A former Cold War code breaker may have cracked the tax code for hedge funds.
James H. Simons, who became a billionaire when he turned his extraordinary mathematical ability from defense work to investing, has deployed an unusual strategy at Renaissance Technologies LLC to skirt hundreds of millions of dollars in taxes for himself and other investors, said people with knowledge of the matter.
The IRS is challenging the technique, which it called “particularly aggressive,” without identifying the hedge fund in the dispute. It is demanding more tax payments from investors in Renaissance’s $10 billion Medallion fund, the people said.
Renaissance sought to convert profit from Medallion’s rapid trading into long-term capital gains, said the people, who spoke on condition of anonymity because the dispute hasn’t been made public. The top federal rate on long-term gains is about half that on short-term. Versions of the strategy, which involved shifting ownership of Medallion’s portfolio to banks including Barclays, were used for most of the past decade, one person with knowledge of the matter said.
The case highlights how hedge-fund and private-equity managers use loopholes to exploit the government’s preferential treatment for long-term investing income. If East Setauket, New York-based Renaissance prevails in its legal dispute with the IRS, dozens of other funds would probably take steps to mimic the firm’s strategy, according to tax advisers. ...
The disagreement between the IRS and Renaissance traces back at least to 2010, when the IRS publicly criticized an unnamed hedge fund for using the strategy. It was referring to Medallion, the people said. ... The IRS contends that Medallion’s arrangement with the banks, in which the fund owned option contracts rather than the underlying financial instruments, is a ruse and that the fund investors owe taxes at the higher rate. Renaissance takes the position that the trades were not tax-motivated, were consistent with current law and were done for legitimate business reasons, according to a person with knowledge of the matter. ....
A proposal this year from U.S. Representative Dave Camp, a Michigan Republican and chairman of the House Ways and Means Committee, would eliminate any possibility that the Renaissance technique could generate tax savings, Rosenthal said. That proposal, a plank in Camp’s effort to overhaul the tax code, would prevent owners of derivatives such as options from earning any long-term capital gains.
The top federal rate on long-term capital gains, derived from selling investments held for more than a year, is currently 20%, compared with 39.6% imposed on wages and investments of less than a year. Before this year, the short-term rate was 35% and the long-term was 15%. The Medallion fund trades stocks and futures so frequently that, absent the tax maneuver, it would generate mostly short-term gains, said the people with knowledge of the matter.
Although tax experts said some of the specifics of Renaissance’s strategy are unusual, figuring out ways to convert a hedge fund’s trading profits into income taxed at the lower, long-term gains rate is one of the holy grails for tax planners. “It’s been going on since there’s been hedge funds,” said David Weisbach, a tax professor at University of Chicago Law School.
One increasingly popular technique is to set up an offshore insurance company that in turn makes the hedge fund investment, as top executives at billionaire John Paulson’s firm did last year. The move was the subject of a Bloomberg News report in February. ...
Renaissance’s strategy involved buying an instrument called a “basket option contract,” from banks including Barclays, the people said. IRS lawyers released an 11-page memorandum in 2010 describing the technique and outlining what they called a “particularly aggressive” example, without naming Medallion and Barclays. The purpose of the memo was for top IRS attorneys in Washington to notify staff in the field about a newly discovered tax-avoidance technique. The IRS had been tipped off to the practice in 2008 by examiners from the U.S. Securities and Exchange Commission. ...
Renaissance’s legal team in the dispute includes Kenneth W. Gideon, a former IRS chief counsel and former assistant Treasury secretary for tax policy. He’s now a partner at Skadden Arps Slate Meagher & Flom LLP in Washington. Gideon declined to comment, other than to confirm he is counsel to Renaissance in an IRS dispute.
Edmund S. Cohen, a lawyer at Winston & Strawn LLP in Washington, helped Renaissance set up the trades and supplied a legal opinion stating that the arrangements complied with tax laws, the people with knowledge of the matter said. Cohen declined to comment.
Tax planners started using derivatives to convert hedge funds’ short-term gains to long-term gains in the 1990s, said Alex Raskolnikov, a tax professor at Columbia University Law School. Congress tried to close the loophole in 1999, enacting a law allowing the IRS to disregard the tax effect of some derivatives, such as swaps and forwards, if they were economically akin to owning the fund directly.
As described in the 2010 IRS memo, the basket option contract used by Renaissance represents an “end run”
around the 1999 law, said Robert N. Gordon, president of Twenty-First
Securities Corp., which advises clients on the tax implications of
investments. Although the transaction is technically an option, it’s
structured in such a way that it is economically almost identical to
owning the portfolio, he said. “We would love to have something
to get long-term gains out of a hedge fund,” Gordon said, adding that
the option described in the memo probably runs afoul of the 1999 law.
“This thing doesn’t work.”...
Simons and his wife, Marilyn, gave $9.6 million to Democratic groups
in 2012, including a “super-PAC” that backed President Obama, according
to data compiled by the Center for Responsive Politics. During the same election cycle, Robert L. Mercer, the firm’s co-chief executive officer, gave $5.4 million to mostly Republican groups, the data show.
has spent more than $2 million since 2002 lobbying Congress and the
Treasury Department on taxes, according to lobbyist disclosure forms.
Some of the lobbying has been for unspecified “tax issues affecting
hedge funds.” None of the disclosure forms mention the IRS dispute.