Back in November I studied Exchange Traded Notes (ETNs), a new genre of product with apparently better tax treatment than its much popular cousin Exchange Traded Funds (ETFs) with ETFs. The innovation of Barclays, ETNs are debt notes 1) issued by financial companies like Barclays, Goldman Sachs and Deutsche Bank and alike, 2) tracking a certain index like currency and commodities, 3) that can be traded in the stock exchange just like ETFs, and 4) being promoted with preferred tax treatment -- that is, there is no required distribution so that investors only have to pay tax when they finally dispose the ETNs.
Unfortunately, the preferred tax treatment is a claim by the issuing banks, and hadn't been confirmed by IRS ... until now.
According to MarketWatch, the IRS recently denied favorable tax treatment of most ETNs on the market:
Barclays PLC has suffered a setback by a U.S. Treasury Department decision that takes away tax advantages touted in exchange-traded notes it manages that give investors access to foreign currencies.
So what's next? My understanding is the new development is merely the IRS interpretation of the law that can be challenged in court.
The Internal Revenue Service ruled Friday that any financial products linked to a single currency should be treated like debt for federal tax purposes, even if they are publicly listed on an exchange like ETNs. The news is the opening salvo in a hotly contested and closely watched battle between the mutual-fund business and the securities industry.
The agency's ruling only affects currency exchange-traded notes, but the IRS has also requested industry comment on ETNs tracking commodities and stocks. Industry observers say a second adverse tax ruling would be another defeat for Barclays and other ETN providers, and stall the industry's growth.
Actually, since Day One, the argument of ETN promoters is always that ETNs are differently structured products -- unlike an ETF which is backed by a pool of investments consisting of the index the ETN is tracking (a S&P 500 index ETF is composed of shares of the 500 companies), an ETN is essentially a debt note, and its investors bear the additional risk of issuing bank's survivability -- and therefore should be taxed differently. As quoted in the same MarketWatch article:
In early November, SIFMA Chief Executive Marc Lackritz wrote a letter to the Committee on Ways and Means defending ETNs, saying the tax treatment of financial products "should be driven by the product's tax attribute -- not by the desire to affect the competitiveness of one product over another in the market."
I mentioned back in November that ETNs' tax advantage, if confirmed, can make it much more appealing than index-tracking ETFs and mutual funds. Can we rule ETNs out now? Maybe not yet. I'll keep tracking its development and report on this blog over time.