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.
In December, the IRS issued a rule stating that any financial instrument linked to a single currency should be treated as debt for federal tax purposes, regardless of whether the instrument is privately offered, publicly offered or traded on an exchange. This means that even reinvested interest is taxable to investors and that gains or losses on sale or redemption will generally be treated as ordinary income.
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 (ERO), iPath GBP/USD Exchange Rate ETN (GBB) and iPath JPY/USD Exchange Rate ETN (JYN). Launched last May by Barclays Bank, these notes are designed to offer exposure to a single currency exchange rate relative to the U.S. dollar. It appears the tax advantage ETNs had over currency-linked ETFs is now gone.
"Ruling 2008-1 provides taxable investors clarity on the tax treatment of foreign currency exchange-traded notes," said Philippe El-Asmar, Barclays head of investor solutions for the Americas. "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 (GBB) is linked to the performance of the British pound/U.S. dollar exchange rate. When the British pound appreciates relative to the U.S. dollar, the GBP/USD exchange rate (and the value of GBB) increases; when the pound depreciates relative to the dollar, the GBP/USD exchange rate and the value of GBB decrease.
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 ruling does not apply to ETNs linked to equities or commodities, but the IRS also issued Notice 2008-2 asking for comments on the appropriate tax treatment of instruments like equity and commodity ETNs.
Ron DeLegge is the San Diego-based editor of www.etfguide.com.