Taxation of Exchange Traded Notes

By Robert A. Velotta, CPA, Cohen & Company, Ltd., Cohen Fund Audit Services, Ltd., Westlake, OH

Editor: Anthony S. Bakale, CPA, MT

An exchange traded note (ETN) is a relatively new investment vehicle that consists of publicly traded notes issued by an underwriting bank with a fixed maturity date and backed solely by the credit of the issuer. The first ETNs were offered in 2006; since that time the number being traded has grown to approximately 60 (as of April 2008), with over $6.1 billion invested in these vehicles. While the market demand for this product has significantly increased, there has been little guidance as to its tax treatment. This item provides an overview of the structure of an ETN and the current tax treatment of these instruments and an update on some of the guidance that has been issued related to taxation of ETNs in Rev. Rul. 2008-1 and Notice 2008-2.

Overview and Structure of ETNs

ETNs are long-term (generally 30 years), unsecured notes issued by a bank that do not require any interest or principal payments prior to maturity. These notes are traded on established securities markets after the initial issuance. While not limited to only these types of investments, ETNs are generally structured to provide investors exposure to commodities, emerging markets, foreign currencies, master limited partnerships, and various other investment strategies.

ETNs differ from traditional notes in that ultimate payment at maturity is equal to the value of the principal payment as if it were invested in the underlying benchmark securities less a fee calculated as a percentage of the ETN’s value. Some ETNs may also accrue interest during their terms. No payment is made by the issuer with respect to the ETN until maturity or redemption of the note. Generally, an investor makes an upfront investment when buying the ETN. The issuer then agrees to pay the investor an amount linked to the performance of the specified benchmark (for example, the S&P 500) less the fee charged by the issuer at the end of the note’s term. Even though the payment to the investor is based upon the performance of the benchmark, there is no ownership of any underlying security to serve as collateral for the note. Accordingly, the holder of an ETN faces the credit risk of the issuer as well as the market risk of the specified benchmark’s performance. While the current issuers of the ETNs are some of the largest financial institutions, the current mortgage crisis serves as a reminder that there is credit risk even with these large institutions.

The prospectus for many ETNs contains language regarding the investment’s taxation that consistently reminds readers to “consult their tax adviser,” but it also maintains that the ETN should be treated as a prepaid forward contract with respect to the underlying index. The rationale for this approach is that the issuer of the ETN is consenting at some agreed-upon future time to pay the note holder an amount equal to the value of the pool of assets referred to. The result of this treatment is that the ETN’s holder would have capital gain or loss treatment upon the sale, redemption, or maturity of the note.

ETNs vs. ETFs

ETNs are often compared to exchange traded funds (ETFs). Both ETNs and ETFs are traded on public exchanges and generally track an index to generate investor returns. However, there are some significant differences. From a tax perspective, most ETFs are structured as regulated investment companies (RICs), which require annual distributions of income and capital gains to shareholders, or are structured as grantor trusts, where the income and gains or losses are taxable to the owners as if the underlying investments were owned directly by the investors.

In contrast, as discussed above, the recommended tax treatment of an ETN is currently as a prepaid forward contract. Under this treatment, the change in the contract’s value (appreciation or depreciation) is taxed only upon sale or redemption and at that time as capital gain or loss. Accordingly, the ETN allows the taxpayer to defer the recognition of income until the disposition of the contract and eliminates the ordinary interest income factor associated with normal debt and notional principal contracts.

Perhaps more significant from an actual investment perspective, ETFs and ETNs differ in the ownership of the underlying assets that generate the investment performance. Specifically, an ETF actually has ownership of the underlying investments, whereas an ETN generates a return based upon a notional ownership of the investments being tracked. Because of this, the ETN has the added credit risk of the ETN’s issuer, as there are no pledged assets serving as collateral to these notes. Since the ETN is structured to provide the investor a return on a particular investment strategy or market without the actual requirement of owning the underlying assets, it may provide investors access to markets or other investment exposure where they might not otherwise be able to obtain direct ownership of the target investment.

For example, RICs are required to meet certain income tests to qualify for their favorable tax treatment. Rev. Rul. 2006-1 held that income from commodity-linked swaps does not create “good” (qualifying) income for RIC purposes. In this ruling, the IRS held that these derivative instruments were not included in the Investment Company Act of 1940’s definition of “securities”; therefore, income from these derivatives did not meet the RIC income requirements of Sec. 851(b)(2).

