Statement of William M. Paul Partner, Covington & Burling, LLP on behalf of the Investment Company Institute Hearing on the Tax Treatment Of Derivatives before the Subcommittee on Select Revenue Measures of the Committee on Ways & Means U.S. House of Representatives

March 5, 2008

Mr. Chairman and Members of the Committee:

My name is William M. Paul. I am a partner with the law firm of Covington and Burling LLP. I appear before you today on behalf of the Investment Company Institute (“ICI”), the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds, and unit investment trusts. Members of ICI manage total assets of $12.33 trillion and serve almost 90 million shareholders.

The topic of derivatives and their taxation is broad, diverse and exceedingly complex. I will not attempt to cover the topic in anything approaching a comprehensive way. Rather, I would like to make some general observations and then turn to a discussion of exchange-traded notes.

I. Derivatives

II. Challenges To The Tax System

III. Approaches To Taxing New Financial Products

IV. Exchange-Traded Notes

A. Description of ETNs

B. Problems That ETNs Present for the Tax System

C. H.R. 4912



I. Derivatives

A derivative is a financial instrument the value of which is determined by reference to one or more financial assets, such as stocks, bonds or commodities. Traditional derivatives include options, forwards and futures contracts. Nontraditional derivatives, that is, derivatives that have been developed more recently, include interest-rate swaps, equity swaps, credit default swaps prepaid forward contracts, and myriad variations on these instruments. The tax rules governing traditional derivatives are fairly well established. Tax rules governing interest-rate swaps, equity swaps and most total return swaps were adopted by Treasury in the early 1990s and have worked relatively well. Issues still exist, however, with respect to equity swaps and total return swaps. No guidance has been issued as yet on credit default swaps or on the treatment of holders of prepaid forward contracts.

One of the factors contributing to the development of new derivatives is the desire of participants in the capital and financial markets to gain more targeted exposure to specific risks. For example, if an institution wants exposure solely to the credit risk of a corporate issuer, holding bonds of that issuer is not sufficient because it entails both interest-rate risk and credit risk. Credit default swaps were developed to enable market participants to isolate pure credit risk from interest-rate risk. Other factors driving innovation in financial products are a desire to avoid regulatory and other restrictions and to reduce inefficiencies associated with existing alternatives. Advances in computer and communications technology have significantly enhanced the ability of Wall Street to develop new financial products in recent years.

The dramatic increase in the use of nontraditional derivatives has been greatly facilitated by the development of standardized agreements to govern transactions in the over-the-counter market. Using standardized agreements makes the market much more efficient because participants do not need to separately negotiate the terms of each transaction. ISDA has been the key player in developing these standardized contracts, which exist for many types of nontraditional derivatives, including credit default swaps.

II. Challenges To The Tax System

Most of our tax rules were developed in simpler times when the economic environment was not nearly as diverse, complex and sophisticated as it is today. If a corporation issued a security for cash, it was generally either stock or debt. Now corporations issue a variety of instruments for cash and the tax question is no longer merely the historic debt-equity question. Instead the question is how should the tax system categorize the instrument and how should it be taxed?

Our annual accounting system for computing income does not deal well with contingencies that are not resolved by the end of the taxable year. In earlier, simpler times this inadequacy was tolerable as the number and scope of transactions raising problems were contained. In the modern era, with its plethora of contingent payment contracts in the trillions of dollars, the pressure on our traditional realization principles is intense. Congress and Treasury have responded in various ways to prevent the deferral that would result under traditional realization principles. Examples include the contingent payment debt rules, which require current accrual at a market rate of interest even though the amount the holder will ultimately receive is unknown; the mark-to-market rules of section 1256, which apply to most exchange-traded derivatives and require the parties to the contract to recognize gain or loss based on the fair market value of the contract on the last day of the year; and section 475, which requires securities dealers to mark their positions to market without regard to whether they are traded on an exchange.

