Wednesday, April 2, 2014

Running Away from a PFIC

Important note before you read: I am wrong in this blog, and I posted a correction in Run away! Run away!

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Three weeks ago, I published a seminal article in the field of U.S. taxation of foreign investments entitled, Getting Eaten by PFIC. My meticulously researched observations together with carefully placed keywords have propelled Investing by Accident to #2 in the Google search results for השקעה בקרן נאמנות אזרח ארה"ב.

This raises three important questions:

1. What can I do to get to #1? Would it help if I wrote another blog using the words השקעה בקרן נאמנות אזרח ארה"ב?

2. What exactly can I do to get Bing to show Investing by Accident at least in the first page of the search results?

3. Is there any way to launch Investing by Accident into the search results for השקעה בתעודות סל אזרח ארה"ב?

Sadly, we may never know the answers to the first two questions; however, we can and must address the third.

The tax treatment for תעודות סל was brought to my attention by Accidental Reader, “AZF,” who suggested that you may not get eaten by PFIC if you invest in an Israeli תעודת סל because it is not an ETF (Exchange Traded Fund) but rather an ETN (Exchange Traded Note).

Is it true? Can you outrun a PFIC by investing in an Israeli-based Exchange Traded Note? 

As with all important questions on taxes, you should definitely ask your own tax adviser for advice because I don’t know anything. The best way to do this would be to send this blog to your accountant with the subject, “my thoughts on the tax treatment of foreign-based ETNs.” Please make sure to post his response into the comments and to put it in quotes even if you are only paraphrasing.

In that spirit, here is what Investing by Accident’s Chief Regional Strategic Tax Advisor told me (thanks, Taxman!):

“If you invest in a תעודת סל, you will not get eaten. At least not yet, and not by a PFIC.”

To be clear on this, by “not yet,” I mean that the U.S. taxation on an Israeli תעודת סל is much like Israeli breakfast cereals. They be totally fine for you. Or, they may slowly kill you.

[Begin Skipping]

Taxes for ETNs

To understand the U.S. tax implications of the Israeli תעודות סל, we need simply need to understand three things:

1. What is an ETN?
2. What is the tax treatment for a domestic (U.S.-based) ETN?
3. Would it make any difference if the ETN was foreign (for example, Israeli)?

How hard could it possibly be to answer these questions?

Actually, it is quite hard. But that should not deter you because you like difficult things. Why else do you drive from supermarket to supermarket looking for Cheerios?

ETNs by Accident

Because you have an internet search engine, you do not need me to tell you that an ETN is basically an “unsecured debt instrument.” When you are searching for this term, it is important that you not accidentally look for an “ENT” which would be doctor who looks like a tree and checks your ears.

In any case, thinking about an ETN as an “unsecured debt instrument” is a good way to put it because you should never leave any unsecured instruments of any type lying around your house. If you do, one of your children will most certainly find it and use it to break something.

In the financial context, the consequences are fairly similar. With the “Note” part of the ETN, you buy a promise to pay (“debt”) from someone (“a financial institutional”). In the case of an ETN, the promise of how much to pay is based on the objective performance after fees (“fees”) of something objective like a stock index. However, because the promise is unsecured, if that someone runs out of money and cannot pay you (“bankruptcy”), your investment would become worthless (“Lehman Brothers”).

The “Exchange Traded” part of the ETN just means that you can buy and sell the “Notes” on an exchange just like a stock.


George is an ordinary U.S. investor who somehow heard about an ETN and buys one. He buys $100 worth of an ETN that promises to pay back his money in 30 years according to the performance of the S&P 500 after fees. George decides to hold onto the ETN for all 30 years because he missed the part about it being “Exchange Traded.” During the 30 years, the S&P 500 provides a total return of 8% after fees every year. After 30 years, George’s ETN is redeemed for $1,093.57.
In the above example, had George been paying attention, he could have sold his ETN on the exchange before the end of the 30 years. At any point in time, the value of the ETN would mirror the performance of the S&P 500. For example, after 10 years, George should be able to sell his ETN for $221.96.

You should notice in this example that George does not own any of the underlying assets that are driving the value of the ETN. In other words, he does not own any of the stocks in the S&P 500. Along with this, he does not receive any income that is generated from these assets. The promise to be paid is based on the “total return” of the S&P 500, which means that the dividends are computed right back into the promise.

For tax purposes, it is clear that when George receives payment at the end of 30 years – or when he sells it before then – he would be obligated to pay taxes on any gains. The question is whether he should be obligated to pay taxes on interest and dividends that are accrued inside of the promise in the note, but which he does not actually receive.

On the one hand, we may think that since George does not own any of these assets, he should not have to pay any tax on them. On the other hand, how could it be so easy to run away from a PFIC?

Taxes on ETNs                       

The IRS is a very helpful organization which is why a simple search on the IRS website will tell you exactly how to treat ETNs. Or, it will as soon as they get around to publishing their thoughts on the matter.

