[Excerpted from: Morrison & Foerster Tax Talk, March 7, 2008]
Overview
Exchange traded funds (“ETFs”) are investment funds whose shares trade on a stock exchange. From a U.S. federal income tax standpoint, ETFs are flow-through vehicles that generally must distribute their income currently.
Taxable U.S. investors include these amounts in their income annually. Viewed as economic cousins of ETFs, exchange traded notes (“ETNs”) are structured notes representing securities issued by corporations, typically financial institutions. ETNs generally do not distribute income currently. Contrary to the current inclusion and ordinary income regime applicable to ETFs, ETNs are treated as prepaid forward contracts for U.S. federal income tax purposes.
As such, under current law, investors in ETNs generally do not report current accruals of income and gain or loss is determined only upon a sale of the note. The following chart summarizes the treatment of ETFs and ETNs under current law.Structure and Tax Treatment to Holders
ETFs =
Pass-Thrus Current Ordinary Income Treatment on Distributions
ETNs =
Structured Notes Income Deferral and Capital Gain
Recent Developments
On December 7, 2007 the Internal Revenue Service (“IRS”) and the Treasury Department (“Treasury”) published Revenue Ruling 2008-1 (“Ruling”) and Notice 2008-2 (“Notice”) addressing the U.S. federal income tax treatment of prepaid forward contracts, which include certain ETNs.
Viewed together, the Ruling and the Notice serve as a warning that the IRS is inclined to require current accrual of income on instruments, such as ETNs, that the market has previously treated under a “wait and see” accounting system.
The Ruling is expected to have an immediate impact only on a narrow class of single currency-linked ETNs. In the Notice, the IRS and Treasury have asked for public comments on a comprehensive list of tax issues regarding the U.S. federal income tax treatment of prepaid forward contracts including ETNs. This request for public comments comes as the tax treatment of ETNs has come under close scrutiny on Capitol Hill in recent weeks.
Legislation was introduced in the United States Congress by Representative Richard E. Neal (D - MA) in December 2007 which, if enacted, would impact the taxation of notes such as ETNs. Under the proposed legislation, a holder that acquires such a note after legislative enactment would be required to include income in respect of the note on a current basis. As of this writing, it is not possible to predict whether the legislation will be enacted in its proposed form, whether any other legislative action may be taken in the future, or whether any such legislation may apply on a retroactive basis.
That said, Treasury official David Shapiro is reported as having announced at a January 18, 2008 session of the American Bar Association Section of Taxation midyear meeting that any IRS guidance affecting the treatment of prepaid forward contracts is not expected to be retroactive.