Developing appropriate regimes for taxing new financial products is a daunting process in many respects. The products are often complex and difficult to understand economically, and they can be used by market participants in various ways, some of which may be more threatening from a tax perspective than others. The fundamental issue that needs to be “gotten right” in developing an appropriate tax response is the economics of the instruments. If the tax treatment is out of whack with the economics, the product will be over-utilized or under-utilized. Moreover, even a relatively small mistake in taxing the economics can lead to extensive over-use (and associated revenue loss). If the tax law makes a mistake in the depreciation of restaurants by using a useful life that is one year too short, the number of excess restaurants built in the U.S. may increase at the margin. But the “bricks and mortar” reality of building restaurants creates significant frictions on the ability to exploit the resulting undertaxation. In the financial products world, this is not the case. The availability of leverage (either direct or indirect) and the ability to add zeros to the end of numbers with the stroke of a pen -- or more aptly, the stroke of a computer key -- make it easy for slight errors to have very significant ramifications.

This is not to say that the development or use of new financial products is primarily tax driven. To the contrary, they are primarily driven by business, investment and economic considerations. Taxes are, however, often an important factor.

One way in which tax is often a factor is in choosing the specific financial product or products that a taxpayer will use to achieve its business or investment objectives. It is widely understood that the same cash flows can be generated by different combinations of financial products that are taxed in different ways.1 Understandably, taxpayers will tend to use the financial product or combination of products that result in the most favorable -- or least onerous -- tax treatment.

Yet another challenge is the flexibility of financial products. In developing appropriate rules, Treasury and IRS are very cautious in “drawing lines” that define whether a product is subject to a particular regime or not. If they draw a bright line, financial products can morph so that they fall either just inside that line or just outside that line, with significant differences in tax treatment as a consequence. One recent example of this phenomenon is so-called “call-spread converts.”

The need to “get it right” in determining the correct treatment for a new financial product means that Treasury and IRS are often slow to respond. In the last twenty years or so, Treasury has struggled mightily and with mixed success to issue much needed guidance in this area. The contingent debt regulations were issued in proposed form and modified and withdrawn several times over a ten-year period before the ultimate approach was finally adopted. Treasury has been thinking about the taxation of prepaid forward contracts since at least 19932 and had a guidance project on its business plan for several years, but has never issued guidance. After an 11-year hiatus following the issuance of the notional principal contract regulations in 1993, Treasury finally addressed swaps with contingent nonperiodic payments in 2004 by issuing proposed regulations that have proved to be highly controversial. Treasury has been studying credit default swaps now for several years. Treasury’s ability to respond to new financial products is also often hampered by questions regarding the scope of Treasury’s authority.

These observations are not intended as a criticism of Treasury. Their caution is understandable. However, the market does not stand still while Treasury reflects. If there is market demand for a product, the market for the product will grow and the tax treatment will be determined by what is known as “market practice.” Even though there is not a hard and fast “Wall Street rule,” it is undeniably the case that it becomes more difficult over time for Treasury, the IRS or even Congress to put the genie back in the bottle.

III. Approaches To Taxing New Financial Products

In evaluating how a new financial product should be taxed, practitioners and Treasury tend to follow the same approach. The first step is typically to identify other products for which tax rules exist and that are similar to the new product in question. Thus, for example, discussions about how credit default swaps should be taxed tend to focus on comparing them to options and notional principle contracts, both of which are closely comparable but not exactly the same. In the case of credit default swaps, comparisons are also made to financial guarantees and insurance.

In conducting this evaluation, the “norm” is to view the product as a single instrument. A convertible bond is often cited as an illustration of this approach. Although a convertible bond is economically equivalent to straight debt and an option to acquire the issuer’s stock, it is treated as a single instrument for tax purposes.

While a new product is typically analyzed as a single instrument, this is not always the case. On occasion, products are “bifurcated” into two or more instruments to determine the appropriate tax treatment. A good example is the treatment of swaps with significant nonperiodic payments, which the regulations bifurcate into a loan and an “on market” swap.3 There are also examples of the tax law integrating two separate but related instruments and taxing them on a combined basis. The straddle rules are an example of partial integration.

