Wednesday, November 26, 2014

Run away! Run away!

In this exciting continuation of being wrong, I present you with the second time in the past few weeks that I have been wrong. Before last week, I would have said that my second wrong is not very surprising for a blog that does everything by accident. However, now that I am the authoritative source on American ex-pat taxation in Israel, this mistake is deeply disappointing.

Wrong #2

In Running Away from a PFIC, I concluded “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.”

Whoops! That’s not true. Israeli ETNs are PFICs. Run away!

Amendment 16

At the time I wrote Running Away from a PFIC, I attempted to research whether there was anything in how Israeli ETNs are structured that would cause them to be different than U.S.-based ETNs. I failed at this because the prospectuses were too hard to read.

I really have no excuse for not finding this summary. It is right on the landing page for ETNso n the Israeli Security Authority’s website.

This document summarizes in plain English (or Hebrew, if you prefer it that way) the new regulations for ETNs that came into effect when the amendment was approved on November 15, 2009. Included in this change is the following:

As part of this switch, the ownership of the ETN's underlying assets will be transferred to investors, and will be in trust on their behalf by the trustee. Currently, these assets are property of the ETN issuer, and are pledged to the trustee.

If the investors in the ETN have ownership in the ETNs assets, I would say that for tax purposes this is no longer a note. Actually, it becomes almost exactly like a fund.

This may be why the summary also says the following:

Amendment 16 aims to regulate and supervise ETNs in a manner similar to the mutual fund market.

I stand corrected. Israeli ETNs are PFICs just like Israeli ETFs.

Authoritative Guidance

Unless you want to get eaten by a PFIC, you should not invest in an Israeli ETN. However, as the authoritative source on this matter, I just need to add that what I just said may still be wrong.

The summary is not a legal document. It is conceivable that the actual, legal way in which ownership of the assets is structured is not so straightforward. In that case, there may still be room to claim that Israeli ETNs are not PFICs.

Specifically, I wonder whether the ETN shareholder actually owns the underlying assets directly. Or, whether the shareholder actually owns something resembling a lien on the assets. I suspect that it could be a lien because under the new regulations, the ETN is still able to function as an ETN.

The basic structure of the ETN under the amendment is that the issuer receives an investment and is obligated to return that investment with an adjustment according to a calculated index (e.g., the S&P 500). The issuer is also obligated to hold the securities that compose this index (e.g., the stocks of the S&P 500) as the underlying assets.

In a fund, the shareholder is entitled to exactly what the underlying assets are worth. However, the ETN (even under the amendment) works a bit differently..

In the ETN, if the underlying assets are not sufficient to repay the obligation (e.g., the underlying assets happen to lag a bit behind the index), the issuer must supplement from his own funds to make up the difference. And the same in reverse. If the value of the underlying assets is more than the obligation, the issuer is entitled to keep the excess.

This important nuance leads me to suspect that the actual legal ownership arrangement between the shareholder and the issuer of the ETN is much more like a lien.

However, I cannot say for certain whether or not this is actually case. I attempted to find the text of Amendment 16, but was not able to find it anywhere. If you have a copy, please send it to me.

I also attempted – again! – to read an actual prospectus for an Israeli ETN. I got further this time, but still could not decode anything specific about the ownership arrangement that could help determine exactly how the ownership is structured.

If you happen to be someone that writes Hebrew prospectuses (or even someone who just reads them), please let me know if you see anything in there that could help us. I would absolutely love to be wrong about this again.

In the meantime, I recommend running away from Israeli ETNs.


  1. You are making me afraid of making Aliyah as you are now always saying run away!

    1. That's a good point, but you have to remember that every 4 steps that you take when you run away in Israel is a mitzvah.