A proposal this year from U.S. Representative Dave Camp, a Michigan Republican and chairman of the House Ways and Means Committee, would eliminate any possibility that the Renaissance technique could generate tax savings, Rosenthal said. That proposal, a plank in Camp’s effort to overhaul the tax code, would prevent owners of derivatives such as options from earning any long-term capital gains.
Frequent Trading
The top federal rate on long-term capital gains, derived from selling investments held for more than a year, is currently 20 percent, compared with 39.6 percent imposed on wages and investments of less than a year. Before this year, the short- term rate was 35 percent and the long-term was 15 percent. The Medallion fund trades stocks and futures so frequently that, absent the tax maneuver, it would generate mostly short-term gains, said the people with knowledge of the matter.
Although tax experts said some of the specifics of Renaissance’s strategy are unusual, figuring out ways to convert a hedge fund’s trading profits into income taxed at the lower, long-term gains rate is one of the holy grails for tax planners.
“It’s been going on since there’s been hedge funds,” said David Weisbach, a tax professor at University of Chicago Law School.
Offshore Investment
One increasingly popular technique is to set up an offshore insurance company that in turn makes the hedge fund investment, as top executives at billionaire John Paulson’s firm did last year. The move was the subject of a Bloomberg News report in February. At the time, Paulson declined to say whether it was done to avoid taxes.
Renaissance’s strategy involved buying an instrument called a “basket option contract,” from banks including Barclays, the people said.
IRS lawyers released an 11-page memorandum in 2010 describing the technique and outlining what they called a “particularly aggressive” example, without naming Medallion and Barclays.
The purpose of the memo was for top IRS attorneys in Washington to notify staff in the field about a newly discovered tax-avoidance technique. The IRS had been tipped off to the practice in 2008 by examiners from the U.S. Securities and Exchange Commission.