The current controversy regarding variable prepaid forward monetization transactions can be viewed as a dispute over whether two separate but related transactions should be integrated in determining the appropriate tax treatment. (This controversy is often confused with the separate, but also current, controversy regarding the treatment of holders of prepaid forward contracts generally and of exchange-traded notes more specifically, which I will turn to in a moment.) The variable prepaid forward contract monetization transaction controversy relates to whether a taxpayer holding appreciated stock should recognize gain when he enters into a forward contract requiring him to deliver a variable number of shares on a specified future date and receives in return an upfront payment equal to 80 to 85% of the current market value of the stock. In Revenue Ruling 2003-7,4 the IRS ruled that if properly structured, this transaction does not result in gain recognition at the time the taxpayer enters the contract and receives the upfront payment. More recently, the Service has learned of variations of the transaction that include a separate but related share lending agreement pursuant to which the taxpayer lends the stock to the same counterparty and authorizes the counterparty to sell the stock subject to an obligation to return identical stock at a later time. The Service has issued a technical advice memorandum, an advice memorandum, and a coordinated issue paper, all taking the position that the share lending agreement is effectively part of the variable delivery forward transaction and that the two in combination result in a current sale.5 The securities industry strongly disagrees with this view and a case presenting the issue has been docketed in the Tax Court.

IV. Exchange-Traded Notes

I would now like to turn to a discussion of a new financial product known as an exchange-traded note (“ETN”). After providing a summary description of ETNs, I will describe the challenges that ETNs present for the tax system. I will then turn to the consideration of possible legislative responses, focusing primarily on the approach reflected in H.R. 4912.

A. Description of ETNs

1. Common Features of ETNs

While there are some variations, ETNs typically have the following features:

a. They are long-term notes (often 30 years) issued by a bank (the “Issuer”).

b. There are typically no interest or other payments on the notes prior to maturity.

c. The notes are issued in denominations of $50 and do not guarantee return of principal.

d. The amount due at maturity is determined by reference to a specified index that (i) takes into account the performance of a specified investment or trading strategy, and (ii) is reduced by an “investor fee” that accrues at a stated rate (ranging from 40 to 125 basis points).

e. ETNs may be redeemed prior to maturity in lots of 50,000 notes or more. The redemption price is the index value of the notes at that time (in some instances reduced by a redemption fee). This redemption feature is designed to ensure that the market price of an ETN corresponds to the value of the index it tracks.

f. Holders of ETNs are subject to the Issuer’s credit risk, i.e., the risk that the Issuer will not be able to pay the notes at maturity or that the market price of the notes may be adversely affected by a decline in the Issuer’s creditworthiness. The redemption feature described above may mitigate this risk.

g. The tax disclosures for ETNs generally indicate that they should be treated as prepaid forward contracts for tax purposes, and the terms of the ETNs require holders and the Issuer to treat the notes that way. The disclosures generally state that holders should not recognize gain or loss prior to the sale, redemption or maturity of the notes and should receive long-term capital gain treatment if they hold an ETN for more than one year.

2. Different types of ETNs

There are currently at least 34 ETNs. I understand that at least eight more have either just launched or are about to launch, with many more in the pipeline. The 34 ETNs that I have had the opportunity to review can be broken down into six categories based on the nature of the index they reference (the “reference index”): (i) commodities, (ii) foreign currencies, (iii) equities, (iv) option strategies, (v) master limited partnerships, and (vi) closed-end funds. ETNs in each of these categories are described below.6

a. Commodity ETNs

There are currently 20 commodity ETNs, the returns on which are tied to various “total return” commodity indexes. Examples include the S&P GSCI Total Return Index, the Dow Jones-AIG Industrial Metals Total Return Sub-Index, and the Rogers International Commodity Index. Each of these indexes tracks the return a taxpayer would receive if he or she entered into a series of commodities futures contracts and also invested in Treasury bills or some other interest-bearing obligations. For example, the S&P GSCI Total Return Index ETN reflects the return a taxpayer would receive by holding Treasury bills and entering into a basket of 24 futures contracts on physical commodities. The relative weightings of the commodities in the index are adjusted over time. The index value is determined by “rolling over” the referenced futures contracts, i.e., as a futures contract approaches its settlement date, it is replaced by a new futures contract on the same commodity.

