Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Tax avoidance with derivatives

Last month, the Permanent Subcommittee on Investigations of the United States Senate published a Staff Report on how hedge funds were using basket options to reduce their tax liability. The hedge fund’s underlying trading strategy used 100,000 to 150,000 trades per day and many of those trading positions lasted only a few minutes. Yet, because of the use of basket options, the trading profits ended up being taxed at the long term capital gains rate of 15-20% instead of the short term capital gains rate of 35%. The hedge fund saved $6.8 billion in taxes during the period 2000-2013. Perhaps, more importantly, the hedge fund was also able to circumvent leverage restrictions.

The problem is that derivatives blur a number of distinctions that are at the foundation of the tax law everywhere in the world. Alvin Warren described the problem in great detail more than two decades ago (“Financial contract innovation and income tax policy.” Harvard Law Review, 107 (1993): 460). More importantly, Warren’s paper also showed that none of the obvious solutions to the problem would work.

We have similar problems in India as well. Mutual funds that invest at least 65% in equities produce income that is practically tax exempt for the investor, while debt mutual funds involve substantially higher tax incidence. A very popular product in India is the “Arbitrage Mutual Fund” which invests at least 65% in equities, but also hedges the equity risk using futures contracts. The result is “synthetic debt” that has the favourable tax treatment of equities.

In some sense, this is nothing new. In the Middle Ages, usury laws in Europe prohibited interest bearing debt, but allowed equity and insurance contracts. The market response was the infamous “triple contract” (contractus trinus) which used equity and insurance to create synthetic debt.

What modern taxmen are trying to do therefore reminds me of Einstein’s definition of insanity as doing the same thing over and over again and expecting different results.

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