Exchange-Traded Notes' Tax Perks Under Attack

Rydex's currency ETFs, including the CurrencyShares Euro Trust (FXE Quote), the CurrencyShares British Pound Sterling Trust (FXB Quote) and the CurrencyShares Japanese Yen Trust (FXY Quote), all have the same expense ratio as the iPath's currency ETNs, just 0.4%.

The IRS' ruling didn't come entirely out of the blue. Barclays has been touting the tax benefits of ETNs since it launched the first ones last year, but with the caveat that there hadn't been a definitive ruling on their tax status. So there was always some uncertainty. And to be fair, the IRS has created a consistent rule for all currency products.

It's good news for the mutual fund industry, which had been lobbying to eliminate ETNs' more favorable tax treatment. Last month the Investment Company Institute, a mutual fund trade group, wrote to the U.S. House Ways and Means Committee, which writes the nation's tax laws, complaining that ETNs' tax treatment put mutual funds at a competitive disadvantage.

ICI spokesman Edward Giltenan says the tax disparity is "unfair to mutual fund shareholders" and that investors could be driven to ETNs primarily on their tax treatment, as opposed to other factors such as diversification, transparency, low costs and overall investment merit.

Mutual funds are pooled investment vehicles that hold actual assets such as stocks and bonds, and they must distribute income annually.

While these returns are taxed at higher rates than those of some ETNs, mutual funds do have one big advantage: No matter how low their assets fall in price, mutual funds can usually be liquidated to repay the shareholder in cash. But ETN investors are exposed to credit risk -- if the issuer goes under, they won't get paid.

While the currency issue has been resolved, the IRS is still considering how ETNs that track stocks and commodities should be taxed, and it has solicited comments. The issue has big stakes. Wall Street investment banks have used these kinds of financial instruments for years, and this could throw that business into chaos.

ETN providers argue that ETNs, which are essentially prepaid forward contracts, don't distribute taxable income until maturity, and investors therefore shouldn't have to pay taxes on something that doesn't exist.

The Securities Industry and Financial Markets Association, or SIFMA, the trade group for more than 650 securities firms, banks and asset managers, said in a rebuttal letter to the Ways and Means Committee that the tax changes would require ETN holders to pay tax on income that they do not receive and may never receive.

"Taxing phantom income that is not actually received is an ill-advised policy that Congress should not pursue with respect to ETNs, prepaid forward contracts or corporate stock," CEO Marc Lackritz wrote last month. "Investors should be taxed on income when it is received. ... This (proposed) policy is akin to taxing a shareholder on the stock's appreciated value even if the stock pays no dividends."