The securities investment universe available to individuals has expanded far beyond just stocks, bonds, mutual funds, and for the adventurous, options. Individuals can now trade just about anything utilizing ETFs/ETNs, as the offerings available have exploded in recent years. With ETFs, individuals are now able to invest in markets that once were the sole domain of institutions or sophisticated investors/traders. Yet few are aware of the pitfalls that await U.S. Investors in some of these vehicles in the form of U.S. Income Tax complications until after the fact, when they learn for the first time in some cases what they have invested in. This article will survey the ETF/ETN universe and highlight some examples of potential tax complications that the typical investor might not be aware of, and will provide some resources for further study.
ETFs and ETNs have exploded in recent years in terms of numbers and varieties, such that today there are 2000 or so U.S.-based ETFs, and over 4000 worldwide, per Statista.com.
Investopedia offers the following ETF definition:
An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold.
ETNs are frequently confused with ETFS, as they are similar in purpose, and in fact the terms are often used interchangeably. ETNs are actually just one of several possible ways an ETF may be structured. The ETN structure has a lot of advantages, but it has one major downside for investors, as will be seen.
Consider this ETN definition from ETF.com:
ETNs, or exchange-traded notes, are debt notes issued by a financial institution. When you buy an ETN, the issuer promises to pay you a certain pattern of return. If you buy an ETN linked to the price of gold, for instance, the value of that ETN will increase if the gold price goes up. The advantage of the ETN structure is that it can be linked to anything, can favor any direction, and can be leveraged, making use of various financial instruments. There are ETNs that track commodities, and ETNs that track hard-to-reach corners of the equity market. They sometimes combine stock or bond positions with options overlays, or use other sophisticated strategies that would be difficult to package into a traditional ETF. In the commodity space, an ETN also offers significant long-term tax advantages compared with most commodity ETFs.
The major difference from ETFs that are not ETNs is that ETNs have a downside that the non-ETN ETFs don't have, in that if the issuing institution goes bankrupt, your investment becomes worthless, no matter how well what it is tracking performs.
To learn more about ETFs/ETNs, I recommend readers become familiar with ETF.com. Registration is free, and there are many excellent articles. A whole series of articles on how ETFs work are available at the site under the tab selection "ETF University", including a discussion of how the supply of ETF shares is regulated via the "authorized participants" mechanism, which keeps ETFs in sync with what they are purportedly tracking. The site is mostly focused on education and helpful tips on navigating the ETF/ETN universe. As part of that focus, the site has some very useful information on ETFs/ETNs and U.S. Income Tax consequences, beginning with the article entitled "2015 Guide to ETF Taxation". Another excellent site is GreenTraderTax.com, which is the website for Green & Co, a firm focused on U.S. Income Taxation for traders and investors of all types. I have mentioned them in previous articles, and have recommended their annual booklet "Green's YYYY Trader Tax Guide", which is updated annually and available at a very reasonable price. In addition to the guide, their website has numerous articles on various investment tax topics available as "blogs", which delve deeper into specific tax issues.
Taxation - General
I will now provide an overview of ETF/ETN taxation, with examples. Note that I am not recommending any of the investments mentioned, nor even recommending ETFs/ETNs per se. My purpose here is limited to tax awareness. Before going further, note that often the best resource for identifying the nature of a particular ETF investment and tax considerations is the prospectus. Further, the sponsoring firm will nearly always have a website, which in addition to providing a prospectus, will often have "readable" articles or "FAQ" sections explaining the nature of the investment and, among other topics, U.S. Income Tax considerations.
Much of the following synopsis has been taken from the ETF.com article "2015 Guide to ETF Taxation", referenced earlier. As per the ETF.com article, ETFs are taxed based upon the asset class of the underlying holdings AND the structure of the fund, which determines how the ETF gains exposure to the underlying asset(s). There are five major asset categories; equities, fixed income, commodities, currencies, and everything else, which ETF.com dubs "alternatives". There are also five structures; open-end funds, unit investment trusts (UITs), grantor trusts, limited partnerships (LPs), and ETNs.
