I.R.S. Cracks Down on Hedge Fund Tax Strategy

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Hedge funds that used a strategy to claim billions of dollars in tax savings will face new scrutiny from the government, according to guidance issued by the Internal Revenue Service on Wednesday.

So-called basket options — complex financial structures that allowed hedge funds like Renaissance Technologies to bypass taxes on short-term trades — will now be labeled listed transactions, the I.R.S. said. This means that anyone using the options must declare them on their tax returns. They will be penalized if they fail to do so.

The new I.R.S. guidance will be retroactive, applying to all transactions as far back as Jan. 1, 2011.

The action comes after a 2014 report by the Senate Permanent Subcommittee on Investigations found that Renaissance was able to avoid more than $6 billion in taxes over more than a decade by using basket options. A dozen other hedge funds also used the basket options — created by Barclays and Deutsche Bank — to bypass taxes on short-term trades between 1998 and 2013, according to the report.

“These banks and hedge funds involved in this case used dubious structured financial products in a giant game of ‘let’s pretend,’ costing the Treasury billions and bypassing safeguards that protect the economy from excessive bank lending for stock speculation,” said Carl Levin, a Michigan Democrat and chairman of the Senate subcommittee at the time. He did not stand for re-election last year.

Renaissance, a $25 billion hedge fund founded by James H. Simons in 1982, was the focus of the investigation. Its Medallion fund, which now manages money for its employees only, was the most prolific user of basket options. The fund has earned an average annual return of more than 35 percent for two decades, according to a spokesman for Renaissance, Jonathan Gasthalter.

Mr. Levin also took aim at the I.R.S for taking six years to investigate Renaissance. “Waiting for tax reform is like waiting for Godot,” he said at a news briefing at the time. The I.R.S. has since taken action against Renaissance for certain years during which it used basket options, according to subcommittee staff members.

Deutsche Bank and Barclays created special options accounts for hedge fund clients in the banks’ names and claimed to own the assets, when in fact the hedge fund clients had full control of the assets and reaped the profits.

The hedge funds would then execute trades — many of them a few seconds in duration — but wait until just after a year had passed to exercise the options, allowing them to report the profits at a lower long-term capital gains tax rate.

Peter F. Brown, co-chief executive of Renaissance, countered accusations that the basket options were used for the main purpose of skirting taxes during a Senate hearing in Washington last summer. Mr. Brown said they were “extremely important” because they gave the hedge fund the ability to increase its returns by borrowing more and to protect against model and programming failures.

On Wednesday, Senator Ron Wyden of Oregon, the ranking Democrat on the Finance Committee, said he welcomed the action by the I.R.S. to “bring the hammer down on these basket options once and for all.”

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