A representative of the Securities Industry and Financial Markets Association [SIFMA] testified before the House of Representatives yesterday that a bill under review that would modify the tax treatment of exchange traded notes would do more harm than good to the investment community. Leslie B. Samuels from the law firm of Cleary Gottlieb Steen & Hamilton, said on behalf of SIFMA that:
We are concerned that H.R. 4912 would impose an overly complex tax regime that would single out prepaid derivative contracts for unfavorable treatment by requiring that investors include amounts in income that they have no right to receive—and may never receive.
He pointed out that mutual funds and ETNs are different types of financial instruments, and should be treated as such. One key difference is that ETN holders have no right to any cash distributions, and ETNs do not confer ownership of any asset to the holder.
Another key point made by Samuels is that:
The difference between the tax treatment of ETNs and mutual funds is based on a fundamental rule of tax law that an investor who has the full right to take cash income, but elects not to, is subject to taxation on that cash as if it were received. Taxpayers cannot avoid tax on cash they could put in their pockets simply by using it for other purposes. This is why investors in mutual funds are taxed currently on distributions from the mutual fund even if they choose to reinvest the cash. In short, investors in mutual funds are taxed on distributions because they have the choice of keeping the cash or reinvesting it.
Because ETN holders do not have any right to cash income from the ETN, any tax imposed on unrealized gains would be a tax on "phantom" income that may never be realized.
Samuel's final point is that ETNs should be treated like prepaid derivative contracts since they are similar in structure. These instruments have been in existence for 15 years, and are not taxed like debt, therefore any attempts to tax them or ETNs as such would be unfair.
ETNs have been under fire from the mutual fund industry as they have become more popular, with firms like Vanguard asking Congress to tax ETNs in the same manner as ETFs and mutual funds to remove one of the advantages of ETNs. As Samuels pointed out yesterday on behalf of SIFMA, these claims are flawed, and most likely based on concern over a new competitor for investor funds, rather than an interest in fairness.