2013 brought some significant changes to tax rates, especially for higher-income investors, but starting 2014, investors of all income levels investing in certain exchange-traded products might have to deal with a whole new set of tax rate changes.
Representative David Camp, a Republican from Michigan and the current head of the House Ways and Means Committee, is proposing a series of tax reforms . Included in his proposal are changes to the way certain financial instruments are taxed, such as derivatives.
Under the proposal, derivatives—which include futures contracts, forward contracts and swaps—would all be taxed as ordinary income regardless of holding period, and any gains would be marked to market at the end of each year.
Also falling under the “derivatives” umbrella in the proposal would be exchange-traded notes (ETNs). Structurally, ETNs are senior, unsecured, unsubordinated debt notes issued by banks that simply promise to track a specific index.
Exchange-traded products get taxed based on their underlying securities and their legal structure. For details, see our fully updated 2013 Complete Guide to ETF Taxation .
Therefore, should the proposals come to fruition, certain ETFs that use futures contracts and swaps— such as commodities pools, as well as ETNs, could see some substantial changes to the tune of hundreds to thousands of basis points in tax rates.
Let’s look at each structure in depth to see what these changes might mean for investors.
Many ETFs, mostly focused on commodities, hold futures contracts and are structured as commodities pools. Some very popular funds with this structure include the $6.9 billion PowerShares DB Commodity Index Tracking Fund (DBC), the $1.2 billion iShares S'P GSCI Commodity-Indexed Trust (GSG) and the $1 billion United States Oil Fund (USO).
Currently, these funds are taxed like futures contracts—when shares are sold, 60 percent of any gains are taxed as long term, while 40 percent of those gains are taxed as short term, regardless of holding period. Also, they are marked to market annually, meaning they are taxed even if they’re not sold.
This is a huge tax advantage for short-term traders, especially for those in higher tax brackets, because you can literally flip the shares in a day or two for a quick profit, and 60 percent of any gains still get taxed at the beneficial long-term rate, which is currently maxed at 20.00 percent.
The 60/40 split rate ultimately comes out to a max blended rate of 27.84 percent. Meanwhile, investors who sell shares in a comparable ETN for less than a year are subject to paying ordinary income, or a maximum rate of 39.60 percent.
Should the proposals come to fruition, all gains would be taxed as ordinary income, which would lessen the tax advantages commodities pools have over ETNs for short-term investors.
Regarding the marked-to-market proposal, commodities pools are, as noted above, already marked to market each year, so the proposal won’t pose any significant changes to investors on that front.
The potential changes to ETN taxation can be even more significant, depending on the asset class, since ETNs target multiple different asset classes. Currently, all ETNs—except currency ETNs, which are already all taxed as ordinary income—are taxed like equities, meaning, long-term rates if the securities are held for more than a year and ordinary income rates for short-term gains.
Some of the most significant areas where investors might see changes include commodities, leveraged/inverse and VIX products.
These types of securities include the $1.9 billion iPath Dow Jones-UBS Commodity Index Total Return ETN (DJP), the $1.4 billion iPath S'P 500 VIX Short-Term Futures ETN (VXX) and the $380 million PowerShares DB Gold Double Long ETN (DGP).
Should Rep. Camp’s proposal be implemented, these ETNs could lose some of their luster over their commodities pools competitors for long-term investors because shares held over a year are currently taxed at the beneficial long-term rate. Plus, they aren’t marked to market at year-end like commodities pools.
Equity ETNs might also be affected. In fact, the largest ETN right now is the $5.5 billion JP Morgan Alerian MLP Index ETN (AMJ). A change to ordinary income rates and marked-to-market rules would mean AMJ could see significantly higher rates for those invested in the ETN for the long haul and make investors jump ship to the $5.2 billion Alerian MLP ETF (AMLP), an open-ended 1940s Act fund structured as a C-corporation.
The $459 million iPath MSCI India Index ETN (INP) is another interesting case. If all its gains are suddenly taxed as ordinary income and marked to market at year-end, I wonder if that would be the tipping point where investors would consider the $97 million iShares MSCI India Index Fund (NYSEArca:INDA), which tracks the exact same index as INP, has a lower expense ratio, carries no credit risk and would still be taxed like equities.
It’s hard to do a complete analysis of how every product might be affected, since further details of the proposal are still in the works and nothing is set in stone. It’s not even set that this all will even happen.
However, keeping an eye out for further developments can certainly be beneficial for those planning on investing in these types of products in the coming years.
At the time this article was written, the author had no positions in the securities mentioned. Contact Dennis Hudachek at firstname.lastname@example.org .
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