b. Foreign Currency ETNs

There are six foreign currency ETNs. Three of these ETNs track the exchange rate between the U.S. dollar and, respectively, the Euro, the British Pound and the Japanese Yen. The terms of these ETNs appear to be identical except for the referenced foreign currency. An investor in these ETNs is entitled to receive at maturity an amount equal to the stated principal amount multiplied by the increase (or decrease) in the specified index, minus the accrued investor fee. The specified index has two components. The “currency component” is equal to the increase or decrease in the specified exchange rate (e.g., Euro/USD) since the notes were originally issued. The “accumulation component” is an interest return tied to an overnight deposit rate in the referenced foreign currency. In Rev. Rul. 2008-1, the IRS ruled that these ETNs are to be taxed as foreign currency-denominated debt instruments.

In recent weeks three additional foreign currency ETNs have been introduced. Two of these ETNs track baskets of currencies and pay a cash yield to holders. The third ETN tracks an index tied to the “carry trade,” which refers to the strategy of borrowing in currencies with low interest rates and lending in currencies with higher interest rates. Currently, the index reflects “borrowings” in five specified currencies and corresponding “loans” in five other specified currencies.

c. Equity ETNs

There are currently five equity ETNs, each of which tracks an index reflecting a segment of the public equities markets. These include the Spectrum Large Cap U.S. Sector Momentum Index, the Morningstar Wide Moat Focus Total Return Index, the Opta S&P Listed Private Equity Index, and an index that tracks the “Dogs of the Dow.”7 By way of example, the “Dogs of the Dow” ETN reflects the return an investor would receive if he or she invested an equal amount in each of the ten stocks included in the Dow Jones Industrial Average that have the highest dividend yield. The index is adjusted each December to add or subtract stocks and to rebalance the weighting of any stocks that remain within the ten “dogs.”

d. Option Strategy ETN

There is one option strategy ETN that reflects the performance of the CBOE S&P 500 BuyWrite Index. This index is designed to measure the total return a taxpayer would receive from owning all of the stocks in the S&P 500 Index and writing a succession of one-month call options on the S&P 500 Index that are either “at the money” or slightly “out of the money.”8

e. Master Limited Partnership ETN

One ETN tracks the return an investor would receive from investing in a number of energy-oriented master limited partnerships (“MLPs”). This ETN tracks the BearLinx Alerian MLP Select Index. Unlike most ETNs, this ETN makes periodic payments, which are tied to the amounts investors would receive as distributions if they invested in the underlying MLPs directly.

f. Closed-End Fund ETN

There is one ETN that tracks an index of 75 closed-end funds. This ETN tracks the Claymore CEF Index, which consists of closed-end funds that are selected based on distribution yield and “discount” to net asset value (i.e., the excess of net asset value over the price at which the fund’s shares trade in the market). This ETN also makes distributions that correspond to the distributions a direct investor in the underlying funds would receive.

B. Problems That ETNs Present for the Tax System

As the Technical Explanation of H.R. 4912 recognizes, ETNs pose two challenges to the system: (i) the treatment of the “time value of money” return on the prepayment and (ii) the fact that the index “represents a series of notional investments and reinvestments” in commodities or securities that would result in the current recognition of gain or loss if an investor engaged in them directly or through a partnership or mutual fund. As further noted in the Technical Explanation:

These two fundamental problems in turn are exacerbated by the very long-term maturities of many ETNs, often 30 years. If the tax analysis proposed by issuers of ETNs and similar instruments were to prevail, investors in such instruments would thus be able to defer tax from the current returns with which they are credited, and from the sales and purchases with which they are credited, for up to 30 years.

