WASHINGTON — Two global banks helped at least a dozen hedge funds skirt full tax payment on more than $100 billion worth of stock trades, according to a congressional investigation made public Monday.
The findings of the Senate Permanent Subcommittee on Investigations will be the subject of a daylong hearing Tuesday.
It also means more trouble for the Internal Revenue Service.
At issue is whether complex financial deals arranged by London-based Barclays Bank and Germany’s Deutsche Bank deliberately helped hedge funds exploit U.S. tax laws for financial advantage and bend rules designed to protect the financial system from excessive borrowing to finance speculative bets.
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The IRS in 2010 warned against the financial instruments at question, but roughly four years later, no additional tax money has been collected from the hedge funds involved, Senate investigators said.
Hedge funds are private investment vehicles for the very wealthy, and their steep costs to join effectively lock out ordinary Americans. They are often partnerships, whose investors are partners who reap the tax savings afforded by the scheme.
The Senate report alleges Deutsche Bank and Barclays conspired with the hedge funds to create a complex investment vehicle that gave the appearance of being a brokerage account like those used by ordinary Americans who play the stock market.
The difference, however, is that these accounts, called “basket options,” involved billions of dollars in rapid and constant computerized trading. The hedge funds, the report said, were taking short-term profits but being taxed as if they were ordinary investors holding stocks for a year or longer. They were taxed at a rate of 15 to 20 percent instead of the rate of ordinary income, which is as high as 39 percent.
In a news conference detailing the complex scheme, committee Chairman Sen. Carl Levin, D-Mich., said the banks and a number of hedge funds established “sort of an alternative universe” in which there were large volumes of trading taking place in minutes, days and months. Most transactions happened in six months or less, but the profits were treated as if the hedge funds were holding the securities for periods of a year or more — long enough to claim the lower tax rate for capital gains.
The scheme took place from 1998 to 2013, according to congressional investigators, even as the two banks were being investigated for other wrongdoing.
The “basket options” instruments also skirted rules against excessive debt used to take risks. Most hedge funds invest seven or eight times the cash they actually have, a process called leveraged investing. Under the basket options afforded by Barclays and Deutsche Bank, the hedge funds could leverage at a ratio as high as $20 for every dollar they had.
This sort of excessive debt used for speculative bets is what brought down investment banks Bear Stearns and Lehman Brothers and led to the 2008 financial crisis.
The IRS had no comment on criticism by Levin, who complained that after issuing its warning in 2010, there has been little enforcement action or collection of taxes owed.