Senate’s Wyden Presses IRS Over Hedge-Fund Tax Strategy

Senate Finance Committee Chairman Ron Wyden asked the Obama administration why the U.S. has failed to end a tax-avoidance strategy used by hedge funds, including John Paulson’s Paulson & Co.

Wyden, an Oregon Democrat, asked the U.S. Treasury Department and the Internal Revenue Service what they’ve done to challenge funds that channel investments through insurance companies in tax havens as a way to lower fund managers’ personal income-tax bills.

“The department and the IRS have been aware of this loophole for over a decade,” and “appear to have made no progress in ending this kind of tax abuse,” Wyden said in a June 12 letter that hadn’t previously been made public.

Wyden cited a Bloomberg News report from last year describing insurance vehicles established by New York-based Paulson & Co. and other fund managers.

Individual investors in hedge funds that trade frequently generally have to pay the ordinary income-tax rate on their earnings each year, whether they withdraw money from the fund or not. The current top marginal rate is 39.6 percent.

By investing in a fund indirectly, through an insurer in a country with no corporate income tax, they can defer taxes until they sell the investment and pay the lower long-term capital gains rate of 20 percent.

Threatening Scrutiny

In 2003, the IRS threatened to scrutinize hedge fund-backed insurers, claiming that some shouldn’t qualify for the tax advantage because they weren’t genuine insurance companies. The IRS notice focused on companies that sell reinsurance, policies that insurers buy to hedge their biggest risks.

In 2012, top executives at Paulson & Co. put $450 million of their own money into a new Bermuda reinsurer known as Pacre Ltd. Pacre had no employees and sold far less reinsurance than the industry norm, and invested virtually all its assets in Paulson & Co. hedge funds.

Other U.S. hedge fund managers who established reinsurers in Bermuda and the Cayman Islands include Steven A. Cohen, David Einhorn, and Daniel Loeb. Cohen sold his reinsurer last year. Spokesmen for the three either declined to comment or didn’t immediately respond to after-hours phone messages and e-mails seeking comment on the letter.

“I am keenly interested in exploring opportunities to work together to solve this serious issue,” Wyden wrote.

Armel Leslie, a spokesman for Paulson & Co., had no immediate comment on Wyden’s letter.

Bloomberg estimates Paulson’s net worth at $13 billion. He opened his money management firm in 1994, and gained attention in 2007 after a wager against the collapsing U.S. subprime mortgage market generated billions of dollars in profits.