Feb. 14 (Bloomberg) -- Barclays Plc introduced a new product that put a scare into Vanguard Group Inc. and the rest of the $13 trillion U.S. mutual-fund industry. Now Congress and the Treasury Department are coming to the funds' aid.

The security, called an exchange-traded note, allows individual investors to buy a type of forward contract linked to commodities and assets ranging from oil to currencies to foreign stock indexes. It has lower fees than mutual funds, is less regulated and, for now, lets holders defer taxable income indefinitely.

While less than $10 billion of the notes have been issued so far, mutual-fund companies see the potential for the new instruments to catch on in a big way with investors. The notes are ``derivatives for the masses,'' said Alex Gelinas, a tax lawyer at Sidley Austin LLP in New York. For the mutual funds, reining them in is ``the issue of the year.''

The funds argue that the way the notes are handled for tax purposes puts their products at a disadvantage. The industry's trade group wants the government to either scrap the notes' favorable tax treatment or extend it to them too.

``This is just, from a mutual fund's perspective, the calm before the storm,'' said Robert Willens, who recently left Lehman Brothers Inc. to found a tax and accounting advisory firm in New York. ``They believe that if the IRS does not take steps to interdict the purported tax benefits,'' the notes will become ``much more than a viable alternative to mutual funds.''

Goldman Joins In

The mutual funds' concern has mounted since Goldman Sachs Group Inc. and Bear Stearns Cos. began to mimic London-based Barclays and sell their own versions of the notes.

Investment banks have been packaging such derivatives into tax-deferrable structured notes for decades for institutional investors. Barclays broke new ground when it began selling the prepaid forward contracts, iPath ETN, last year to individuals.

In response, the Investment Company Institute, the trade association representing Vanguard and other funds, sent letters to Congress and Treasury calling the tax advantages of exchange- traded notes ``unwarranted, unintended and unfair.''

It got results. The Treasury Department in December said the interest income generated by currency-related notes can't be deferred because they are debt instruments. It may rule on other types of notes this year.

The group then persuaded Massachusetts Representative Richard Neal, a Democrat who heads a House Ways and Means subcommittee, to introduce legislation denying tax benefits to the notes and other derivatives and prepaid forward contracts.

`Unlimited' Deferral

``The law is not intended to provide unlimited deferral of taxes,'' said Neal, whose state is home to Boston-based Fidelity Investments, the world's largest mutual-fund company. Neal is planning hearings.

Some observers warn of wider implications from government intervention.

``Taxable derivative contracts are all impacted by this,'' said Viva Hammer, a law partner at Crowell & Moring LLP who specialized in derivatives taxation at Treasury until last year. ``That's a huge, huge market.''

U.S. commercial banks generated a record $18.8 billion in revenue from all derivatives products in 2006, although that number declined in 2007 because of weak credit markets, according to the Comptroller of the Currency.

Be Wary

Greg Zerzan, head of global public policy for the International Swaps and Derivatives Association, said policy makers should be wary of raising taxes on forward contracts.

``Proceeding in a direction that leads to taxation of appreciated-but-unrealized gains on financial products will ultimately harm growth and investment,'' Zerzan said.

Representatives of Valley Forge, Pennsylvania-based Vanguard, the No. 2 U.S. mutual-fund company, and Barclays, the third-largest U.K. bank, referred calls to their trade groups.

Shahira Knight, a managing director at the Securities Industry and Financial Markets Association, which represents banks such as Barclays, said the Neal legislation would result in owners of exchange-traded notes having to pay taxes on ``phantom income.''

Exchange-traded notes generate a return based on the value of a benchmark index for currencies, commodities or equities, such as the Standard & Poor's 500 Index. Unlike mutual funds, they are prepaid forward contracts, making them a form of debt security.

Also unlike mutual funds, which are required to make regular taxable distributions to investors, income earned on exchange-traded notes is tax-deferred. And the notes may qualify for lower capital-gains-tax rates if sold.

Las Vegas Meeting

At a meeting of tax lawyers last month near Las Vegas, three panels drew standing-room-only audiences to hear from Internal Revenue Service and Treasury officials.

John Rogers III, the lead IRS official examining the issue, told the lawyers it was easy to rule that exchange-traded notes tied to currency swaps are a form of debt and thus generate taxable interest. The agency continues to struggle with the tax implications of other forms of the notes, he said.

Daniel Culloton, an analyst at Morningstar Inc., an investment adviser, said mutual-fund companies are concerned that investors will flock to exchange-traded notes at their expense if the tax benefits are upheld.

Merrill Lynch & Co. sells an exchange-traded note bearing the Morningstar name.

``It's a legitimate threat because they are superior from a tax standpoint,'' Culloton said.

To contact the reporter on this story: Ryan J. Donmoyer at rdonmoyer@bloomberg.net

Last Updated: February 14, 2008 00:06 EST