Otaxes

Financial Innovation and Taxes: The Case of Exchange Traded Notes

Suneel Udpa, Ph.D

Professor, Saint Mary’s College of California

Tel. No. (925) 631-4752

Email: sudpa@stmarys-ca.edu

The author would like to thank Myron Cheung, Kyoseok Lee, Veronica Lo, Alan Wu, and Zhaoyang Yang for their input.

Financial Innovation and Taxes: The Case of Exchange Traded Notes

ABSTRACT

The innovation in financial engineering over the past 30 years has been remarkable. Tax planning is the most common and strongest motivation for much of this innovation. The paper analyzes financial innovation and income tax policy responses by examining Exchange Traded Notes (ETNs) – a financial product recently offered to retail investors. Exchange Trades Notes are senior, unsecured, unsubordinated debt security whose returns are linked to the performance of a market benchmark.

The ETNs as structured, under the current tax regime, provides a significant tax advantage to the holder since they can defer taxes by as many as 30 years if redeemed on maturity or at a much lower rate, compared to other comparable instruments, if redeemed after one year. Congress has been concerned for a long time about aggressive tax planning and tax-motivated financial instruments and transactions. The article examines the impact of a new rule proposed by Congress in December of 2007 that taxes the implied accrued interest on ETN’s even without realization of such interest. The paper suggests that the impact of the proposed rule on ETN’s returns is on average a little less than one percentage point.

I. INTRODUCTION

Wall Street is continually coming up with new financial instruments and innovative financial transactions that are of interest to investors, members of Congress, financial institutions and academicians. There have been several studies that have examined these innovations. Finnerty (1993) examined SIGNs (Stock Index Growth Notes) that were issued by the Republic of Austria in 1991....