Senate investigators have determined that some of the most powerful investment firms on Wall Street schemed their way into billions of dollars in tax breaks.

A report (pdf) by the U.S. Senate’s Permanent Subcommittee on Investigations says more than a dozen hedge funds used “basket options” over a 15-year period to avoid paying hundreds of billions in taxes they would otherwise have owed to the U.S. Treasury.

One firm in particular, Renaissance Technologies, used complex financial structures created by founder James H. Simons to capture its $6 billion in savings. Simons—who worked as a code breaker for the National Security Agency in the 1960s—retired from Renaissance in 2010 and currently serves as its non-executive chairman.

Other basket options were devised by Barclays and Deutsche Bank, and other hedge funds that took advantage of them included Steven A. Cohen’s SAC Capital Advisors (now known as Point72 Asset Management) and George Weiss Associates. SAC changed its name as part of its guilty plea with the government on insider trading charges.

“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,” Senator Carl Levin (D-Michigan), chairman of the subcommittee, told the media.

Alexandra Stevenson at The New York Times described the basket options as structured accounts “that allowed hedge funds to bypass taxes on short-term trades.”

The two banks noted by investigators “used the options to build special accounts for their hedge fund clients in their own names and claimed they owned the assets when it was, in fact, the hedge fund clients that exercised full control of the assets, determining each trade and reaping all the profits,” Stevenson added.

The structure of the basket options also allowed the hedge funds to borrow up to $17 for every dollar in an account rather than the 50 cents on the dollar that broker-dealers are restricted to according to limits that go back to the 1930s.

The Internal Revenue Service (IRS) has been investigating Renaissance Technologies’ use of these tax structures for six years, ever since the Securities and Exchange Commission alerted them to the practice.

“To say [the IRS has] not moved swiftly is an understatement,” said Levin.

Renaissance’s legal team that is defending the firm against the government’s investigation includes Kenneth W. Gideon, a former IRS chief counsel and former assistant Treasury secretary for tax policy.

When asked at a 2008 Congressional hearing if he would “support repealing this tax loophole” and pay the customary tax rate, Simons responded, “That would be OK with me.”

-Noel Brinkerhoff, Danny Biederman

To Learn More:

Abuse of Structured Financial Products: Misusing Basket Options to Avoid Taxes and Leverage Limits (Senate Permanent Subcommittee on Investigations) (pdf)

Senate Inquiry Faults Hedge Funds’ Tax Strategy (by Alexandra Stevenson, New York Times)

Simons Strategy to Shield Profit from Taxes Draws IRS Ire (by Zachary R. Mider and Jesse Drucker, Bloomberg)

Barclays Bank Fined $453 Million for Rigging California and Western Energy Markets (by Ken Broder, AllGov California)