Equities and fixed income ETFs are structured as open end funds, UITs, or ETNs, and do not usually present the investor with unexpected tax issues. A difference between an open-end fund and a UIT is that a UIT must fully replicate the index being tracked, and cannot re-invest dividends back into the trust, so a UIT may have more distributions than a similar ETF that is not a UIT. From the standpoint of Income Tax considerations, here is no difference.
An example of an open end fixed income ETF is the iShares TIPS Bond ETF (NYSEARCA:TIP).
While I am not sure about this, I think an example of a UIT fixed income ETF is the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT). Note: My hint that TLT is a fund that tracks the ICE U.S. Treasury 20+ Year Bond Index.
An example of a fixed income ETN is the iPath U.S. Treasury 10-Year Bull ETN (NASDAQ:DTYL).
Regardless of structure, holders of equity and fixed income ETFs will receive 1099s identifying tax treatment of distributions as either dividends (qualified or not qualified), interest (taxable or exempt), capital gains distributions (always taxable as long-term), or return of capital (not taxable, but reduces basis in the holding). If shares were sold during the year, 1099B forms will be received, and the capital gain / loss will be determined and categorized as short-term or long-term. In other words, sales are treated the same as sales of stock.
Commodity ETFs have historically been either grantor trusts, limited partnerships, or ETNs, although some new commodity ETFs are open end funds. Grantor trust structures have been used for ETFs that "physically hold" precious metals. These funds issue 1099s, and there may be capital gains distributions from small, incremental sales of metals to cover fund expenses. If shares are sold by the holder, a 1099B will be received. These assets are considered collectibles by the IRS, and gains will be taxed at the taxpayer's marginal rate for short-term gains, and again at the taxpayer's marginal rate for long-term gains, subject only to a cap of 28%.
Commodity ETFs that hold futures contracts to gain exposure to a given commodity are usually structured as limited partnerships (LPs). Gains inside the fund are taxed at the futures 60/40 rates (60% long-term and 40% short-term) regardless of how long a position was held by the fund. As the fund is a partnership and thus a "pass-through" entity, the investor will receive a K-1 in lieu of a 1099, and the holder may realize taxable events from partnership activity during the year. Holders will also need to annually adjust their basis in the investment, depending upon the information shown on the K-1. Tax treatment of sales of holdings by the investor will be as per the K-1 package sales schedule.
Examples of commodity ETFs structured as LPs are the PowerShares DB Commodity Index Tracking ETF (NYSE:DBC), the United States Natural Gas ETF (NYSEARCA:UNG), and the iShares S&P GSCI Commodity-Indexed Trust ETF (NYSEARCA:GSG).
There are also commodity ETNs available, which bypass the tax complications of the collectibles and LP funds, but of course have the ETN downside of dependency upon the soundness of the sponsor. Examples here are the iPath S&P Crude Oil Total Return Index ETN (NYSEARCA:OIL) and the iPath Bloomberg Commodity Index Total ReturnSM ETN (NYSEARCA:DJP).
Per the ETF.com article, the new open-ended commodity ETFs achieve their status, avoiding K-1 complications, by investing in commodity futures contracts through an offshore subsidiary. The holder will only have to deal with 1099s, with distributions treated as ordinary income or capital gains. A review of the prospectus of one of the first funds of this type, the First Trust Global Tactical Commodity Strategy ETF (NASDAQ:FTGC), states that distributions will be treated thusly, but note that the prospectus also devotes considerable space to "Tax Risks", wherein it is pointed out that the tax assumptions of the fund are under review by the IRS, and subsequent rulings could affect the fund detrimentally, and even result in the fund being closed. Another example is the PowerShares DB Optimum Yield Diversified Commodity Strategy Portfolio ETF (NASDAQ:PDBC). The prospectus for PDBC contains similar language in the "Tax Risk" section.
Currency ETFs abound, allowing an investor to invest in currencies without becoming a forex trader. These ETFs can be structured as open end funds, grantor trusts, LPs, or ETNs.
