Unplugging Heartbeat Trades and Reforming the Taxation of ETFs
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, instead of a pro rata basket of the ETF’s portfolio. The distributed securities are appreciated 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 unwarranted and gives ETFs an unfair tax advantage over mutual funds, publicly traded partnerships, and direct investments by investors. Although these redemptions could be treated as taxable exchanges between the ETF and an AP under substance-over-form principles, given the vagaries of the tax common law, Congress should simply eliminate the exemption for in-kind redemptions. Congress could alternatively 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.
- I. Introduction
- II. An Overview of Regulated Investment Company Taxation
- III. Subchapter M’s Failure to Match Taxable and Economic Income and Loss
- IV. The Rise of Exchange Traded Funds
- V. The Origins of Section 852(b)(6)
- VI. The Mutual Fund Relief Valve of Section 852(b)(6) Becomes the ETF Tax Bonanza
- VII. Exploiting Section 852(b)(6): Heartbeat Trades and Capital Structure Arbitrage
- VIII. Tax Common Law and Heartbeat Trades
- IX. Section 852(b)(6) Needs to be Reformed
- X. Section 852(b)(6) Should Be Reformed
Investment companies, including mutual funds and exchange traded funds (ETFs), play an ever-increasing role in U.S. financial markets. At the end of 2020, investment companies held total assets of $29.7 trillion, with $23.9 trillion (80%) invested in mutual funds and $5.4 trillion (18%) in ETFs.1
Inv. Co. Inst., 2021 Investment Company Fact Book 33 at II (61st ed. 2021) [hereinafter Factbook], https://perma.cc/3ZLY-KZGX;id. at 41 fig. 2.2. Investment companies also include closed-end funds and unit investment trusts (UITs), which held about 0.9% and 0.2%, respectively, of investment company assets. Id. Many early ETFs were organized as UITs. Two of these early UITs, SPDR S&P 500 ETF Trust (SPY) and PowerShares QQQ Trust, Series 1 (QQQ), still represent a significant portion of total ETF trading volume and net assets. Exchange-Traded Funds, 83 Fed. Reg. 37332, 37336 (proposed Jul. 31, 2018). This article does not address UITs. For a history of the development of index funds, including ETFs, see Robin Wigglesworth, Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever (2021).
Factbook, supra note 1, at 43 fig. 2.4.
Id. at 47 fig. 2.7.
The growth over the last two decades in U.S. ETFs has been meteoric. In 1999, there were only thirty ETFs of a total of 18,926 investment companies; by 2020, there were 2,296 ETFs of a total 16,127 investment companies.4
Id. at 40 fig. 2.1.
Id. at 41 fig. 2.2 (ETF assets); id. at 40 fig. 2.1 (number of ETFs). In contrast, the number of mutual funds grew from 7,970 to 9,027, and the assets held by mutual funds grew from $6.8 billion to $23.9 billion over the same period. Id. at 40 fig. 2.1 (number of mutual funds); id. at 41 fig. 2.2 (mutual fund assets).
This trend shows no signs of abating. Dimensional Fund Advisors, a large U.S. asset manager, announced in 2020 that it would begin to offer ETFs for the first time in its forty-year history.6
Lewis Braham, DFA’s Plan to Launch 3 ETFs Marks the End of an Era, Barron’s (Oct. 2, 2020), https://perma.cc/3SY4-3G6P. TheETFs were converted from mutual funds.
See, e.g., Claire Ballentine, If Your Mutual Fund Becomes an ETF, Here’s Why, Bloomberg (Apr. 1, 2021), https://perma.cc/FY68-DQ6M;Brian Cheung, ‘Floodgates’ open on mutual funds converting into ETFs, Yahoo Fin. (Aug. 13, 2021), https://perma.cc/3RTU-LKMB.Heather Bell, JP Morgan to Convert 4 Mutual Funds, ETF.com (Aug. 11, 2021), https://perma.cc/RF6H-4F7M.
Although ETFs and mutual funds are generally subject to the same regulatory and tax regimes,8
Investment companies are subject to the provisions of the Investment Company Act of 1940 [hereinafter the 1940 Act], and regulated investment companies are subject to the provisions of Subchapter M of the Internal Revenue Code. Certain ETFs, which invest in commodities, currencies, and futures, are not subject to the 1940 Act. As of 2021, these ETFs held assets of $82 billion of the $4.4 trillion total ETF assets. Factbook, supra note 1, at 84 fig. 4.2.
