GainsKeeper Blog

IRS Rules Against Currency Linked Exchange Traded Notes (ETNs) and Indicates it is Reviewing Tax Advantages of Other Types of ETNs

December 26, 2007

On Friday, December 7th, 2007, the IRS issued Revenue Ruling 2008-1 and Notice 2008-2 that affect exchange traded notes (ETNs). Rev. Rul. 2008-1 addresses only certain foreign currency related ETNs. Notice 2008-2 indicates that the IRS is more broadly scrutinizing a wide range of tax issues relating to prepaid forward contracts as well as all ETNs—not just currency related ETNs. The bottom line is that Rev. Rul. 2008-1 essentially eliminates the advantageous perceived tax treatment of currency related ETNs and Notice 2008-2 suggests that the IRS could possibly issue guidance or challenge the desired tax treatment of other types of ETNs.

An ETN is a security that includes two distinct elements: 1) a cash settled forward contract contingently obligating the holder/investor and the issuer to make payments on a future date with respect to the future value of a referenced item such as a stock, commodity, currency or interest rate index relative to an agreed amount and 2) a prepayment by the investor that is held for the benefit of the issuer to provide a source of funds with respect to the forward contract. A prepaid forward contract also involves these two distinct elements. ETNs are a relatively new type of retail financial product that are offered by several dealers. The ETN market rapidly developed into a multi-billion dollar market and competes with certain types of mutual funds and exchange traded funds (ETFs).

The structure of an ETN is intended to provide the investor with two distinct tax benefits versus economically comparable contingent debt investments: 1) avoidance of ongoing accruals of contingent income based on the reference measure (income is intended to be recognized on maturity of the ETN) and 2) capital gain rather than ordinary income with respect to the contingent payment (note the typically significantly lower tax rate on capital gains as compared to interest income). Some ETNs provide certainty of return for the principal invested while others do not.

Rev. Rul. 2008-1 essentially eliminates the desired tax treatment of currency related ETNs. It holds that certain currency related prepaid forward contracts are treated as debt for U.S. tax purposes even though it is possible that the amount repaid at the end of the instrument’s term may be less than the amount initially deposited. This holding results in current accruals of income and ordinary income rather than capital gain treatment. Thus holders are actually subject to tax on accruals before the receipt of payment at maturity (and lose the desire capital gain treatment). One key point that could be troubling is that the ruling is not prospectively effective and therefore appears to be applicable to currency related ETNs that were issued before December 7, 2007. In fact, Rev. Rul. 2008-1 describes an instrument issued on January 1, 2007.

Notice 2008-2 is of broader concern beyond currency related ETNs and forwards. It indicates that the IRS is considering issuing guidance that could require ordinary income accruals by holders during the term of the transaction that would issue adversely affect the intended tax treatment of all ETNs as well as other forms of prepaid forward contracts. Notice 2008-2 also includes a laundry list of other tax issues that the IRS is considering relating to prepaid forward contracts and ETNs. One major area of uncertainty relates to the potential effective date of any adverse guidance that the IRS might issue. In other words, how will future IRS guidance affect previously issued ETNs and prepaid forward contracts? Dealers and investors may hope for prospective guidance but should temper this hope given the retroactive holding of Rev. Rul. 2008-1.

Concerns had previously been raised that the IRS could issue adverse guidance and now that time has come. So far, however, only currency related ETNs are directly affected under Rev. Rul. 2008-1. In fact, some may argue that by limiting its attack to currency ETNs, the IRS has implicitly accepted the existing favorable tax treatment of other types of ETNs. However, the concurrent release of Notice 2008-2 must be considered. Whether the IRS Notice will chill the market for other types of ETNs and prepaid forwards remains to be seen. And we will have to wait to see precisely what other guidance, if any, the IRS ultimately issues.

In spite of these questions, this round of IRS guidance is clearly a significant setback for the intended tax advantages of ETNs and prepaid forwards. Investors should carefully consider the potential tax risks of investing in ETNs given the recent IRS ruling and notice.


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