Master limited partnerships have been popular alternative yield-generating assets among income-minded investors in today’s low-yield environment. However, when investing in MLP-related exchange traded products, investors should understand the difference between an exchange traded fund and an exchange traded note, as the two investment vehicles are not the same.
The main difference between MLP ETFs and MLP ETNs is the tax consequences for distributions for each investment vehicle.
While both MLP-related ETFs and ETNs track an underlying benchmark index comprised of MLPs, ETFs that focus on MLPs are structured as C corporations, whereas ETNs are organized as an unsecured debt issued by an underwriting bank.
To qualify as an MLP, the companies must pass through at least 90% of their income to investors, making the assets an attractive yield-generating investment.
However, since MLP ETFs are structured as a C corp., these corporations are also required to pay corporate income tax on distributions before the distributions are passed through to investors — MLP ETFs are required to pay corporate taxes on returns. As the underlying positions increase in value, the fund will accrue a deferred tax liability (DTL) to account for taxes that will be owed should the position be sold, according to Alerian.
This DTL is assessed at the corporate tax rate of 21% plus an assumed rate attributable to state taxes. The DTL is removed from the Net Asset Value (NAV) of the fund — if the value of the underlying portfolio rises from $100 to $110, the fund’s NAV will move from $100 to $107.9. Additionally, fund investors are also taxed on the fund dividends and capital gains distributions.
Consequently, MLP ETF investors may be double-taxed. While this is not an explicit cost, ETF investors would see the results of the corporate tax liabilities through wider tracking error than the performance of the underlying MLPs.
On the other hand, ETNs, unlike ETFs, do not hold physical shares of the underlying companies of the index. An ETN is an unsecured debt security that promises to pay out the value of the index at its maturity, along with any distributions. However, since the note is a debt security, it is exposed to the default risk of the underwriting bank. Additionally, coupons are taxed at ordinary income rates, and ETNs may come with lower income as the expense ratio is removed from coupon payments.
Both MLP ETFs and ETN investors are issued a 1099 form instead of the traditional K-1s associated with MLP stocks during tax season. Additionally, MLP ETFs and ETNs can be used in individual retirement accounts without negative consequences, whereas MLP units held in an IRA may be required to pay distributions from unrelated business taxable income in the year it is realized.
For more news, information, and strategy, visit the Energy Infrastructure Channel.