The ICI very much agrees with this statement regarding the challenges posed to the tax system by ETNS. Before turning to a discussion of H.R. 4912, I would like to make a few observations about both the “time value of money” and “constructive ownership” aspects of ETNs.

The “time value of money” concern focuses on the prepaid forward structure of ETNs -- the “wrapper” if you will -- without regard to the nature of the underlying assets and whether the composition of those assets changes over time. The holder makes an upfront payment some 30 years before the issuer is obligated to perform under the contract and is compensated for doing so by the fact that his return under the contract is tied to prices in the cash market (i.e., the current market price) instead of the forward price. (Alternatively, the holder is compensated by an explicit interest factor as part of the ETN index formula.) Even though the total amount the holder will ultimately receive is contingent, a portion of the holder’s ultimate return is attributable to the time value of the prepayment. Generally speaking, the holder’s ultimate return will be greater as a result of the prepayment by an amount equal to the future value of the prepayment at maturity, with such future value computed using an appropriate interest rate.

In contrast, the constructive ownership concern views the prepaid forward contract merely as a means to accomplishing the full economics of ownership without the tax consequences of ownership. This concern focuses on what is going on inside the contract -- inside the wrapper. Approaches motivated by this concern, notably section 1260, try to ensure that the taxpayer does not achieve better tax results from ownership through a derivative than he or she would receive through a direct investment. Under this view, the appropriate treatment from a time value-of-money perspective is tied to how time value associated with a direct investment in the underlying would be treated. For example, if the underlying is simply 100 shares of some nondividend-paying stock, a constructive ownership approach would not attempt to tax any time value of money return. It would simply attempt to tax the prepaid forward consistently with (or at least no better than) taxation of direct ownership of the underlying stock.

I think of these alternative approaches to ETNs as analogous to the approach to partnership taxation under subchapter K. In certain respects, subchapter K views the partnership as an entity (an “entity approach”) and in others it looks through the partnership to the underlying assets and activities of the partnership (the “aggregate approach”). In much the same way, a time-value-of-money approach looks at the wrapper and a constructive ownership approach looks at what is going on inside the wrapper.

C. H.R. 4912

On December 19, 2007, Congressman Neal introduced H.R. 4912 (the “Bill”) addressing the tax treatment of ETNs and other prepaid forward contracts. The Bill would require holders of “prepaid derivative contracts” to include an amount equal to the “interest accrual amount” in taxable income each year. Such amount would be treated as interest income. The Bill would not affect the tax treatment of the issuer of a prepaid derivative contract.

The interest accrual amount for any taxable year is generally equal to the product of the holder’s adjusted basis in the contract at the beginning of the year multiplied by the monthly short-term applicable federal rate (“AFR”) for the first month of such taxable year. However, if “notional amounts are credited” under the contract at a higher rate, then the income accrual amount is computed by multiplying the holder’s adjusted basis in the contract by such higher rate. If a holder acquires or disposes of a contract during the taxable year, the interest accrual amount for the year is prorated based on the relative portion of the year that the holder held the contract. The holder’s basis in the contract would be increased by the interest accrual amounts included in the holder’s gross income.

Distributions with respect to a contract would not be includable in income. Distributions would first reduce the holder’s basis in the contract and distributions in excess of basis would be treated as gain from a sale of the contract. Any loss on the disposition of a contract would be an ordinary loss to the extent of basis increases attributable to the interest accrual amounts included in the holder’s income.

