Congressman Neal Takes Shot at ETNs

by: ETNMan

As if it were not enough that the IRS issued a revenue ruling clarifying the tax treatment of foreign currency linked exchange traded notes (ETNs) – as well as other structured products – and a Notice questioning the tax treatment of other ETNs (both issued on Friday 12/7/2007), were not enough, Congress now officially enters the mix. Or should I say a singular Congressman enters.

On Wednesday night, Representative Richard Neal [D. MA], Chairman of the Subcommittee on Select Revenue Measures, introduced a bill to cause the current taxation of ETNs (and other structured notes). Not one other member of Congress co-authored the legislation or made any statement about it. Representative Neal introduced the bill literally moments before the House adjourned for the 2007 legislative year. Rep. Neal, from the proud state of Massachusetts, is a long-time supporter of the mutual fund industry. The investment company institute (the ICI – or mutual fund lobby) has been harassing members of Congress, and anyone else that will listen, for weeks about the "unfair" tax treatment of ETNs versus ETFs and mutual funds (bunch of hypocrites).It's not envisioned that the Neal bill will amount to anything more than what it appears – senseless pandering to one's constituents.

However, it does lend insight into where the ICI wants this issue to go.If the Neal bill were to gain traction and ultimately be enacted as law it would force U.S. holders of ETNs to accrue some current income. Most ETNs currently pay no coupon or other distributions (other than BSR and GCE). The bill would force holders of other ETNs to accrue current income for tax purposes at the federal short-term rate and such income would be taxed at ordinary income rates – not capital gain rates.

Other gains with respect to the ETN would be eligible for long-term capital gains treatment. While this is not a horrible outcome it would place ETNs on a more level (although not equal) playing field with ETFs tax wise.However, this is the whole problem. ETNs are not ETFs and there is no need to tax the two the same other than the ICI's constant crying to Congress and Treasury.

The ICI should honestly be embarrassed! To complain about the tax treatment of a competitor product in the marketplace while every mutual fund / ETF attempts to make itself more tax efficient (sometimes going to extreme measures). The ICI itself has been petitioning Congress for years to forego current taxation of mutual fund shareholders that elect dividend reinvestment. Now they cry foul about a competitor product that is able to achieve such results – hideous.

While I can't blame Rep. Neal (after all most of his campaign contributions come from mutual fund companies) I do think there needs to be a voice of reason on the Hill to stop the insanity and recognize that mutual funds and ETFs are manager run investment vehicles that have privileges that ETNs do not. ETNs are purely passive securities that provide the return of a public index. Mutual funds – and now, to some extent, ETFs are actively managed. The indices that ETFs track are proprietary in some cases and based upon non-registered instruments (high yield bonds, muni bonds, etc…), which ETNs are incapable of. Why should there be inconsistent operating rules but consistent tax treatment? ETNs and ETFs are fundamentally different --- different tax treatment is OK. ETNs and ETFs can coexist. The ICI should drop its discriminatory and protectionist stance.