Fund industry's ETN challenge may backfire

The mutual fund industry's push for raising taxes on exchange-traded notes may come back to hurt the industry when it asks Congress to defer taxes on mutual funds, the ranking minority member of a House Ways and Means subcommittee said. The Investment Company Institute should "articulate a tax policy beyond simply arguing for a level playing field," Pennsylvania Rep. Phil English told InvestmentNews. Mr. English is the ranking Republican member of the Ways and Means select revenue measures subcommittee, which held a hearing March 5 on legislation introduced by subcommittee chairman Richard Neal, D-Mass., which would end tax deferrals for ETNs and other prepaid forward contracts and tax them at ordinary income tax rates. Currently, many ETNs are taxed at lower capital gains rates. At the same time, however, Mr. English said he sympathizes with the Washington-based ICI. "I think ICI is genuinely conflicted on this, and has been forced into a position of having to weigh some truly unsatisfactory alternatives." "The obvious answer is to basically create a deferral for people who are involved with mutual funds," Mr. English said. Legislation known as the Generate Retirement Ownership Through Long-Term Holding (Growth) Act of 2007, which was introduced by Rep. Paul Ryan, R-Wis., would allow investors in taxable mutual funds to defer capital gains taxes until their shares are sold. However, Mr. English said, "I don't believe the current majority in Congress has the ideological flexibility to consider doing that." The legislation introduced by Mr. Neal is being driven by "the majority's hunger for revenue," he said. "What they're doing is [looking for ways to raise money] rather than coming up with the best strategy for dealing with these sorts of investments." Indeed, a Democratic tax counsel on the Ways and Means Committee, who declined to speak for direct attribution, agreed that the Growth Act is not a bill "that the Democratic members have been very interested in the past."

'GIVEN UP'

But most officials with the mutual fund industry "have given up" on the effort to get the Growth Act passed, the staff aide said. "ICI is the only entity putting it on their priority list," the staff aide said. There are no current plans for Ways and Means to act on Mr. Neal's legislation, according to the staff aide. But the language could be added to legislation likely to come up later in the year to mitigate the impact of the alternative minimum tax or to extend other tax breaks that are usually renewed annually, the aide said. The legislation, which would raise revenue for the government, has not yet been scored for an estimate. ICI and the Securities Industry and Financial Markets Association of New York and Washington are on opposing sides in the debate. ICI argues that ETNs, which now have about $5 billion in assets and are growing rapidly in the retail market, should not be given any tax advantages that mutual funds do not enjoy (InvestmentNews, Dec. 3). "Chairman Neal's bill is a good first step toward addressing the tax disparity that could compel average investors to purchase ETNs, which do not offer the same high level of regulatory oversight and investor protections provided by mutual funds," said ICI spokesman Ed Giltenan. ETNs combine features of bonds and exchange-traded funds. They are an unsecured, unsubordinated debt security that pays returns based on the performance of a market index. Many do not make coupon payments. They are traded on major exchanges, and they can also be held until maturity, typically 30 years. The value of ETNs can drop if the issuer's credit rating falls. Mr. Neal's bill would require investors in ETNs to assume they were earning interest annually using the applicable federal tax rate used by the Internal Revenue Service to calculate imputed interest. The bill "adopts a one-size-fits-all approach to ETNs," said Travis Larson, spokesman for SIFMA. "It imposes an overly complex tax regime. It ends up taxing phantom income," he said. Investors in ETNs that do not make coupon payments do not receive a profit until they are sold, at which time they are taxed, Mr. Larson said. "ETNs could lose their value," he said. "Then you would have taxed the investor on profits he or she never would realize." The Treasury Department currently is taking comments from the public on the tax treatment of ETNs. The comment period closes May 31. Congress should allow the IRS to make a determination of the proper tax treatment, said Michael Shulman, a partner in the Washington office of New York law firm Shearman & Sterling LLP. Mr. Shulman, who represents broker-dealers, testified against the Neal bill at the Ways and Means subcommittee hearing. It is not necessarily inappropriate for mutual funds and ETNs to be taxed differently, Mr. Shulman argued. "Mutual funds are just different in that holders are taxed on cash that they receive or that they have the option of receiving," he said. "Holders of ETNs don't receive any cash until the end of the term." E-mail Sara Hansard at shansard@investmentnews.com.