The U.S. Internal Revenue Service (IRS) cracked down hedge funds by issuing guidelines designed to end effectively “basket options,” a financial strategy used to avoid billions of dollars in capital gains taxes.

Hedge funds using basket options are required to report it on their tax returns under the guidelines issued by the IRS on Wednesday. The firms are also required to correct their past returns if they used the tax strategy since January 1, 2011.

IRS basket options

IRS responded to Sen. Wyden’s’ demand

Last month, Senator Ron Wyden, a ranking member of the Senate Committee on Finance sent a letter to Treasury Secretary Jacob Lew requesting the immediate issuance of guidance to shut down basket options. According to Wyden, hedge funds use basket options as a tax shelter.

“The law is very clear in this are—basket options are a tax shelter. The IRS and Treasury have clear authority to shut down these transactions today. These investment vehicles have avoided over $1 billion in taxes. It is time to shut down these arrangements once and for all. Therefore, I ask that the Treasury Department and IRS to take regulatory steps expeditiously to shut down basket options arrangements,” wrote Sen. Wyden.

Last year, a Senate subcommittee reported that at least 13 hedge funds were using basket options to avoid federal taxes.

The Senate Permanent Subcommittee on Investigations accused Barclays and Deutsche Bank of helping hedge funds avoid taxes. The subcommittee recommended the implementation of tougher actions from authorities.

The subcommittee found that basket options were in accounts supposedly held by banks, but hedge funds control those accounts. Hedge funds bought and sold assets, and profited from short-term taxable trading. Hedge funds paid lower tax rates on long-term capital gains by reporting that their profits came from exercising options rather than from underlying short-term trades.

The subcommittee identified Renaissance Technologies as the largest user of basket options. The firm saved an estimated $6.8 billion in taxes. At the time of the report, a spokesman for Rennaissance said the firm believed that the tax treatment was appropriate under the existing law.

Sen. Wyden applauds IRS action to shut down basket options

Today, Sen. Wyden issued a statement applauding the action of the IRS and the Treasury Department to shut down basket options.

“I applaud the Treasury Department and IRS heeding my call to take action and bring the hammer down on these basket options once and for all. 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.”