Clash of the trade groups – ICI’s positions versus Sifma

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By:
John Ferry
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In its letter to the House of Representatives’ Committee on Ways and Means, the Investment Company Institute (ICI) argues that ETNs provide investment opportunities similar to those provided by many mutual funds.

The gloves come off

"By utilizing a gap in the tax laws regarding prepaid forward contracts, however, these ETNs provide their investors with tax treatment that is far superior to that provided to mutual fund shareholders," says ICI. "Specifically, investors in these ETNs receive tax-free deferral of their income and gains; mutual fund shareholders, in contrast, are taxed currently on the fund’s income and gains (even when such income and gains are reinvested automatically in the fund)."

ICI says that given the similarities between ETNs and mutual funds, the disparate tax treatment is "inappropriate absent a compelling tax policy rationale", and claims that no such rationale exists. "Indeed, tax policy points squarely in the opposite direction. The Internal Revenue Code provides a comprehensive tax regime for mutual funds, including various qualification requirements that funds must meet. ETNs have circumvented these tax rules while providing a substantially similar investment," it says.

In response, the Securities Industry and Financial Markets Association (Sifma) says that the tax treatment of financial products should be driven by the product’s tax attributes, and "not by a desire to affect the competitiveness of one product over another in the market".

Sifma continues: "Today, mutual funds and ETNs are taxed differently because they are fundamentally different products with different characteristics." It says that because investors who buy shares in mutual funds own the underlying securities and receive dividend income from those securities annually – where the dividend income can be taken in the form of cash or used to purchase more shares of the fund at the investor’s choosing – the investor pays taxes on the dividends because he has actual receipt of the income. If the mutual fund liquidates then the investor receives a pro rata share of the fund’s securities because he owns the securities in the fund.

By contrast, an ETN is a contract between an investor and an issuing company. The investor simply gives the issuer cash, and the issuer agrees to pay the investor a certain amount at a future date, based on the return of a market benchmark or index. So the investor, unlike with a mutual fund investment, owns no underlying securities and receives no dividends. "Investors receive income from an ETN only by allowing it to mature or by selling it on the exchange, at which point tax is imposed on the income realized by the investor. If the investment company liquidates, the investor owns no underlying securities – he must stand in line with other unsecured creditors and risks losing his entire investment," highlights Sifma.

Sifma says the proposal to tax ETNs in a way similar to funds is akin to taxing a stockholder on the stock’s appreciated value even if the stock pays no dividends. The change would make ETN holders pay tax on income they do not receive. "It is unclear how this phantom income would be calculated," says Sifma.

Sifma says ETFs and mutual funds are different for a number of reasons, including the types of risk they provide and the exposure the investor gets. "The request to change the tax treatment of ETNs is driven by concerns over competitiveness and not by sound tax policy," says the trade body.