In a year that tax increases are already creating a stir, a proposal in the U.S. House sets its aim squarely on the world of ETF taxation.
2013 brought some significant changes to tax rates, especially for higher-income investors, but starting 2014, investors of all income levels investing in certain exchange-traded products might have to deal with a whole new set of tax rate changes.
Representative David Camp, a Republican from Michigan and the current head of the House Ways and Means Committee, is proposing a series of tax reforms. Included in his proposal are changes to the way certain financial instruments are taxed, such as derivatives.
Under the proposal, derivatives—which include futures contracts, forward contracts and swaps—would all be taxed as ordinary income regardless of holding period, and any gains would be marked to market at the end of each year.
Also falling under the “derivatives” umbrella in the proposal would be exchange-traded notes (ETNs). Structurally, ETNs are senior, unsecured, unsubordinated debt notes issued by banks that simply promise to track a specific index.
Exchange-traded products get taxed based on their underlying securities and their legal structure. For details, see our fully updated 2013 Complete Guide to ETF Taxation.
Therefore, should the proposals come to fruition, certain ETFs that use futures contracts and swaps— such as commodities pools, as well as ETNs, could see some substantial changes to the tune of hundreds to thousands of basis points in tax rates.
Let’s look at each structure in depth to see what these changes might mean for investors.
Many ETFs, mostly focused on commodities, hold futures contracts and are structured as commodities pools. Some very popular funds with this structure include the $6.9 billion PowerShares DB Commodity Index Tracking Fund (NYSEArca: DBC), the $1.2 billion iShares S&P GSCI Commodity-Indexed Trust (NYSEArca: GSG) and the $1 billion United States Oil Fund (NYSEArca: USO).
Currently, these funds are taxed like futures contracts—when shares are sold, 60 percent of any gains are taxed as long term, while 40 percent of those gains are taxed as short term, regardless of holding period. Also, they are marked to market annually, meaning they are taxed even if they’re not sold.
This is a huge tax advantage for short-term traders, especially for those in higher tax brackets, because you can literally flip the shares in a day or two for a quick profit, and 60 percent of any gains still get taxed at the beneficial long-term rate, which is currently maxed at 20.00 percent.
The 60/40 split rate ultimately comes out to a max blended rate of 27.84 percent. Meanwhile, investors who sell shares in a comparable ETN for less than a year are subject to paying ordinary income, or a maximum rate of 39.60 percent.
Should the proposals come to fruition, all gains would be taxed as ordinary income, which would lessen the tax advantages commodities pools have over ETNs for short-term investors.
Regarding the marked-to-market proposal, commodities pools are, as noted above, already marked to market each year, so the proposal won’t pose any significant changes to investors on that front.