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  • U.S. Senate’s Hearing Illuminates Taxation of “Basket Options”
    July 2014

    The U.S. Senate’s Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs (the “Subcommittee”) issued a report on July 22, 2104 entitled Abuse of Structured Financial Products: Misusing Basket Options to Avoid Taxes and Leverage Limits (the “Report”).[1] The Report is the result of an extensive inquiry by the Subcommittee’s members and staff, including a public hearing held on July 22, into transactions in the form of options contracts entered into by Deutsche Bank AG (“Deutsche Bank”) and Barclays Public Limited Company (“Barclays”) with certain hedge funds. Although such transactions are no longer offered by these banks, the amount of tax at issue appears to be significant (although many of the tax years may be closed).  The Report is another illustration of the strategy of the Subcommittee to publicize significant tax-aggressive transactions in an effort to discourage other large taxpayers from taking aggressive tax positions in the future.
     
    Overview
     
    For a number of years, Deutsche Bank and Barclays entered into “basket option contracts” with hedge funds.[2] Provided the contracts were outstanding for more than one year, a hedge fund entering into a basket option contract took the position that it recognized a long-term capital gain when the option was exercised and produced a profit. By contrast, the hedge fund’s trading income would have likely been taxed at a higher rate in the hands of its investors if the hedge fund had entered into the transactions directly through a brokerage account.  The option contracts also allowed the hedge fund to avoid the margin rules that would apply if the hedge fund had traded through a brokerage account.  Leverage ratios of 18:1 or higher were achievable with basket options, according to the Report.[3]
     
    In November 2010 the IRS issued a Generic Legal Advice Memorandum, AM2010-005 - Hedge Fund Basket Option Contracts, which concluded that such contracts (i) should not be treated as options for U.S. federal income tax purposes, (ii) the hedge funds entering into such contracts should be treated as the owner of the securities traded under the basket option, and (iii) the hedge funds should recognize trading gain or loss currently, rather than deferring that gain or loss until the year that the option was exercised. Immediately after the GLAM was issued Deutsche Bank ceased offering basket option contracts with a maturity of more than one year. Barclays, however, continued to offer such contracts to its sole hedge fund customer until 2013.
     
    The Report also states that the SEC has concluded that basket options allowed “a handful of hedge funds, in less than five years, to avoid paying taxes totaling an estimated $915 million.”  According to the Report “other data suggest the total tax avoidance could exceed $6 billion.” The tax avoided most likely would be estimated as the difference between the top ordinary income tax rate of individuals and the lower capital gains tax rate for individuals.
     
    According to the Report, at least one hedge fund is under audit with respect to these transactions, and the case in the IRS’s Appeals Office.  The matter has not been addressed in the courts.
     
    Summary of the transactions
     
    Deutsche Bank developed its basket option product before Barclays, and their products differed and evolved.  However, the transactions shared certain common characteristics. The key elements of a basket option are illustrated by the Barclays’ transaction as summarized in the GLAM:
     
    The bank would sell a cash-settled call option written on a portfolio of securities to the hedge fund in exchange for a premium equal to one-tenth of the initial market value of the portfolio. In order to hedge its exposure under the option contract, the bank would purchase the portfolio. It would pay for the portfolio using the option premium and finance the remaining 90 percent.
     
    The strike price of the call option was set at the initial value of the portfolio. The option would expire more than one year from the date of issue, thus allowing the hedge fund the opportunity to realize a long-term capital gain.
     
    The option included a “knock-out” provision that required the option to be terminated and the portfolio liquidated if the portfolio’s value fell by an amount equal to the option premium. Thus, the bank faced relatively little risk that the portfolio would decline more than 10 percent of its initial value jeopardizing the bank’s loan principal.
     
    When the option was written, the bank also would enter into a management contract with an affiliate of the hedge fund to manage the portfolio according to certain guidelines. The bank paid the hedge fund a management fee for its services.  This annual fee was set at 0.1 percent of the assets under management, not the standard “2 and 20” management fee that hedge firms typically charge. [5]  The hedge fund’s affiliate was to provide trading instructions to the bank; however, the bank was not contractually obligated to follow such instructions. In transactions examined by the Subcommittee, the hedge fund was a high-frequency trader, and, apparently, executed the trades itself using its own software.  Thus, the bank had no opportunity to intervene and stop or modify the hedge fund’s trades.
     
    Assuming the option was exercised when it was in the money, the bank would pay the hedge fund the trading gains realized on the portfolio of securities during the period the option was outstanding reduced by (i) any trading losses realized, (ii) commissions and other trading costs, and (iii) the cost of financing 90 percent of the portfolio. Thus, the economics of the option mimicked those of a leveraged brokerage account while potentially producing a long term capital gain for the hedge fund.
     
    Recommendations of the Subcommittee
     
    The Report contains four recommendations: (i) the IRS should collect additional taxes owed on basket option profits, (ii) federal financial regulators, as well as the treasury and the IRS, should intensify their warnings against, scrutiny of, and legal actions to penalize bank participation in tax motivated transactions, (iii) the IRS and Treasury should revamp the TEFRA regulations relating to audits of large partnerships and Congress should consider amendments to TEFRA to facilitate such audits, and (iv) the Financial Stability Oversight Council should work with other federal agencies to establish new reporting and data collection methods to enable financial regulators to analyze the use of derivatives and structured financial products created to circumvent federal leverage limits.
     
    Observations
     
    The resources devoted to creating the Report demonstrates the seriousness of the Subcommittee (as well as its substantial resources). The Subcommittee subpoenaed, collected and reviewed over 1.5 million pages of documents, conducted 23 interviews and briefings, and spoke with academics other tax experts concerning the tax treatment of basket options.
     
    As noted above, today neither Deutsche Bank nor Barclays enters into basket option contracts with a maturity greater than one year. Thus, the Subcommittee’s purpose is not to discourage ongoing transactions. Rather, the Subcommittee’s purpose appears to be to discourage large taxpayers (e.g., public companies, financial institutions and hedge funds) from entering into tax-aggressive transactions in the future by creating a threat of negative publicity for such transactions, even those that have ceased.
     
     
    [1] Available at http://www.hsgac.senate.gov/subcommittees/investigations/hearings/abuse-of-structured-financial-products_misusing-basket-options-to-avoid-taxes-and-leverage-limits. Senator Levin previously has held hearings investigating the tax planning of well-known U.S. companies, including Microsoft and Hewlett-Packard in 2012, Apple in 2013 and Caterpillar earlier in 2014.
    [2] Deutsche Bank began offering basket options in 1998. Barclays began offering basket options in 2002. Based on the Report, only a handful of hedge funds used these contracts. During the period 1998 to 2014,127 basket option contracts were sold.
    [3] Leverage is limited to 2:1 in a brokerage account.
    [5] 2 percent of the net asset value and 20 percent of gains in excess of a hurdle rate.