ETFs, ETNs and Your Taxes: Street One's Paul Weisbruch Explains All

| About: PowerShares DB (DBC)

Paul Weisbruch is the VP of ETF/Index Sales and Trading at Street One Financial, an ETF liquidity provider focused on quality trade execution as well as portfolio construction and product strategy in the ETF space. He has been actively involved in the ETF space from both a product and trading standpoint since 2000. Prior to joining the team at Street One, Paul served as the Director of RIA and Institutional ETF Sales at RevenueShares ETFs from December 2007 until November of 2009.

In the lead up to April 15, Paul took time out of his busy schedule to discuss tax issues related to ETFs and ETNs with Seeking Alpha's Jonathan Liss.

Jonathan Liss (JL): What are the benefits of holding ETFs and ETNs vs. open-ended mutual funds from a taxpayer perspective? Are there disadvantages?

Paul Weisbruch (PW): Open ended mutual funds are pooled investments, where the shareholder has no control over the actions of the other shareholders in the pool, but is still subject to the consequences of the actions of those other shareholders. Case in point, in 2008, the equity markets were hammered as everyone knows, with unprecedented investor losses of principal. However, many mutual funds also distributed long term capital gains.

How is this possible? Fund managers, in order to meet cash redemptions, were forced to sell stocks, which triggered taxable events, and in many cases even though the market was cratering, stocks were still being sold for long term capital gains. Think of it this way. If a shareholder of Fund XYZ who owned shares since 1991 sold in 2008 during the market fallout, that investor was still up on his/her investment and "got out of the pool." However, because of the inherent limitations of mutual funds, the action of this investor as well as hordes of others generated taxes for those buy and hold investors who didn't sell out in 2008. So, investors were faced with the rare but extremely uncomfortable situation of a massive loss of principal coupled with long term capital gains owed on top of it.

ETFs are treated differently for tax purposes. An investor has much more control of their individual tax situation. The capital gain/loss situation is solely determined by when that investor decides to sell shares, and the taxes are dependent on whether the investment was sold for a gain or a loss in reference to the original purchase price, and is in no way related to the actions of other investors. ETFs are not pooled investments like mutual funds, and that said there is greater transparency for the investor from a tax standpoint, and the investor has the ultimate control over tax consequences.

Exchange Traded Notes (ETNs) will not make taxable distributions, unlike mutual funds, and the investor has full control over the timing of taxation (i.e. when they decide to sell their ETN). Also, ETNs do not have interest payments nor dividend distributions, so no taxes will ever be associated with these items.

As far as disadvantages, an investor runs the risk I suppose of legislation changing at some point that could possibly cripple some or all of the positive tax attributes of ETFs and ETNs. Although I don't believe the chances of this occurring are of high probability, nor imminent, it is something to bear in mind. According to the Barclays iPath ETNs website, the IRS and the U.S. Treasury are actively re-considering ETN tax treatment, so ETN and ETF investors should continually pay close attention to possible legislative changes and consult with their accountant or financial planner should anything on the tax landscape be altered in any way.

JL: One difference between Commodity ETFs and ETNs is that ETFs provide K-1s to their shareholders whereas ETNs are subject to 1099 reporting when sold. Why the different tax treatment?

PW: Commodity ETFs typically own futures on a commodity, or the actual commodity itself through the storage of a basket. ETFs that use futures (PowerShares DB Commodity Index Tracking Fund - DBC, for example), receive special IRS tax treatment, where 60% of the gains are taxed at the long term capital gains rate and 40% of the gains taxes as short term capital gains, all subject to the individual investor's ordinary income tax rate. Keep in mind that this does not take into account the holding period. So even if an investor owns a commodity ETF for a few days, or a few weeks, 60% of any gains are still taxed at the more advantageous long term capital gain level. This is a major selling point and probably one that most investors overlook.

The K-1 issuance for commodity ETFs has to do with the legal structure that the commodity ETFs were originally formed under. For example, DBC and USO are structured as Limited Partnerships, although publicly traded ones, and Schedule K-1s are distributed to owners of Limited Partnerships, whether they are ETFs or not. K-1s will be distributed each year to holders of Commodity ETFs regardless of if the positions were sold or not. From an investor standpoint, to make sure that you understand exactly what you are investing in at all times so that there are no surprises come tax time, it pays to find out how your ETF or ETN is legally structured.

