IRS cracks down on hedge funds

The U.S. Internal Revenue Service is cracking down on hedge funds, challenging a tax strategy called "basket options" that is used to claim billions of dollars in tax savings, the New York Times reported.

Hedge funds using the options must declare them on their tax returns and they will be penalized if they fail to do so, the newspaper reported, adding the new requirement was being backdated four years.

"The law is very clear in this area - basket options are a tax shelter. Today's guidance from the Administration is a win for taxpayers and brings us one step closer to a more fair and equitable tax code," Senator Ron Wyden, the top Democrat on the Senate Finance Committee, said in a statement on Wednesday.

Wyden sent a letter to U.S. Treasury Secretary Jack Lew last month calling for the tax shelter to be closed.

The head of a powerful U.S. Senate panel presented the findings of a year-long probe into basket options last July, accusing Deutsche Bank AG and Barclays Plc of helping hedge funds avoid taxes and calling for tougher action from the authorities.

The products offered by the banks were styled as options in an account that was nominally held by the bank, but was in fact controlled by the hedge funds, which bought and sold the assets, and profited from taxable short-term trading, the panel said.

The hedge funds then paid the lower tax rate on long-term capital gains, arguing that profits came from exercising the option, rather than from the underlying short-term trades. But the options were fictional, the panel found.

The IRS said in 2010 that basket options do not function like an option and should not be treated as such, but that opinion has no status as an official rule, and the IRS has not yet pressed any cases.

The new IRS guidance will apply retrospectively to transactions back to Jan. 1, 2011, the NYT reported.