Open ended currency ETFs can pay out distributions quarterly or annually, with gains from forward currency contracts taxed at the futures Sec. 1256 60/40 rates, according to ETF.com. A review of the prospectus for a representative fund, the WisdomTree Chinese Yuan ETF (NYSEARCA:CYB), merely states that distributions may be taxed as ordinary income or capital gains. Regardless of how this is determined by the fund, the holder will rely on the 1099 received to properly report distributions. Sales of shares by holders will be the same as equity funds, reported on 1099B and taxed as short term or long term gain or loss. Besides CYB, another example of this type of fund is the WisdomTree Brazilian Real ETF (NYSEARCA:BZF).
The CurrencyShares fund group of ETFs are structured as grantor trusts. These provide exposure to spot exchange rates of the specified currency vs the U.S. Dollar. Interest on holdings of the fund in excess of expenses are distributed to holders and taxed as interest, i.e. ordinary income. Holders may also be taxed on sales by the trust to pay expenses, as gains or losses. If expenses of the trust were paid from sales, the holder may be able to deduct his share of the expense as a miscellaneous itemized deduction. Sales of shares by holders are considered equivalent to gains / losses from spot exchange currency trading, and are taxed as ordinary income or loss per IRC Section 988 default taxation. It may be possible to make an election to be taxed per Sec. 1256 60/40 capital gain / loss treatment. More on this follows below. Examples of these types of ETFs are the CurrencyShares Canadian Dollar Trust ETF (NYSE:FXC), the CurrencyShares Swiss Franc Trust ETF (NYSE:FXF), and the CurrencyShares Australian Dollar Trust ETF (NYSE:FXA), to name three of the CurrencyShares funds.
Currency LP funds are similar to commodity LP funds, in that they use futures contracts to gain the currency exposure. Examples are the PowerShares DB USD Bear ETF (NYSEARCA:UDN), the counterpart PowerShares DB USD Bull ETF (NYSEARCA:UUP), the ProShares UltraShort Euro ETF (NYSEARCA:EUO), and the ProShares UltraShort Yen ETF (NYSEARCA:YCS). These funds are limited partnerships, and holders receive K-1s, with all the attendant tax complications. See the commodity LP Funds comments preceding for a disheartening review of the tax impacts of K-1s.
Currency ETNs - Not as Straight-Forward as Other ETNs
Tax treatment for currency ETNs is a bit confusing. The IRS in Rev. Rul. 2008-1 specified that foreign-currency ETNs are to be treated as debt securities under Sec. 988 for U.S. Tax purposes. A review of the U.S. Tax section of the prospectus for the iPath EUR/USD Exchange Rate ETN (NYSEARCA:ERO) reveals a lengthy treatise on debt security taxation, getting into subtopics such as OID for debt securities, whereby interest is taxable as accrued and/or paid, and continues with definitions and treatment of Warrants, Global Securities, Preference Shares, and American Depository Shares. The prospectus for the iPath GBP/USD Exchange Rate ETN (NYSEARCA:GBB) is similar.
Seeking some clarity, if not sanity, a document search on the topic reveals the following prose from sec.gov, which is replicated on Barclay's iPath website, which seems reassuring:
What is Revenue Ruling 2008-1? - Revenue Ruling 2008-1, issued on December 7, 2007, holds that certain financial instruments linked directly to the value of a foreign currency-regardless of whether the instrument is privately offered, publicly offered or traded on an exchange-should be treated like debt for federal tax purposes. Revenue Ruling 2008-1 is relevant to iPath exchange rate and GEMS ETNs.
What is Barclay's reaction to Revenue Ruling 2008-1? - The ruling provides investors clarity on the tax treatment of certain financial instruments linked directly to the value of a foreign currency-regardless of whether the instrument is privately offered, publicly offered or traded on an exchange.
What does the ruling mean for iPath currency ETN investors? - The ruling means that any interest accrued (net of fees) during the life of these ETNs will be taxed as ordinary income on a current basis, even though that interest is reinvested and not paid out until the holder redeems the ETN or the ETN matures. It also means that gain or loss from the sale, redemption or maturity of the ETNs will generally be ordinary.
