Exchange-Traded Notes: IRS Fires a Shot Across the Bow of "Wait and See" Taxation


On December 7, 2007 the Internal Revenue Service (“IRS”) and the Treasury Department (“Treasury”) published Revenue Ruling 2008-1 (“Ruling”) [1] and Notice 2008-2 (“Notice”) [2] addressing the U.S. federal income tax treatment of prepaid forward contracts which include certain

exchange-traded notes (“ETNs”). Viewed together, the Ruling and the Notice serve as a warning that the IRS is focused on whether the market’s “wait and see” accounting system for ETNs and similar instruments is appropriate. However, the immediate impact will only be on a narrow class of

single currency-linked ETNs.

As we have previously discussed, ETNs have collided, tax-wise, with exchange-traded funds (“ETFs”) and mutual funds because the U.S. federal income tax treatment of ETNs is perceived by the financial markets to be more favorable than the U.S. federal income tax treatment of ETFs and

mutual funds.[3] This is because most ETNs are treated as prepaid forward contracts rather than debt instruments under current law. As such holders generally adopt “wait and see” taxation: they do not include income on ETNs currently and report capital gain or loss when ETNs are sold.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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