Definitive Guide To MLP ETFs And ETNs

April 04, 2013


Pooling MLPs to diversify from a single line of business, however, creates challenges. Under current tax laws, a traditional mutual fund (a 1940 Act regulated investment company) can’t invest more than 25% of fund assets in publicly traded partnerships like MLPs. Indeed, a small industry of advisory shops has emerged that advise high-net-worth clients on which MLPs to buy in what proportions to create the diversification that funds hadn’t been providing.

The first pooled investment vehicles to solve this problem were closed-end funds that structured themselves as C-corporations as opposed to traditional 1940 Act open-end funds. These closed-end funds chose not to be taxed as registered investment companies (RICs), but rather as corporations. These were the first-generation MLP products to launch, but the closed-end nature meant they were prone to big premium spikes, limiting their usefulness.

Enter ETFs. In recent years, the exchange-traded fund industry has launched a series of MLP-related offerings that attempt to deliver diversified exposure to multiple MLPs by getting around the 25% RIC rule. Investors can choose between two structures—exchange-traded notes or exchange-traded funds—both of which have unique issues.

MLP ETNs are exchange-traded debt instruments that are, fundamentally, a promise to pay a pattern of returns mirroring an index of MLPs. As debt instruments, any income they offer investors is treated just like a bond coupon, which means they pay ordinary income tax rates. This obviates the very reason many investors seek out MLPs in the first place—the chance to receive regular distributions with the favorable “return of capital” tax treatment. However, appreciation in the MLP index is deferred and taxed at capital gain rates when the MLP ETN is sold or matures. ETNs also expose the investor to the credit risk of the issuer—generally a small risk, but like any piece of corporate debt, a non-zero one.

MLP ETFs, on the other hand, actually invest directly in MLPs. They avoid the 25% RIC holding rule referenced above by structuring themselves as regular corporations, just like any other United States C-corporation (and like the enterprising closed-end funds before them) and forfeit the special tax treatment accorded traditional ETFs—tax treatment that allows a traditional ETF to pay out its income currently, take a deduction for its payment of dividends, and thereby reduce or eliminate corporate tax at the ETF level. C-corporations are entirely stand-alone entities as far as the tax code is concerned.

This means any income earned by the C-corporation must go through a round of tax treatment before anything is returned to investors (just as Microsoft must pay its own taxes before paying a dividend) and then net distributions to shareholders (after payment of the corporate tax) are taxed again in the hands of the shareholders. That means the distributions of MLPs, and any net appreciation in their value, are taxed at the corporate level before they are passed on to the shareholders, and then taxed again as dividend income once that pass-through takes place. Again, this compromises the very tax efficiency many MLP investors are seeking (as well as the tax efficiency of traditional ETFs), and makes any anticipated tax efficiency from the MLP ETF dependent upon extremely complex calculations.

When choosing an MLP ETF or ETN, understanding the pros and cons of each structure in detail is critical.


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