I.R.S. Cracks Down on Hedge Fund Tax Strategy

http://www.nytimes.com/2015/07/09/business/dealbook/irs-cracks-down-on-hedge-fund-tax-strategy.html

by jgalt212 • 11 years ago

90 129 11 years ago

chollida1• 11 years ago

In my opinion this is a much better article on the subject.

http://www.bloomberg.com/news/articles/2014-07-21/renaissanc...

Essentially the US has a few different taxes you can pay as an investor. There is a short term tax on trading profits and a longer term holder tax for "investors" which is lower.

This obviously creates a situation where people will do their best to make their trading fall into the later category.

What Deutsche did was to sell hedge funds an option on a basket(collection) of stocks that was held longer than a year. Not surprisingly, a year is long enough to qualify for hte lower long term investment tax on capital gains.

The IRS has called shenanigans on this and the below quote is probably the biggest reason why:

"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."

gohrt6• 11 years ago

The rules are deeply arbitrary, and goes to the nature of financials as being rather abstract concepts with arbitrary definitions.

I buy stock in a firm, that firm makes a lot of profit, but I don't liquidate my position. How is that different (short-term vs long-term gains) from me selling their stock and buying another stock?

It's even the same word: A retail business sells its stock (product), and sells it's stock (shares)

Ultimately, taxing "realized" gains can never be logical, since "realization" is a fictional concept not grounded in reality. Taxing consumption is relatively straighforward to describe (but hard to implement), and taxing wealth is slightly harder (since it's hard to mark the value of some assets)

eli• 11 years ago

The difference is the people who make the tax rules want to encourage one kind of behavior over another, regardless of anything else. You're free to think that's a fundamentally bad idea, but it isn't "arbitrary," it's the basic idea of Behavioral Economics.

tosseraccount2• 11 years ago

I buy a stock for $10. 2 years later, I sell it for $20. I get taxed on a $10 capital gains income tax.

How is this not "logical" ? Can you explain better?

dragonwriter14• 11 years ago

Ultimately, taxing "realized" gains can never be logical, since "realization" is a fictional concept not grounded in reality.

Trading an asset vs. holding it is a non-fictional concept very much grounded in reality.

Attributing significance to it is, in a sense, arbitrary in the same sense that any assignment of significance is, but its definitely not a fictional concept divorced from reality.

madez2• 11 years ago

    “A retail business (...) sells it's stock”

How is this to parse?

The contraction “it’s” means either “it has” or “it is”. So, the quoted expression expands either way to a syntactically malformed expression with two verbs.

Could it be intended to mean the following?

    A retail business’ (...) sells — it has stock

s73v3r2• 11 years ago

Stockholders who hold less than a year are going to have very different goals for the company than those who hold for several years. That's the difference.

JumpCrisscross• 11 years ago

A fairer way to resolve this might be letting Renaissance pay the long-term while Deutsche pays at least the difference between the short-term and the long-term rates. If Deutsche Bank wants to pay Renaissance's taxes for the latter, that's fine by me.

ISL2• 11 years ago

  U.S. Constitution, Article I, Section 9:
  No Bill of Attainder or ex post facto Law shall be passed.

How does that square with the article's

"The new I.R.S. guidance will be retroactive, applying to all transactions as far back as Jan. 1, 2011."

jeremyt• 11 years ago

Well, in this case the IRS isn't passing a retroactive law, they are clarifying the interpretation of an existing law.

tanderson9210• 11 years ago

The need to clarify the point implies that it was interpreted differently in the past. So this change in interpretation being applied retroactively is what the OP is concerned with.

whatgoodisaroad• 11 years ago

My guess would be that because this is "guidance" rather than a law or "bill" then this is not ex post facto application.

In other words, the law is and aways has been that one should pay the appropriate taxes. OTOH, guidance informs the IRS how to interpret market activity in the past and classify it as legal or illegal.

dragonwriter14• 11 years ago

Ex post facto laws are criminal laws making criminal acts that were not criminal before the law was passed, or increasing the criminal punishment for crimes committed before the law was passed.

Retroactive tax laws are not ex post facto laws, and, anyway, this isn't even a retroactive tax law, its a decision about the manner in which the IRS will apply a law already on the books, which is only sustainable to the extent to which it is, in fact, consistent with the law already on the books. Its essentially the IRS coming to the view that they have not been properly enforcing existing law, and that will change for enforcement going forward (there are limits to how far back the IRS can go in enforcement actions, which presumably is the basis for the 1/1/2011 date.)

ceejayoz• 11 years ago

No new law is being passed.

p0ckets• 11 years ago

The IRS doesn't pass laws, it's just issuing a guideline on how it will interpret existing tax law.

sneak• 11 years ago

But if those interpretations are authoritative and violation of the current IRS interpretation (but not the previous one) means you get prosecuted in federal court, how is that not effectively the ability to retroactively change laws?

alexbock• 11 years ago

I'm guessing the idea here is that the IRS is changing how they interpret their own internal policy for how they will use the powers given to them by an existing law, rather than outright passing a new law with retroactive effects.

