It's the holiday season - a time when people's thoughts turn to turkey, mistletoe and taxes.
Yes, taxes. We're getting letters, emails and phone calls galore asking about the tax treatment of commodity-based exchange-traded funds [ETFs] and exchange-traded notes [ETNs]. Precious few greeting cards, but lots of tax queries. Go figure.
Before tackling the subject, let's be clear: tax advice should come from a tax professional. Individual circumstances vary from taxpayer to taxpayer. We can only offer a basic survey of the ETF/ETN landscape for investors here.
So, let's start with ETFs. ETFs, like their mutual fund cousins, are "pass-through" vehicles. Holders of ETF interests have a pro-rata stake in the gains and losses - and the resulting tax consequences - earned by the underlying portfolio. For commodity ETFs, there are two kinds of portfolios extant, each treated differently by our friends at the Internal Revenue Service.
ETF grantor trusts holding bullion such as streetTRACKS Gold Shares (NYSE: GLD), the iShares COMEX Gold Trust (AMEX: IAU) and the iShares COMEX Silver Trust (AMEX: SLV), take on the tax characteristics of a "collectible." While you hold the ETF, bullion sales are made from the portfolio to pay the trust's operating expenses. Your share of any net capital gains realized through these transactions are subject to tax at a maximum tax rate of 28 percent, if the bullion was held by the portfolio for more than 12 months. The fund's issuer supplies a year-end statement to shareholders detailing the portfolio's expenses and sales.
In addition, your sale of long ETF shares, or the covering purchase of ETF shares sold short, are also subject to tax if a gain is realized. The bases for gains and losses need to be adjusted for taxes previously paid as the result of portfolio bullion sales, so some accounting may be necessary to determine the tax bite. For long positions held more than 12 months, the maximum tax rate will, again, be 28%. For long positions closed out within 12 months or for short positions covered by a closing purchase, ordinary income rates - which could be as high as 35% - apply.
Keep in mind that the PowerShares precious metals funds (AMEX: DBP, AMEX: DGL and AMEX: DBS) aren't subject to this tax treatment because they hold futures in portfolio, not bullion.
ETFs holding futures contracts - such as the United States Oil Fund (AMEX: USO), the iShares S&P/GSCI Fund (AMEX: GSG), the PowerShares DB Commodity Index Fund (AMEX: DBC), and the three PowerShares precious metals futures funds noted above - inherit the tax liabilities of IRC Section 1256 contracts. Under the Code, open futures positions must be "marked to market" at the end of each calendar year for tax settlement. Simply put, that means all futures are treated as if they were offset (sold, in this case) on the last business day of the year - with resulting gains or losses taken - and re-established on the first business day of the following year.
When portfolio futures are sold or marked to market, gains and losses are treated as 60 percent long term, 40% short term. For taxpayers in the highest marginal bracket, that results in a maximum blended tax rate of 23%, regardless of holding period. Tax liabilities are engendered from the portfolio manager "rolling" futures forward as well as when the ETF shares themselves are sold (or bought back if originally shorted) by the investor. Once again, ETF shareholders rely upon the fund issuer to pass along year-end tax information in the form of a letter or a K-1 partnership return in order to determine adjusted cost bases or sales proceeds.
If the foregoing seems complicated, rest assured it is. Even for tax pros. We've saved the simplest for last.
Commodity ETNs are, for now at least, simplicity in action. The reason for this is that there's no underlying portfolio involved. ETNs are senior long-term debt instruments issued by a bank or financial institution that promises to pay investors the note's face amount at maturity, adjusted for the performance of a particular commodity index. These are zero-coupon issues; they make no income distributions prior to maturity.
ETN issuers argue that the instruments are "prepaid contracts" for tax purposes. As such, no income tax liability arises during the holding period. Ordinary capital gains and losses are realized - and taxable - upon the sale of ETNs held long, upon the covering purchase of ETNs sold short, or when ETNs are redeemed or matured. The maximum tax rate - for a short-term capital gain - is 35%.
So far, the IRS hasn't challenged the ETN issuers' tax interpretation, but nothing says the agency can't. A letter ruling is due soon that may shed more light on the IRS's intentions.
And there you have it. That wasn't so bad, was it? Hopefully, this clears up some of the burning questions that may have been nagging you or your accountant.
Oh, you don't have an accountant? Well, you can take this handy-dandy guide with you when you shop for one this holiday season.