A fund may not offer to exchange its securities for anything other than its NAV without SEC approval. 15 U.S.C. § 80a-11 (2021); 17 C.F.R. § 270-22c-1(a) (2021) (requiring redemption or purchase price to be at the current NAV which is next computed after the redemption or purchase request).
In 2019, the SEC finalized rules that facilitate the formation of new ETFs by exempting them from certain provisions of the Investment Company Act of 1940, especially the requirement to obtain an exemptive order prior to launch.10
Exchange Traded Funds, 84 Fed. Reg. 57162, 57166 (Oct. 24, 2019) (codified at 17 C.F.R. pts. 210, 232, 239, 270, 274) [hereinafter Rule 6c-11].
Precidian ETFs Trust, Investment Company Act Release Nos. 33440, 84 Fed. Reg. 14690 (Apr. 8, 2019) (notice) and 33477 (May 20, 2019) (order) and related application. Prior to the Precidian order, ETFs disclosed daily their portfolio components. In contrast, the Precidian ActiveShares ETFs are not required to disclose their portfolio components. Precidian discloses portfolio prices every second.
For long-term taxable investors, another important advantage of ETFs over mutual funds is their much-touted tax efficiency,12
See, e.g., Rabih Moussawi, Ke Shen, and Raisa Velthuis, The Role of Taxes in the Rise of ETFs (Sept. 22, 2022) (working paper), https://perma.cc/5BSX-BUZA(concluding that migration of flows from active mutual funds to ETFs is driven primarily by tax considerations); Ben Johnson & Alex Bryan, Measuring ETFs’ Tax Efficiency Versus Mutual Funds, Morningstar (Aug. 7, 2019), https://perma.cc/FPZ6-BVV8.
The committee that selects stocks comprising the S&P 500 typically replaces 25 to 30 companies per year or 5% or 6% of the index. David Blitzer, Inside the S&P 500: Selecting Stocks, S&P IndexologyBlog (July 9, 2013), https://perma.cc/C8PY-WUEP.Other indices may have a slightly higher turnover. In contrast, many equity mutual funds have annual turnover exceeding 100%.
The more important driver of ETF tax efficiency is Section 852(b)(6), which exempts from tax in-kind distributions of appreciated securities paid to redeeming shareholders. In-kind redemptions, while rare for mutual funds, constitute the DNA of ETFs, as in-kind contributions and redemptions by authorized participants (APs) help to ensure that an ETF’s share price closely tracks its NAV.
In an in-kind redemption, an ETF manager can distribute low basis securities and minimize the ETF’s unrealized gains. Even if an ETF subsequently sells securities in its portfolio because of changes in the index or a taxable merger, these sales may not generate taxable gains if the securities held by the ETF have a high basis or the ETF has capital losses to offset any realized gains. Consequently, an ETF’s taxable investors will not pay tax until they sell their shares.14
An ETF investor will be taxed on distributions received from an ETF attributable to dividends, short-term capital gains, or interest.
Since mutual funds rarely make in-kind distributions, they do not have the same opportunities as ETFs to dispose of low basis securities tax free. When a mutual fund sells shares to rebalance its portfolio or because it experiences net redemptions, such sales may generate capital gains and necessitate further distributions to avoid entity-level tax. All year-end shareholders will be taxed on their share of these gains15
Capital gains dividends, which are dividends consisting of a fund’s net capital gains, are generally distributed at year-end.
To avoid recognizing gains, a fund manager could sell high basis securities, but leaving low basis securities in the fund would increase the fund’s unrealized gains or overhang for current and future shareholders. Mutual funds generally endeavor to avoid significant overhang, because unrealized gains may dissuade taxable investors from purchasing shares of the fund, since these new investors will be taxed on these past gains when they are realized.16
Ethan Yale, Mutual Fund Tax Overhang, 38 Va. Tax Rev. 397 (2018).
Primarily because of their tax efficiency,17
Moussawi et al., supra note 12.
