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(Changes sourcing to IRS document from New York Times; addsbackground)
July 9 (Reuters) - The U.S. Internal Revenue Service iscracking down on hedge funds, challenging a tax strategy called"basket options" that they have used to avoid taxes estimated atbillions of dollars.
Under IRS guidance issued on Wednesday, hedge funds usingthe options must report them on their tax returns and correctpast returns if they used them since Jan. 1, 2011.
The guidance came after a U.S. Senate subcommittee reportedlast year that at least 13 hedge funds were using basket optionscreated by banks to avoid federal taxes.
"The law is very clear in this area - basket options are atax shelter," Senator Ron Wyden, the top Democrat on the SenateFinance Committee, said in a statement.
Wyden sent a letter to U.S. Treasury Secretary Jack Lew lastmonth calling for the tax shelter to be closed.
Former Senator Carl Levin, a Democrat who was then head ofthe powerful U.S. Senate Permanent Subcommittee onInvestigations, presented the findings of a year-long probe intobasket options last July, accusing Deutsche Bank AG and Barclays Plc of helping hedge funds avoid taxes andcalling for tougher action from the authorities..
Spokesmen for Deutsche Bank and Barclays declined tocomment.
The basket options were in accounts nominally held by thebanks, but were in fact controlled by the hedge funds, whichbought and sold the assets and profited from taxable short-termtrading, the Senate subcommittee said.
The hedge funds then paid the lower tax rate on long-termcapital gains, saying profits came from exercising the optionsrather than from the underlying short-term trades.
But the basket options were not really options, the Senatepanel found.
The largest user of the options, Renaissance TechnologiesCorp, saved an estimated $6.8 billion in taxes, the panel'sreport said.
A spokeswoman for Renaissance did not immediately return acall seeking comment. At the time of the report, a spokesman forthe hedge fund said Renaissance believed the tax treatment wasappropriate under current law.
The IRS said in 2010 that basket options did not functionlike actual options and should not be treated as such. Thatopinion had no status as an official rule, however, and the IRShas not yet pressed any cases. (Reporting by Supriya Kurane in Bengaluru; Additional reportingby Dena Aubin in New York; Editing by Kevin Drawbaugh and LisaVon Ahn)
