Derivative alchemy used to transform short to long term capital gains for tax purposes

Bloomberg ran an interesting article on how a major hedge fund used bank sponsored derivatives to transform short-term capital gains to long-term capital gains for tax purposes.

Regular readers know that a substantial portion of the activities that banks conduct behind the veil of opacity provided by derivatives is to arbitrage some form of regulation (tax is a form of regulation).

The veil of opacity is important, because if the bank were required to disclose to all market participants the derivative and its terms, nobody would buy the derivative.

In this case, the primary purpose of the derivative was to arbitrage the tax code.

As described in the memo and by people with knowledge of the matter, the transaction worked as follows: Barclays bought a portfolio of stocks and other instruments that fund managers at Renaissance wanted to trade. The bank hired the fund managers to oversee the portfolio, paying them a nominal fee. 

Then Medallion bought an option with a term of two years, whose value was linked to the worth of the portfolio. Renaissance had full discretion to trade the securities in the portfolio. 

Medallion could claim it owned just one asset -- the option -- which it held for more than a year, allowing any gain to be treated as “long-term” when its investors reported the income on their personal tax returns. 

“The profits are just being transmuted, through the alchemy of derivatives, to a preferenced return,” said Urban Institute’s Rosenthal.