Special rules apply in the case of contracts that are publicly traded. First, the interest accrual amount for a taxable year is capped at the mark-to-market gain for the year. Second, if this cap is triggered for a taxable year, the excess interest accrual amount not taken into income is carried forward to the next taxable year and increases the interest accrual amount for such year. Third, although the holder’s basis in the contract for gain and loss purposes will be increased by the interest accrual amount includable in income for the year (after application of the mark-to-market cap), the holder’s adjusted basis for purposes of computing the interest accrual amount in the following year is increased by the full income inclusion amount determined without regard to the mark-to-market cap. A contract is treated as publicly traded if (i) it is traded on a qualified board or exchange, or (ii) the issuer (or a person acting on the issuer’s behalf) regularly provides firm bid and ask quotes to the public with respect to the contract.

The Bill would not apply to any contract held for less than one year that is disposed of before the due date for filing the tax return for the tax year in which the contract was acquired. The Bill also would not apply to any contract that is marked to market with respect to the taxpayer.

The Bill defines a “prepaid derivative contract” as any “prepaid contract” with a term greater than one year that is a derivative instrument with respect to (i) one or more securities, (ii) one or more commodities, or (iii) any financial index. Excluded from the definition are instruments that are treated for tax purposes as: (i) stock, (ii) debt, (iii) a partnership interest, (iv) part of a constructive ownership transaction to which section 1260 applies, (v) a hedging transaction within the meaning of section 1256(e)(2), (vi) a notional principal contract, or (vii) an option. The Treasury Department is given authority to apply the Bill’s provisions to options that are “economically similar” to a prepaid derivative contract. The term “prepaid contract” is defined to mean any contract under which there is no substantial likelihood that the taxpayer will be required to pay any additional amount under the contract.

The Bill would apply to contracts acquired after the date of enactment.


The ICI supports the Bill as an important first step in addressing ETNs.9 We have a number of technical suggestions and comments, which we will provide to the staff. For the remainder of this testimony, I would like to focus on our “big picture” comments.

As noted above, the Technical Explanation of the Bill identifies both the “time value of money” concern and the “constructive ownership” concern. However, the Bill itself addresses only the former concern. The Bill would require holders to accrue interest income on their investment in the contract under a modified version of the OID rules. The Bill generally does not attempt to implement “constructive ownership” policies based on notional gains recognized inside the contract.

We believe that a comprehensive approach to ETNs is needed. We are concerned that an approach that accrues interest at the short-term AFR (currently 3.2%) may be insufficient to achieve appropriate taxation of ETNs consistent with applicable tax policies. We are just at the beginning of creativity in the ETN world, and without a comprehensive and robust response, we suspect that Congress will need to revisit this area in the near term to respond to continued developments. We believe that the Bill could be enhanced by expanding on the concept of “notional amounts credited under the contract” (“NACUC”). The Technical Explanation makes clear that the Bill limits NACUC to explicit interest or dividend yields inside the contract. The concept of notional amounts credited under the contract could be expanded to include notional gains realized inside the contract. For example, the commodity ETNs reflect the return from trading strategies in futures contracts. As those notional futures contracts are closed out or settled, the resulting gains are, in some sense, credited under the contract and could appropriately be included in income of the holders.

In our view, it is more important for the tax system to respond to the constructive ownership concerns raised by ETNs than to the time-value-of-money concerns. The arguments for taxing the time value of money return to prepaid forward contracts are economically sound, but our tax system has to date generally refrained from imputing an interest-like return when the return on the instrument is totally contingent.10 In contrast, we believe that the constructive ownership policy is well established in our tax system and much more compelling.

As articulated in the legislative history of section 1260, that policy mandates that a taxpayer who replicates economic ownership of a referenced asset through a derivative should not receive better tax treatment than one who owns directly. This policy is fundamental to protecting the tax base tied to returns on capital investment.

