IRS Ends Currency ETN Advantage

March 24, 2008

IRS Ends Currency ETN Advantage
The Internal Revenue Service has issued a ruling that ends the tax advantage that currency-based exchange-traded notes have over competing currency products, such as the CurrencyShares exchange-traded funds issued by Rydex Investments. In truth, it puts the ETNs at a slight disadvantage for most investors.

Historically, currency investing has been very tax-inefficient. Investors in a currency-based ETF have two sources of returns—interest income and changes in the value of the currency. Both receive terrible tax treatment as ''ordinary income,'' with rates up to 35 percent. The iPath currency ETNs had a huge advantage on the tax front, with gains from interest income and currency appreciation taxed at a long-term capital gains rate of 15 percent.

However, the new ruling, issued December 7, 2007, says ETNs—along with any financial instrument linked to a single currency—should be treated as ''debt'' for federal tax purposes. This means that all gains—interest and otherwise—are taxable as ordinary income, at rates up to 35 percent. Moreover, shareholders will owe taxes each year on interest income even if that income is incorporated into the value of the note, as it is with ETNs, and even though they won't realize that income until they sell the ETN.

Importantly, this ruling does not apply to other ETNs. The IRS has issued a request for comment on how taxes should be handled for other ''prepaid forward contracts,'' such as the popular commodity ETNs. However, some think that the currency decision does not bode well for the remaining tax-advantaged ETNs.

 

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