Citi's partial principal at risk notes tied to Dow Industrials may raise tax concerns for some

By Emma Trincal

New York, Aug. 4 - Citigroup Funding Inc.'s 0% market-linked partial principal at risk notes due 2017 linked to the Dow Jones Industrial Average offer a good risk/return profile. But for some investors, the tax treatment, due to the quasi full principal-protection feature, may represent an impediment.

The payout at maturity will be par plus the index return, subject to a minimum payout of $9 per $10 principal amount of notes, according to a 424B2 filing with the Securities and Exchange Commission.

"The risk/return profile is good: You have no cap, and you have a 90% downside protection. It's unlimited upside with limited downside risk. That's a nice feature," said Steve Doucette, financial adviser at Proctor Financial.

But for this adviser, the product has some drawbacks - notably its long duration and its tax treatment. As such, the notes would only fit the needs of very bearish investors, according to him.

Running for cover

"This is more catastrophe insurance," he said.

"Six years is a long time. Who knows what is going to happen then?

"If in six years your index is up, the protection is useless anyway. Why would you be holding a note for six years?"

Doucette noted that he prefers buffers to floors in general because he is more concerned with the initial losses.

"The 90% protection is nice, but it's the reverse from my thinking," he said. "I'd rather much have protection on the first 10% or 20% losses with a buffer than losing the first losses no matter what."

For example, an 11% decline in the index would result in a 1% loss for investors in a note with a 10% buffer. With Citigroup's notes, however, an 11% decline in the index would result in a 10% loss for investors.

Ordinary income

Notes that offer a guaranteed return of principal, even not at 100%, are treated as debt under Federal taxes.

Although the noteholders do not receive interest payments, they are required to report a prorated portion of interest each year as income, according to the prospectus.

This tax, called original issue discount, is calculated based on a comparable cost of borrowing for the issuer, the prospectus said.

It has to be paid each year by the investor at the ordinary income tax rate, which is typically higher for wealthy investors than the capital gain tax rate of 15% currently.

"This is for very bearish investors who think that the world is going to fall on its face," said Doucette.

"But you're paying a tax penalty on this. Some of our high-net-worth clients can pay anywhere between 35% and 40% in income taxes.

"If I put them into this note, they'll be paying an extra 20% to 25% in taxes," he said comparing the debt tax treatment of the notes with the capital gains tax rate an investor would pay on a capital-at-risk product.

"Why would I do that and have my money locked in for six years?

"The only time this note pays [off] is if the Dow is down more than 10% in six years. But how can you tell six years from now? It's a hard one.

"This is a note for a broker providing a client some comfort rather than trying to maximize his return, because you give your client a terrible tax return."

Debt is debt

For Howard Simons, president at Rosewood Trading, taxation is not that relevant.

"It's not bad. I'd say the only big issue here is the counterparty risk," he said.

Taxation can be problematic, he said, as investors accrue income based on a comparable yield and while not receiving any interest, they still have to pay income taxes prior to maturity when the actual return is paid.

"That's a disadvantage," he said.

"But if you hold it in a tax-deferred account, the problem is resolved. I think it looks pretty good," he said.

If compared to equity products, the notes present obvious tax issues, he said.

"But you have to like the risk characteristics of equity to choose equity," he said.

Considering the 90% principal protection, Simons instead said the note should be seen for what it is: a debt instrument.

"If you look at this as a substitute for fixed income, then it makes a lot of sense," he said.

"What kind of interest would you get with a bond? Nothing point nothing!

"Would you rather have something that gives you the upside of the Dow Jones with the ordinary income tax or a bond that penalizes you for earning nothing?"

The notes (Cusip: 17317U717) will price in August.

Citigroup Global Markets Inc. is the underwriter.

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