IRS Deals Setback to Barclays Forex-Linked ETNs

Late Friday the IRS released Revenue Ruling 2008-1 which effectively crushes the expected tax treatment of the Barclays exchange traded notes (ETNs) linked to individual foreign exchange rates. In the ruling the IRS argues that the fx-linked notes are nothing more than regular debt instruments (bonds) with a payout linked to the relevant fx rate. The result of this is that U.S. investors in ERO, GBB and JYN will be forced to accrue income for tax purposes each year they hold their investment even though the security pays no actual cash distribution (i.e., phantom income is generated for tax purposes).

This is indeed a set-back to the still immature ETN marketplace. However, the upshot is that the IRS did not make the same determination with respect to the rest of the ETN marketplace. This represents a tacit approval of what most tax practitioners had believed, that most ETNs are properly treated as forward contracts for U.S. tax purposes – which results in U.S. investors recognizing only long-term capital gains when they elect to exit the investment, assuming they have held the investment for more than 12 months at such time.

Indeed, simultaneously with the release of the above mentioned ruling, the IRS issued Notice 2008-2 which requests public comments on the proper tax treatment of ETNs. The Notice suggests that ETNs other than fx-linked (and other investments known in the tax world as pre-paid forward contracts, a.k.a. “structured notes”) are currently properly taxed as forward contracts but that, from a policy perspective, different forms of taxation may be more appropriate. The other forms of taxation suggested by the IRS include annual mark-to-market and other forms of phantom income generating taxation.

It is suspect, to say the least, why the IRS has waited nearly 100 years to question the tax treatment of forward contracts (to be fair, the IRS did raise the question in 1993, and a couple of times thereafter but never did anything about it). But now with the advent of ETNs and the uproar within the House Ways & Means Committee being raised by the big mutual fund industry association (the ICI), the issue is apparently finally ripe. Although, like in 1993, the IRS may just be asking questions . . . with answers still decades away. In the meantime I would keep buying ETNs (other than the fx-linked variety) since any change to the tax status will surely be prospective only in the wake of Notice 2008-2 tacitly endorsing their current tax status.

Disclosure: Author has no position in any stocks/funds mentioned in this article.