Exchange-Traded Notes' Tax Perks Under Attack

The IRS says that returns of ETNs that invest in currencies must be treated as ordinary income.
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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.

Rydex's currency ETFs, including the

CurrencyShares Euro Trust

(FXE) - Get Report

, the

CurrencyShares British Pound Sterling Trust

(FXB) - Get Report

and the

CurrencyShares Japanese Yen Trust

(FXY) - Get Report

, 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."