Tax Analysts Blog

Hedge Fund 'Basket' Options and the Second Hundred Years’ War

Posted on Jul 29, 2014

“The investigation of the income tax returns for each successive year reveals the increasingly stubborn fight of wealthy individuals and corporations against the payment of their fair share of the expense of their Government.”

Treasury Secretary Henry Morgenthau, 1937

“More and more enterprises organized abroad by American firms have arranged their corporate structures aided by artificial arrangements . . . which maximize the accumulation of profits in the tax haven . . . in order to reduce sharply or eliminate completely their tax liabilities.”

President John F. Kennedy, 1961

“Too often, too many of these corporations use complex structures, dubious transactions and legal fictions to shift the profits from those products overseas, avoiding the taxes that help support our security, stability and productivity.”

Sen. Carl Levin, 2012

At the Senate Homeland Security and Governmental Affairs Permanent Subcommittee on Investigations hearing last week, subcommittee Chair Carl Levin decried the use of artificial structures known as basket options that allow hedge funds to avoid billions in taxes. It was the latest (and possibly last) round in Levin’s long-standing fight against abuse of the tax code by both individuals and multinationals. The senator’s struggle, which will come to an end when he leaves Congress next year, is merely one series of battles in an over-100-year war between wealthy corporations and taxpayers on one side and federal tax collectors on the other. And it’s a war that the government is steadily losing.

Treasury Secretary Henry Morgenthau was instrumental in calling attention to how taxpayers were using legal structures to avoid taxes in the 1930s. In a May 1937 letter to President Franklin Roosevelt, the secretary highlighted “the defeat of taxes through doubtful legal devices which have no real business purpose? or utility, and to which a downright honest man would not resort to reduce his taxes.” In addition to calling for a higher standard of morality in tax compliance (something that should sound familiar to anyone following the latest debate over taxes paid by Starbucks, Google, Apple, and inverting firms), Morgenthau discussed the use of multiple trusts, foreign personal holding corporations, offshore insurance companies, and percentage depletion.

Although the tax code has changed dramatically since Morgenthau’s days, some of the devices he sought to combat still exist in one form or another. Trusts, foreign holding corporations, and offshore reinsurance companies remain at the heart of taxable income reduction techniques used by individuals and corporations alike.

President Kennedy’s fight should be even more familiar to tax observers. In a special message on taxation to Congress, Kennedy targeted artificial arrangements “between parent and subsidiary regarding intercompany pricing, the transfer of patent licensing rights, the shifting of management fees, and similar practices which maximize the accumulation of profits in the tax haven.” This language could have easily come from the OECD’s base erosion and profit-shifting action plan or a 2014 congressional hearing on leaky transfer pricing rules or earnings stripping techniques.

Like Morgenthau and Kennedy, Levin’s fight against tax avoidance has been broad and largely quixotic. The PSI’s hearings have targeted individual tax evasion using offshore accounts (which led to the UBS scandal), Apple’s profit-shifting techniques (which rely heavily on shell companies in low- and no-tax foreign jurisdictions), the failure of the IRS to audit large partnerships, and the latest, hedge funds’ use of basket options. Levin’s goal has been to shut down artificial, substanceless devices used by taxpayers (both corporate and individual) to strip the U.S. tax base. He hasn’t been that successful.

While Congress, the IRS, and Treasury may be complicit in many of the structures used to avoid tax, the government has tried repeatedly to limit the use of substanceless transactions and entities. The code is replete with antiabuase rules, while the IRS has issued hundreds (if not thousands) of pages of regulations, revenue rulings, and other guidance designed to stop taxpayers from engaging in transactions that lack a business purpose outside tax reduction. But taxpayers and their lobbyists have proved to be far more clever over the years, keeping the rules loose enough to allow room for aggressive tax planning.

The first Hundred Years’ War was dominated by England, until a remarkable turnaround from France snatched victory from the jaws of defeat . The federal government can only hope that history will repeat itself in the century-old conflict between the nation’s fiscal system and those that want to contribute as little as possible to it.

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