ETNs Would Lose Tax Edge in House Republican ProposalRichard Rubin and Kevin Dugan
Exchange-traded notes, which mimic investments in securities without an annual tax bite, would lose that edge under a proposal from the top Republican tax writer in Congress.
Representative Dave Camp, a Michigan Republican, wants to require mark-to-market taxation of derivatives. Through that system, ETN holders would determine the products’ value each year and pay taxes at ordinary income rates on any change, even if they haven’t sold the securities.
“Structured notes are really a creature of the current tax code,” said Daniel Crowley, a partner at K&L Gates LLP in Washington and a former lobbyist for the Investment Company Institute, which represents mutual funds. “Otherwise, there would be no reason for them to exist.”
Camp is incorporating a draft of his plan into a broader overhaul of the U.S. tax code. His proposal on derivatives would have wide-ranging effects in the financial world. The change would sap enthusiasm for exchange-traded notes, which have attracted about $17 billion from U.S. investors, according to data compiled by Bloomberg.
Lawyers, accountants, investors and market participants have been trying to determine the probable winners and losers under Camp’s plan since he released it Jan. 24. Sage Eastman, a spokesman for Camp, said there is no estimate as to whether the proposal would increase or reduce tax revenue.
Camp said he’s proposing the tax-code modernization to keep up with changes in financial products and make the rules simpler and more fair. He has also said his bill would curb Wall Street’s ability to hide and disguise risk by using derivatives.
Lawyers are still parsing the potential effects on convertible debt, straddles and futures markets. So far, the financial industry’s representatives in Washington have been relatively quiet about the proposal.
Scott Talbott of the Financial Services Roundtable, Will Acworth of the Futures Industry Association and Lauren Dobbs of the International Swaps and Derivatives Association declined to comment on Camp’s plan.
The Securities Industry and Financial Markets Association has been gathering input from its members and plans to provide feedback to Camp that emphasizes potential unintended consequences, said Payson Peabody, managing director and tax counsel at the Washington-based group.
“We understand that this is part of a larger project, tax reform project, which we generally support,” he said. “We know there are other pieces of this, so we don’t want to lose the forest for the trees.”
The largest U.S. banks would be unaffected, at least when it comes to their own holdings. Current tax law already requires them to mark their derivative portfolios to market annually.
Among the most straightforward calculations is the effect on exchange-traded notes. The securities, issued by companies such as Barclays Plc and JPMorgan Chase & Co., are derivatives whose value is tied to another investment, such as a stock market index.
Holders of assets that generate dividends and capital gains must pay taxes in the year those are received. By contrast, an ETN doesn’t generate such income, and holders don’t have to pay taxes until they sell the note.
Camp, a Michigan Republican and chairman of the Ways and Means Committee in the House of Representatives, wants to change that and establish parity between derivatives and other investments.
A 2011 report from Congress’s Joint Committee on Taxation showed how investors can take advantage of the variable tax treatment of different financial instruments to obtain the lowest tax rates on gains and the greatest benefit from losses.
Camp’s plan would reduce the alternatives for investors, said David Shapiro, a principal at PricewaterhouseCoopers LLP in Washington. They could own ordinary assets, which would mean taxes only upon the sale and capital gains rates. Or they could own derivatives, which would mean mark-to-market accounting and ordinary income taxation each year.
“This proposal is essentially taking some of those choices off the menu,” said Shapiro, who was senior counsel for financial products at the Treasury Department from 2007 to 2009. “But it’s also keeping the fundamental choice there.”
The top tax rate for ordinary income is 39.6 percent, compared with a 20 percent top rate for capital gains. The investment income of top earners is also subject to a 3.8 percent additional tax, which would apply to capital or profits from derivatives.
Camp’s broader tax overhaul would lower individual rates and perhaps change capital gains rates. He hasn’t said what the new top rates would be.
The plan may make tax receipts more volatile in a crisis with falling asset prices, as in 2008. That’s because investors with losing positions could subtract their paper losses from their other income, Shapiro said.
Camp’s proposed change may cause difficulty for holders of exchange-traded notes that aren’t tied to underlying securities, because tougher tax rules would apply and investors wouldn’t have another alternative.
One use of the notes is to provide a chance to profit from volatility, usually by investing in securities that replicate the Chicago Board Options Exchange Volatility Index, commonly known as the VIX.
The benchmark is sometimes referred to by investors as the Fear Index because it surges during periods of economic uncertainty, such as when Standard & Poor’s cut the U.S.’s sovereign debt rating to AA+ from AAA in August 2011.
There is no way to invest in volatility with non-derivative instruments, said Samuel Lee, an analyst at Morningstar Inc. in Chicago. Exchange-traded funds tied to the VIX rely on investments such as options or futures, he said.
“We would consider that a change for the worse,” Jerry Miccolis, chief investment officer of the Madison, New Jersey-based Brinton Eaton Associates Inc., said about Camp’s proposal.
While Miccolis used to invest in volatility through exchange-traded and structured notes, now he uses swaps, he said. Less than half of his $230 million fund invests in volatility.
“You ought to be able to control when it is you have to claim a gain or loss for tax purposes,” he said, a choice denied to derivatives owners under the Camp proposal. “That control shouldn’t be taken out of your hands.”
The iPath S&P 500 VIX Short-Term Futures ETN is the largest VIX-tied exchange-traded note, with $1.17 billion under management, according to data compiled by Bloomberg.
Because the proposal would tax derivatives in a similar way to mutual funds, investors probably won’t stop buying the notes, said Dan Besse, managing director at Pacilio Wealth Management in Westport, Connecticut.
“I don’t think this proposed tax change would have a radical effect on the use of ETNs,” he said. “Although a lot of wealth managers, including us, are aware of tax ramifications, we’re trying to make the best and most suitable investments for our clients.”
Investors would adjust and shift money to other investments, K&L Gates’s Crowley said. That’s especially true because the proposal would apply only prospectively to investments made starting in 2014.
“I see all of this as causing some dislocations in the short term, but ultimately people will get used to complying with the new rules,” he said. “It will undoubtedly cause some squawking in the near term.”
The market’s relatively small size means that most investors won’t be affected by tax changes, Lee said. The $17 billion in investor-owned ETNs amounts to less than 1 percent of the $1.93 trillion exchange-traded product market, according to a December report by BlackRock Inc., which promotes iPath notes.
“I think it would hurt more speculators and other types of investors who have a reliance on this, but the average Joe Schmo is not going to really notice any changes,” he said.