Even more concerning is that creative tax advisors have now begun to exploit Section 852(b)(6). The financial press has publicized certain structured trades, denominated “heartbeat trades,”18
Elisabeth Kashner, The Heartbeat of ETF Tax Efficiency [hereinafter Heartbeat), Factset (Dec. 18, 2017), https://perma.cc/3EDP-7B3N;Elisabeth Kashner, The Heartbeat of ETF Tax Efficiency Part Two: Knowing the Players [hereinafter Players], Factset (March 22, 2018), https://perma.cc/5LCA-9NUL;Elisabeth Kashner, The Heartbeat of ETF Tax Efficiency Part Three: Trade Forensics, Factset (Apr. 5, 2018) https://perma.cc/VC5L-9MZ7;Zachary Mider, Rachel Evans, Carolina Wilson, and Christopher Cannon, The ETF Tax Dodge is Wall Street’s ‘Dirty Little Secret’, Bloomberg (March 29, 2019), https://perma.cc/98C9-JHPE.
Sam Potter, BlackRock ETFs Get Billions Via Trades Hinting at Tax Avoidance, Bloomberg (Jun. 24, 2021), https://perma.cc/P6MZ-ULY8(describing $13.5 billion inflows into five funds in suspected heartbeat trades due to rebalancing of FTSE Russell indices).
In promulgating Rule 6c-11 in 2019, the SEC specifically permitted ETFs to use “custom baskets,” which include a basket of a non-representative selection of the ETF’s portfolio holdings, in issuing or redeeming securities. This rule provides the securities law blessing for heartbeat trades20
Rule 6c-11, 84 Fed. Reg. 57162, 57184–57189; 17 C.F.R. § 270.6c-11(a)(1) (defining custom basket). Custom baskets and heartbeat trades are discussed infra at Part VII.A. and B.
Another example of the exploitation of Section 852(b)(6) is Vanguard’s launch of ETFs as a separate share class of some of their large mutual funds.21
See infra at Part VII.D.
Vanguard has further turbocharged this capital structure arbitrage by overlaying it with heartbeat trades. The financial press reported that the Vanguard funds used heartbeat trades in 2018 to distribute significantly appreciated shares of Monsanto that were on the verge of being acquired in a taxable transaction by Bayer and thereby avoided recognizing billions of dollars of gains for its mutual fund and ETF shareholders.22
Mider et al., supra note 18.
Through a combination of the in-kind redemption rule of Section 852(b)(6) and heartbeat trades, many ETFs offer superior tax treatment to investing through an after-tax IRA: no tax until sale or disposition of the ETF shares, and any gains are taxed as long-term capital gains.23
Contributions to an after-tax IRA are not deductible, and hence must be made with after-tax dollars. Any realized earnings are exempt from current taxation, but withdrawals in excess of the amount contributed are treated as ordinary income. Thus, an investor in a tax-efficient ETF would currently recognize their share of the fund’s ordinary dividends, but it would recognize long-term capital gains upon exiting the investment. Holding the same investment in an after-tax IRA, the investor would not be taxed currently on dividends but would recognize ordinary income upon withdrawing the investment gains. Furthermore, if the shares of the ETFs are held at death, the shareholder’s heirs will receive them with a stepped-up basis, which eliminates any unrealized capital gains. IRAs are not eligible for a stepped basis at death.
Under tax common law principles, heartbeat trades could be treated as taxable exchanges between an ETF and the participating AP. Given the vagaries of the tax common law and the breadth of the current statutory exemption for in-kind redemptions, there is authority to respect the separate treatment of the related contributions and redemptions. Furthermore, solely eliminating heartbeat trades—currently the most egregious tax pathology of ETFs—would still leave intact Section 852(b)(6), which allows ETFs to eliminate, tax free, unrealized gains and serves as a capital gains siphon for mutual funds with ETF share classes.
Congress should revise Subchapter M by eliminating tax-free heartbeat trades, preventing ETFs from siphoning capital gains from mutual funds, and preventing the loss of basis through in-kind redemptions. Although the tax exemption of Section 852(b)(6) has been in the Internal Revenue Code since 1969, this Article argues that Congress should reconsider the exemption for in-kind redemptions by either eliminating the rule or significantly narrowing the circumstances in which it applies. Given that the current regime violates fundamental norms of sound tax policy and costs the Treasury significant revenue,24
A preliminary estimate by the Joint Committee on Taxation is that repealing Section 852(b)(6) would raise $206 billion over the next 10 years. Dawn Lim & Richard Rubin, Democratic Tax Proposal Takes Aim at ETFs, Wall St. J. (Sept. 15, 2021), https://perma.cc/EE4D-ZX83.
