Taxing times for ETNs

A number of US dealers have leapt into the exchange-traded note market on the back of the success of Barclays Capital's iPath programme. But new rules proposed last December could alter the tax treatment of these instruments, to the detriment of investors. Will this stymie the growth of the market? Wietske Blees reports

US dealers have been caught by surprise by the success of the exchange-traded note (ETN) market. Ever since the first ETN was launched by Barclays Capital in June 2006, volumes have climbed at breakneck pace, reaching $4 billion as of October 2007, according to the Securities Industry and Financial Markets Association. Keen to build market share, a handful of rival dealers have jumped into the market, with Credit Suisse, Goldman Sachs, Lehman Brothers and UBS all launching ETN programmes of their own in recent months.

Key to their popularity is a perception that ETNs offer preferential tax treatment over similar products such as exchange-traded funds (ETFs). However, recent clarifications to the tax rules look set to eliminate these advantages, causing some observers to speculate the acceleration in the growth of these products could slow.

The tax benefits have been achievable due to certain structural features of the ETN market. Investors do not receive coupons or dividends during the life of the note, and principal is paid at maturity, based on the value of a specified index or benchmark minus fees. For tax purposes, dealers and investors have treated these products as prepaid forwards, a classification that means the investor need only recognise a gain or loss once the notes are sold or redeemed, with capital gains tax paid on that amount - known as 'wait-and-see' accounting. In other words, the investor can control when he or she pays tax and is able to defer capital gains tax until maturity. So long as the investor holds the note for more than one year, any capital gain would be taxed at just 15%.

In comparison, ETFs generally pay income plus any capital gains to investors annually - both of which are taxable. What's more, because any capital gain is considered short term, it is taxed at a higher rate than the 15% charged for ETNs held for more than one year. This gave rise to accusations that ETNs are little more than a tax dodge, with members of the fund industry complaining that the tax treatment of these products is unfair.

The US Internal Revenue Service (IRS) appears to agree. On December 7 last year, it issued an edict clarifying the tax treatment of single-currency-linked ETNs. Under the new rules - which came into effect immediately and apply retroactively - single-currency ETNs will now be treated as foreign currency debt, rather than prepaid forwards. This means any interest accrued during the life of the note is taxable on a current basis, and any income realised by the investor when the note is sold or redeemed is taxed as ordinary income.

The IRS didn't stop there. It also issued a separate notice asking for public comments on the appropriate tax treatment of other instruments currently classified as prepaid forwards, such as equity and commodity ETNs. In particular, it focuses on whether the investor should be required to accrue income over the life of the note, the appropriate character of income accruals (whether capital or ordinary), the relevance of their exchange-traded nature and whether foreign investors should be subject to withholding tax on any income accrual.

Comments are due by May 13, but many observers expect changes to be made to the tax treatment of all ETNs, with any modifications likely to be made retroactive. Even if an immediate decision is not taken by the IRS, Congress may step in to force through an amendment in the law. On December 19, congressman Richard Neal, chairman of the subcommittee on select revenue measures, introduced a bill covering the taxation of prepaid contracts, declaring he wished to curb vehicles providing unlimited tax deferral to investors. Under the proposed legislation, ETN investors would be required to accrue interest income each year, with the amount determined by a short-term interest rate - in effect, taxing investors on income they haven't actually received.

Market participants have responded with alarm, noting that the proposed changes could cause confusion among investors. "To have a full-blown controversy over the tax treatment of a widely held class of instruments is unusual, and it is certainly a challenge for the industry," says Thomas Humphreys, a partner at law firm Morrison & Foerster in New York.

Dealers point out there are significant differences between ETNs and ETFs, justifying the difference in tax treatment. For a start, ETN investors do not receive annual dividends, unlike ETF holders. If the tax rules were modified, investors would be getting taxed on income they had not received, critics argue.

In addition, investors who buy an ETF effectively own the underlying assets held by the fund. ETNs work differently. They are senior, unsecured debt securities issued by a dealer, designed to track a specific index. However, investors do not own the underlying assets. Instead, the issuer promises to pay the index performance minus fees - meaning the investor is exposed to the credit risk of the issuer. If the bank defaults, an ETN investor would lose his or her investment, unlike an ETF investor, who would have recourse to the assets held by the fund.

"In my opinion, wait-and-see taxation would be the appropriate tax treatment, because investors may never receive what appears to be income today," argues Humphreys.

Dealers agree. "In an ETN, an investor could lose everything. It's a delta-one instrument, so to add a phantom income concept to the taxation of ETNs is a fairly aggressive move," says Mike Clark, director and head of structured products distribution for the Americas at Credit Suisse in New York.

A change in the tax treatment would appear to eliminate one of the major attractions of investing in ETNs. Nonetheless, despite the change to single-currency ETNs in December and the anticipated modification of the rules around equity and commodity ETNs, a handful of new banks have entered the market in recent months.

On February 21, Lehman Brothers launched its Opta ETN platform with three products: the Opta Lehman Brothers Commodity Index Pure Beta Total Return ETN; the Opta Lehman Brothers Commodity Index Pure Beta Agriculture Total Return ETN; and the Opta S&P Listed Private Equity Index Net Return ETN. This was followed by Deutsche Bank, which launched three ETNs linked to the Deutsche Bank Liquid Commodity Index - Optimum Yield Gold on February 28. Morgan Stanley followed suit on March 17, launching two currency ETNs - one referenced to the renminbi and the other linked to the Indian rupee.

