Two of Europe’s largest banks, Barclays PLC and Deutsche Bank, have sold complex financial products that allowed hedge funds to avoid US taxes, a US Senate report said on Tuesday.
The scheme has cost the federal government billions of US dollars in tax revenues, according to the report by the US Senate’s permanent subcommittee on investigations of the Committee on Homeland Security and Governmental Affairs.
The committee said an investigation revealed how British bank Barclays and Germany’s Deutsche Bank developed two types of so-called “basket options” — instruments indexed on market values, such as stocks and commodities — to help the hedge funds skirt US taxes.
From 1998 to last year, Barclays and Deutsche Bank sold 199 basket options to more than a dozen hedge funds, which used them to conduct more than US$100 billion in trades.
The banks and the hedge funds used the basket options to open proprietary trading accounts in the names of the banks, making it look like the banks owned the assets.
However, the hedge funds exercised total control over the assets, executed all the trades, and reaped all the trading profits, the report said.
“The ‘option’ functioned as little more than a fictional derivative, permitting the hedge fund to cast short-term capital gains as long-term gains and authorizing financing at levels otherwise legally barred for a customer’s US brokerage account,” the report said.
The banks offering the “options” benefited from the financing, trading, and other fees charged to the hedge funds initiating the trades.
The democratic chairman of the subcommittee, Carl Levin, said the investigation focused on two important issues: “tax avoidance by profitable companies and wealthy individuals, and reckless behavior that threatens the stability of the financial system.”
The US’ Internal Revenue Service (IRS) publicly identified in 2010 that type of option product was “abusive,” yet the IRS has not collected taxes on many of the basket option transactions, the report said.
“Americans are tired of large financial institutions playing by a different set of rules when it comes to paying taxes,” said Senator John McCain, the ranking republican member of the committee.
Deutsche Bank, in an e-mailed statement to reporters, said the options discussed in the report were “at all times fully compliant with applicable laws, regulations and guidance.”
The German bank said it ceased to offer them in 2010.
The Wall Street Journal reported on Tuesday online that the New York Federal Reserve had uncovered serious problems at Deutsche Bank’s giant US operations, “including shoddy financial reporting, inadequate auditing and oversight and weak technology systems.”
In a letter to Deutsche Bank executives last December cited by the Wall Street Journal, a senior official with the New York Federal Reserve wrote that financial reports produced by some of the bank’s US arms “are of low quality, inaccurate and unreliable. The size and breadth of errors strongly suggest that the firm’s entire US regulatory reporting structure requires wide-ranging remedial action.”
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