Staff of S. Finance Comm., 117th Cong., Discussion Draft on Wyden Pass-through Reform, Section-by-Section Summary (Sept. 10, 2021), https://perma.cc/JTE5-GS2S.
The growth of ETFs coupled with the exploitation of Section 852(b)(6) has laid bare some major infirmities of Subchapter M. Given that Subchapter M is over 80 years old, Congress should reconsider the taxation of public investment companies and their shareholders and enact a regime that would aim to better equalize the tax treatment of individual investors, mutual funds, ETFs, and partnerships that invest in public securities.26
The taxation of U.S. investment companies has begun to attract the attention of legal scholars over the last decade due to the growth in ETF assets under management and the salience of the Section 852(b)(6) tax subsidy. See, e.g., Samuel D. Brunson, Mutual Funds, Fairness, and the Income Gap, 65 Ala. L. Rev. 139, 160 (2013) (recommending that investors be able to exclude up to ten percent of their dividend income from mutual funds from the investors’ taxable income); John C. Coates IV, Reforming the Taxation and Regulation of Mutual Funds: A Comparative Legal and Economic Analysis, 1 J. Legal Analysis 591, 614–18 (2009) (discussing a wide array of mutual fund reforms); Jeffrey M. Colon, The Great ETF Tax Swindle: The Taxation of In-kind Redemptions, 122 Penn St. L. Rev. 1 (2017); Steven Z. Hodaszy, Tax-Efficient Structure or Tax Shelter? Curbing ETFs’ Use of Section 852(b)(6) for Tax Avoidance, 70 Tax Law. 537, 599–605 (2017) [hereinafter Hodaszy, Section 852(b)(6) Tax Shelter] (arguing that ETFs should be required to reduce the basis of their remaining securities by the unrecognized gain of distributed securities) and Steven Hodaszy, ETFs Use Section 852(b)(6) for Tax Avoidance, Not Just Tax Deferral: So Why is this Loophole Still Open, 75 Tax Law. 489 (2022) [hereinafter Hodaszy, Section 852(b)(6) Loophole] (same); Lee A. Sheppard, ETFs as Tax Shelters, 130 Tax Notes 1235, 1240 (2011) (critiquing § 852(b)(6)) and Lee A. Sheppard, ETFs as Tax Dialysis Machines, 165 Tax Notes Federal 909 (Nov. 11, 2019); Shawn P. Travis, The Accelerated and Uneconomic Bearing of Tax Burdens by Mutual Fund Shareholders, 55 Tax Law. 819, 853–57 (2002) (detailing scenarios under which Subchapter M can result in acceleration of tax for fund shareholders and arguing that fund shareholders should not be taxed on reinvested capital gains but only when shares are sold, or non-capital gain dividends are received).
Open-end mutual funds, closed-end funds, and ETFs constitute regulated investment companies (RICs)27
The 1940 Act regulates “investment companies.” 15 U.S.C. § 80a-3(a)(1) (defining investment company to mean any issuer that holds itself out as being engaged primarily in the business of investing or trading in securities). The investment companies that are subject to the provisions of the 1940 Act are face-amount certificate companies, unit investment trusts, and management companies. 15 U.S.C. § 80a-4(1)-(3). To elect to be a RIC, a company must be a U.S. corporation that is registered under the 1940 Act as a management company, which includes open-end funds and closed-end funds. 15 U.S.C. § 5(a)(1)–(2). Unit investment trusts, business development companies, and certain common trust funds also can qualify as RICs, but they are not discussed further in this Article. I.R.C. § 851(a)(1) and (2).
To be a RIC, an investment company elects RIC status and must derive at least 90% of its gross income as passive income, e.g., dividends, interest, and gains from the sale of stock or securities, and satisfy certain asset diversification requirements. I.R.C. § 851(b)(2) (defining gross income test); id. § 851(b)(3) (defining diversification test). The 1940 Act also imposes diversification tests on investment companies. 15 U.S.C. § 80a-5(b)(1)–(2). An investment company that fails either the income or asset tests may still qualify as a RIC if it makes certain disclosures and undertakes steps to remediate the failure. I.R.C. § 851(d)(3) (failure to satisfy asset tests) and 851(i) (failure to satisfy gross income test).
