the hedge fund and not to the bank, the hedge fund is treated as the beneficial owner for tax purposes. But remember that the IRS Is underresourced and outmanned by the lucratively compensated tax advising teams for funds and other wealthy institutions. “If they [the hedge funds] win, that will signal to the rest of the hedge-fund community that aggressive strategies can work.,” said Steven Rosenthal from the Urban Institute (a former tax partner at Ropes & Gray).
Related articles
tax breaks for wealthy; corporate tax shouldn’t be reformed away; seed patents are a real scandal
Simons Strategy to Shield Profit From Taxes Draws IRS Ire – Bloomberg
I hope the IRS nails them to the wall. Transparently phony transactions and shell corporations should be considered money laundering, and everyone involved jailed.
A perfect example of the hypocrisy of those calling for simplifying the tax code. There was a time that the code was relatively simple, and the simple code was exploited, more regulations issued to prevent that exploitation.
This is why we can’t have nice things.
I’ve often wondered whether the “better” law schools teach their students how to uphold the law or how to to circumvent the law.
the hedge fund gains aren’t ordinary income; they’re short term capital gains and other investment income taxed at the ordinary rate. But it’s portfolio income, not trade/business income.
@ Jack: no, they don’t teach circumvention. they teach the law, and you pick up tax planning when you practice.
from the practitioner’s standpoint, btw, this strategy was pretty neat. obviously aggressive from an audit standpoint, and probably doomed to fail, but still pretty neat. one of those ideas best discussed and admired but not implemented, since the economic substance doctrine was always going to be used to defeat it.