Meanwhile, Credit Suisse jumped into the ETN market on April 2, launching notes linked to the Credit Suisse Global Warming Index, an equally weighted index tracking the stocks of 50 companies focused on minimising global warming. Its Swiss rival, UBS, launched its own E-Tracs platform on April 4, beginning with eight ETNs linked to different sub-indexes of the UBS Bloomberg Constant Maturity Commodity index.

So, why the continued interest from issuers? Proponents say there are still plenty of reasons to invest in ETNs, despite the change in tax rules. One advantage is access to new asset classes, say dealers. "There is a fundamental need for ETNs to give investors access to more difficult-to-reach markets. This is one of the primary reasons for ETNs' existence," says Philippe El-Asmar, head of investor solutions for the Americas at Barclays Capital in New York

ETFs are classified as investment companies registered under the Investment Company Act of 1940. As such, there are significant restrictions on what they can invest in - for instance, they have a limited ability to invest in commodity futures contracts. ETNs do not face the same restrictions, enabling them to access a wide variety of asset classes, from currencies to private equity.

"About 85% of ETFs are linked to global equities, which offer limited diversification possibilities. There is this void of underlying opportunities in the exchange-traded market to which ETNs offer a solution," says Warun Kumar, a managing director in the structured investments group for the Americas at Lehman Brothers in New York.

Indeed, a variety of products are expected to be launched in the coming months, giving investors an even wider choice of asset classes. "We'll see more and more innovation beyond pure delta-one structures, such as leveraged structures and hedge fund strategies. ETNs are the perfect delivery vehicle for those types of strategies, because they are best delivered in derivatives format," says Credit Suisse's Clark. "We're currently working on a market-neutral index, which will provide for high alpha and high Sharpe ratio products, but that will be liquid and available for retail investors."

Another advantage of ETNs is the absence of tracking error, say dealers. While ETFs attempt to mimic a specified benchmark by buying the underlying securities, the pool of assets within the fund may not exactly match the benchmark, leading to potential tracking error. When an investor buys an ETN, however, the issuer is obligated to deliver the index performance minus fees (typically between 40 basis points and 125bp a year) - in other words, the tracking error is born by the dealer rather than by the investor. "An ETN has no tracking error because the issuer is not trying to use a portfolio to replicate an index. It is the issuer that bears that risk and absorbs it," explains Clark.

That means the investor is swapping one risk (tracking error) for another (credit risk of the issuer). Nonetheless, proponents stress there is a regulatory obligation to provide two-way prices, meaning an investor can buy and sell on an exchange. In addition, most ETNs allow investors to redeem their notes at fair value on a daily basis. "Because of these liquidity alternatives, the only real credit risk you are talking about is flash credit default risk, whereby a company's credit rating would be downgraded from, say, AA to CCC overnight," says Kurt Nelson, managing director and head of ETNs at UBS in the US.

ETNs are also quicker to get to market than ETFs, enabling dealers to react rapidly to market circumstances, says Nelson. "It is easier to bring a product to market if you structure it as an ETN. Rather than registering an ETF as an investment company or a trust, we're simply issuing a structured note from our debt platform."

Nonetheless, the possible tax changes hang over the market like a dark cloud, and it is far too early to determine how investors will respond to further changes in rules. Despite this, dealers remain bullish, with some claiming further clarity from the IRS may actually help the growth of the instrument. "Getting clarity on the tax treatment will give a lot of people comfort about the viability of the product," says Kumar of Lehman Brothers.

Others point out that the IRS consultation document does not necessarily mean further changes to the tax rules will be forthcoming. "There are many instances in which the IRS has issued a notice without taking further measures, but it could also issue a ruling or propose a regulation," says Humphreys of Morrison & Foerster. "It is really anybody's guess at this stage."

Even if changes to the tax regime do occur, it seems unlikely to dampen dealers' enthusiasm for this new product. "Any investment instrument we issue will have some sort of tax treatment, one way or the other. In our view, that is just a side note for ETNs. We value these products because they are cost-effective, inexpensive, transparent and liquid, and they allow investors access to a different set of asset classes," says UBS's Nelson. ETN issuers just need to hope investors feel the same way.

WHAT IS AN EXCHANGE-TRADED NOTE?

Exchange-traded notes (ETNs) are senior, unsecured debt securities of an issuer, designed to track a specified index. The product does not pay annual coupons and is not principal-protected. At maturity or sale of the note, the investor would receive the index performance, minus fees (which usually range between 40 basis points and 125bp). The notes are traded on an exchange.

Unlike exchange-traded funds (ETFs), ETNs do not own the underlying assets. Instead, the issuer has an obligation to deliver the return of the index. While this removes tracking error, the investor is exposed to the credit risk of the issuer.

In contrast, ETFs are typically registered investment companies that pay annual cash distributions - dividends and capital gains. The fund owns the underlying assets, and the fund manager is obligated to deliver the net asset value minus fees (typically between 15bp and 85bp) upon redemption.

See also:

• Whither the benchmark?

• Structured Products House of the Year - Barclays Capital (for 2007)