May 4, 2017 - Haoshen Zhong

Are my Exchange Traded Notes PFICs?

Debts instruments that sound somewhat like shares

This is a question that came by way of email:

I own some exchange traded notes. Are those PFICs?

In this post, I will discuss the factors that you can examine to check whether buying a particular debt instrument carries any risk related to passive foreign investment companies. Then, we can check if exchange traded notes are debt or shares.

What are exchange traded notes?

Exchange traded notes (ETN) is a type of debt instrument. They have a fixed maturity date. They pay interest, but the rate of interest depends on an index or market benchmark. They are senior, unsecured, and unsubordinated debt securities. They are not backed by any assets. Only the credits of the underwriting bank back the ETNs.

What are PFICs?

Passive foreign investment companies (PFICs) is a specific classification under US tax law. When a US person owns shares in a PFIC, the US person is subject to extremely punitive tax and reporting rules.

There are many rules for determining whether the instrument you own represents shares in a PFIC, but for today’s post, we only care about the following: To be subject to PFIC rules, what you own must represent shares in a foreign corporation.

If all you own is a debt that a foreign corporation owes, then you do not own shares in a foreign corporation. Thus, if we can show that ETNs are debt rather than shares, then we can say that they are not PFIC shares.

ETNs should be debts

In the not too distant past, affiliated corporations issued debts to each other that generated interest deductions but provided benefits of shares of stock to the creditors. Thus, the IRS and the courts developed a set of tests to determine whether an alleged debt instrument is really a share in the debtor, and Congress codified some of the factors used in these tests.

Statutory factors suggest ETNs are not shares

Congress has given us 5 factors for determining if an instrument is debt or stocks. IRC 385(b).

First, is there an unconditional promise to pay, on demand or with a maturity date, a principal sum and a promise to pay interest? An ETN clearly has a promise to pay principal and interest through a maturity date. An ETN is like a debt here.

Second, is the debt subordinate to other debts? An ETN is not subordinate to any other debts, unlike shares. An ETN is like a debt here.

Third, does the debtor corporation have a high debt to equity ratio? We do not know the answer here, but the worth of an ETN is strongly tied to the credit-worthiness of the underwriting bank. Thus, it is unlikely that the bank would have an outrageously high debt to equity ratio. But let us say this factor does not favor debt or shares of stock.

Fourth, can the debt be converted to shares? An ETN cannot be converted to shares. An ETN is like a debt here.

Fifth, what is the relationship between the debtor and creditor? The buyers of ETNs are just buyers on a public exchange. They are not related to the bank. It is unlikely that the buyers and the bank are colluding to disguise shares as debt. An ETN is like a debt here.

Under the Congressional criteria, exchange traded notes are like debts.

Case law suggests ETNs are not shares

The IRS and courts have developed additional factors. See e.g. Notice 94-47; Charter Wire vs US, 309 F.2d 878 (7th Cir. 1962). Here are some relevant examples.

What is the name given to the instrument? ETNs are named notes rather than stock. An ETN is like a debt here.

What is the source of the payment? Here, the ETNs pay interest according to a market index. But even if we assume that the market index is an index of dividends that corporations pay on the market, the interest paid on the ETN is not related to the profits of the issuer. A bank that is making losses must still pay interest on the ETN. An ETN is like a debt here.

What is the intent of the parties? Both the buyers and the issuer appear to what a debtor-creditor relationship. An ETN is like a debt here.

Is there participation in management? Holders of ETNs have no right to vote in shareholder meetings and no right to direct the management of the issuing entity. An ETN is like a debt here.

What is the security for the debt? There is no security for ETNs. The ETN holder is not entitled to any assets of the issuer. An exchange traded note is like a debt here.

Exchange traded notes are most likely debt instruments rather than shares

ETNs are like debts under almost all factors that distinguish between debts and disguised shares. It is almost certain that ETNs are debt instruments rather than shares. Because ETNs are not shares in a foreign corporation, owners of ETNs do not have PFIC issues–they do not own shares of PFICs.

When in doubt, follow the label the issuer gave to the instrument

The test for whether a particular instrument is debt or stock is an “all facts and circumstances test”. What this means is that the IRS and the courts have relatively wide discretion to weigh the factors differently, depending on how they perceive the transaction overall. Sometimes you can look at the factors, and the result does not clearly favor debt or stock.

Congress gave us a bit of confidence in how we should report a publicly traded security, even if it did not opt to give us certainty in the outcome:

The characterization (as of the time of issuance) by the issuer as to whether an interest in a corporation is stock or indebtedness shall be binding on such issuer and on all holders of such interest (but shall not be binding on the Secretary).

Except as provided in regulations, paragraph (1) shall not apply to any holder of an interest if such holder on his return discloses that he is treating such interest in a manner inconsistent with the characterization referred to in paragraph (1). IRC §385(c)(1), (2).

When the result is ambiguous, there is an easy solution. In general, the law requires us to follow what the issuer of the instrument says it is. These alleged debt instruments are labeled as note. So unless it is clear that they are in fact shares, we should follow the label and treat them as notes.

The IRS is free to disagree, but because we are following statutory command, the most the IRS can do is impose taxes and interest for underpayment.