In 2008, the IRS released a ruling with the catchy title, “Rev. Rul. 2008-1,” that answered part of the question. In this ruling, the IRS said that ETNs which are based on foreign currency should be treated as debt for tax purposes. This means that if you buy an ETN in dollars that invests in euros, you must pay tax on any interest that is accrued on the euros every year, just like you would pay taxes on any interest that you receive. When the ETN matures – or when you sell it – the gain would be considered like interest and would be taxed at the rate of ordinary income.

The IRS did not address all other ETNs. Instead, they published “Internal Revenue Bulletin:2008-2” in which they requested feedback before they make a ruling. The deadline for providing feedback was May 13, 2008, but we haven’t heard anything yet from the IRS.

I’m going to assume that we haven’t heard anything yet because the deadline has been extended but they never told anyone. This would mean that my feedback can still be heard. All the IRS would need to do is search on Google for, “what at least 1 American living in Israel thinks about taxation of ETNs.” I’m just guessing here, but most likely they wouldn’t find it if they searched on Bing.

In any case, as a foremost non-expert on the issue, I would be honored to accept your all-expense paid trip to Washington, D.C., to speak in front of a congressional committee on this issue. Or, I’ll pay my own expenses. Whatever you want. Just please don’t send the PFIC after me.

Honest Guidance

Without guidance from the IRS on the taxation of ETNs, what should we do?
The truth is that no one really knows. The best article that I could find on this raised the concern that if there is no clear guidance on this from lawmakers or from the IRS, then the public may begin to rely on the companies that sell ETNs for guidance on taxes.

That sounded like a pretty good idea to me, so I turned to Barklays. Who to know better how to tax ETNs than the one who thought of them in the first place?

In their tax guidance, Barklays dutifully follows the ruling by the IRS and will help you make sure to pay taxes on any interest that you receive from ETNs based on foreign currency. For ETNs based on other assets, such as those based on “equities” and “fixed income,” their guidance is that you should pay tax only when you sell, and you do not need to pay tax any interest or dividends that are incorporated as part of the underlying index every year. Furthermore, all gains on these ETNs should be considered “capital gains” for tax purposes.

This is exceptionally incredible to me because we have been looking at ETNs as a way to simply not get eaten by a PFIC. As it turns out, if we follow the guidance from Barklays, we would have an astounding tax advantage. Not only could we defer taxes on dividends, we could actually pay a lower tax rate on interest!

For example, according to this guidance, instead of buying a mutual find that is based on a bond index, we could buy the equivalent ETN instead. Then, instead of having to pay tax on the interest every year at the rate of ordinary income, we could accrue this interest into the value of the ETN and pay the rate of capital gains only when we sell.

Loyal readers should not find this to be too surprising. By now, you should expect great things like this to happen by accident.

In all honesty, it is hard for me to imagine that this tax advantage will not be closed. However, the IRS has yet to respond on this issue and not much has come from the lawmakers. The last we heard from Congress was in 2007 when a bill was introduced that got as far as “Introduced.” It is very surprising that it has not gotten any further since it was able to the get the support of a total of “1” co-sponsor very quickly.

[End Skipping]

So basically, the tax treatment for ETNs goes something like this: no one knows what you are supposed to do, and you can go ahead and take advantage. All this could change at any time and you just may get eaten. But, you’ll probably have a lot of company because a lot of people are buying ETNs, and you will all be able to suffer together.
[Begin Skipping Again]
Foreign-Based ETN’s

Now that we’ve cleared up the tax treatment for ETNs (assuming, of course, that what we just did is considered “clear”), we can turn to the question of whether foreign-based ETNs would be treated any differently.

Provided that they are structured the same way, there is no reason why ETNs that you buy outside of the United States would be treated any differently than those you buy in the United States. This would mean:
  • An Israeli ETN based on another currency would be taxed just like any currency-based ETN, meaning that you must pay tax on any interest that is accrued every year. Similarly, when you sell, all gains would be taxed as ordinary income.
  • An Israeli ETN based on a stock or bond index would be treated just like any ETN of the same type. In other words, you may ask Barklays for advice.
The only catch I can think of is that the Israeli ETN will need to be structured the same way as a similar domestic ETN. To determine this is the case, I want to tell you that you should read the prospectus carefully, but that is going to be hard for two reasons.

First, it is in Hebrew. I don’t mean easy Hebrew like you see on cereal boxes. (By the way, תפוחים means “puffed”, not “apples”. This should be clear to you because the first letter is vocalized with a שווא.) No, I mean Hebrew as in the pun-based riddles that your kids bring home from school.

Don’t get me wrong. They start out perfectly fine, as in: “He is a very hot and can burn you. She is half of a heterosexually married couple.” The trouble is when you get past the first round. That’s when you get to the riddles that sound like they were made up by a Hebrew speaking daemon that ate a book of SAT analogies:

He happens sometime after the beginning. When she comes by, you shouldn’t complain because that is what you have been praying for, isn’t it?