In many ways, ETNs can be viewed as the next generation of constructive ownership transactions that section 1260 is designed to address. When section 1260 was enacted in 1999, derivatives were being used to provide economic ownership of hedge funds and mutual funds without the tax consequences of direct ownership. A taxpayer and an investment bank would enter into a forward contract or other “total return” derivative with, say, a three-year term. After three years, the taxpayer would receive an amount measured by the value of the hedge fund plus distributions he would have received had he held the interest in the hedge fund directly over the three years. As with ETNs, the result was that ordinary income and short-term gains were deferred and converted to long-term gains. ETNs use improved technology -- in the form of dynamic indexes -- to fall outside the scope of section 1260. The dynamic index functions as a synthetic mutual fund or partnership, so much so that ETNs even impose a notional “investor fee” (e.g., 125 basis points) per year that mimics a mutual fund management fee or the fee an investor would pay a financial advisor to manage a portfolio of directly owned securities. Section 1260 does not apply because instead of referencing the return on a partnership or mutual fund, ETNs reference the return on a dynamic index. Notwithstanding the advances in technology, the results obtained by investing in ETNs are precisely the results that section 1260 was intended to stop.

The rules addressing investments in passive foreign investment companies (“PFICs”) can be viewed as a precursor to section 1260. In the relatively simple days when that legislation was enacted, U.S. taxpayers were deferring and converting investment income by investing in off-shore funds that do not make current distributions of income or gains. Congress responded in 1986 with rules to prevent such deferral and conversion.11 In their current form, the PFIC rules provide three alternative regimes. The “default” regime is very much like the section 1260 regime. Long-term gain treatment is denied and the taxpayer is generally required to treat any gain as arising ratably over his holding period and pay interest on the implicit deferral of tax. Recognizing the harshness of this regime, Congress provided the “qualifying electing fund” (“QEF”) regime, which affords the taxpayer the option of including in income currently his share of the PFIC’s income and long-term capital gain. In order for this election to be available, the PFIC must agree to provide the taxpayer with the requisite information each year. More recently, Congress has added a mark-to-market election with respect to PFIC stock that is publicly traded. If this election is made, all mark-to-market gain is treated as ordinary income and mark-to-market losses are treated as ordinary to the extent of prior mark-to-market gains.

While amending section 1260 to cover ETNs is possible, the consequences that follow under that provision would effectively kill most ETNs. Accordingly, we would support an alternative approach along the lines of expanding the concept of notional amounts credited under the contract under H.R. 4912, as described above.

Note that such an approach would require the issuer to provide the requisite information to holders in a way that is closely analogous to the requirements for the QEF election under the PFIC rules. Indeed, the three approaches contained in the PFIC rules could provide a model for addressing the deferral and conversion afforded by ETNs. If the issuer provides the necessary information, the holder would include in income the notional income and gains credited for the year (the QEF analogue). Alternatively, because ETNs are publicly traded, the holder could elect mark-to-market treatment. If the holder fails to elect either of these regimes, the default rule could be the section 1260 regime.


1For example, the cash flows of a zero coupon bond can be created by buying a stock and entering into a forward contract to sell the stock.  Similarly, the cash flows from buying a zero-coupon bond and a call option on a stock are the same as the cash flows from buying the stock and a put option to sell the stock.

2 See preamble to T.D. 8491, 58 Fed. Reg. 53125, 53126 (Oct. 14, 1993).

3See Treas. Reg. §1.446-3(g)(4).

42003-1 C.B. 363.

5See TAM 200604033; Advice Memorandum 2007-004; LMSB Coordinated Issue Paper 04-1207-077.

6The information provided about existing ETNs reflects my best understanding based on information I have had the opportunity to review and may be incomplete. 

7The formal name of this index is the “Dow Jones High Yield Select 10 Total Return Index.”

8An at-the-money call option has an exercise price equal to the current value of the underlying stock.  An out-of-the-money call option has an exercise price above the current value of the underlying stock.

9While this discussion focuses on ETNs, the ICI is not opposed to the Bill’s application to prepaid forward contracts that are not publicly traded.

10But see Treas. Reg. 1.446-3(g)(4), supra.

11See Code §§1291-1298.