Renaissance Technologies is a hedge fund known to use quantitative methods to obtain an advantage in the market. Today we learned they are going to be required to explain in front of a Senate committee how they use complex derivatives products to gain an advantage when filing their taxes.

Jim Simons Renaissance

Renaissance to join Barclays and Deutsche Bank in explaining on Investigations

Renaissance will join representatives from Barclays PLC (ADR) (NYSE:BCS) (LON:BARC) and Deutsche Bank AG (NYSE:DB) (ETR:DBK) in explaining to the Senate Permanent Subcommittee on Investigations, led by US Senator Carl Levin, just why and how a series of complex derivatives investments, known as basket options, are used to provide tax advantages. The committee is investigating tax-avoidance strategies by large United States companies like Apple and Caterpillar as well, according to a New York Times report.

Basket options are similar to stock options except they provide the buyer the right, but not the obligation, to purchasing an underlying basket of stocks or other assets, not just a single stock.

Tax advantage for derivatives

Derivatives have typically enjoyed a tax advantage over other investments. This is said to be largely due to the influence of the key derivatives exchanges and their patrons in Congress, including former US Congressman Dan Rostenkowski, former chairman of the powerful House Ways and Means Committee. The favorable treatment includes 60 percent of the gains from derivatives transactions are generally considered long term gains, while 40 percent are taxed at the short term rate – regardless of the duration of the trade. Long term gains allow for tax avoidance. It is unknown how the basket options differ from this tax treatment.

There has been numerous attempts to change this favorable tax treatment on derivatives, including US President Obama proposing ending the tax break in his 2010 budget. All have failed. It is unclear as to the Senate committee’s intentions in this hearing relative to potentially eliminating the tax treatment; as well, the exact nature of the “basket option” transactions is not entirely clear.

Tax treatment for the option transactions

“We believe that the tax treatment for the option transactions being reviewed by the P.S.I. is appropriate under current law,” Jonathan Gasthalter, a spokesman for Renaissance Technologies, said in an emailed statement to the Times. “Renaissance looks forward to assisting the committee on Tuesday,” who has also been cooperating with the IRS on the matter, according to the report.

Renaissance Technologies and their Medallion Fund “is the best hedge fund that Insider Monkey has come across,” according to a report in the hedge fund research firm. Medallion Fund employs high frequency trading and exploits inefficiencies in the stock market, according to the report by the hedge fund analysis firm. “One strategy they use takes advantage of the inefficiencies in the execution of large transactions. One of their algorithms determines whether a very large order is executed and front runs it. As a result Medallion experiences high transaction costs and high expenses. That’s why they charge a 5% fixed fee.”  The fund has traditionally additionally charged 20 percent of profits, but in 2000 it increased that performance fee to 36 percent and then to 44 percent, according to the report.