Imagine an investment that gives you exposure to an underlying asset or index with low fees and no tracking risk. The investment allows you to gain direct, levered, inverse, or “kinked” exposure to a range of assets that you ordinarily would not be able to purchase. Now imagine that the investment is listed on an exchange, and is traded in “chunks” that are small enough for the retail investor. You have just imagined an exchange traded note (an ETN).
Banks have been issuing ETNs since 2006. The first two ETNs tracked the value of two commodity indices. Since then, ETNs referencing equities, fixed income, FX, equity volatility, and carbon emissions have been issued.
ETNs are generally documented as unsecured debt instruments. However, they do not bear many of the economic hallmarks of debt, such as a guaranteed return of principal, or regular coupon payments. Instead, an ETN is simply a bet between the issuer and the holder regarding the performance of the underlying asset or benchmark, less a notional financing fee. For example, a simple ETN may provide direct, unleveraged exposure to the ABC stock index. Assume that, at issuance, the ABC index is trading at $100. An investor would pay the issuer $100 for the right to a pay-out, at maturity, equal to the level of the ABC index. If the index were trading at $120 at maturity, the holder would have the right to receive $120 from the issuer at maturity. By contrast, if the index were trading at $95 at maturity, the holder would have the right to a payment of only $95.
ETNs may offer levered, direct, or inverse exposure to their referenced assets or benchmarks. A levered ETN provides a multiple of exposure to its underlier. For example, a 2X ETN on the ABC stock index would increase by $2 for each $1 increase in value of the ABC stock index, and would decrease in value by $2 for each $1 fall in value of the index, and the value of an inverse ETN on the ABC stock index would vary inversely with the value thereof. The pay-out on an ETN may also be “kinked,” whereby the value of the ETN will vary at different rates relative to changes in the underlier depending on the value of the underlier.
Levered ETNs are generally “reset” each day, to provide levered daily returns. The result is that longer-term returns on levered ETNs may differ significantly from returns in the underlying investment.
Because ETNs reference a purely notional portfolio, they do not suffer from the “tracking risk” that can affect exchange traded funds (ETFs). Although issuers generally hedge their exposure to ETNs by going “long” the applicable underlier, issuers are not required to hedge, and holders have no security interest in the underlier.
Subject to certain narrow exceptions, there is no case law or governmental guidance directly on point regarding the proper tax characterization of ETNs. Commentators and practitioners generally take the position that, although the correct treatment is unclear, most ETNs are best treated as prepaid cash-settled forward contracts, but that the lack of authority on point leaves open the risk of alternative characterizations. Potential tax consequences to the holder vary accordingly.
- Forward Contract. Most ETNs are best characterized as prepaid, cash-settled forward or option contracts. As discussed above, ETNs are, in substance, a cash-settled bet regarding the performance of the applicable reference asset or benchmark. The pay-out on an ETN is referenced to the level of the notional asset or benchmark at maturity. Although not always articulated in the legal documents, the pricing of an ETN will generally reflect a “baked in” notional financing fee, analogous to the cost of carry reflected in a forward price. ETNs differ from debt instruments because there is no right to a return of principal or stated interest rate, and they differ from outright ownership of notional assets because there is no right to possession of the assets in the event of issuer bankruptcy, and, in the case of ETNs on equities, there is no right to vote the underlying shares or to collect dividends. Because of this, commentators and practitioners generally take the position that characterization as a prepaid, cash-settled forward contract is the closest to economic reality.
To the extent that an ETN is characterized as a prepaid forward contract, gain or loss should not be taken into account until the ETN is sold, exchanged, or redeemed. Gain or loss should be treated as capital when recognized, and should qualify for favorable long term capital gain rates, if the ETN is held for more than a year.
- CPDI. There is also a chance that ETNs may be characterized as so-called “contingent payment debt instruments” (CPDIs) for U.S. federal income tax purposes. To the extent that an ETN were characterized as a CPDI, the holder would be required to take imputed interest into account currently as ordinary interest income. Imputed interest payments would increase the holder’s basis in the ETN, and any gain or loss from the disposition of the ETN would generally be ordinary.
- Look-Thru. There is also a risk that the Service might treat the holder of an ETN as the beneficial owner of the applicable underlier(s). If this were the case, the tax consequences to the holder of the ETN would vary depending on the nature of the underlying assets:
- Many ETNs reference regulated futures contracts and options on futures contracts (“section 1256 contracts”) that are required to be marked to market by holders of positions therein.If a taxpayer who held an ETN of this type were treated as the beneficial owner of the applicable underliers, the taxpayer would be required to mark its position in the ETN to market currently.Gain or loss therefrom would be treated as 60% long-term capital gain or loss, and 40% short-term capital gain or loss, regardless of the taxpayer’s holding period in the ETN interest.
- If an ETN did not hold section 1256 contracts, but reset its value on a daily basis, there would be a risk that the holder thereof would be required to recognize short-term capital gain or loss with respect to the ETN interest on a daily basis.
- If an ETN held metals or other instruments that are “collectibles” for federal income tax purposes, there would be a risk that the holders thereof would be subject to tax upon disposition thereof at the special rate applicable to collectibles.
- FX Is Different. In 2008, the Service issued guidance that clarified the proper treatment of certain ETNs that reference FX.1 In the transaction reviewed in the guidance, on Day 1 the holder of the ETN paid the issuer the USD equivalent of 100 euros, translated at the spot rate. At maturity, the issuer paid the holder the USD equivalent (translated at the spot rate on the maturity date) of 100 euros, plus an amount equal to interest payable in euros, accrued and compounded between Day 1 and the maturity date. The Service held that, even though the instrument was documented as a USD-denominated ETN, it was, in substance, a euro-denominated debt instrument. As a result thereof, the holder was required to take original issue discount (OID) into account currently, and to take FX gain or loss into account upon receipt of payments.
Given the foregoing, many ETNs that reference FX should be treated as FX-denominated debt instruments for U.S. federal income tax purposes. If this is the case, interest, OID, and FX gain or loss will be accounted for as follows:
- To the extent that interest or OID is required to be accrued prior to receipt, it is included in income currently, translated at the average FX rate for the applicable accrual period.
- FX gain or loss is recognized with respect to interest or OID to the extent of the difference between the average FX rate at which the interest was accrued, and the spot rate on the date of receipt of cash; and,
- FX gain or loss is recognized with respect to principal to the extent of the difference between the principal amount translated at the spot rate on the date of acquisition of the instrument and the spot rate on the date of receipt of principal.
OID is treated as ordinary interest income, and FX gain or loss is also treated as ordinary income. Therefore, FX ETNs will, generally, give rise to current recognition of ordinary income.