...but that justification seems like a horribly slippery slope. If you accept that logic, what stops congress from passing a law that creates the "Criminal Investigation Service" and gives their director the power to make things illegal? Would he then be allowed to make a "policy change" retroactively making something illegal and arresting them for it?

edit: I think Peugh v. United States actually answers this. Retroactive application of changes to US sentencing guidelines by a government commission were ruled to be a violation of ex post facto protections.

DannyBee• 11 years ago

1. In the US, the supreme court has repeatedly held that the ex-post-facto clause only applies to criminal laws (See Calder v. Bull, which was decided in 1798).

This is actually consistent with the history of the clause (It was understood to apply to criminal laws. Motions were made to change the wording to say it also applied to civil cases, they were turned down)

2. This is not a law, and may not even be administrative rulemaking (depending on what exactly they issued)

Of course, even if it was, you have a mechanism to challenge it if they hold you to it: the courts.

ISL2• 11 years ago

If the IRS doesn't think I've paid my taxes, I can go to prison.

Doesn't that make this particular case a criminal one?

a3camero• 11 years ago

I wouldn't be so quick to buy into the modern idea that this prohibition was always aimed at criminal laws. Excerpted from a paper I wrote in law school on the topic (sources at end of post):

Newly independent Americans in the late 1700s were very concerned with “this shameful abuse of power”, “those engines of oppression”, ex post facto laws. American businessmen were concerned with the macroeconomic effects and unfairness of interference with contracts by provincial/state legislatures.

One of the shameful abuses was the “paper money laws” that changed outstanding debts by permitting payment in paper money where the contract originally called for the use of gold or silver. There was widespread fear of the drying up of credit (in the context of an ongoing major depression at the time) as a result of concern that loans might not be paid back due to legislative intervention.

The dictionary of reference in 1739, Giles Jacob’s Law Dictionary, defined “ex post facto” as “a Term used in the Law, signifying some Thing done after another Thing that was committed before”.

Check out these sources: William Winslow Crosskey, “The True Meaning of the Constitutional Prohibition of Ex-Post-Facto Laws” (1947) 14 U Chicago L Rev 539

Roger W Weiss, “The Issue of Paper Money in the American Colonies, 1720-1774” (1970) 30 J of Economic History 770

Elmer E Smead, “The Rule Against Retroactive Legislation: A Basic Principle of Jurisprudence” (1935) 20 Minn L Rev 775

Harold J Krent, “The Puzzling Boundary Between Criminal and Civil Retroactive Lawmaking” (1996) 84 Georgia L J 2143

W David Slawson, “Constitutional and Legislative Considerations in Retroactive Lawmaking” (48) California L Rev 216

pcurve• 11 years ago

Maybe all cap gains should just be taxed at the same rate. 1 year threshold his so artificial.

mikeyouse• 11 years ago

I think this is a fine idea.. Just tax them at whatever your marginal tax rate is less 5% and call it a day. The rich would howl at the suggestion, but it'd go a long way toward removing complexity.

dragonwriter14• 11 years ago

Just tax them at whatever your marginal tax rate is less 5% and call it a day. The rich would howl at the suggestion

Well, their accountants and financial advisers might, since their work of structuring things to make sure most gains are long-term and in the right categories would be less valuable. But cutting taxes for all taxpayers -- including the rich -- on short-term games, and for most taxpayers on several categories of long-term games, may not that widely object to by people paying capital gains taxes in the first place.

ska3• 11 years ago

I don't see how that is more artificial than taxing cap gains at a different rate than salary, or any number of other examples in the tax codes.

All of these things are done to change the incentives about something, you can't expect them to be consistent without reference to those goals (and even then...)

ska3• 11 years ago

really? I'm honestly confused at responding to this with downvoting.

dragonwriter14• 11 years ago

In a tax system with progressive marginal rates on annual income, treating income resulting from action over multiple years as earned in the year realized results in a artificial increase in the tax burden on those with that kind of income pattern. So, there's a sense in which treating capital gains earned over multiple years differently than capital gains earned over a single year or less (the latter taxed as general income), given the progressive nature of the tax system.

Of course, irregular income from other sources that isn't simple hourly work often also can result in windfalls from work over a longer period of time, or naturally intermittent so that an a large income one year is the result of a pattern of activity that also resulted in a smaller income other years. A simple way to address this that isn't specific to capital income is to tax all income equally, but allow, within certain bounds, income to be recognized for tax purposes, and associated taxes paid, in advance of realization and, perhaps in certain cases, deferred and recognized over a period of years after realization.

This would mitigate any overtaxing of cashing out events that took many years to "earn" the income, without favoring any particular kind of income or creating gameable thresholds.

tosseraccount2• 11 years ago

What about inflation?

