Currency ETNs Get Adverse Tax Ruling

December 18, 2007

SAN DIEGO (ETFguide.com) - The tax advantage of exchange-traded notes (ETNs) linked to currencies has evaporated and the status of notes linked to commodities and stocks remains in limbo.  

Last week, the U.S. Internal Revenue Service issued a rule stating that any financial instrument linked to a single currency regardless of whether the instrument is privately offered, publicly offered or traded on an exchange should be treated like debt for federal tax purposes. This means that any interest is taxable to investors, even though the interest is reinvested and not paid out until the holder sells any such financial instrument, including an ETN, or the contract, matures. It also means that gain or loss on sale or redemption will generally be ordinary, and investors will not be able to elect capital gain treatment. 

This is a major setback for currency linked ETNs and will primarily affect the tax treatment of three iPath Currency ETNs - the iPath EUR/USD Exchange Rate ETN (Ticker: ERO), iPath GBP/USD Exchange Rate ETN (Ticker: GBB), and iPath JPY/USD Exchange Rate ETN (Ticker: JYN). Launched in May 2007 by Barclays Bank, these notes are designed to offer exposure to a single currency exchange rate relative to the US dollar.

Because of the new ruling, it appears the tax advantage ETNs had over currency linked ETFs is now gone.

PowerShares Capital Management and Rydex Investments stand to benefit most from the ruling. Rydex has eight ETFs linked to single currencies and PowerShares has three currency related products. 

The Revenue Ruling does not apply to ETNs that are linked to equities or commodities. The IRS also issued Notice 2008-2 asking for comments on the appropriate tax treatment of instruments described as prepaid forward contracts, which is how investors currently treat the equity and commodity ETNs for tax purposes.

"Ruling 2008-1 provides taxable investors clarity on the tax treatment of foreign currency exchange traded notes," said Philippe El-Asmar, Managing Director, Head of Investor Solutions, Americas, at Barclays Capital. "Institutional and individual investors increasingly recognize that currency exposure may constitute a separate asset class to provide portfolio diversification and add potential portfolio returns. The iPath Currency ETNs provide simple, transparent and cost-effective access to three significant exchange rates."

The iPath Currency ETNs are senior, unsecured, unsubordinated debt securities linked to the performance of an exchange rate.

As an example, the return on the iPath GBP/USD Exchange Rate ETN is linked to the performance of the British pound/U.S. dollar exchange rate. The GBP/USD exchange rate is a foreign exchange spot rate that measures the relative values of two currencies, the British pound and the U.S. dollar. When the British pound appreciates relative to the U.S. dollar, the GBP/USD exchange rate (and the value of GBB) increases; when the British pound depreciates relative to the U.S. dollar, the GBP/USD exchange rate and the value of GBB decreases.