An open-end mutual fund is one that issues “redeemable securities,” which entitle the holder to receive from the issuer his proportionate share of the issuer’s current net assets, or the cash equivalent thereof. 15 U.S.C. §§ 80a-2(a)(32) and 80a-5(a)(1) (defining redeemable security and open-end company, respectively).
15 U.S.C. § 80a-5(a)(2) (defining closed-end company to be any management company that is not an open-end company). A closed-end fund can also raise capital via rights offerings and distribute capital via tender offers.
17 C.F.R. § 270.6c-11(a)(1) (defining ETF). If certain conditions are satisfied, an ETF will be deemed to issue “redeemable securities” under Section 2(a)(32) of the 1940 Act. 17 C.F.R. § 270.6c-11(b)(1). ETFs organized as UITs do not fall within the purview of Rule 6c-11 but operate pursuant to exemptive orders.
Although a RIC must generally be a U.S. corporation, Subchapter M modifies the U.S. corporate double tax regime by permitting a RIC to deduct dividends paid against its investment company income and net capital gain dividends paid against its net capital gain.32
I.R.C. § 852(b)(1) and (3)(A) (imposition of corporate tax on investment company taxable income and net capital gains over capital gain dividends); I.R.C. § 852(b)(2)(D) (deduction for dividends paid against investment company income excluding net capital gains and tax-exempt interest dividends). Investment company taxable income is regular corporate taxable income but with certain adjustments, such as the exclusion of net capital gain, the disallowance of a deduction for any net operating loss (NOL), and the disallowance of the dividends received deduction. Id. § 852(b)(2). Investment company taxable income does not include tax-exempt interest.
To the extent that a RIC does not distribute or is not deemed to distribute its investment company income or its net capital gains, it will be subject to corporate tax. Furthermore, to retain the benefits of Subchapter M, a RIC is generally required to distribute or be deemed to distribute annually at least 90% of its investment company taxable income and 90% of its tax-exempt interest income, computed without regard to the deduction for dividends. I.R.C. § 852(a)(1)(A)–(B). If a RIC does not satisfy the distribution requirements, it will be taxed as a regular C corporation.
Subchapter M implements many aspects of a pass-through tax regime: the deduction for dividends paid eliminates tax at the entity level, and RIC shareholders get look-through treatment for their share of a RIC’s net capital gain, tax-exempt interest, and qualified dividends.34
I.R.C. § 854(b)(1)(B) (qualified dividends); id. § 854(a) (treating capital gain dividend not as dividend for purposes of Sections 1(h)(11) and 243); id. § 852(b)(3)(B) (treating capital gain dividend as long-term capital gain); id. § 852(b)(5)(B) (treating exempt-interest dividend as tax-exempt interest under Section 103).
See id. § 853(a)(1).
Subchapter M does not fully reflect pass-through tax principles. For instance, a RIC’s short-term capital gains are taxed as ordinary dividends.36
When short-term capital gains are distributed to foreign shareholders, however, they retain their character as capital gains. See id. § 871(k)(2)(D) (exempting foreign persons from tax on short-term capital gain dividends distributed by a RIC). See Jeffrey M. Colon, Foreign Investors in U.S. Mutual Funds: The Trouble with Treaties, 35 Va. Tax Rev. 483 (2016).
I.R.C. § 66(a)(1). These investment expenses also do not offset favorably taxed net capital gains or qualified dividend income. See Rev. Rul. 2005-31, 2005-1 C.B. 1084. For individuals, prior to 2018, such expenses would have been deductible under Section 212, but subject to the two percent floor for miscellaneous itemized deductions of Section 67(a). Under Section 68(g), which prohibits any miscellaneous itemized deduction until post-2025 taxable years, none of these expenses are deductible.
A RIC can indefinitely carry over a capital loss. I.R.C. § 1212(a)(3)(A). Net operating losses, in contrast, cannot be carried over to reduce a RIC’s income in a subsequent year. Id. § 852(b)(2)(B). But since a loss reduces a fund’s NAV, it also reduces a shareholder’s gain or increases loss upon a sale of the RIC shares. Id. § 852(b)(2)(B).
