New bill would tax ETNs' presale gains

By Aaron Hochman-Zimmerman

New York, Dec. 20 - Legislation filed Wednesday by Rep. Richard Neal, D.-Mass., is intended to close the gap in the taxation between exchange-traded notes and both mutual funds and exchange-traded funds.

The new bill, slated for consideration in 2008, aims to tax ETNs in the vein of mutual funds, which incur taxes on dividends.

The bill, HR 4912, "provides rules for the tax treatment of prepaid derivative contracts, which includes exchange-traded notes," Neal said on the floor of Congress, Wednesday.

"Holders of such instruments will be required to include, as interest, income each year an amount determined by reference to a short-term interest rate," he said.

Currently, ETNs are treated as prepaid forward contracts which do not pay dividends or incur taxes on unrealized earnings. Investors in ETNs only receive income upon the sale of the security.

In an extreme case, if an ETN issuer filed for bankruptcy before the notes are redeemed, investors would receive no income at all, but would still be taxed on earlier income they had been assumed to receive under some new proposals.

However it plays out, the controversy over tax treatment of these instruments will encourage investors to pick one over another rather than hurting individual retail buyers, said Thomas Humphreys, a partner and tax law specialist for the law firm Morrison & Foerster, LLP.

"I don't think you'll have winners and losers ultimately," Humphreys told Prospect News, when asked about what sort of investor is affected by the bill.

"You end up having a real debate about the appropriate taxation for a range of financial instruments," he said, adding: "That is a good thing."

As ETNs become more popular amongst investors, allowing them to be taxed only when redeemed is "changing with the times," he said.

Although there are efforts by Neal and the Investment Company Institute - the trade group for the mutual fund industry - to introduce new taxes on ETNs, "for the next six months we are going to be arguing for the status quo," said Keith Styrcula, the chairman of the Structured Products Association.

The association organized an event Wednesday evening at which Humphreys was a speaker to rally the structured products industry in opposition to new tax rules.

The supporters of Neal's new legislation consider ETNs a tax shelter with an unfair advantage over mutual funds.

"Unless the tax treatment of retail ETNs is corrected, mutual funds stand to become substantially less attractive to investors solely for tax reasons," ICI president Paul Schott Stevens wrote to Rep. Charles Rangel and Rep. Jim McCrery of the House Ways and Means Committee.

The full text HR 4912 has not yet been released to the Library of Congress.

Earlier this month, the Internal Revenue Service ruled that notes linked to the euro/dollar, pound/dollar and yen/dollar exchange rates will be taxed as if they are debt instruments, a decision that specifically applied to Barclays Bank plc's iPath exchange-traded notes but applied to all financial products, regardless of whether the instrument is privately offered, publicly offered or traded on an exchange.

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.

The news came in a ruling Friday from the Internal Revenue Service that any financial instrument linked to a single currency should be treated like debt for federal tax purposes.

The ruling does not apply to exchange-traded notes that are linked to equities or commodities.

But he 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, among other securities, for tax purposes.

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