Jim Simons’ Renaissance Technologies and its internal HFT fund Medallion are no strangers to questions about tax avoidance. Last July, a Senate subcommittee report alleged that Renaissance, with the help of Deutsche Bank (of course) and Barclays, skirted leverage limits and avoided paying ordinary income tax on billions in trading profits by using basket options. Here, from the Senate report, is how the scheme worked:
The basket option contracts examined by the Subcommittee investigation were used by at least 13 hedge funds to conduct over $100 billion in securities trades, most of which were short-term transactions and some of which lasted only seconds. Yet the resulting short-term profits were frequently cast as long-term capital gains subject to a 20% tax rate (previously 15%) rather than the ordinary income tax rate (currently as high as 39%) that would otherwise apply to investors in hedge funds engaged in daily trading. While the banks styled the trading arrangement as an “option” under which profits from short-term trades would be treated as long term capital gains, in essence, the banks loaned the hedge funds money to finance their trading and allowed them to trade for themselves in highly leveraged positions in the banks’ proprietary accounts and reap the resulting profits. The banks offering the “options” benefited from the financing, trading, and other fees charged to the hedge funds initiating the trades. In the end, the trading conducted by the hedge funds using the basket option accounts was virtually indistinguishable from the trading conducted by hedge funds using their own brokerage accounts, and provided no justification for treating the resulting short-term trading profits as long-term capital gains.
There you go. And while it sounds (and looks) complicated, it was all, as we explained at the time, motivated by a very simple desire to reclassify short-term capital gains into long-term profits, in the process saving about 25% of the absolute profit from any transaction.
How much did this 17X leveraged, “fictional derivatives” scheme cost taxpayers, you ask? Around $6 billion apparently, and as it turns out, Renaissance wasn’t done coming up with creative and technically legal ways to avoid paying the Treasury because as Bloomberg reports, the firm’s employees will now get to invest their retirement in Medallion (the firm’s internal HFT high-flyer) tax free:
It’s one of the sweetest employee perks in the hedge-fund world: a chance to invest in Medallion, the wildly profitable fund created by market legend James Simons.
Now, with deft legal maneuvers and a blessing from Washington, the firm Simons started is giving its employees an even richer opportunity -- a tax-advantaged, fee-free ticket to one of the world’s top-performing hedge funds.
In a series of unusual moves, Renaissance Technologies abolished its 401(k) plan and won the government’s permission to put pieces of Medallion fund inside Roth IRAs. That means no taxes -- ever -- on the future earnings of a fund that averaged a 71.8 percent annual return, before fees, from 1994 through mid-2014.
How is this possible? Well, the first step was to eliminate 401(k)s and move everyone into IRAs, which Renaissance did in 2010. Next, Renaissance’s lawyers told the Labor Department that in their view, it wasn’t entirely fair that the firm’s employees were stuck investing their retirement savings in traditional funds offered through the likes of Fidelity because after all, carbon-based portfolio managers have a tough time replicating HFT-like returns. Two years, and a lot of paperwork later, Renaissance was granted a waiver which allowed for the inclusion of Medallion fund in employees’ IRAs. Renaissance has since set up another 401(k) which, thanks to a second government waiver, also includes Medallion. More from Bloomberg:
After questioning that yielded a foot-high stack of public records, the Labor Department granted the exemption in 2012.
As of the end of 2013, Renaissance was running an employer IRA plan that attracted $86.6 million in initial investments and had 259 active participants.
Assets in the plan jumped 49 percent to $153 million during its first full year of existence in 2013, and almost all of that came because of growth in the funds, rather than new contributions or rollovers. The fee-free version of Medallion returned about 47 percent that year, compared with about 25.5 percent for the fee-paying version.
While seeking the IRA exemption, Renaissance also set up a new 401(k). (Such plans permit greater annual contributions than IRAs.)
Renaissance then returned to the Labor Department to ask for permission for the new 401(k) to invest in Medallion, too. In November 2014, the Labor Department said yes..
For Renaissance employees, the results of the firm’s maneuvers are fee-free, tax-advantaged investments and the prospect of ballooning balances in their Roth IRAs.
For those wondering exactly what all of this means in real money terms, consider this:
From 2001 through 2013, the fund’s worst year was a 21 percent gain, after subtracting fees. Medallion reaped a 98.2 percent gain in 2008, the year the Standard & Poor’s 500 Index lost 38.5 percent.
If Medallion repeats that 13-year performance, a $300,000 taxable investment would turn into $4.7 million. A Roth IRA funded with $300,000 would be worth $26.3 million -- and a no-fee version would be even bigger.
So, while America's policemen, firemen, and school teachers are subjected to daily headlines trumpeting billions in underfunded pension liabilities, hedge fund employees (especially those who work for HFTs) are going to do just fine.
Who loses as a result of all of the above? Well frankly, you do...
“This is an issue of fairness, and taxpayers end up paying the price" -- Senator Ron Wyden
