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Are exchange-traded notes unfair?

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Scott Jagow: There’s a new investment option out there you might not have heard about. It’s called an exchange-traded note. Large banks like Barclays are offering them. It’s essentially a mutual fund IOU. So the bank says at a later date, we will pay you the value of a certain set of stocks.

But these exchange-traded notes seem to come with an unexpected tax advantage that mutual funds don’t have. In fact, the mutual-fund business is pretty upset about it. Mr. Sloan, what’s got ’em so upset?

Allan Sloan: Well, it goes like this. Let’s say if you own in a taxable account a mutual fund that owns stocks, the dividends that those stocks pay are taxable to you every year. The company pays the mutual fund, the mutual fund distributes the dividends to you, and it’s taxable as a dividend. However, with these notes, instead of paying you a dividend every year, these notes roll the dividend into the notes. So you don’t actually get a distribution. And because you’re not getting a distribution, there’s no tax due until you sell the thing, and then it’s all taxed at the capital gains rate.

Jagow: Yeah, I mean it sounds like a, not a bad deal for the investor.

Sloan: Right, well it would be a great deal for the investor — and I’m an investor, Scott, I mean it’s not like, you know . . .

Jagow: Yeah, so what’s the problem?

Sloan: Well, the problem is I have this child-like idea that someone has to pay taxes to support the United States. I know it’s childish, I know it’s immature and probably makes me some sort of zealot. And now to Barclays credit, they insist — and I believe them — that they designed these exchange-traded notes to be a product so that a retail customer could buy stuff that normally only big people buy, and the tax advantage turned out to be secondary. But now that they think there is one, of course, they’re promoting it — but that’s not what they had in mind. So this would be great for Barclays if it works, it would be great, you know, to own this stuff in a taxable account and not pay any tax on my dividends. But I think it would be terrible social policy.

Jagow: Well, are any regulators gonna do anything about this?

Sloan: That’s the zillion-dollar question, and I guess we’re gonna have a test case one of these days. But so far, there’s been no official comment out of the Treasury or the Internal Revenue Service. And because it’s not a mutual fund, there are no taxes due on whatever the assets earned until somebody gives you a check, which they right now don’t plan to do.

Jagow: All right, Allan Sloan from Fortune Magazine. Thanks.

Sloan: You’re welcome, Scott. Happy taxes.

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