JoshTriplett7• 11 years ago

There's a massive difference between the long-term and short-term gains rates. And, hedge fund folks aside, long-term capital gains are also the taxes that apply to retirees drawing income from years of investments. Raising those rates would cause serious problems for folks who have already done all their financial planning and investing, and cannot afford to pay higher taxes.

gnopgnip2• 11 years ago

Raising those rates would have very little impact for retirees as many are in the 15%-25% marginal tax brackets as it is.

dragonwriter14• 11 years ago

And, hedge fund folks aside, long-term capital gains are also the taxes that apply to retirees drawing income from years of investments. Raising those rates would cause serious problems for folks who have already done all their financial planning and investing

Raise them prospectively based on the date of asset purchase, starting some specified time after the date the change is adopted. Problem solved.

danhak• 11 years ago

And, hedge fund folks aside, long-term capital gains are also the taxes that apply to retirees drawing income from years of investments. Raising those rates would cause serious problems for folks who have already done all their financial planning and investing, and cannot afford to pay higher taxes.

Tax-sheltered vehicles such as IRAs and 401Ks already exist specifically for retirement. That's unrelated to the issue of preferential tax treatment for capital gains, which is not limited to retirees and is completely regressive, privileging those who already have access to capital over those who rely on their labor for income.

throwaway6497• 11 years ago

This made my jaw drop: "Its Medallion fund, which now manages money for its employees only, was the most prolific user of basket options. The fund has earned an average annual return of more than 35 percent for two decades."

$25 billion is all employees money; Even if we exclude Simon's money ($14 billion) it is a ton. 35% avg annualized returns for 20 years. Simply stunning.

Tycho6• 11 years ago

Actually the Medallion fund is only about $6 billion I believe. The rest of the money is managed in funds which are open to non-employees (and those ones don't make anything close to 35% annualised returns).

auntienomen3• 11 years ago

One other wibble: the 35% isn't the average, but rather the smallest annual return.

MagicWishMonkey• 11 years ago

Do you know which funds are available to non-employees?

discardorama• 11 years ago

The fund [Medallion] has earned an average annual return of more than 35 percent for two decades.

OK, can someone explain this? Most people say that "you can't beat the market in the long term", "market is efficient", etc. So how can these people have done so well over more than 20 years??

gphil2• 11 years ago

Because out of the many thousands of funds who attempt it, some are bound to end up beating the market. You can't know in advance which funds are going to the be the best over the next two decades.

Tycho6• 11 years ago

That's completely incorrect... the chances of a fund having that record through luck alone are astronomically low.

Tycho6• 11 years ago

Nobody really knows how they've done it.

But in order for markets to be efficient there needs to be lots of constant arbitrage, and anyone who pulls off an arbitrage trade makes a profit. So maybe the Medallion fund just does a lot of the arbitrage that makes markets so efficient.

hiou• 11 years ago

As far as I am aware the Medallion fund is not in any way publicly available. I believe it's an exclusive fund to a small number of investors who are involved directly with Renaissance. It would make a lot of sense to it's success as not having to scale past a certain point allows them to avoid a lot of uncertainty when taking models live.

joshstrange• 11 years ago

"you can't beat the market in the long term"

Without cheating that may be true.

logfromblammo2• 11 years ago

There are several plausible hypotheses.

My personal favorite is, "They trade on non-public information, and use a complex trade algorithm for the purposes of plausible deniability."

Another is, "They got lucky."

Another likely one is "The reporter did not calculate average annual return correctly."

One that I find dubious: "They actually are that good at investing."

For giggles: "They are using hedge funds to launder drug money."

I'm sure there are other ways to explain it, but that return just sounds way too good to be true.

Maarten882• 11 years ago

Or maybe they move the most successful trades from client's funds into this employee fund, and move the unsuccessful ones out to client's funds?

maaku• 11 years ago

Google Berkshire Hathaway. Today you will learn something new.

Tycho6• 11 years ago

I think the most interesting part is not the tax, but this:

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.

refurb• 11 years ago

Anyone else find this kind of "scammy" sounding?

How can they have a 35% average annual return over the past 25 years and guarantee that you won't take a loss at all?

Reminds me of Madoff.

Tycho6• 11 years ago

I think the most likely explanation is that they were just shifting all the tail risk to DB and Barclays, who didn't know any better or thought the portfolios would never experience losses beyond the option premium.

fuzzieozzie• 11 years ago

Hedge funds adding value.

programminggeek• 11 years ago

If we didn't use the tax code to create bizarre incentives, we'd arguably have more honest behavior.

hkmurakami• 11 years ago

The new I.R.S. guidance will be retroactive, applying to all transactions as far back as Jan. 1, 2011.

Regardless of the particulars of any taxation expectations, there's something about retroactive policy changes that seems to defy the spirit of law to me.

sitihn2• 11 years ago

Long-term investments stabilize the economy and should be encouraged through the tax-code.

sitihn2• 11 years ago

Long-term investments provide stability to the economy and should be encouraged through the tax-code.

Renaissance pursued a strategy of tax avoidance and should be punished.

jdsgold• 11 years ago

what if a hedge fund bought an at the money call option on the underlying security and sold an in the money put at an arbitrary price such as a dollar in order to convert the short term capital gains to long term capital gains

I.R.S. Cracks Down on Hedge Fund Tax Strategy

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