In contrast, there have been several private letter rulings since 2006 (the most recent of which is Letter Ruling 200822012, issued on May 30, 2008) stating that ETNs, as debt instruments, do meet the definition of securities under the Investment Company Act and therefore generate qualifying RIC income. In an even more widespread application, the ETN may give investors the ability to have market exposure to various foreign markets that may restrict or limit foreign investment in the actual securities being traded.

In addition, because ETNs do not actually own the underlying investments, there is less likelihood of tracking error. ETFs, on the other hand, must maintain a basket of securities and will have limitations on the basket due to diversification requirements; they may incur additional transaction costs associated with rebalancing in order to track a specified index that an ETN does not have.

Rev. Rul. 2008-1

In Rev. Rul. 2008-1, the Service ruled that a foreign-currency-based prepaid forward contract is taxed as debt for U.S. tax purposes. The example in this ruling is as follows: The ETN’s holder delivers $100 to the issuer in exchange for the ETN, where the issuer is to deliver the U.S. dollar equivalent of an amount of euros in three years (the maturity date) after the original issuance of the note. The payment is calculated based upon the original amount of converted euros (in the example, it is assumed that $100 = €75 on the start date) plus a compound stated rate of return (interest) less a specified percentage of the note value labeled as a fee payable to the issuer.

The example states that the legal remedies provided in the instrument are not materially different than legal remedies associated with instruments treated as debt for federal tax purposes. Ultimately, the actual amount repaid to the investor is equal to the change in the foreign currency exchange rate, plus the interest component, less the issuer fee. The example also states that there is a significant possibility that the amount payable to the holder may be less than $100 at the time of repayment and that the functional currency of the holder is the U.S. dollar.

Rev. Rul. 2008-1 relies upon several court cases and Sec. 988 and the related regulations in determining that the ETN is a debt instrument for U.S. tax purposes. These cases provide that the acquisition of a debt instrument or becoming an obligor is a Sec. 988 transaction if the amount that the taxpayer is entitled to receive or required to pay is determined by reference to the value of a nonfunctional currency (in this example, the euro). Furthermore, the revenue ruling determines that a financial instrument with payments determined by reference to a single currency can be debt, even if all payments are made in another currency and foreign currency fluctuations may cause the amount of U.S. dollars received at maturity to be less than $100. Rev. Rul. 2008-1 also determined that the treatment of this instrument as debt for U.S. tax purposes is not affected if the instrument is privately offered, publicly offered, or traded on an exchange.

Notice 2008-2

Rev. Rul. 2008-1 is significant because the IRS stated that foreign-currency-based ETNs are to be treated as debt for U.S. tax purposes. However, the revenue ruling did not address other ETNs, such as those linked to commodities or stocks. Concurrent with the issuance of Rev Rul. 2008-1, the Service issued Notice 2008-2, requesting public comment on the proper tax treatment of all ETNs. Specifically, the IRS requested comments related to the many alternatives that have been considered in addressing the taxation of prepaid forward contracts. The Service issued 14 bullet points for public comment. Some of the more pertinent points include:

  • The appropriate method of accruing income or expense (e.g., mark-to-market, the noncontingent bond method rules under Regs. Sec. 1.1275-4, etc.), if accrual is deemed appropriate;
  • The appropriate character (ordinary vs. capital and, if ordinary, whether it is considered interest income) of any income accruals;
  • Whether the tax treatment should be dependent on the nature of the underlying investments;
  • Whether the constructive ownership rules of Sec. 1260 should apply to prepaid forward contracts;
  • Whether the transactions should be treated as debt under the regulations of Sec. 7872;
  • How these transactions should be treated with respect to international taxpayers;
  • The identification of other similar arrangements to prepaid forward contracts that should have similar tax consequences; and
  • Appropriate transition rules and effective dates.

Given the wide variety of potential tax treatments described above, it is clear that Congress or Treasury need to provide firm guidance in this area. Final comments under Notice 2008-2 were due to the IRS by May 13, 2008. As of the writing of this item, no guidance has been issued by the Service.


As is often the case, Wall Street moves significantly faster in creating new products than Congress or Treasury can react. Congress and Treasury are currently contemplating the issuance of widespread guidance on the taxation of ETNs and other prepaid forward contracts that would mitigate the tax deferral of these investments. Tax practitioners should be aware of these developments as ETNs and other newly created investment products make their way more and more into the hands of the retail investor. Due to the overall lack of guidance and general uncertainty related to the taxation of these products, investors are more likely to rely on the statements in the offering documents as well as the opinion of their own tax advisers as to the tax consequences of these investments.


Anthony S. Bakale is with Cohen & Company, Ltd. Baker Tilly International in Cleveland, OH

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.

If you would like additional information about these items, contact Mr. Bakale at (216) 579-1040 or

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