Exchange-traded notes (ETNs) are structured either as debt securities or prepaid executory contracts, and that makes a critical difference in tax treatment.
“The tax treatment of ETNs is often complicated to determine,” said New York City tax attorney Roger D. Lorence. “You have to review the tax section of each prospectus. In many cases, the offering is an undivided interest in the underlying positions, such as futures, so that the ETN is not an interest in an entity nor itself a security. However, other ETNs are structured as a debt instrument, usually with leverage concerning some index (such as natural gas futures).
ETNs structured as debt securities are taxed similarly to other securities with the realization method for capital gain or loss. (Realization is when you sell the security.) They are subject to Section 1091 wash-sale loss adjustments, which can raise tax liabilities. (Scroll to the end of the blog for more on wash-sale loss adjustments.) Section 475 ordinary gain or loss treatment should apply to these debt securities, too, if the trader qualifies for trader tax status (TTS) and makes the election on time.
ETNs organized as prepaid executory contracts (also referred to as prepaid forward contracts) are not securities. They calculate a rate of return or interest rate based on the movement of an underlying financial instrument, futures index, or equities index. The ETN holder does not own the underlying instrument or index. This can have a significant impact on tax liabilities, as it likely means that Sections 1091 wash sales and 475 MTM should not apply to them. ETN prospectuses say they don’t address Sections 1091 and 475.
Report the sale or exchange of ETNs organized as prepaid executory contracts when realized as short-term and long-term capital gains and losses, except currency ETNs which are ordinary gain or loss treatment.
Here’s the problem when it comes time to preparing tax returns: Most brokers categorize all types of ETNs as securities on 1099-Bs and make wash-sale loss adjustments. Those adjustments might defer tax losses to the subsequent year, thereby raising tax liabilities. When it comes to ETN prepaid executory contracts, consider deviating from the 1099-B to reverse out wash-sale loss adjustments on these ETNs. Explain why in a tax return footnote. If this presents a significant change in tax liability, consider obtaining a “substantial authority” letter from a tax attorney to support the tax filing. The broker carries over these wash sale loss adjustments as an increase in cost basis in the subsequent year, so don’t forget to reverse that, too. Deviating from 1099-Bs raises complications, so consult a tax advisor.
Options on ETNs: There is a similar problem with CBOE-listed options on volatility ETNs and ETFs. Many broker 1099-Bs classify these options as securities, but there is substantial authority to treat them as non-equity options, which are Section 1256 contracts. As Section 1256 contracts, they are not subject to wash-sale loss adjustments and qualify for lower 60/40 capital gains tax rates. (See How To Apply Lower Tax Rates To Volatility Options, Tax Treatment For Exchange Traded Notes.)
ETN debt securities prospectus
See the Credit Suisse Velocity Shares prospectus applicable to ETN symbol XIV and five related volatility ETNs. Here are excerpts from pages 75-76:
“Debt Securities U.S. Holder Payments or Accruals of Interest Payments or accruals of ‘qualified stated interest’ (as defined below) on a debt security will be taxable to you as ordinary interest income at the time that you receive or accrue such amounts (in accordance with your regular method of tax accounting).
Purchase, Sale and Retirement of Debt Securities: When you sell or exchange a debt security, or if a debt security that you hold is retired, you generally will recognize gain or loss equal to the difference between the amount you realize on the transaction (less any accrued qualified stated interest, which will be subject to tax in the manner described above under Payments or Accruals of Interest) and your tax basis in the debt security.”
ETN prepaid executory contracts prospectus
Among the most-popular traded ETN symbols are VXX, VXZ, XVZ, all prepaid executory contracts issued by iPath. According to 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 UBS Velocity Shares prospectus applicable to EVIX and EXIV states: “In the opinion of our counsel, Sullivan & Cromwell LLP, the Securities should be treated as a pre-paid forward contract…”
Volatility ETN products
In order of volume http://etfdb.com/etfdb-category/volatility/
- iPath S&P 500 VIX ST Futures ETN (VXX) – Prepaid*
- iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB) – Prepaid
- iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) – Prepaid
- iPath S&P 500 Dynamic VIX ETN (XVZ) – Prepaid
- iPath Series B S&P 500® VIX Mid-Term Futures ETN (VXZB) – Prepaid
- Credit Suisse VelocityShares Daily Long VIX Short-Term ETN (VIIX) – Debt**
- UBS VelocityShares VIX Short Volatility Hedged ETN (XIVH) – Debt
- UBS VelocityShares 1X Daily Inverse VSTOXX Futures ETN (EXIV) – Prepaid
- UBS VelocityShares VIX Variable Long/Short ETN (LSVX) – Debt
- UBS VelocityShares VIX Tail Risk ETN (BSWN) – Debt
- UBS VelocityShares 1X Long VSTOXX Futures ETN (EVIX) – Prepaid
Listed on securities exchanges: NYSE, Nasdaq, or Bats.
*Prepaid: The iPath volatility ETNs are prepaid executory contracts
**Debt: a debt security
Tax attorney weighs in
Lorence takes a look at the prospectus for the UGAZ ETN by Credit Suisse, which states that the offerings are short-term debt obligations, longer-term debt obligations, and warrants.
“The debt obligations are clearly described by tax counsel as producing interest income and similar interest-type income (e.g., market discount),” Lorence said. “Debt obligations are classified as securities for Section 1091; although there are issues about whether some commodities offerings, such as futures, are also securities, the UGAZ debt obligations would be securities for Section 1091. Wash sale rules for debt securities limit the substantially identicality of debt obligations by requiring that they be essentially the same bond for market value purposes (e.g., same issuer, same or virtually the same coupon and maturity). In all cases dealing with ETNs and ETFs, I have found these just to be marketing labels, and the tax consequences have to be found in the tax disclosure in the prospectus.”
Wash sale loss adjustments
Congress doesn’t want taxpayers to realize “tax losses” that are not “economic losses.” If you close a securities transaction and re-open it right away, you haven’t closed your financial position in that security. At year-end, many taxpayers do “tax loss selling” of securities in December, and the IRS wash sale rules defer the loss if the taxpayer re-purchases a substantially identical position within 30 days before or after, which means into January of the subsequent year. Thirty days is an eternity for day and swing traders. (Learn more about wash sales.)
Darren Neuschwander CPA contributed to this blog post.