The End of the ETN Tax Advantage?

02/11/2013 9:30 am EST

Focus: ETFs

John Spence of discusses an important tax benefit that investors may lose under a new legislative proposal.

Exchange traded notes would lose a key tax benefit under a proposal from House Republican Dave Camp of Michigan, according to a Bloomberg News report.
Camp wants to require mark-to-market taxation of derivatives. “Through that system, ETN holders would determine the products’ value each year and pay taxes at ordinary income rates on any change, even if they haven’t sold the securities,” according to the story.
“Holders of assets that generate dividends and capital gains must pay taxes in the year those are received,” Bloomberg reports. “By contrast, an ETN doesn’t generate such income, and holders don’t have to pay taxes until they sell the note.”
ETNs have important differences from exchange traded funds, or ETFs. ETNs are debt securities issued by financial institutions that promise to pay the return of an index, minus fees and taxes. Therefore, investors are exposed to the credit risk that the issuer goes bankrupt.
ETFs, meanwhile, are tradable baskets of securities in which shareholders own a slice of an actual portfolio, similar to traditional mutual funds. ETFs can hold stocks, bonds, futures contracts, currencies, commodities, or other assets.
In the US, there are 1,239 ETFs with total assets of $1.4 trillion. The ETN market is much smaller, with 206 products and $17.4 billion, according to
Tax treatment between ETFs and ETNs differ markedly with regard to distributions, says Morningstar analyst Abraham Bailin. “An ETN is technically a debt security, and as such, its distributions are taxed at ordinary income rates, like any taxable bond,” he explained.

ETNs do not hold index constituents and investors are taxed on capital gains upon sale, Bailin said.
“I don’t think this proposed tax change would have a radical effect on the use of ETNs,” said Dan Besse, managing director at Pacilio Wealth Management, in the Bloomberg story. “Although a lot of wealth managers, including us, are aware of tax ramifications, we’re trying to make the best and most suitable investments for our clients.”
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