Rising Concerns Over Tax-Saving ETFs in the U.S.
Billions are now pouring into U.S. exchange-traded funds (ETFs) that many see primarily as tax-saving tools. This trend has raised eyebrows among politicians and some industry experts, who caution that it could attract scrutiny from tax authorities.
Numerous fund companies are establishing ETFs that aim to lower taxable interest and dividend income or minimize capital gains taxes on investors’ existing stock holdings.
The more contentious of these are the Section 351 or ETF swap funds, which are designed specifically for investors with large portfolios who would face hefty tax bills from selling appreciated assets. This year alone, at least seven of these funds, collectively managing $2.2 billion, have been introduced, with four more in the pipeline.
“Everyone is approaching this creatively, which is positive. But, at some point, you wonder how far is too far,” noted Brittany Christensen from Tidal Financial Group, which manages $50 billion and oversees 351 out of nearly 300 ETFs.
Some U.S. politicians are already voicing their opposition to these funds. In June, Ron Wyden, the leading Democrat on the Senate Finance Committee, proposed legislation aimed at banning tax-free transfers of appreciating securities to 351 funds.
Jeffrey Colon, a law professor at Fordham University, remarked that unless Congress intervenes, the taxes collected from publicly traded investment vehicles will likely decline “inevitably.”
“The Wyden proposal is a necessary first step to address the emerging tax abuses surrounding ETFs,” he commented, highlighting a “growing urgency” given the rising popularity of ETFs and the emergence of swap funds.
“The government is aware of these challenges, but so far there’s been no obvious intention to tackle them. The investment company’s lobby is quite powerful,” he added.
In the U.S., ETFs have historically been more tax-efficient than traditional mutual funds, largely due to unique aspects of the tax system. Mutual funds often trigger capital gains taxes when they sell assets at a profit, while ETFs can generally avoid such taxes through “in-kind transactions,” which do not involve cash exchanges.
However, 30 years post-creation of ETFs, some issuers are developing even more tax-efficient options. Less controversial varieties seek to minimize taxable coupon and dividend income by rotating holdings just before their payout dates.
In August, F/m Investments launched two bond ETFs aimed at taking advantage of this strategy, which aims to turn monthly interest income into unrealized capital gains while also reducing withholding taxes for non-U.S. investors.
Other firms, such as Round Hill Investments and LionShares, have introduced similar funds focused on equity investments.
It remains unclear how extensively investors will exploit these tax loopholes, although some funds are already yielding savings.
The Alpha Architect 1-3 Month Box ETF, known as BOXX, which invests in options mimicking short-term bond portfolios, has attracted net flows of $8.6 billion since its inception, amassing $9 billion in total assets. This translates to around $400 million in profit. The Financial Times reported that if investors paid a 20% long-term capital gains tax instead of the highest interest income tax rate, they could save $68 million.
“This is an important trend because taxes are often a top priority for investors. ETFs are finding innovative ways to manage their tax exposure,” said Brian Armor from Morningstar.
The Section 351 Fund, named after a previously seldom-utilized segment of the U.S. Internal Revenue Code, is viewed as enhancing capital inflows. Wealthy investors can convert their existing shares into ETF shares without incurring capital gains taxes.
Tidal’s Christensen expressed concerns that the Internal Revenue Service might scrutinize stock donations, particularly those from employee stock plans, especially if divided into multiple 351 conversions for portfolio diversification, as required by tax rules.
“When will the IRS begin to look at this and consider its implications for those involved in compensation equity plans?” she wondered. “This represents a novel use of Section 351, and it raises potential red flags.”
Exchange Traded Concepts has numerous similar launches lined up, with CEO Garrett Stevens indicating that “billions more” are planned.
Some initiatives appear directed at family offices, contemplating why they shouldn’t operate within a more tax-advantageous framework. Stevens highlighted existing arrangements for holders of real estate and pension contracts that allow for tax-free rotations.
“This isn’t groundbreaking. It’s an IRS rule,” he stated. “Everything we’re doing is legal; we’re not sidestepping any regulations. However, there are likely unintended consequences tied to the tax code.”
In contrast, Elizabeth Kashner from FactSet pointed out that these strategies, alongside other elements in the tax code utilized by wealthy individuals, “clearly deviate from the intended framework of the tax code. This doesn’t align with the consensus on how our nation should operate.”
She added, “From an equity standpoint, investors can significantly dodge taxes while accessing a large portion of their assets, while the broader population suffers revenue loss to the Treasury.”
