Exchange-Traded Notes' Tax Perks Under Attack

Exchange-traded notes have been marketed as a tax-efficient way to invest in currencies and other hard-to-reach asset classes.

But their tax treatment has suddenly changed from a selling point to a potential drawback.

Earlier this month, the Internal Revenue Service ruled that ETNs -- or at least the ones tracking foreign currencies -- should be considered debt for federal tax purposes.

That means that even if you hold the shares for more than a year, you won't qualify for the lower long-term capital gains rate of 15%. Both capital gains and interest will be taxed as ordinary income, which is subject to rates up to 35%.

The ruling affects only the currency ETNs, including the iPath EUR/USD Exchange Rate ETN(ERO), which tracks the euro's movement against the dollar; the iPath GBP/USD Exchange Rate(GBB), which tries to equal the performance of the British pound; and the iPath JPY/USD Exchange Rate ETN (JYN), which follows the Japanese yen.

ETNs are a kind of senior, unsecured debt whose return is linked to exchange rates, commodity prices or stock indices. They're typically issued by an investment bank.

Unlike exchange-traded funds or mutual funds, ETNs don't hold stocks, bonds or derivatives. When the index or exchange rate they track increases, this performance is reflected in the value of the ETN. That means investors don't realize a return until the securities mature in 30 years or they sell them on the open market.

Prior to the IRS ruling, investing in Barclays' iPath currency ETNs was more tax efficient than holding foreign currencies outright or investing in Rydex's CurrencyShares, competing exchange-traded products that track exchange rates. Like currencies, gains from the CurrencyShares were always taxed as ordinary income, no matter how long they were held.

But investors who held currency ETN shares for more than year were only subject to he long-term capital gains rate. For investors in the 35% tax bracket, paying just 15% was like finding money.

The IRS ruling eliminates this more favorable tax treatment. The ETNs don't hold currency, but the IRS is saying that if you want to invest in currencies, it doesn't matter what the financial instrument looks like -- privately offered, publicly offered or traded on an exchange, they all get treated the same, which is to say unfavorably.

"Currency gains are considered by Congress to be ordinary income," says Tom Humphreys, partner at the New York law firm Morrison & Foerster. "Because people were trying to claim capital gains on regular currency transactions, Congress wanted a level playing field for currency."

In one sense, the ruling doesn't just level the playing field, it actually puts currency ETNs at a disadvantage to Rydex' CurrencyShares. That's because, unlike ETNs, CurrencyShares hold actual currencies. So on top of capital gains, they also generate income because the money sits in overnight notes. (ETNs don't give off income, but it was implied that interest would be incorporated into the ETNs' total value, which could also be taxed as a long-term gain.)

The ruling means that ETN shareholders need to pay annual taxes on this interest, just like the CurrencyShares investors. But unlike CurrencyShares investors, ETN investors don't actually get their hands on the income before they get the tax bill -- they have to wait until they sell their shares.