Subchapter M thus reflects both separate-entity and pass-through tax principles.39
Other separate entity tax principles reflected in Subchapter M include taxing RICs on their retained income and gains at corporate rates, taxing shareholders on contributions of property to RICs, treating RICs as corporations for reorganizations and contributions, and requiring RICs to maintain earnings and profits accounts for retained earnings.
A RIC’s NAV is the fair market value (FMV) of its net assets (assets minus liabilities) divided by the number of outstanding shares. It reflects both the basis of a RIC’s assets, including realized but undistributed income and gains, and its unrealized gains and losses. A mutual fund shareholder purchases or redeems shares of a fund at the fund’s NAV, which becomes the shareholder’s basis in the fund shares in the case of a purchase and amount realized in the case of a sale.40
An open-end fund may not offer to exchange its securities for anything other than its NAV without SEC approval. 15 U.S.C. § 80a-11; 17 C.F.R. § 270-22c-1(a) (requiring redemption or purchase price to be at the current NAV which is next computed after the redemption or purchase request).
Although Subchapter M provides look-through treatment for certain items of investment company income, it mandates separate entity treatment for transactions in dealings in RIC shares. Consequently, a selling or redeeming shareholder recognizes gain or loss based on the difference between the shareholder’s basis in the sold or redeemed shares and the amount realized;41
Since stock of an investment company is generally a capital asset, any gain or loss recognized on the sale or exchange of the stock will be capital, and the seller’s holding period will generally determine whether it is short-term or long-term. Redemptions of shares of publicly offered RICs are treated as sales or exchanges. I.R.C. § 302(b)(5).
If a shareholder has received an actual or deemed capital gains distribution and holds the RIC share for six months or less, any loss recognized on the sale or exchange is long-term loss to the extent of the capital gain dividend. I.R.C. § 852(b)(4)(A). This rule prevents a shareholder from purchasing a share shortly before a capital gain distribution and then selling it and realizing a short-term loss. Since a fund’s NAV declines by the amount of the distribution, the long-term capital gain distribution would approximate the short-term capital loss if the shares were sold shortly after the distribution. For taxable investors in the highest tax brackets, the loss would offset income taxed at 40.3%, while the long-term gain would be taxed at 23.8%. A similar rule disallows any loss on the sale of stock of a RIC held six months or less to the extent of any tax-exempt interest dividend. I.R.C. § 852(b)(4)(B).
One exception is if a RIC does not distribute all of its capital gains, in which case it is taxed on undistributed net capital gains. I.R.C. § 852(b)(3)(A). The RIC may designate an amount of undistributed capital gains, and the RIC’s shareholders at year end will include that amount in income. They are treated as having paid their share of the RIC’s taxes and can increase their share basis by the difference between the designated amount and tax paid. I.R.C. § 852(b)(3)(D).
The separate entity treatment of dealings in RIC shares, especially mutual funds, can lead to the temporary over- or under-taxation of RIC taxable shareholders, which is illustrated in the following examples.
Example 1: Buying into Tax Overhang
A mutual fund has one shareholder, S1, and one share outstanding. S1’s basis is $10, the fund’s NAV is $30, and the fund has $20 of unrealized gain or tax overhang. All this appreciation accrued while S1 held the share and is reflected in the difference between S1’s basis and the fund’s NAV. S2 purchases a share for $30, the fund’s NAV. Immediately after S2 becomes a shareholder, the fund sells its appreciated assets and recognizes $20 of gain, which will be distributed and taxed $10 each to S1 and S2, provided both remain shareholders when the gain is distributed.
By purchasing shares at NAV, S2 also purchases his share of the tax overhang—$10 (50% of $20).43
For a detailed examination of tax overhang, see Yale, supra note 16.
After distribution of $10 to each S1 and S2, the fund’s NAV drops to $20,44
NAV was $30 ($60 assets/two shares) when S2 invested. After distribution of the $20 of realized gains, the NAV drops to $20 ($60 – $20)/two shares.
