James Simons, who became a billionaire when he turned his extraordinary mathematical ability from Cold War code breaking to investing, deployed an unusual strategy at his Renaissance Technologies hedge fund to skirt hundreds of millions of dollars in taxes for himself and other investors, according to people with knowledge of the matter. The Internal Revenue Service is challenging the technique, which it called “particularly aggressive,” without naming the hedge fund in the dispute. It’s demanding more tax payments from investors in Renaissance’s $10 billion Medallion Fund, said the people, who declined to be identified because the matter hasn’t been made public.
Renaissance’s strategy involved buying an instrument called a basket option contract from Barclays (BCS) and other banks so it could convert profit from Medallion’s rapid trading into long-term capital gains, according to the people. The top federal rate on long-term gains is about half that on short-term gains. IRS lawyers released an 11-page memorandum in 2010 describing the technique and outlining an example, without naming Medallion and Barclays. Jonathan Gasthalter, a spokesman for Renaissance, would say only that “the dispute is ongoing and being handled in the appropriate forum.” Kerrie Cohen, a spokeswoman for Barclays, declined to comment. The IRS also declined to comment, citing confidentiality laws.
As described in the memo and by people with knowledge of the matter, the transaction worked as follows: Barclays bought a portfolio of stocks and other instruments that Renaissance fund managers wanted to trade—then hired Renaissance to manage it, paying a nominal fee. Medallion then bought an option with a term of two years, the value of which was linked to the portfolio’s value. Medallion could say it owned just one asset—the option—which it held for more than a year, allowing any gain to be treated as long-term when its investors reported the income on their personal tax returns. “The profits are just being transmuted, through the alchemy of derivatives, to a preferenced return,” says Steven Rosenthal, a former tax lawyer who is a fellow at the Urban Institute in Washington.
It couldn’t be determined whether Renaissance is still using the strategy or how much the IRS wants investors to pay in back taxes. A former Renaissance employee, who spoke on condition of anonymity, says the firm notified him years after he left that the IRS was challenging the tax technique and told him that he might have to pay more than $90,000 in additional taxes if the firm loses. He says Renaissance assured him the trade was a common and legitimate technique and said the IRS was trying to rewrite the rules retroactively.
Although tax experts say some specifics of Renaissance’s strategy are unusual, figuring out ways to convert a hedge fund’s trading profit into income taxed at the lower, long-term gains rate is the holy grail for tax planners. “It’s been going on since there’s been hedge funds,” says David Weisbach, a tax professor at the University of Chicago Law School.
Congress tried to close the loophole in 1999, enacting a law allowing the IRS to disregard the tax effect of some derivatives, such as swaps and forwards, if they were economically akin to owning the fund directly. The basket option contract described in the 2010 IRS memo represents an “end run” around the 1999 law, says Robert Gordon, president of Twenty-First Securities, which advises clients on the tax implications of investments. “This thing doesn’t work,” he says, because while the transaction is technically an option, it’s structured in such a way that it is almost identical to owning the portfolio.
A proposal this year from U.S. Representative Dave Camp (R-Mich.), chairman of the House Ways and Means Committee, would eliminate any possibility that the Renaissance technique could generate tax savings, according to Urban Institute’s Rosenthal. That proposal, part of Camp’s effort to overhaul the tax code, would prevent owners of derivatives such as options from earning any long-term capital gains.
Simons, 75, who retired from Renaissance in 2010 as one of the best-performing managers of all time and now serves as its nonexecutive chairman, didn’t respond to a request for comment. The Bloomberg Billionaires Index estimates his fortune at $12 billion.
Testifying before Congress in 2008, Simons was asked about the “carried interest” tax loophole that allows fund managers to claim a lower tax rate on some fees they earn. The issue drew attention during last year’s presidential election when the Republican nominee, Mitt Romney, disclosed he had paid just 13.9 percent of his 2010 income in taxes. Romney benefited from a rule that allows him to count some of his compensation from running private equity firm Bain Capital as long-term capital gains. Representative Elijah Cummings (D-Md.), asked Simons whether he would “support repealing this tax loophole” and paying the ordinary rate. “That would be OK with me,” Simons said.