IRS ruling on single-currency iPath notes raises broad questions for structured products

By LLuvia Mares

New York, Dec. 11 - A ruling by the Internal Revenue Service on the tax treatment for Barclays Bank plc's iPath exchange-traded notes linked to the pound, yen and euro, has market insiders worried of what the future holds for other ETNs and the structured products market as a whole.

Market insiders said they don't know whether the tax issue uncertainty will decrease the ETNs' popularity amongst investors.

"The question is how far will the Treasury go with this?" said Keith Styrcula, Structured Products Association chairman.

"The SPA stands ready to assist the Treasury in any way possible to make the case that we should maintain the status quo. Maintaining the status quo on prepaid forwards is the best course of action for American investors, financial services [providers] and taxpayers."

In a ruling issued Friday, the Internal Revenue Service stated that any financial instrument linked to a single currency regardless of whether the instrument is privately offered, publicly offered or traded on an exchange, including the iPath ETNs, should be treated like a debt for federal tax purposes.

As a result, any interest accrued during the contract is taxable to investors, even though with the iPath notes it is reinvested and not paid out until the holder sells the notes or the contract matures.

The ruling, number 2008-1, also means that gain or loss from the sale or redemption of the notes will be ordinary and investors will not be able to elect capital gain treatment, Barclays said.

"It's a very narrow ruling on the part of the IRS," said a market specialist, who did not want to be identified.

"Effectively there were two things that Treasury Department came out with, one is the revenue ruling that single currency exchange-trade notes were going to be taxed as ordinary income - so the taxation most ETNs have enjoyed will not be a variable for single-currency structured products. It doesn't affect the currency basket."

The IRS also issued a notice asking for comments on the appropriate tax treatment of instruments described as prepaid forward contracts, which is how investors currently treat the equity and commodity exchange-traded notes for tax purposes.

According to a market source, the IRS started poking around ETNs after receiving numerous complaints from the Investment Company Institute regarding what the institute, the trade association for mutual funds, believes was unfair tax treatment for mutual fund shareholders.

"ICI basically hates the concept of exchange-traded notes," said a market source. "They are afraid it's going to bite into the $12 trillion monopoly of mutual funds. They don't mind exchange-traded funds taking in $550 billion because those are owned by fund companies."

ICI welcomes inquiry

"Essentially we are pleased the Treasury Department is considering these important public policy questions about exchange-traded notes," said Edward Giltenan, ICI spokesperson. "As we have said in our opinion, the tax disparity is unfair to mutual fund shareholders."

The market source said the ICI has made it a mission for the last year to find a way to impose a tax burden on ETN shareholders.

"They finally got Treasury interested in looking at the taxation of prepaid forwards on a global basis, which can have profound impact on the structured products business domestically and overseas as well," said Styrcula.

"What can happen is if the Treasury Department gets it wrong, the outcome can be very similar to what we had with principal-protected notes, which have tax disadvantages, [and are now] at only 1/20th the size of the market in Europe."

The market source said in Europe principal-protected notes are deemed to be equivalent to mutual funds.

"Principal-protected notes are to European investors what mutual funds are to American investors," he said. "So the mutual fund industry is extremely frightened by structured products technology, especially in the form of ETNs, which could pose some stiff competition [to mutual funds] in the free market."

SPA to 'vigorously rebut'

Styrcula said SPA expects the Treasury Department to conduct a full inquiry into prepaid forwards and how they work.

"There are several questions they are asking in the request for comments. Basically suggesting that there are other forces trying to suggest that prepaid forwards are a tax shelter, and they are not. We want to vigorously rebut that one-sided propaganda that's been out for the past six months."

Styrcula said now is just the bottom of the first inning of a nine inning game and it is now the structured products industry's turn to bat.

"We look forward to making the case that there should be no change in the status of how prepaid forwards are treated," he said.

In a statement responding to the IRS announcement, Philippe El-Asmar, managing director, head of investor solutions, Americas, at Barclays Capital, said: "Ruling 2008-1 provides taxable investors clarity on the tax treatment of foreign currency exchange-traded notes.

"Institutional and individual investors increasingly recognize that currency exposure may constitute a separate asset class to provide portfolio diversification and add potential portfolio returns. The iPath Currency ETNs provide simple, transparent and cost-effective access to three significant exchange rates."

Three Barclays iPath products are covered by the guidance: the iPath EUR/USD Exchange Rate ETN (ticker ERO), the iPath GBP/USD Exchange Rate ETN (ticker GBB), and the iPath JPY/USD Exchange Rate ETN (ticker JYN).

Barclays has already issued prospectus supplements for the three iPaths directly affected and also added warnings to the other iPath securities that tax treatment could change.

A planned offering of Buffered Super Track notes linked to a basket of indexes and exchange-traded funds had a similar warning.

And UBS AG issued a prospectus supplement on Tuesday for its performance securities with partial protection, performance tracking securities, return optimization securities, performance securities with contingent protection and performance securities with partial protection warning that the Internal Revenue Service is "actively considering" changes to the tax treatment of these notes, which are not exchange traded.

Pricing supplements for reverse convertibles and a sale of buffered return enhanced notes linked to the S&P 500 index filed with the Securities and Exchange Commission on Tuesday by Lehman Brothers included a similar warning.

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