The shifting of the tax from S1 to S2 on the fund’s economic gains occurs because Subchapter M does not have a mechanism to allocate the taxable gains of a fund to the shareholders who have economically earned those gains or to adjust the basis of fund assets by gains recognized by redeeming shareholders. The fund’s taxable gains are simply taxed to the shareholders who own shares when the fund distributes those gains, regardless of whether those shareholders have benefitted economically from those gains. This also occurs when a shareholder purchases shares of a fund that has realized gains but not yet distributed them to shareholders.
Example 2: Buying into Realized Gains
A mutual fund has one shareholder, S1, and one share outstanding. S1’s basis is $10, the fund’s NAV is $30, and the fund has $20 of realized but undistributed gains. S2 purchases a share for $30, the fund’s NAV. Immediately after S2 becomes a shareholder, S1 redeems his share for $30 and recognizes $20 of gain. Assuming the fund does not realize any additional gains or losses, at year end, S2 will receive and be taxed on $20 of realized gain, all of which arose before S2 became a shareholder.
S2 economically paid for the realized gains when she purchased the fund share at NAV. The receipt of the $20 of realized gains is merely a return of S2’s invested capital and not a distribution of a return on S2’s invested capital. Upon distribution of the $20, the fund’s NAV drops to $10, but S2’s share basis remains at $30. S2 has been temporarily overtaxed by $20, which will not be remedied until S2 redeems her share.
Like in Example 1, S2 is overtaxed in Example 2 because Subchapter M does not have a mechanism to allocate the taxable gains of a fund to the shareholders who have economically earned those gains—S1 in Example 2—or to adjust the basis of fund assets by gains recognized by a redeeming shareholder—the $20 recognized by S1 in Example 2.
Subchapter M’s failure to adjust a fund’s basis in its assets for losses recognized by a redeeming shareholder permits fund-level losses to be temporarily used twice.
Example 3: Doubling Up on Losses
A mutual fund has one shareholder, S1, and one share outstanding. S1’s basis is $30, the fund’s NAV is $10, and the fund has $20 of unrealized loss. All this depreciation accrued while S1 held the share and is reflected in the difference between S1’s basis and the fund’s NAV. S2 purchases a share for $10, the fund’s NAV. Immediately after S2 becomes a shareholder, S1 redeems his share for $10, and recognizes a $20 loss.
The fund’s unrealized built-in loss, which lowered the fund’s NAV and was responsible for S1’s tax loss when he redeemed, can offset $20 of future realized fund-level gains when the loss is realized. For instance, assume that the fund immediately sells the assets after S2 invests for $10 and recognizes a loss of $20. If the fund invests the $10 in assets that subsequently appreciate to $30 and are sold for a gain of $20, the realized loss can offset the realized gain. S2 will not have any taxable income even though he has $20 of economic gain and will recognize this gain only when he redeems his shares. The same $20 of loss is thus used temporarily twice, once by S1 and once by S2.
The financial press has become more attentive to the negative consequences of buying shares of funds with realized gains and regularly cautions investors to be wary of investing in funds that are expected to make significant year-end capital gains distributions.45
See, e.g., Debbie Carlson, Brace Yourself for a Large Tax Hit from Mutual-Fund Payouts, MarketWatch (Dec. 13, 2021), https://perma.cc/DG5L-F5A9;Tom Herman, A Tax Trap Many Fund Investors Fall Into, Wall St. J. (Oct. 22, 2019), https://perma.cc/W3BX-BETZ;and Christine Benz, The Lowdown on Mutual Fund Capital Gains 2019 Edition, Morningstar (Nov. 14, 2019), https://perma.cc/W4NB-TKU3.Even the funds of sponsors that have a reputation for focusing on tax efficiency, such as Vanguard, can generate significant tax liabilities in the absence of economic gains. See Jason Zweig, The Huge Tax Bills That Came Out of Nowhere at Vanguard, Wall St. J. (Jan. 21, 2022), https://perma.cc/8KMH-ERES(noting that certain Vanguard target date funds reported distributing 15% of total assets as capital gains).
See, e.g., Distributions by Fidelity Mutual Funds, Fidelity, https://perma.cc/TP92-XBT8.
The issue of tax overhang (defined as unrealized gains) has been the subject of many studies by financial economists47
See, e.g., Michael Barclay, Neil D. Pearson, and Michael S. Weisbach, Open End Mutual Funds and Capital Gains Taxes, 49 J. of Fin. Econ. 3 (1998) (finding evidence that managers reduce overhang to attract new investors); Daniel Bergstresser & James Poterba, Do After-Tax Returns Affect Mutual Fund Inflows, 63 J. of Fin. Econ. 381 (2002).
