An elite investment that cuts taxes

By Tim Middleton

For nearly two decades, institutions and wealthy individuals have invested in what are called prepaid derivatives contracts. These clever tools, tailored to the specific needs of elite investors, help them do things like shelter income from taxes.

Now you, too, can buy derivatives. The mutual fund industry just doesn't want you to.

These derivatives for everyday investors are called exchange-traded notes, or ETNs. They have the look and feel of exchange-traded funds, or ETFs, often tracking key indexes or commodities. But they're less regulated, and they sport significant tax advantages.

They've attracted only perhaps $6 billion in assets since the first one was introduced 18 months ago, but they have the $11.72 trillion mutual fund industry squealing.

"Mutual funds say this is unfair competition," says Alex Gelinas, a partner in the New York office of law firm Sidley Austin. "Anybody with $2,000 in an IRA can invest in an incredible array of financial products that in the past were just not available."

A tax increase on investors?

Nearly a third of the 30 or so ETNs have been introduced this year. They include BearLinx Alerian MLP Select Index (BSR, news, msgs), which allows you to lay down a bet beside the biggest master limited partnerships in the oil patch; DB Gold Double Long (DGP, news, msgs), which gives you two times any rise in the price of gold; and Opta LBCI Pure Beta Agriculture Total Return (EOH, news, msgs), which opens a tax-deferred door to the nation's granary.

The tax breaks are under attack from the fund industry, which wants them stricken and has gotten a bill to do that introduced in the House of Representatives. The ETN industry turns that argument on its head, calling the House bill a tax increase and threatening to throw the weight of Wall Street against it.

Though the ETN market is small, it's growing. And private contracts structured the same way constitute a marketplace worth hundreds of billions of dollars.

"Tax increases of this magnitude are quite controversial," warns Shahira Knight, the managing director of the Securities Industry and Financial Markets Association.

The new kid on the block

Since ETNs sound like ETFs and work like many mutual funds, what's the difference?

ETFs and mutual funds own things like stocks, bonds and even gold. ETNs are promissory notes issued by firms such as Lehman Bros. (LEH, news, msgs), the "LB" in the name of the agriculture portfolio Opta LBCI. They don't actually own anything; they just pledge to deliver something, such as the return of an index, later in exchange for money now. As such, they are debt.

Ordinarily, the earnings of debt securities are subject to current taxes. One category of ETN, those attached to specific foreign currencies, has been judged by federal authorities to be subject to tax.

But the other categories, notably those aligned with equities and commodities, represent debt in an accounting sense but not in a tax sense, the ETN industry argues.

"From a tax perspective, they're not debt because the amounts involved are at risk," says Knight. "An ETN is like a stock. You not only may not get any returns, you may not get your principal back, either."

So under current tax law, income and capital gains earned by ETNs roll up as part of principal and aren't taxed until they mature, usually 30 years from the date of issuance. In your portfolio, they behave like non-dividend-paying stocks; you don't pay taxes until you sell them.

That's all well and good, except that mutual funds and ETFs are required to distribute income to shareholders at least annually. Shareholders pay taxes on that income as it's earned.

For example: Shareholders of an ETF competitor to the Lehman Bros. agriculture fund, PowerShares DB Agriculture (DBA), must pay taxes every Dec. 31 on that year's gains, even if they have held on to them and not actually realized any gains. That built-in tax deferment gives ETNs an advantage over traditional funds that has the fund industry worried.

Should there be a law?

The Investment Company Institute, the fund industry's trade association, wants derivatives taxed the same way the securities they represent would be taxed if they weren't considered derivatives -- analogous to the way PowerShares DB Agriculture is taxed in the case of commodities. The association supports HR 4912, legislation proposed by U.S. Rep. Richard E. Neal, to accomplish this. Neal, a Massachusetts Democrat, is the chairman of the House Subcommittee on Select Revenue Measures.

Meanwhile, the Treasury Department, which could accomplish the same goal through regulation, has opened a comment period on the idea that closes May 31. Washington insiders haven't tried to handicap the controversy, noting that each side controls many trillions in investor assets and each contributes heavily to political coffers.

Continued: Another advantage

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