Update May 8, 2018: Some ETNs, like VELOCITYSHARES 3X LNG NTRL GS ETN (UGAZ), are debt obligations taxed as securities. (Check the tax section of the ETN prospectus.)
An Exchange Traded Note (ETN) calculates its rate of return or interest rate based on the movement of an underlying financial instrument, futures index, or equities index. In IRS jargon, an ETN is a prepaid executory contract or prepaid forward contract based on the relevant financial instrument or index. The ETN holder does not own the underlying instrument or index, so he or she should not use Section 1256 treatment. Report ETN income when realized as short-term and long-term capital gains and losses, except currency ETNs which are ordinary gain or loss treatment.
Is there an alternative tax treatment using Section 1256?
In my June 27, 2016, blog post Tax Treatment For Volatility Products Including ETNs, I said tax treatment for ETNs was uncertain. I wrote: In the iPath S&P 500 VIX ST Futures ETN (VXX: NYSEArca) prospectus, the tax attorneys suggested that Section 1256 is a “possible alternative” tax treatment. The VXX prospectus said: “Moreover, it is possible that the IRS could seek to tax your ETNs by reference to your deemed ownership of the Index components. In such a case, it is possible that Section 1256 of the Internal Revenue Code could apply to your ETNs, in which case any gain or loss that you recognize with respect to the ETNs that is attributable to the regulated futures contracts represented in the applicable Index could be treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss, without regard to your holding period in the ETNs…”
My above 2016 blog post attracted lots of queries from ETN traders interested in tax advantageous Section 1256 treatment. Some ETN traders requested us to provide “substantial authority” for using Section 1256 treatment on VXX.
No “substantial authority” for using Section 1256 on VXX
Our tax attorney Mark M. Feldman JD, of counsel to Green, Neuschwander & Manning, LLC wrote the following.
I researched whether there is “substantial authority” for the position that 1256 applies to VXX. My conclusion is that there is no substantial authority. Substantial authority (in contrast to “reasonable basis”) requires that the position be anchored in some authority, and not simply be a reasonable possibility. See Treas. Reg. section 1.6662-4(d)(3).
We had discussed (see Green’s June 2016, blog post) whether Rev. Rul. 2008-1 might be relied upon to say that you look through to the underlying positions. After further analysis, and review of articles about Rev. Rul. 2008-1, my conclusion is that Rev. Rul. 2008-1 does not stand for the proposition that you look through to the underlying positions. Rather, Rev. Rul. 2008-1 should be understood as follows, based on its facts:
At inception, the holder delivers the U.S. dollar equivalent of 75 euros, and at maturity, the issuer is required to pay the U.S. dollar equivalent of 75 euros plus the U.S. dollar value at maturity on a return based on euro interest rates. Accordingly, the Service concluded that, for U.S. federal tax purposes, the Instrument is euro-denominated indebtedness of the issuer subject to Section 988. The fact that intervening currency fluctuations may cause the amount of U.S. dollars that the holder receives at maturity to be less than the amount of U.S. dollars that the holder paid at inception did not affect the characterization of the instrument of debt, which, according to the Service, was based on an analysis of payments with respect to the euros.
Thus, Rev. Rul. 2008-1 is simply an application of Section 988: treating this as debt which has an interest rate but is denominated in foreign currency. The Rev. Rul. might not be expanded to cases (like VXX) where the payment is more similar to a derivative contract. Even if the Rev. Rul. were so expanded, this would mean that VXX is treated as indebtedness, not that you look through to its underlying components.
The language of the VXX Prospectus (including the 2016 Prospectus), suggesting that one possible treatment would be to look through to the underlying components is based, presumably, on Notice 2008-2 (the “Notice”), not Rev. Rul. 2008-1. The Notice does not say that looking through is the proper treatment, but merely that the IRS is considering “whether the tax treatment of the transactions should vary depending on the nature of the underlying asset (for example, stocks vs. commodities).” That sentence is not sufficient to create substantial authority. (See also 2015 Tax Notes Today 202-8 “VIX IN STICKS AND VAX IN STACKS”, which references articles on VIX-related products and does not change this conclusion.)
In fact, in response to the Notice, there was a paper presented by the New York State Bar Association Tax Section (2008 Tax Notes Today 125-20, at note 26) which recommended to the IRS that Section 1256 60/40 treatment not be extended to ETNs.
New York City tax attorney Roger D. Lorence, of counsel to Green, Neuschwander & Manning LLC says, “I agree with Mark Feldman’s analysis. Instruments that are debt obligations (in form) do not give rise to 1256 treatment. The taxpayer would be arguing against the form of the transaction, which is problematic.”
According to List of ETNs ExchangeTraded – First Bridge Data, there are many ETNs to trade on exchanges.
- The iPath Bloomberg Commodity Index Total Return ETN (DJP) prospectus says its “senior secured debt securities.” The tax considerations section discusses taxation of securities, Original Issue Discount (OID), and variable rate securities. The DJP prospectus does not mention Section 1256.
- The iPath GSCI Total Return Index ETN (GSP) product summary says its “unsecured debt obligations.” The GSP prospectus calls for “Notes Treated as Prepaid Forward or Derivative Contracts.” Like VXX, the prospectus mentions the IRS may assert alternative treatment based on Section 1256.
See IPathETN.com U.S. Federal Income Tax Considerations: “For U.S. federal income tax purposes, Barclays Bank PLC and investors agree to treat all iPath ETNs, except certain currency ETNs, as prepaid executory contracts with respect to the relevant index. If such iPath ETNs are so treated, investors should recognize gain or loss upon the sale, redemption or maturity of their iPath ETNs in an amount equal to the difference between the amount they receive at such time and their tax basis in the securities. Investors generally agree to treat such gain or loss as capital gain or loss, except with respect to those iPath ETNs for which investors agree to treat such gain or loss as ordinary, as detailed in the chart below.” The iPath chart lists currency ETNs subject to ordinary gain or loss treatment. That’s consistent with IRS Revenue Ruling 2008-1 analyzed above. The other ETNs call for capital gain and loss treatment.
ETN investors agree to tax treatment
ETN prospectuses and Website content, including iPath above, state “investors agree to treat all ETNs, except certain currency ETNs, as prepaid executory contracts.” That’s a departure from typical prospectuses which recommend holders adopt a particular tax treatment.
When ETN prospectuses mention alternative tax treatment calling for Section 1256, they say the IRS may assert Section 1256 mark-to-market treatment based on various factors; they are not recommending a holder consider using Section 1256 treatment.
Volatility products with Section 1256 treatment
If you want Section 1256 tax breaks on volatility products, then trade volatility futures like the CBOE Volatility Index (VIX).
Options on VXX ETN
Some clients asked me how options on VXX are treated for tax purposes. I got this reply from our tax attorney Roger D. Lorence. “I located nothing directly on point. However, the better view in my understanding would be that these options are nonequity options and therefore Section 1256 contracts. The options are listed on CBOE and are therefore listed options on a qualified board or exchange. The underlying is, e.g., VXX ETNs. The tax opinion in the prospectus for the ETNs (Sullivan and Cromwell) is that these are prepaid forward contracts, and the holder has an executory contract for the delivery of the underlying futures contracts. Therefore the CBOE listed options are a derivative contract several levels removed from the ultimate underlying. If a holder were to exercise the CBOE options theoretically, they would not receive equity in a single stock or a narrow-based group of stocks based on a narrow-based index.”
Tax attorneys Mark M. Feldman and Roger D. Lorence contributed to this blog post.