But, I digress. My point is that the first reason it is hard to read the prospectus for an Israeli ETN is because it is written in demonic Hebrew.

The second reason that it is hard is because I am not an expert, and I can’t tell you what you should be looking for. But that part may be ok because even the experts don’t know what you should be looking for. It will take time for the IRS to process all of my feedback, and in the meantime there are few court rulings to follow.

If you followed my link to the article I referenced earlier, you would have found that the most important consideration for tax purposes seems to be whether or not, when you own an ETN, you actually have “ownership” in the underlying assets that are generating the interest and dividends. If you do, then you should have to pay tax on the interest and dividends every year. If not, then you can continue to ask Barklays for advice.

I’m not an expert, but if you are somehow able to read the prospectus, I suggest looking to make sure that as the owner of the ETN you do not not own the underlying assets. The other place to look would be the regulations for Israeli ETNs. The thing to consider with these is whether any of the provisions (such as the limits as to what the issuer of an ETN may do with the underlying assets of a תעודת סל) would make a difference if anyone ever tested the question of whether owners of Israeli ETNs have “ownership” in its underlying assets.

This is the end of my non-expert opinion on the matter. At this point, I think you will agree that the best way to find out for sure how a תעודת סל should be taxed is to invest millions of shekel in them. After several years, the amount of taxes you will have deferred will be high enough that the IRS will want to investigate your tax return. Hopefully, they will take you to court, and based on your success or failure, we will all know how these should be taxed. Let me be the first to thank you in advance for helping us out on this one.

[End Skipping Again]

To summarize, the bottom line is that you will not get eaten by a PFIC if you buy a תעודת סל. However, at some point you may get eaten by something else if the tax guidelines for ETNs are ever clarified.
Two Steps Backward, One Step Forward

This all began because we want to invest in Israel. The obvious way to do this is simply to invest in individual stocks and bonds.
However, because we like complexity, we were looking for an easier way to invest such as by buying Israeli mutual funds that would track an index. But, we know that we can’t invest in Israeli mutual funds without getting eaten by a PFIC. We learned this the hard way by reading the entire post on Getting Eaten by a PFIC without using the Skipping Tags.

Thanks to an alert Accidental Reader, we have now discovered that תעודות סל are a viable investment option for U.S. taxpayers, assuming that these taxpayers are comfortable with the risk that “viable” could become “not all viable” at any time.

This is great because now we have choices, and we love choices. Why else are we always so happy to go shopping for cereal in Israel? 


  1. What about buying a Palladium ETF since all the precious metals are all in China?

    1. I didn't talk about in this blog, but one good use case for ETNs is to invest in commodities. If you buy an ETF for this, you'll have of the tax consequences of actually owning the commodities.

      In terms of whether you should invest in commodities, that's a totally different story. If you are, however, wouldn't you want a diversified one like RJI or DJP?

  2. It is all about the risk/return ratio. The diversified commodity ETFs have a different market beta than equities, but in general are balanced and follow the global economy, not a regional economy. But sometimes the palladium, gold, etc. are like Bitcoins...they can have huge quick swings sometimes and wild rides. Not sure how to explain that one in Hebrew yet.

  3. אני לא מבין כלום

    1. You should have used the skipping tags... :)

  4. Bitcoin is being shut down. Sell now!

  5. I found this blog by accident. Your friends from Google down the street in Matam told me.

  6. Should we invest more in the Google class C shares? Thoughts?

  7. Donny - should we invest in Microsoft or Google Israel? Do you have a good book to recommend on Microsoft? I found this one on Google

    1. I don't have particular thoughts on investing in either company, although I noticed that Microsoft has been showing up a value investment recently; e.g. check out

  8. Unfortunately you are wrong regarding the classification of Israeli ETN's.

    As per the Joint Investments in Trust Law (Amendment 16):

    Establishment of ETNs – ETNs are to be established through agreements signed by ETN management companies, and companies serving as trustees for the arrangement. “ETNs” are to be defined in a manner similar and equivalent to that employed for mutual funds, and ETN issuers are to be defined as ETN managers (equivalent to fund managers).

    Those ETNs will cease operating under a legal structure which sees them as “debt certificates” issued as a security pursuant to a prospectus, and will migrate to a legal structure essentially similar to that of mutual funds, where investors hold ownership rights in the assets.

    Corporate governance – The amendment will apply those corporate governance principles governing the mutual fund market on the ETN market as well.

    Therefore since Israeli ETNs are defined by Israeli law in a manner similar and equivalent to that employed for mutual funds... and operate under a legal structure essentially similar to that of mutual funds... in my opinion they are clearly PFICs.

    1. Thank you for this note. I think you are right that ETNs are PFICs. I posted a correction this blog here: