Exchange-traded notes to lose tax edge in House proposal

Capital Gains

The top tax rate for ordinary income is 39.6%, compared with a 20% top rate for capital gains. The investment income of top earners is also subject to a 3.8% additional tax, which would apply to capital or profits from derivatives.

Camp’s broader tax overhaul would lower individual rates and perhaps change capital gains rates. He hasn’t said what the new top rates would be.

The plan may make tax receipts more volatile in a crisis with falling asset prices, as in 2008. That’s because investors with losing positions could subtract their paper losses from their other income, Shapiro said.

Camp’s proposed change may cause difficulty for holders of exchange-traded notes that aren’t tied to underlying securities, because tougher tax rules would apply and investors wouldn’t have another alternative.

Volatility Index

One use of the notes is to provide a chance to profit from volatility, usually by investing in securities that replicate the Chicago Board Options Exchange Volatility Index, commonly known as the VIX.

The benchmark is sometimes referred to by investors as the Fear Index because it surges during periods of economic uncertainty, such as when Standard & Poor’s cut the U.S.’s sovereign debt rating to AA+ from AAA in August 2011.

There is no way to invest in volatility with non-derivative instruments, said Samuel Lee, an analyst at Morningstar Inc. in Chicago. Exchange-traded funds tied to the VIX rely on investments such as options or futures, he said.

“We would consider that a change for the worse,” Jerry Miccolis, chief investment officer of the Madison, New Jersey-based Brinton Eaton Associates Inc., said about Camp’s proposal.

While Miccolis used to invest in volatility through exchange-traded and structured notes, now he uses swaps, he said. Less than half of his $230 million fund invests in volatility.

“You ought to be able to control when it is you have to claim a gain or loss for tax purposes,” he said, a choice denied to derivatives owners under the Camp proposal. “That control shouldn’t be taken out of your hands.”

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