The Barclays document further states that holders will receive 1099s. I believe that all of the complexities on OID, etc. as discussed in the prospectus will be determined by the fund, and the holder only needs to report what is on the 1099 received. But note that sales of the ETN shares will be taxable as ordinary income or loss, regardless of how long held, which is consistent with Sec. 988 default taxation. ETF.com states that, similar to spot currency forex traders, it may be possible to elect Sec. 1256 60/40 capital gain/loss tax treatment in lieu of the default Sec. 988 taxation. If this is desired and actually possible, assuming the rules are consistent with the rules for forex traders, this election must be made prior to entering the trade, via a statement filed with a third party or at least notarized, which is unlikely to happen unless an investor really knows what they are doing before investing.
To summarize, currency ETNs are treated differently from other ETNs. One final note on currency ETNs; all of these resources state that the tax treatment has not been finalized by the IRS, and things could change in the future.
As summarized in the ETF.com taxation article:
Alternative funds seek to provide diversification by combining asset classes or investing in nontraditional assets, and generally come in one of three structures: open-end funds; limited partnerships; or ETNs. The construction of many alternative ETFs can be complicated, but the taxation of gains made from selling shares in the funds fall in line with their respective structures.
To clarify the last statement, sales of shares of open-end alternative funds will be taxed like sales of equity ETFs, per 1099B forms received; sales of LP alternative ETFs will be per K-1 sales schedules; and sales of ETNs will also be like equity ETF sales, per 1099B forms, unless the ETN is a currency ETN, in which case sales will be taxed as ordinary income / loss, per Sec. 988.
An example of an alternative ETF structured as an open-end fund is the WisdomTree Managed Futures Strategy ETF (NYSEARCA:WDTI), which achieves the feat of being an open end fund via an offshore subsidiary which actually holds the futures contracts.
An example of an alternative ETN taxed as a currency ETN is the iPath Optimized Currency Carry ETN (NYSEARCA:ICI).
Distributions can be complicated for some alternative ETFs, such as the sub-group known as "BuyWrite ETFs". Taxation depends upon whether the options utilized are equity options or index options, and whether the options are deemed "qualified", which generally means "at or out of the money and at least 30 days to expiration, when written." Further complications can be introduced if positions taken are considered a "straddle". Other than being generally aware of how the fund determines gains and losses reportable to holders, one must rely on the fund to report these gains / losses correctly, per the IRS restrictions, on the 1099 received. Examples of BuyWrite ETFs are the PowerShares S&P 500 BuyWrite Portfolio ETF (NYSE:PBP) and the Horizons S&P 500 Covered Call ETF (NYSEARCA:HSPX).
To restate the obvious, the investor needs to review the prospectus and the fund sponsor website to determine ahead of time what the fund invests in and how, to determine the tax implications, not to mention the suitability, risks, and rewards of the investment being contemplated. This is doubly so for ETFs which do not fall into the basic categories, but rather are in the "alternatives" category.
ETF Alternatives to MLPs
ETF.com has an excellent article on ETF alternatives to investing in MLPs, entitled "The Definitive Guide to MLP ETFS & ETNS". To access the article, select tab "ETF News & Strategy", then click on "White Papers", then select the subject article. The article discusses these entities in depth, explaining how they attempt to deliver the benefits of MLP ownership without the tax complications. Another useful ETF website is ETFdb.com, which has free sections and subscription sections. Click here to get a list of 25 ETFs/ETNs that invest in MLPs from ETFdb.com, which can then be evaluated per the criteria suggested in the ETF.com article.
The universe of ETFs/ETNs available today is truly mind-boggling, with a choice seemingly available for just about any market bet one cares to make. Like many initially good ideas, it has gone way beyond what makes any sense for the typical investor. Still, knowing about the asset classes / structures and how to determine the risks, rewards, and tax impacts of a choice under consideration can only benefit the individual investor, often from learning what to avoid. My objective here is that this article and the resources highlighted will assist readers in evaluating any ETF/ETN investments being considered, and avoid undesirable complications.
Disclosure: I am/we are long GLD, SLV.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am a practicing tax practitioner, focusing on tax preparation for individuals. While I am employed by a nationally-known tax preparation firm, and have taken advantage of tax training courses offered by the firm, this article represents my own interpretations of tax law, utilizing the resources identified in the article. Thus, the article has not been reviewed or vetted by any other party. Since November 2015, I have been an "enrolled agent", which is a recognition of tax competency awarded by the IRS for candidates that have passed three Special Enrollment Exams.