Unplugging Heartbeat Trades and Reforming the Taxation of ETFs

Jeffrey M. Colon ‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎‏‏‎ ‎

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The much-touted tax efficiency of equity exchange traded funds (ETFs) has  historically been built upon portfolios that track indices with low turnover and the  tax exemption for in-kind distributions of appreciated property.  

This rule permits ETFs to distribute appreciated shares tax-free to redeeming  authorized participants (APs) and reduce a fund’s future capital gains. ETFs and  APs, working together, exploit this rule in so-called heartbeat trades in which an  ETF distributes shares of a specific company or companies to a redeeming AP, in stead of a pro rata basket of the ETF’s portfolio. The distributed securities are ap preciated shares of companies that are on the verge of being acquired in a taxable  transaction or that are slated to be removed from the index tracked by the ETF. In  the absence of heartbeat trades, the ETF would recognize gain from the sale of the  shares.  

Through everyday redemptions and heartbeat trades, equity ETFs are able to  make tax-free portfolio adjustments and avoid generating capital gains until their  shareholders sell their shares. The quasi-consumption tax treatment of ETFs is un warranted and gives ETFs an unfair tax advantage over mutual funds, publicly  traded partnerships, and direct investments by investors. Although these redemp tions could be treated as taxable exchanges between the ETF and an AP under sub stance-over-form principles, given the vagaries of the tax common law, Congress  should simply eliminate the exemption for in-kind redemptions. Congress could al ternatively limit the exemption to redemptions consisting of a pro rata portion of an  ETF’s portfolio. Either alternative would limit tax-free portfolio adjustments and  better align the taxable and economic gains of ETF shareholders.

Recommended Citation

Jeffrey M. Colon, Unplugging Heartbeat Trades and Reforming the Taxation of ETFs, 2 U. Chi. Bus. L. Rev. 53 (2023).

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