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Abstract: 

Exchange-traded notes have raised fundamental tax policy issues, which include issues of timing and characterization of income, as well as whether the entire tax system for financial products needs a complete overhaul and whether economically equivalent financial instruments should be taxed equally. Revenue Ruling 2008-1, Notice 2008-2, and H.R. 4912 (the “Response”) were largely a reaction to the creation of exchange-traded notes. The first portion of this article provides background information to the Response by (1) providing a description of a typical ETN, (2) describing how the market came to the conclusion that ETNs, which have debt-like characteristics, are prepaid forward contracts for federal income tax purposes, (3) discussing the taxation of comparable direct investments in the referenced index through investment vehicles such as mutual funds and the mutual fund industry’s reaction, and (4) discussing the taxation of ETNs from the issuer’s perspective. The second portion of this article discusses the Response, which clarifies existing law and eliminates the tax advantages for certain ETNs the yield of which is derived from foreign currency indices (“foreign currency ETNs”) and which may change the applicable tax regime for all prepaid forward contracts, not just ETNs, from open transaction treatment to a current accrual regime.

Keywords: Exchange-traded notes; taxation

Affiliations:  1: Morrison & Foerster LLP.