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It looks like a day of reckoning may be nearing for exchange-traded notes [ETN]. Fund Action recently reported that a meeting is scheduled within the next few days at the Internal Revenue Service and the Department of the Treasury will publicly discuss the ETN tax issue.

The favorable tax treatment of ETNs is something we have written extensively on at IndexUniverse.com since the first notes were launched in June 2006. Barclays Bank and other ETN issuers (Goldman Sachs and Bear Stearns) have made the argument—supported by their tax counsels that ETNs should receive similar tax treatment to index-linked structured products... tax treatment that puts the notes at an advantage compared with open-end mutual funds and traditional exchange-traded funds [ETFs].

For instance, the prospectus for the iPath Dow Jones AIG Commodity Index Total Return ETN (DJP) states that the note should be treated as a prepaid contract with respect to its underlying index. That means that all the interest income and spot return on the index will be rolled up into the value of the note, and investors will only pay taxes when they sell or when the notes reach their 30-year maturity.

By comparison, a commodity ETF like the iShares GSCI Commodity ETF (GSG) or the PowerShares DB Commodity ETF (DBC) gets hit with a double-whammy on the tax front:

• First, any interest income in the fund is paid out and taxed as regular income;
• Second, the funds are "marked-to-market" at the end of the year, meaning the IRS treats the funds as if you sold them on December 31... even if you didn't. If the fund is up, you pay capital gains taxes, with 60% treated as long-term gains and 40% treated as short-term gains.

Similar—and indeed more favorable—treatments apply to the currency ETNs.

Dale Collinson, director of PricewaterhouseCoopers and a former IRS official, told Fund Action that the government could intervene with legislation in order to preserve competition. He said action had been taken in previous cases when tax disparities threatened competition.

This raises some interesting questions. ETNs are, by definition, very different from ETFs. They convey no ownership or assets, just a promise from the issuer that a certain amount will be paid upon redemption or maturity. The value of the note is determined by the index it tracks and by the creditworthiness of the issuer. A reasonable investor may not want to take on the credit risk of putting a significant portion of their portfolio into ETNs. In this light, the competition issue could be a bit of a red herring.

However, Fund Action also reports that government tax collectors believe ETNs could become a sort of mass tax shelter. After all, ETNs are easily accessible by both small- and large-scale investors, and if assets grew considerably, the impact on tax revenues could eventually become substantial. Given that ETNs are not yet widely known, the tax advantages could be stripped away without causing much of a fuss among constituents. (Then again, it might be hard to rule against ETNs while preserving the tax treatment for structured products... a much bigger market, and one that is established among a moneyed and influential constituency.)

Nothing will likely be decided at the upcoming meeting, but it will be useful to find out which way the wind blows on the ETN tax issue. If ETN tax advantages appear to have a limited life span, we might expect assets to decline.

Written by Heather Bell

Source: The IRS Considers Cracking Down on ETNs' Preferential Tax Treatment