Another nuance between Commodity ETFs and ETNs is that those Commodity ETFs that use futures in their investment strategy often have a cash component in the fund that is invested in government bonds, which earns interest. On some occasions, dividends will be paid to shareholders based on this interest, so this is another item to consider for tax purposes.

Commodity ETNs are not physically backed like Commodity ETFs, but are instead debt obligations, or secured notes. These ETNs are designed to track a commodity based index and are managed by the financial institution whom releases and secures the product (i.e. UBS, Barclays, etc.). ETNs do not pay interest or dividends like Commodity ETFs because again, there is no underlying basket of futures or physical commodities in the product structure. Instead, Commodity ETNs are seen as "prepaid contracts" where an investor's only tax concern is upon the sale, redemption, or maturity of the ETN itself. This is a somewhat cleaner way for the investor to account for taxes each year, as they would receive a 1099 for tax purposes, but only upon selling the ETN, much as they would for a "'40 Act Fund."

JL: What is the difference in tax treatment between commodity ETFs that hold hard assets like GLD and SLV vs. futures-based commodity ETFs like DGL and DBS?

PW: Commodity ETFs that hold hard assets like GLD and SLV are structured as "Grantor Trusts" as opposed to Limited Partnerships, like the futures based Commodity ETFs. Since these grantor trusts own precious metals as the underlying asset, IRS governance says that an investor who directly invests in precious metals should be subject to "collectibles" tax at ordinary income tax rates upon the sale of the trust. So owning something like GLD or SLV will generally not result in the issuance of a K-1 or a Form 1099, so it is up to the individual investor to report any gains as "collectibles."

Another difference between Grantor Trust Commodity ETFs and Futures based Commodity ETFs (Limited Partnerships), is that the Grantor Trusts will not generate interest/dividends income at any point. As explained in question #2, futures based commodity ETFs like DGL and DBS will subject the investor to the issuance of an annual K-1, regardless of if the funds were sold or not, and may distribute dividends to shareholders depending on the cash component in the ETFs themselves and how it is invested and earning interest.

JL: Moving over to bond and fixed income ETFs, what are the differences in the way these funds are taxed? What does it mean when a bond fund is advertised as 'tax-free'?

PW: First off, since the underlying bonds in fixed income ETFs earn interest regularly, when this is distributed to ETF shareholders, this interest is taxed on 1099s as interest, not as dividends, and subject to taxation as ordinary income. Many investors mistakenly assume that fixed income ETF distributions would be treated the same way as a dividend paid out quarterly on an individual equity or an equity ETF. Fixed income ETFs generally have higher yields than equity ETFs and for this reason will likely not be as tax efficient.

Additionally, since fixed income ETFs are composed of a basket of underlying bonds that will experience maturity at some point, bonds are routinely removed from the index at maturity, and replaced with newer issues. Thus, the turnover rate within the fixed income ETFs themselves can be higher than in an equity ETF and this is also a reason for less tax efficiency than an equity ETF.

A bond ETF that is advertised as "tax-free" refers to the fact that interest payments on municipal bonds are exempt from Federal taxes. Furthermore, if a state resident purchases a municipal bond issued by his home state, the interest payments may be exempt from state taxes in addition to Federal taxes. Going another layer down, if a specific locality issues a municipal bond and a citizen of that locality purchases that bond, interest payments may be exempt from Federal, state and local taxes. So, "tax-free" bond ETFs refer to municipal bond ETFs, of which the product lineup has expanded rapidly in recent months, with new entrants such as Grail Advisors, Market Vectors, PIMCO, and PowerShares challenging the mainstays like iShares and State Street SPDRs.

JL: Can you address differences in the way the Build America Bond ETF (NYSEARCA:BAB) is taxed vs. typical Muni bond ETFs like MUB?

PW: BAB holds Build America Bonds, which are municipal bonds, but taxable. They also offer higher yields than tax exempt municipal bonds like those owned within MUB. Unlike interest received by MUB which is tax-exempt, BAB interest paid out is taxable due to the nuances of the Build America Bond program and how it incentivizes issuers.

Why would someone want to own a municipal bond ETF that is subject to taxation? Two reasons: Higher potential yields, and also certain investors who cannot take advantage of the tax benefits of traditional tax-exempt munis including pension funds, endowments and foundations, foreign investors as well as qualified account investors. All of these individuals may see BAB as much more appealing than MUB.

