IRS Ends Tax Advantage For Currency ETNs

The Internal Revenue Service has issued a ruling that ends the tax advantage that currency-based exchange-traded notes (ETNs) have over competing currency products, such as the CurrencyShares exchange-traded funds (ETFs) issued by Rydex Investments.

In fact, the new ruling puts the ETNs at a slight disadvantage for most investors.

This gets complicated if you haven't been following matters, so here is the Cliff's Notes of what happened.

Historically, currency investing has been very tax-inefficient. Investors in a currency-based product like Rydex's Euro Currency Trust ETF (FXE) have two sources of returns, and both receive terrible tax treatment:

• Interest income: FXE literally holds euros in a bank in Europe, where they earn local interest rates. This interest income is paid out to investors quarterly as "ordinary income," subject to tax rates up to 35%.
  
• Changes in the value of the currency: If the euro gains on the dollar, FXE goes up. When investors sells FXE—no matter how long they hold it—those gains are also taxed as ordinary income, with rates up to 35%. There is no possibility for gains to be taxed at the long-term capital gains tax rate of 15%, because the IRS does not consider currencies an "investment."

Until today, the iPath currency ETNs had a huge advantage on the tax front.

First, rather than having the interest income paid out directly to shareholders, virtual interest income was accumulated into the price of the ETN itself. Investors didn't have to pay taxes on this income until they sold. Moreover, as long as they held the ETN for more than a year, this income would qualify as long-term capital gains, with tax rates of just 15%.

Second, the original iPath prospectus suggested that ETNs could be classified as "pre-paid contracts with respect to their indexes." Under that definition, any long-term gains from currency appreciation were taxed at the 15% long-term capital gains rate.

In other words, all gains could be deferred in the ETN and eventually taxed at 15%. In contrast, interest income in the ETFs was taxed immediately, and all gains of any kind were taxed at 35%.

It was a huge advantage.

The new ruling, however, throws all of that on its head.  According to the new ruling, issued December 7, 2007, ETNs—along with any financial instrument linked to a single currency, regardless of whether that instrument is privately offered, publicly offered or traded on an exchange—should be treated as "debt" for federal tax purposes. This means that all gains—interest and otherwise—are taxable as ordinary income, with rates up to 35%. Moreover, shareholders will owe taxes each year on interest income even if that income is incorporated into the value of the note, as it is with ETNs. In other words, shareholders will have to pay taxes each year on interest, even though they won't realize that income until they sell the ETF.

In sum, currency ETNs have gone from having a huge tax advantage—with gains deferred and taxed at the 15% long-term rate—to a slight disadvantage, as investors now have to pay taxes out of pocket on interest they will not receive until they sell the fund.

Does Not Apply To Other ETNs  ... Yet

Importantly, this ruling does not apply to other ETNs. In fact, the IRS has issued a request for comment on how taxes should be handled for other "prepaid forward contracts," such as the popular commodity ETNs.

What's interesting about this ruling, however, is that the IRS has taken the step of defining an entire class of investment (currencies) as subject to one type of taxation, rather than allowing different products to dodge or not dodge that tax treatment based on how they are structured.

In a sense, that's a victory for rationality and clarity.

Comments

[currensea]

Does this apply to Forex funds traded through a broker on the fly? I mean, not as part of an ETF, but rather on a contract basis, buying and selling different currencies as those relative markets rise and fall.

Thanks in advance for the answer: [e-mail]

[sgmunson]

Just wondering if this also applies to physical currency in hand, where there is no contract involved?