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

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IV. SYSTEMIC CONCERNS
In its Generic Legal Advice Memorandum of November 2010, the IRS rejected the
attempt to use basket option structures to try to convert short-term trading profits into long-term
capital gains with lower tax rates. It also initiated a review of the largest basket options user to
evaluate its tax liability. While those actions have begun to address some of the specific conduct
examined in this investigation, they are incomplete and unresolved. The basket option case
studies also raise four larger, systemic concerns.
Invalidating Derivative Tax Schemes. First, the basket option case studies are
emblematic of a larger effort by some tax practitioners and sophisticated financial firms to claim
that derivatives can be used to lower tax liability even when those derivatives mimic economic
activity giving rise to taxable income. Treasury, the IRS, and Congress need to make it clear that
derivatives alone cannot magically eliminate or lower tax liability. As part of that effort, tax
regulations providing special benefits to derivatives, such as the U.S. source rule for swaps,
should be revised or eliminated, and the message driven home that financial engineering using
derivatives is insufficient to avoid income taxation.
Analyzing Circumvention of Leverage Limits. Second, basket options are just one
example of derivatives and other arrangements being used to circumvent federal limits on the use
of borrowed funds to purchase securities. In the case of RenTec, basket options were used to
provide it with leverage levels as high as 20:1, which the hedge fund said it had been unable to
achieve in other settings under federal rules.
In recent years, a few studies have examined how financial institutions, using derivatives,
structured financial products, and other arrangements, have weakened or circumvented federal
leverage limits. 495 One recent study by the Office of Financial Research in the Treasury
Department noted that “data [is] currently insufficient to understand the exposures and the extent
of leverage” being used in the U.S. financial system. 496
The Financial Stability Oversight Council, working with the Office of Financial Research
and other federal agencies, should establish new reporting and data collection mechanisms to
gather the data needed for an indepth analysis of the extent of leverage in the U.S. financial
495 See, e.g., 9/2013 “Asset Management and Financial Stability,” prepared by the Office of Financial Research
of the U.S. Department of the Treasury, at 1, 17-18
http://www.treasury.gov/initiatives/ofr/research/Documents/OFR_AMFS_FINAL.pdf (examining in part asset
management industry use of leverage); Concept Release on Use of Derivatives by Investment Companies,
prepared by the SEC,76 Fed. Reg. 55238 (Sept. 7, 2011) (examining in part investment company use of
derivatives to create leverage); 7/6/2010 “ Report of the Task Force on Investment Company Use of
Derivatives and Leverage,” prepared by the American Bar Association Business Law Section, Committee on
Federal Regulation of Securities, Task Force on Investment Company Use of Derivatives and Leverage,
https://apps.americanbar.org/buslaw/blt/content/ibl/2010/08/0002.pdf; 2012 “SEC Concept Release Tackles
Investment Company Use of Derivatives,” The Review of Securities & Commodities Regulation, vol. 45,
Jay G. Baris and Andrew J. Donohue, http://media.mofo.com/files/Uploads/Images/120308-Securities-
Commodities-Regulation.pdf.
496 9/2013 “Asset Management and Financial Stability,” prepared by the Office of Financial Research of the U.S.
Department of the Treasury, at 18, http:
//www.treasury.gov/initiatives/ofr/research/Documents/OFR_AMFS_FINAL.pdf.