JL: How are gains on the value of Currency ETFs such as DBV or FXE taxed? How about interest income?

PW: Some currency ETFs including Rydex's CurrencyShares, like precious metals ETFs such as GLD and SLV, are structured as Grantor Trusts. Therefore, as the trust itself increases in value, a tax liability for the ETF shareholders accrues, to be taxed as ordinary income. CurrencyShares, like FXE for example, own the actual currency in a U.S. dollar denominated custodial account. PowerShares also offers Currency ETFs such as UUP, UDN and DBV and these products hold currency futures contracts instead of actual currencies. Like Commodity ETFs that invest in futures, gains in Currency ETFs like PowerShares are taxed according to the 60/40 (long term/short term) capital gains rule that was mentioned earlier, and shareholders receive K-1s each year, regardless of if they sold the fund or not.

Unlike futures based PowerShares Currency ETFs, funds like CurrencyShares which are Grantor trusts will only be taxed upon sale of the ETFs, according to capital gains rules that apply to equities. Both CurrencyShares and the PowerShares currency ETFs earn interest that accrues daily and is reinvested monthly, and both are taxed as regular income for investors.

JL: Are there specific tax-related issues on leveraged and/or short ETFs that investors should be aware of such as an increased likelihood of year-end capital gains distributions?

PW: During certain markets, leveraged and short ETFs are capable of distributing very large capital gains to shareholders and 2008 is a classic example. Some short ETFs distributed capital gains as high as 86% that year. And the capital gains that are distributed have nothing to do with if you sold the ETF or not, but will be paid out even if you still own the ETF at the end of a year, and taxed as ordinary income. So one must be cognizant that if they plan on holding a short or leveraged ETF for a longer time period, that they will be taxed each year on capital gains (if there are any) even if they haven't sold the position yet.

JL: Are active ETFs more likely to trigger end of year capital gains distributions than index funds?

PW: First off, active ETFs are much more tax efficient than traditional mutual funds in that they use a "lowest in, first out" strategy for tax management within the funds themselves, while mutual funds use "highest in, first out," which creates embedded capital gains over time. The "in-kind" transactions within ETFs, and active ETFs in this case, allow the ETF fund manager to dispose of the lowest cost basis stocks through creation/redemption as opposed to the highest cost basis stocks.

Because of increased turnover within active ETFs, which should be expected since many of the strategies are driven by portfolio rebalancing or specific research, it is true that active ETFs are mathematically more likely to have a higher potential for year end capital gains distributions than passive index ETFs. However, since active ETFs on the market do not have the lengthy operating track record that the passive index ETFs do, I would be careful on blindly assuming that active ETFs will always be less tax efficient than passive ETFs purely on theory, and wait for sufficient empirical data to be available before leaping to a blanket conclusion.

JL: Can you briefly explain Tax Loss Harvesting and include an example of how investors can use ETFs to offset a capital gains tax liability?

PW: Some investment managers, even those whom for 99% of the year concentrate on selecting individual stocks, are pros at using ETFs when it comes to tax loss harvesting. Investors can identify a lagging mutual fund, individual stock, or even an ETF where they have a capital loss in a given tax year, sell the position and book the capital loss, and reinvest immediately back into the market in an ETF. The caveat is to make certain that the position sold and the ETF purchased are not "substantially identical", and you should consult with your tax advisor for guidance specifically on this.

However, years like 2008 gave investors a historic opportunity to book large capital losses into the market's extreme weakness that year, and immediately reinvest into the market with ETFs. Why would you do this? In a year where you have many booked capital gains, you can offset these gains opportunely with capital losses, lowering your tax liability. In years like 2008 where virtually no one had gains, you could have booked the capital losses and used them as carry forwards to offset future portfolio gains in years to come.

Example: An investor who owned Bank stocks in 2008 and was taking a drubbing, could have sold off the positions, booked the capital losses, and reinvested the proceeds that same day, in any financial services/banking ETF (XLF, RYF, RWW, KBE, etc.) and maintained market exposure with the chances of appreciation. The investor could apply those capital losses that tax year, or use them as carry forwards.

JL: Thanks Paul. This has been extremely enlightening.

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