ABUSE OF STRUCTURED FINANCIAL PRODUCTS- Misusing Basket Options to Avoid Taxes and Leverage Limits MAJORITY AND MINORITY STAFF REPORT

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SENATOR CARL LEVIN Chairman SENATOR JOHN McCAIN Ranking Minority Member PERMANENT SUBCOMMITTEE ON INVESTIGATIONS ELISE J. BEAN Staff Director and Chief Counsel ROBERT L. ROACH Counsel and Chief Investigator DAVID H. KATZ Senior Counsel AHMAD SAROUR Detailee ANGELA MESSENGER Detailee MARY D. ROBERTSON Chief Clerk ADAM HENDERSON Professional Staff Member HENRY J. KERNER Staff Director and Chief Counsel to the Minority MICHAEL LUEPTOW Counsel to the Minority BRAD PATOUT Senior Policy Advisor to the Minority ELISE MULLEN Research Assistant to the Minority AMY DREISIGER Law Clerk MICHAEL AVI-YONAH Intern MOHAMMAD ASLAMI Law Clerk OWEN DUNN Law Clerk REBECCA PSKOWSKI Law Clerk PATRICK HARTOBEY Law Clerk to the Minority Former Subcommittee Staff Who Contributed 7/21/14 CHRISTOPHER A. REED Congressional Fellow JACOB ROGERS Law Clerk SAMIRA AHMED Law Clerk MEGAN SCHNEIDER Law Clerk to the Minority Permanent Subcommittee on Investigations 199 Russell Senate Office Building – Washington, D.C. 20510 Majority: 202/224-9505 – Minority: 202/224-3721 Web Address: http://www.hsgac.senate.gov/subcommittees/investigations
ABUSE OF STRUCTURED FINANCIAL PRODUCTS: Misusing Basket Options to Avoid Taxes and Leverage Limits TABLE OF CONTENTS I. EXECUTIVE SUMMARY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 A. Subcommittee Investigation. . . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 B. Investigation Overview. . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 C. Findings of Fact. . . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 1. Profiting from Basket Options .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 2. Turning a Blind Eye. . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 3. Claiming Short-Term Trading Profits As Long-Term Capital Gains. .. . . . . . . . . . 6 4. Ceding Control. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 5. Assessing Risk. . . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 6. Avoiding Leverage Limits . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 7. Producing a Low Audit Rate . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 8. Failing to Enforce Leverage Limits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 D. Recommendations . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 1. Collect Additional Taxes Owed on Basket Option Profits. . .. . . . . . . . . . . . . . . . . 7 2. Stop Bank Participation in Abusive Tax Structures. . .. . . . . . . . . . . . . . . . . . . . . . 7 3. Revamp TEFRA. . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 4. Stop Circumvention of Leverage Limits . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 II. BACKGROUND. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 A. General Description of Derivatives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 (1) Taxes, Leverage Limits, and Transparency Problems. . . . . . . . . . . . . . . . . . . . . . . 9 (2) Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 (3) Basket Options On a Basket of Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 B. Overview of Tax Principles.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 (1) Short and Long-Term Capital Gains Tax Treatment. . . . . . . . . . . . . . . . . . . . . . . . 17 (2) Taxation of Stock Dividends. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 (3) Section 1260. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 (4) Substance Over Form Doctrine. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 (5) 2010 IRS Basket Options Memorandum. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 III. BASKET OPTION CASE STUDIES.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 A. Basket Option Participants. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 (1) Deutsche Bank. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 (2) Barclays. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 (3) Renaissance Technologies LLC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 (4) George Weiss Associates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 i
Page 1: United States Senate PERMANENT SUBC
Page 5 and 6: ABUSE OF STRUCTURED FINANCIAL PRODU
Page 7 and 8: 3 client entered into a contract wi
Page 9 and 10: 5 Although the Subcommittee does no
Page 11 and 12: 7 4. Ceding Control. Although the i
Page 13 and 14: 9 II. BACKGROUND This chapter provi
Page 15 and 16: 11 dealers and sets the margin requ
Page 17 and 18: 13 exercising the option. 33 The fi
Page 19 and 20: 15 Since the hedge fund’s gain or
Page 21 and 22: 17 managed account which, in the ca
Page 23 and 24: 19 corporation, and are instead tre
Page 25 and 26: 21 The abusive derivatives used pri
Page 27 and 28: 23 over form doctrine is that the t
Page 29 and 30: 25 securities in the basket. 95 It
Page 31 and 32: 27 Jürgen Fitschen and Anshu Jain
Page 33 and 34: 29 as the consolidation point withi
Page 35 and 36: 31 Financial Officer, Chief Complia
Page 37 and 38: 33 as U.S. persons, among other typ
Page 39 and 40: 35 which was initially designed by
Page 41 and 42: 37 Barclays COLT Options. In 2002,
Page 43 and 44: 39 C. Development of MAPS and COLT
Page 45 and 46: 41 the trades were placed and execu
Page 47 and 48: 43 option accounts. 254 In other wo
Page 49 and 50: 45 Because the investment advisor,
Page 51 and 52: 47 changed the formula used to calc
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49 D. Analysis of Basket Option Cas
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51 of its investment portfolio betw
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53 The financing charges and transa
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55 Removing Palomino, a shell corpo
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57 • RenTec is effectively entitl
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59 Barclays’ SEC filing also incl
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61 accounts established in the name
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63 (ii) Constantly Changing Asset M
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65 selection was at the discretion
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67 Percentage Allocations. Because
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69 protection. 357 He explained tha
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71 The technique that RenTec used w
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73 In addition to moving assets fro
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75 (a) Facilitating Tax Avoidance B
Page 81 and 82:
77 Mr. Haas’ description of the 2
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79 legal opinion from outside couns
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81 available to Renaissance pursuan
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83 as their hedge fund clients - th
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85 continuing with the Option Trans
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87 Within the bank, some executives
Page 93 and 94:
89 Attempts to Develop New Structur
Page 95 and 96:
91 IV. SYSTEMIC CONCERNS In its Gen
Page 97:
93 as publicly traded partnerships,
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ABUSE OF STRUCTURED FINANCIAL PRODUCTS- Misusing Basket Options to Avoid Taxes and Leverage Limits MAJORITY AND MINORITY STAFF REPORT

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