Tax Proposals May Affect Exchange-Traded Funds

Morgan Lewis

Recently proposed tax legislation, if enacted, would fundamentally alter the taxation of exchange‑traded funds. This LawFlash discusses the potential consequences of such legislation on industry participants, including retail investors.

On September 10, 2021, US Senate Finance Committee Chairman Ron Wyden (D-Oregon) released draft tax legislation (the Wyden Draft) focused primarily on eliminating perceived opportunities for abuse from the partnership taxation. However, the Wyden Draft also included provisions that affect exchange-traded funds (ETFs) registered under the Investment Company Act of 1940 (‘40 Act) taxed as regulated investment companies (RICs) and ETFs subject to rules applicable to publicly traded partnerships (PTPs) (often referred to more broadly as “exchange-traded products” or “ETPs”). Subsequently, on September 15, the House of Representatives Ways and Means Committee announced the completion of its markup of draft tax legislation (the Ways and Means Draft) that may inadvertently affect ETPs treated as “grantor trusts” for US federal income tax purposes.

It is currently unclear whether any of the provisions in either the Wyden Draft or the Ways and Means Draft will become law.

‘40 ACT ETFS TAXED AS RICS

Over approximately the prior 15 years, there has been a significant amount of commentary and misunderstanding regarding Section 852(b)(6) of the Internal Revenue Code of 1986, as amended (the Code), which is unique to the taxation of RICs. By way of background, RICs are corporations for tax purposes. Under current law, corporations generally must recognize gain on the distribution of appreciated property to their shareholders. However, RICs that issue redeemable securities—which include most ‘40 Act ETFs—are exempt from this rule when distributing appreciated property pursuant to a redemption request from a shareholder. Specifically, Section 852(b)(6) permits a RIC to distribute appreciated property to a shareholder without recognizing gain. Notably, although Section 852(b)(6) may prevent a RIC from recognizing capital gain, and therefore prevent additional taxable distributions to the RIC’s shareholders, Section 852(b)(6) does not result in a stepped-up tax basis in the shares of the RIC and therefore does not prevent non-redeeming shareholders from recognizing gain when they subsequently sell their shares. Proposed changes in the Wyden Draft would repeal Section 852(b)(6), causing RICs to recognize any gain on in-kind distributions of appreciated property. If enacted, the proposed changes would be effective for tax years beginning after December 31, 2022.

Although the elimination of Section 852(b)(6) would technically affect all registered investment companies that seek to qualify as RICs—including mutual funds, “business development companies” or “BDCs” and certain closed-end funds that have received the IRS’s approval to use Section 852(b)(6))—this proposed change is expected to primarily affect ETFs. Many ETFs rely heavily on in-kind distributions of securities as a key component to implementing their investment strategy, and Section 852(b)(6) is a fundamental aspect of how ETFs operate by accepting in-kind contributions and by making in-kind redemptions. Because RICs are required to distribute their income and gains each year to avoid entity-level tax, a repeal of Section 852(b)(6) would likely cause an ETF that generates gains from the distribution of appreciated securities pursuant to redemption requests to sell securities in the market for the purpose of generating the cash needed to satisfy its annual distribution requirements. Such sales may generate additional capital gains, further increasing the ETF’s distribution requirements. Additional resulting distributions would generally be taxable to the non-redeeming shareholders, even though the gains would be generated by the redeeming shareholders’ redemption requests. The repeal of Section 852(b)(6) may also cause ETFs to incur additional transaction costs from selling securities into the market, with such additional costs borne by the non-redeeming shareholders. In addition, the need to satisfy increased annual distribution requirements may make it difficult for index-based ETFs to properly track their underlying indexes.

Notably, this proposal only appears in the Wyden Draft. The Ways and Means Draft would not repeal Section 852(b)(6).

