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The Internal Revenue Service has issued a ruling that ends the tax advantage that currency-based exchange-traded notes have had over competing currency products, including exchange-traded funds. In fact, the new ruling puts the first generation of ETNs at a slight disadvantage for most investors.
When the first ETNs launched, their prospectuses suggested that all gains in the funds (both interest income and gains from currency appreciation) could be taxed at the long-term capital gains rate of 15% (provided that the ETNs were held for a year or longer). That contrasted with the negative tax treatment assigned to most currency products, where all gains are taxed as regular income (with rates up to 35%), regardless of how long the positions are held. But on December 7, 2007, the IRS announced that all financial instruments linked to a single currency (including ETNs) were to be treated as “debt” for federal tax purposes. This means that all gains—interest and otherwise—are taxable as ordinary income, with rates up to 35%. The IRS also said that shareholders will owe taxes each year on interest income. That’s a problem for holders of the original ETNs, as those notes do not pay out interest income to shareholders; instead, the interest is incorporated into the value of the note, and is not realized by the shareholder until the note is sold. As a result, ETN holders will have to pay taxes out of pocket. Since the announcement, new ETNs have been launched that do pay interest income. Importantly, this ruling does not apply to noncurrency-based ETNs. The IRS has issued a request for comment on how taxes should be handled for these and other ”prepaid forward contracts.” |
