Mutual funds, structured products face off on proposed tax rules for ETNs

By Kenneth Lim

Boston, March 5 - The mutual fund industry and structured products advocates on Wednesday drew battle lines on proposed changes to the tax treatment of derivative products, but all acknowledged that the current rules could be improved.

"I think it was a very dynamic and interesting discussion, with interesting points from both sides," Keith Styrcula, president of the Structured Products Association, told Prospect News.

The U.S. House Subcommittee on Select Revenue Measures, chaired by Rep. Richard E. Neal of Massachusetts, on Wednesday held a hearing on the tax treatment of derivatives, which includes prepaid derivative contracts and exchange-traded notes.

The hearing was organized to discuss proposed legislation by Neal to treat some derivatives such as ETNs more like other debt instruments, which are taxed based on accrued gains over time. ETNs are currently treated like capital goods, which are taxed based on gains when the notes are sold or mature.

In a written testimony to the subcommittee, Styrcula cautioned that the proposed legislation, known as H.R. 4912, would put exchange-traded notes at a tax disadvantage and stifle investment growth in the United States, especially in the face of competition from Europe.

He noted that Europe and Asia treat ETN gains as long-term capital gains if held for longer than a year.

"The United States is just now catching up with Europe in structured products sales - after a decade-long headstart - and imposing a singular, disadvantageous tax scheme on our industry will have vast and devastating consequences on our ability to compete on a global basis," he wrote.

He wrote that a change in the current tax rules would be welcome. But such a move should not target ETNs and financial derivatives, only, he added.

'A potentially dangerous precedent'

"The SPA respectfully submits that any attempt to single out financial derivatives, prepaid forwards, and structured products in the absence of a full consideration of all other financial instruments is a potentially dangerous precedent that could have vast and unforeseen consequences in the global arena," he wrote.

Leslie B. Samuels of the firm Cleary Gottlieb Steen & Hamilton, who represented the Securities Industry and Financial Markets Association (Sifma) at the hearing, echoed those views.

Mutual funds see 'highly favorable' treatment

The strongest advocates for the proposed bill appeared to be from the mutual funds industry.

In his opening statement, Gus Sauter, chief investment officer and managing director of The Vanguard Group, said ETNs enjoy an unfair tax advantage over mutual funds.

"ETNs are presented as a way to convert investment returns into long-term capital gains and to defer payment of tax until the derivative is sold or redeemed, possibly many years in the future," he said. "No comparable financial product is taxed so favorably. Regulated futures contracts, for example, are marked to market annually (that is, treated as sold at the end of each year, and taxes may be owed, without an actual sale), though they are also exchange-traded forward contracts like ETNs.

"I am told that this highly favorable treatment is the result of a gap or loophole and not an express policy decision, that ETNs are simply bringing to a head a question that has been left unresolved for many years: how prepaid forward contracts should be taxed."

The tax laws on such derivatives must be changed and clarified as soon as possible before more retail investors buy such products, he added, which would make it "increasingly complicated to reset expectations and adopt a sound and comprehensive tax policy."

Samuels notes 'complexity'

Cleary Gottlieb's Samuels said that comparing ETNs to mutual funds is not so straightforward. Mutual fund investors have a right to receive cash distributions, but not ETN investors, he said. ETNs also do not represent ownership of any assets, whereas mutual fund investors effectively own the underlying securities, he added.

"In light of the complexity of the issues that will need to be resolved in order to arrive at fair and administrable tax rules, we respectfully suggest that the legislative review be coordinated with the Treasury's consideration of these same issues," Samuels said in his written testimony. "We look forward to participating in this important dialogue."

After the hearing, Styrcula noted that the mutual fund industry, through industry group Investment Company Institute, is also trying to get deferred taxation for mutual funds.

"For everything that the industry claims about wanting to even out the playing field, they appear to be making efforts to make mutual funds tax advantaged against other instruments," he said.

Styrcula said an overhaul of the tax laws for financial products would be timely, but it must be done with input from the financial sector and will likely not be achieved overnight.

"My personal point today is that it's imperative that neither Treasury nor congress regulate ETNs and structured products in a vacuum," he said.

Wholesale revision 'more fruitful'

Rep. Phil English, R.-Pa., echoed those sentiments.

"Mutual funds have sought for some time the ability to defer some or all of the gains that currently must be distributed and taxed at the investor level," he said in his opening statement. "Additionally, some of those same companies that offer mutual funds have developed a product that provides many of the benefits of a mutual fund, including diversification and exposure to a variety of types of risk, without requiring annual distributions of income.

"In my view, this demonstrates that clever minds can always find ways to torture the tax code into producing the desired result. In light of this, it may prove more fruitful to look at the labyrinth of rules currently on the books for financial products generally and determine whether a wholesale revision is needed."

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