COMMODITY POOLS TAXED AS PUBLICLY TRADED PARTNERSHIPS

Another proposal in the Wyden Draft that has the potential to disrupt the ETF industry is the provision pertaining to PTPs. This provision would eliminate an avenue by which PTPs qualify to be treated as partnerships rather than as taxable “C corporations.” If enacted, the provision would cause many PTPs to be treated as C corporations and thus, subject them to entity-level tax. Current law generally treats all PTPs, including master-limited partnerships (MLPs), commodity/futures based PTPs, and real estate PTPs, among others, as C corporations, unless certain exemptions are met. One such exemption applies if 90% or more of a PTP’s gross income consists of “qualifying income” within the meaning of Section 7704(d) of the Code, and the Treasury Regulations thereunder (the Qualifying Income Exemption).[1]

The Wyden Draft would eliminate the Qualifying Income Exemption, which would cause many PTPs to be subject to entity-level tax as C corporations for tax years beginning after December 31, 2022. The proposed changes do not appear to affect other exemptions that allow certain PTPs to avoid treatment as a corporation. Because ETFs cannot, as a practical matter, fit within the other exemptions, they rely on the Qualifying Income Exemption. The section-by-section summary of the Wyden Draft states that “[PTPs] often have hundreds of thousands of partners and it is nearly impossible for the IRS to properly administer these entities. Furthermore, these entities do not pay corporate taxes and thereby erode the corporate tax base.”

In contrast, the Ways and Means Draft proposes to expand the types of “qualifying income” permitted by the Qualifying Income Exemption to include certain income from the generation of electric power or thermal energy and from certain renewables among other energy sources. Accordingly, there does not appear to be a consensus between the Wyden Draft and the Ways and Means Draft as to modifications of the Qualifying Income Exemption.

ETPS TAXED AS GRANTOR TRUSTS

Many fixed investment ETPs (holding metals, currency, commodities, cryptocurrency) and Unit Investment Trusts (often holding non-diversified baskets of securities) are treated as so-called “grantor trusts” described in Sections 671-679 of the Code. Contributions to a grantor trust and distributions from a grantor trust to its shareholders (technically “grantors”) are generally not tax recognition events, because the shareholders are considered to be owners of a pro rata portion of the trusts’ underlying assets, and the grantor trusts are, in effect, disregarded for tax purposes. As a result, a contribution by, or distribution to, a shareholder is ignored as a transaction between the shareholder and itself.

One of the proposed changes in the Ways and Means Draft may unintentionally alter the way these trusts operate. Specifically, newly proposed Section 1062 of the Code would override the otherwise applicable treatment of grantor trusts in determining whether “any transfer of property between a trust and the a [sic] person who is the deemed owner of the trust (or portion thereof)” is treated as a “sale or exchange.” There does not appear to be any indication that this proposal is intended to affect the operation of fixed investment ETPs; rather, it appears intended to address certain estate and tax planning transactions that are inapplicable to investment funds structured as grantor trusts. Nonetheless, as drafted, the proposal applies to “any transfer,” which could be interpreted to encompass in-kind distributions and in-kind contributions routinely used by fixed investment trusts without subjecting the trusts or their shareholders to recognition of gain. Accordingly, the proposal, if enacted in its current form and interpreted to apply to fixed investment trusts, could fundamentally alter the taxation and operation of those trusts.

Morgan Lewis will continue to monitor the Wyden Draft and the Ways and Means Draft as they move through the reconciliation process, as well as any similar proposals, and will keep you informed of their potential ramifications if enacted.

[1] “Qualifying income” generally includes interest, dividends, real property rents, gain from the sale or other disposition of real property, income and gain from certain mineral and natural resource mining and production, gain from the sale or disposition of a capital asset or Code Section 1231 property, and in the case of a partnership whose principal activity is the buying and selling of commodities, income and gain from commodities (not described in Code Section 1221(a)(1)) or futures, options, or forward contracts with respect to such commodities (including foreign currency transactions of a commodity pool).

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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