You can think of a margin loan as being like an option on the underlying security: if I lend you $50 (nonrecourse) against a $100 share of stock, and tomorrow the stock is worth $45, then you’ve lost $50 and I’ve lost $5, same as if I wrote you a $50 strike put option on the stock.1 This isn’t quite right – margin calls, etc. – but what it lacks in precision it gains in tax efficiency:
James H. Simons, who became a billionaire when he turned his extraordinary mathematical ability from defense work to investing, has deployed an unusual strategy at Renaissance Technologies LLC to skirt hundreds of millions of dollars in taxes for himself and other investors, said people with knowledge of the matter.
The Internal Revenue Service is challenging the technique, which it called “particularly aggressive,” without identifying the hedge fund in the dispute. … Renaissance’s strategy involved buying an instrument called a “basket option contract,” from banks including Barclays, the people said.
That’s from today’s wonderful Bloomberg article about the IRS’s investigation. Here’s the IRS memo about the trade. Here’s the trade.2 Actually wait: here’s the trade, twice. You can just read down the left side if you enjoy getting mad at evil tax-dodging hedge funds, or just read down the right side if you don’t want to believe that Jim Simons could ever get up to no good:
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