
I.R.S. Cracks Down on Hedge Fund Tax Strategy - jgalt212
http://www.nytimes.com/2015/07/09/business/dealbook/irs-cracks-down-on-hedge-fund-tax-strategy.html
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chollida1
In my opinion this is a much better article on the subject.

[http://www.bloomberg.com/news/articles/2014-07-21/renaissanc...](http://www.bloomberg.com/news/articles/2014-07-21/renaissance-
avoided-more-than-6-billion-tax-report-says)

Essentially the US has a few different taxes you can pay as an investor. There
is a short term tax on trading profits and a longer term holder tax for
"investors" which is lower.

This obviously creates a situation where people will do their best to make
their trading fall into the later category.

What Deutsche did was to sell hedge funds an option on a basket(collection) of
stocks that was held longer than a year. Not surprisingly, a year is long
enough to qualify for hte lower long term investment tax on capital gains.

The IRS has called shenanigans on this and the below quote is probably the
biggest reason why:

> "Illustrating how rapidly the contents of the “baskets” were shuffled, one
> option reviewed by the committee had more than 129 million underlying trades
> in a single year, the subcommittee said. Many of Renaissance’s stock
> investments lasted mere minutes or seconds, it said."

~~~
gohrt
The rules are deeply arbitrary, and goes to the nature of financials as being
rather abstract concepts with arbitrary definitions.

I buy stock in a firm, that firm makes a lot of profit, but I don't liquidate
my position. How is that different (short-term vs long-term gains) from me
selling their stock and buying another stock?

It's even the same word: A retail business sells its stock (product), and
sells it's stock (shares)

Ultimately, taxing "realized" gains can never be logical, since "realization"
is a fictional concept not grounded in reality. Taxing _consumption_ is
relatively straighforward to describe (but hard to implement), and taxing
_wealth_ is slightly harder (since it's hard to mark the value of some assets)

~~~
dragonwriter
> Ultimately, taxing "realized" gains can never be logical, since
> "realization" is a fictional concept not grounded in reality.

Trading an asset vs. holding it is a non-fictional concept very much grounded
in reality.

Attributing significance to it is, in a sense, arbitrary in the same sense
that any assignment of significance is, but its definitely _not_ a fictional
concept divorced from reality.

~~~
jsprogrammer
"Trading an asset"

What exactly are you trading? Bits in a database that mark ownership of a
fraction of a fictional entity?

~~~
leereeves
Not a 'fictional' entity; a legal construct (perhaps multilayered) that groups
ownership of real assets and/or obligations of real people.

~~~
jsprogrammer
The fiction is to believe that 'a legal construct (perhaps multilayered) that
groups ownership of real assets and/or obligations of real people' is an
entity.

~~~
tghw
You're basically saying that contracts are fictional. Try entering into a
contract, then behaving as if it's fictional by ignoring your responsibilities
in the contract, and you will quickly find out how real they are.

~~~
jsprogrammer
>You're basically saying that contracts are fictional.

Nope (although, that may be true, in some sense), I am not saying that. I am
saying the thing many refer to as an 'entity', as in, 'the corporate entity',
is a fictional thing. It has no real, inherent or independent physical
existence apart from the people that choose to represent it.

~~~
tghw
There's no fundamental difference between a corporate entity and a contract.
Just because it has no physical manifestation doesn't mean it's a fiction.

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ISL

      U.S. Constitution, Article I, Section 9:
      No Bill of Attainder or ex post facto Law shall be passed.
    

How does that square with the article's

"The new I.R.S. guidance will be retroactive, applying to all transactions as
far back as Jan. 1, 2011."

?

~~~
DannyBee
1\. In the US, the supreme court has repeatedly held that the ex-post-facto
clause only applies to criminal laws (See Calder v. Bull, which was decided in
1798).

This is actually consistent with the history of the clause (It was understood
to apply to criminal laws. Motions were made to change the wording to say it
also applied to civil cases, they were turned down)

2\. This is not a law, and may not even be administrative rulemaking
(depending on what exactly they issued)

Of course, even if it was, you have a mechanism to challenge it if they hold
you to it: the courts.

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ISL
If the IRS doesn't think I've paid my taxes, I can go to prison.

Doesn't that make this particular case a criminal one?

~~~
dragonwriter
> If the IRS doesn't think I've paid my taxes, I can go to prison.

No, if the IRS doesn't think you've paid your taxes, they can attempt to
collect the unpaid taxes.

OTOH, if the Department of Justice can prove in a criminal prosecution that
you've violated the criminal provisions of the tax law, you can go to prison.
If the IRS thinks you've done that (which is different from just not paying
your taxes), they can refer you to the DoJ for prosecution.

This change to IRS guidance doesn't change the criminal provisions of the tax
law that would apply were the government to prosecute you, therefore, the
change is not a change to criminal law, retroactive or otherwise.

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throwaway6497
This made my jaw drop: "Its Medallion fund, which now manages money for its
employees only, was the most prolific user of basket options. The fund has
earned an average annual return of more than 35 percent for two decades."

$25 billion is all employees money; Even if we exclude Simon's money ($14
billion) it is a ton. 35% avg annualized returns for 20 years. Simply
stunning.

~~~
Tycho
Actually the Medallion fund is only about $6 billion I believe. The rest of
the money is managed in funds which are open to non-employees (and those ones
don't make anything close to 35% annualised returns).

