Then, on December 7, the US Internal Revenue Service ended the beneficial tax treatment for a small number of ETNs linked to foreign exchange underlyings. It issued a ruling ruling 2008-1 stating that any financial instrument linked to a single currency, regardless of whether the instrument is privately offered, publicly offered or traded on an exchange, including an ETN, should be treated like debt for federal tax purposes. That means any interest paid to investors is taxable, even though such gains are not paid out until the contract matures. However, at the same time, and in a joint statement, the IRS and the US Treasury issued a notice that says they are examining the tax policy on ETNs to work out whether the parties to ETN transactions should be required to accrue income/expense during the term of the deal.
"Ruling 2008-1 provides taxable investors clarity on the tax treatment of foreign-currency ETNs" Philippe El-Asmar, Barclays
ETNs are debt securities that have to date been structured as simple, linear products linked to the performance of an index. Unlike an ETF (exchange traded fund), an ETN is not backed by a specific pool of assets but rather amounts simply to an agreement by the notes issuer to give the buyer the returns of an index or benchmark. The market in its current form got off the ground in June 2006, when Barclays Capital launched its iPath series of products, which are listed on the New York Stock Exchange and the American Stock Exchange. Since then other issuers, such as JPMorgan, Goldman Sachs and Deutsche Bank, have entered the market, and by December 25 ETNs were listed.
Three of Barclays iPath products are affected by the IRS ruling. They are linked to the pound, the yen and the euro versus the dollar exchange rates. The bank put out a statement to its clients stating that the notes would now "be considered debt for federal tax purposes, even though the holders initial investment and repayment are made in US dollars, and the holder may get back fewer US dollars than it invested".
Philippe El-Asmar, New York-based managing director and head of investor solutions for the Americas at the bank, is remaining diplomatic. "Ruling 2008-1 provides taxable investors clarity on the tax treatment of foreign-currency ETNs," he says.
In November, ICIs letter to the Committee on Ways and Means the House of Representatives body that handles tax legislation urged the legislators to "eliminate the unwarranted and unintended tax advantages" that retail ETNs that are taxed as prepaid forward contracts appear to have over mutual funds.
In response, Sifma says investors should be taxed on income when it is received. "The request to change the tax treatment of ETNs is driven by concerns over competitiveness and not by sound tax policy," it says.