US – IRS cracks down on hedge funds’ tax strategy

The US Internal Revenue Service is cracking down on hedge funds, challenging a tax strategy called “basket options” that is used to claim billions of dollars in tax savings, the New York Times has reported.

Hedge funds using the options must declare them on their tax returns and they will be penalized if they fail to do so, the newspaper reported, adding the new requirement was being backdated four years.

The head of a powerful US Senate panel presented the findings of a year-long probe into basket options last July, accusing Deutsche Bank AG and Barclays Plc of helping hedge funds avoid taxes and calling for tougher action from the authorities.

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 taxable short-term trading, the panel said.

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

The IRS 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 yet pressed any cases.

The new IRS guidance will apply retrospectively to transactions back to Jan 1, 2011, the NYT reported.