~~~
auntienomen
One other wibble: the 35% isn't the average, but rather the smallest annual
return.

~~~
ssanders82
"average annual return of more than 35 percent"

I don't think they meant every year was greater than 35%, I interpreted it as
the overall average is more than 35%.

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discardorama
> The fund [Medallion] has earned an average annual return of more than 35
> percent for two decades.

OK, can someone explain this? Most people say that "you can't beat the market
in the long term", "market is efficient", etc. So how can these people have
done so well over more than 20 years??

~~~
logfromblammo
There are several plausible hypotheses.

My personal favorite is, "They trade on non-public information, and use a
complex trade algorithm for the purposes of plausible deniability."

Another is, "They got lucky."

Another likely one is "The reporter did not calculate average annual return
correctly."

One that I find dubious: "They actually are that good at investing."

For giggles: "They are using hedge funds to launder drug money."

I'm sure there are other ways to explain it, but that return just sounds way
too good to be true.

~~~
Maarten88
Or maybe they move the most successful trades from client's funds into this
employee fund, and move the unsuccessful ones out to client's funds?

~~~
logfromblammo
Oh, I like that one too, but how would they cover their asses in the event of
an audit? Retroactive accounting?

~~~
Maarten88
If they can move ownership for a year, they'll certainly have no problems
moving it for a few hundred milliseconds...

I think they'll probably use a database that's "eventually consistent" ;-) I

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programminggeek
If we didn't use the tax code to create bizarre incentives, we'd arguably have
more honest behavior.

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Tycho
I think the most interesting part is not the tax, but this:

 _The options also were attractive because they limited the risk of loss to
the amount paid for each option, Renaissance said. “No other investment
structure of which we are aware provides both high leverage and loss
protection,” Renaissance said._

~~~
refurb
Anyone else find this kind of "scammy" sounding?

How can they have a 35% average annual return over the past 25 years and
guarantee that you won't take a loss at all?

Reminds me of Madoff.

~~~
Tycho
I think the most likely explanation is that they were just shifting all the
tail risk to DB and Barclays, who didn't know any better or thought the
portfolios would never experience losses beyond the option premium.

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pcurve
Maybe all cap gains should just be taxed at the same rate. 1 year threshold
his so artificial.

~~~
JoshTriplett
There's a massive difference between the long-term and short-term gains rates.
And, hedge fund folks aside, long-term capital gains are also the taxes that
apply to retirees drawing income from years of investments. Raising those
rates would cause serious problems for folks who have already done all their
financial planning and investing, and cannot afford to pay higher taxes.

~~~
dragonwriter
> And, hedge fund folks aside, long-term capital gains are also the taxes that
> apply to retirees drawing income from years of investments. Raising those
> rates would cause serious problems for folks who have already done all their
> financial planning and investing

Raise them prospectively based on the date of asset purchase, starting some
specified time after the date the change is adopted. Problem solved.

~~~
JoshTriplett
That would only solve the problem of not penalizing existing retirees. It
would force all people currently saving for retirement to save 10-15% more to
pay this new pile of tax. And what, precisely, do they get in return for that
added tax burden?

~~~
dragonwriter
> And what, precisely, do they get in return for that added tax burden?

They get the relative burden of taxation shifted off the of other sources of
income, including the source they are using to get money to pay for
retirement. (The specific effect depends on _how_ that relative shift is
used.)

In any case, if the current favorable treatment of capital is inequitable,
there is no entitlement for people to expect it to continue going forward.

~~~
JoshTriplett
Alternatively, if the goal here is to stop hedge funds from taking advantage
of long-term capital gains, perhaps it would make more sense to cap the
_amount_ of gains exempted as long-term and make the rest short-term. Set a
cap well above what the vast majority of individuals would hit, and below what
any aggregate fund would hit. For instance, "long-term capital gains can only
be applied to the first $150k of gains per year; gains above that are always
taxed at the short-term rate".

> They get the relative burden of taxation shifted off the of other sources of
> income, including the source they are using to get money to pay for
> retirement. (The specific effect depends on how that relative shift is
> used.)

You say that as though an increase in taxes here will be used to decrease
taxes elsewhere. That does not match the reality of changes to tax law; tax
revenue will simply increase, with no changes to taxes elsewhere.

> In any case, if the current favorable treatment of capital is inequitable,
> there is no entitlement for people to expect it to continue going forward.

There is no entitlement for government to apply arbitrary taxes and expect
people to bear it, either, without providing a commensurate improvement in
value.

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hkmurakami
_> The new I.R.S. guidance will be retroactive, applying to all transactions
as far back as Jan. 1, 2011._

Regardless of the particulars of any taxation expectations, there's something
about retroactive policy changes that seems to defy the spirit of law to me.

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jdsgold
what if a hedge fund bought an at the money call option on the underlying
security and sold an in the money put at an arbitrary price such as a dollar
in order to convert the short term capital gains to long term capital gains

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fuzzieozzie
Hedge funds adding value.

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sitihn
Long-term investments provide stability to the economy and should be
encouraged through the tax-code.

Renaissance pursued a strategy of tax avoidance and should be punished.

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sitihn
Long-term investments stabilize the economy and should be encouraged through
the tax-code.

