U.S. panel says Barclays, Deutsche Bank helped funds avoid taxes

WASHINGTON, July 21 Mon Jul 21, 2014 5:00pm EDT

WASHINGTON, July 21 (Reuters) - The head of a powerful U.S. Senate panel has accused Deutsche Bank AG and Barclays Plc of helping hedge funds avoid taxes, calling for tougher action from the authorities.

The banks sold complex option products to Renaissance Technology Corp that saved it and other hedge funds billions of dollars in taxes, Democratic Senator Carl Levin, who heads the U.S. Senate Permanent Subcommittee on Investigations, said on Monday.

"Ordinary Americans had to shoulder a tax burden of billions of dollars, a burden that was shrugged off by these hedge funds," Levin told a news conference.

"And those same Americans will pay the price as the excess risk from massive over leveraging once again destabilizes our economy as it has in the past."

Levin's committee presented the findings of a year-long probe into so-called basket options, which Levin said can be misused to lower taxes, and plans to grill representatives from the banks and Renaissance in a public hearing on Tuesday.

The hearing by one of the Senate's most high-profile panels comes less than a month after New York's attorney general filed a fraud lawsuit against Barclays, accusing the British bank of giving an unfair edge to high-frequency traders.

And Deutsche Bank, facing an array of investigations into the conduct of its staff that includes the Libor benchmark rate scandal, has set aside another 1.8 billion euros ($2.43 billion) to pay fines after already paying more than 5 billion euros over the past two years.

But Levin stopped short of accusing either bank or the hedge funds of doing something illegal, and Deutsche said the option products it offered were "at all times fully compliant with applicable laws, regulations and guidance."

A Renaissance spokesman said: "We believe that the tax treatment for the option transactions being reviewed by the (panel) is appropriate under current law. These options provide Renaissance with substantial business benefits."

Barclays also said it had been fully compliant with the law, and that it had cooperated with the committee.

FICTIONAL OPTIONS

The two banks enabled at least 13 hedge funds to conduct over $100 billion in securities trades, the panel said. The profits were taxed as long-term capital gains, even though the positions were often held for only seconds. In the case of Renaissance alone, the fund paid an estimated $6.8 billion less in taxes because short-term trading profits are taxed at a much higher rate, the report said.

The products offered by the banks were styled as options in an account that was nominally held by the bank, but was in fact controlled by the hedge funds, which bought and sold the assets, and profited from the trading, the report said.

The hedge fund then paid the lower tax rate on long-term capital gains, arguing that profits came from exercising the option, rather than from the underlying trades. But the options were fictional, the panel found.

The U.S. tax authority, the Internal Revenue Service, said in 2010 that basket options do not function like an option and should not be treated as such, but that opinion has no status as an official rule, and the IRS has not pressed any cases.

Renaissance has been debating the issue with the IRS for six years, the spokesman said. The two banks have now stopped offering the products, the panel said.

Levin's panel issued a number of recommendations from the report that were largely targeted at the IRS, urging it to audit hedge funds that used basket options, and calling for a change in legislation to make it easier to look at large partnerships such as hedge funds, which go largely unaudited.

"The IRS hasn't completed their review. It's about time they do. It's long overdue," Levin said.

Another problem with basket options was that they enabled funds to take on more debt than otherwise possible, potentially posing a risk to the overall financial system, the report said.

Renaissance used basket options to borrow 20 times as much money as was put in the accounts. The fund had been unable to achieve such so-called leverage levels in other settings under federal rules, the report added.

($1 = 0.7397 Euro) (Reporting by Douwe Miedema. Editing by Andre Grenon)