Derivatives are certainly having their day in the sun. Congress is considering new tax treatment for certain derivatives, including prepaid derivative contracts and exchange-traded notes (ETNs). The House Ways & Means Committee held a hearing today on the matter. It’s part of an ongoing debate: The mutual-fund industry has complained that derivatives—especially ETNs, which are growing in popularity with retail clients—are very similar to mutual funds, and yet get better tax treatment. ETN makers and brokerages take a different view. After all, a change in ETN tax treatment might doom the vehicle to niche status forever.
“I've heard there's a lot of controversy surrounding ETNs in the financial-services industry,” says Adam H. Rosenzweig, Associate Professor at Washington University School of Law. Under current tax laws, prepaid derivatives like ETNs are usually treated like capital assets. Investors don’t pay capital gains taxes on the ETN until it is sold or matures, despite any trading the manager might do in the underlying reference assets. Mutual-fund investors, on the other hand, are required to pay capital gains taxes every year, so the fund manager’s trading does matter, and can get expensive.
Under the proposed legislation, ETNs and other prepaid derivatives would be treated more like debt instruments: Investors would be required to accrue a fixed amount of interest over time, which would then be taxed at (potentially higher) ordinary income rates. “This could make it more expensive for investors to buy this instrument,” says Rosenzweig.
Brokerage-industry trade group SIFMA, represented by Leslie B. Samuels of the firm of Cleary Gottlieb Steen & Hamilton, testified before the committee that the industry worries the bill, H.R. 4912, might cause more problems than it solves.
"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 said. Mutual funds and ETNs are very different financial instruments, he argued, and, therefore, deserve different tax treatment. For one thing, ETN investors have no right to receive cash distributions, and ETNs do not represent ownership of any assets—in fact ETN holders are exposed to the risk of loss of all, or substantially all, of their investment in a contract.
“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,” says Samuels in SIFMA’s statement. “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.”
SIFMA argues further that applying tax rules developed for debt instruments (where investors are entitled to a return of principal) does not fit the risk profile of prepaid derivative contracts. The proposed laws would essentially require taxation of “phantom” income, which could force the investor to either liquidate their investment in the contracts (where such investments are liquid), or come up with cash to pay the tax by selling other investments or foregoing other investment opportunities.
Because of the complexity of the issue, Samuels recommended that further review of the tax laws applicable to the instruments be coordinated with the, “Treasury's consideration of these same issues.”
In announcing the hearing, Chairman Richard Neal, D-Mass., stated, "The expanding derivatives market is already a $516-trillion global enterprise, only some of which is subject to regulation and transparency. I think it is appropriate for Congress to review the tax rules as they apply to these complex financial products, and determine whether changes may be necessary.”