An ETF's taxation is ultimately driven by its underlying holdings. Since funds are structured differently according to how they gain exposure to the underlying asset, an exchange-traded fund's tax treatment inherently depends on both the asset class it covers and its particular structure.
Currency funds that hold futures contracts are regulated by the Commodity Futures Trading Commission as commodity pools, but they’re classified for tax purposes by the IRS as limited partnerships (LPs). Therefore, “LP” will be used to refer to the structure of these funds.
Currency ETFs come in one of four structures: open-end funds; grantor trusts; LPs; or ETNs.
|MAXIMUM CAP GAINS TAX RATE|
|Open End ('40 Act)||20%||39.60%|
|UIT ('40 Act)||N/A||N/A|
|Grantor Trust ('33 Act)||39.60%||39.60%|
|Limited Partnership ('33 Act)*||27.84%**||27.84%**|
|ETN ('33 Act)||39.60%||39.60%|
**Max rate of blended 60% LT/40% ST
NOTE: These rates are NOT inclusive of the 3.8 percent Medicare surcharge tax or any additional taxes applicable from the phase-out of itemized deductions and personal exemptions.
Currency Open-Ended Funds
WisdomTree and PIMCO are the only issuers to offer currency ETFs structured as open-ended funds. These funds do not hold currency notes or futures contracts. Instead, most of their funds hold the bulk of their assets in U.S. Treasury bills and repurchase agreements (repos), while gaining exposure to the reference currencies through forward-currency contracts and swaps.
Tax implications for these funds are similar to equity funds. According to issuers’ prospectuses, gains are taxed as long-term capital gains (maximum 20 percent) if held for more than one year; if held for one year or less, gains are taxed as ordinary income.
Meanwhile, distributions can be taxed as ordinary income from its Treasury holdings and/or short-term and long-term gains from its holdings in forward-currency contracts.
Currency Grantor Trusts
CurrencyShares are structured as grantor trusts. Each CurrencyShares product gives investors exposure to spot exchange rates of the underlying currency by holding the foreign currency in bank accounts.
The taxation of CurrencyShares products is straightforward. All distributions and gains from the sale of shares are taxed as ordinary income (maximum 39.6 percent), regardless of how long they’re held by the investor.
Currency Limited Partnerships
Similar to commodity LP funds, currency funds that hold futures contracts are structured as LPs. The tax implications for currency LP ETFs are the same as commodity LP ETFs—gains are subject to the same 60 percent/40 percent blend, regardless of how long the shares are held. They’re also marked to market at year-end and are reported on K-1s.
Currency Exchange-Traded Notes
Some uncertainty surrounds the taxation of currency ETNs. Due to an IRS ruling in late 2007—Revenue Ruling 2008-1—gains from currency ETNs are now generally taxed as ordinary income (maximum 39.6 percent), regardless of how long the shares are held by the investor.
However, according to the prospectuses of some currency ETNs, investors might have an option to classify gains as long-term capital gains if a valid election under Section 988 is made before the end of the day that the ETN was purchased.
Also, even though currency ETNs don’t pay out any distributions to its shareholders, if a note generates any income throughout the year, investors can be subject to pay taxes on this “phantom income” at year-end.
Choosing The Right Fund For You
While CurrencyShares offers the “purest” way to gain exposure to a currency through an exchange-traded product, any distributed income or gains from selling shares are taxed as ordinary income, so investors don’t get any long-term capital gains tax advantages.
WisdomTree’s and PIMCO’s open-ended funds might have a tax advantage for long-term investors, but for better or worse, funds using forward contracts don’t always perfectly follow spot exchange rates of the underlying currency. Also, most of the gains from forward contracts get distributed either quarterly or annually.
Similar to commodities, currency limited partnership ETFs can be beneficial for short-term traders because of the blended maximum 27.84 percent rate even if shares are held for less than one year. But investors need to deal with K-1 forms, and shares are marked to market if they’re held over into a new calendar year.
As always, the choice comes down to the individual. Nonetheless, it pays to have a full understanding of the potential tax treatments so you can make an informed decision.
Disclaimer: We are not professional tax advisors. This article is for informational purposes only and not intended to be tax advice. Tax rules can change. Individuals should always consult with a professional tax advisor for details about the tax implications of investment products and their personal taxes.
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