Yale, supra note 16.
Bergstresser and Poterba found that an increase of 10% in a fund’s overhang decreased new money net inflows by between 1.7% and 2.3%. Bergstresser & Poterba, supra note 47, at 406 tbl. 10.
Barclay, et al., supra note 47, at 30, 33.
The issue of managers reducing overhang potentially creates a double conflict between managers and tax-exempt shareholders, and between taxable and tax-exempt shareholders.51
For a discussion of the issue of co-investment by taxable and tax-exempt shareholders in mutual funds, see Jeffrey M. Colon, Oil and Water: Mixing Taxable and Tax-Exempt Shareholders in Mutual Funds, 45 Loy. U. Chi. L. J. 773 (2014).
Barclay, et al., supra note 47, at 30, 33. Tax-exempt shareholders may benefit, however, if any increased AUM reduces per‑share administrative costs.
Given that co-investment by taxable and tax-exempt shareholders is ubiquitous, these conflicts are inevitable. The explosive growth in the assets held in tax-exempt accounts has resulted in many funds having more AUM of tax-exempt shareholders than taxable shareholders.53
Clemens Sialm & Laura Starks, Mutual Fund Tax Clienteles, 67 J. Fin. 1397 (2012).
Id.
These conflicts and the failure to manage them were laid bare at the end of 2021 when Vanguard lowered its minimum investment for its institutional target retirement funds. Tax-exempt corporate retirement funds moved from the standard funds to the institutional funds, which required the standard funds to sell appreciated assets to pay the redeeming shareholders. The sales generated significant tax liabilities for taxable shareholders. See Zweig, supra note 45.
Subchapter M has certain structural shortcomings that can drive a wedge between the economic and taxable income of fund shareholders. The failure of Subchapter M to adjust the basis of fund assets by gain or loss realized by departing shareholders can leave too much or too little fund-level gain for remaining shareholders. The absence of a mechanism in Subchapter M to allocate built-in gain, built-in losses, or realized gains to existing shareholders can lead to new shareholders being taxed on the economic gains, or benefitting from the economic losses, of historic shareholders. These structural deficiencies result in the temporary over- or undertaxation of taxable mutual fund shareholders and may cause managers to undertake uneconomic trades to mitigate these structural limitations.
These problems present significant challenges for taxable investors in mutual funds. The explosion of ETFs over the last two decades has been driven by their enhanced tax efficiency, which has largely eliminated the issue of overhang in practice for their shareholders. At the same time, it has introduced a significant distortion between the tax burdens borne by individual investors, ETF shareholders, and mutual fund shareholders.
The most important development for public investment companies in the last thirty years is the invention of the ETF.56
The first ETF was listed in Canada. See David Berman, The Canadian Investment Idea that Busted a Mutual-fund Monopoly, The Globe and Mail (Feb 19, 2017), https://perma.cc/KG3S-TH6R.The first U.S. ETF, the Standard & Poor’s Depository Receipts or SPDRs, was approved by the SEC in 1993. See Frances Denmark, Happy 20th Birthday, ETFs: A Look Back at Nate Most and His Novel Idea, Institutional Investor (July 3, 2013), https://perma.cc/A3TU-BWUZand The ETF Story Podcast, Bloomberg (2018), https://perma.cc/3X4U-L2VB.See also Wigglesworth, supra note 1 at 166–83 (detailing the birth of SPDRs).
See, e.g., Martin Small et al., Four Big Trends to Drive ETF Growth, Blackrock (May 2018), https://perma.cc/8DZ2-RZUJ.
Recognizing that the growth in the AUM of ETFs required a more accommodating and flexible regulatory regime, the SEC, in 2019, adopted new Rule 6c-11. This rule permits ETFs to operate without the delay and expense of requesting exemptive relief from certain provisions of the 1940 Act, which ETFs had been required to do.58
Rule 6c-11, supra note 10, at 37, 333–37, 334. An ETF would typically request exemptive relief under Sections 2(a)(32), 5(a)(1), 22(d) and (e), 12(d)(1), 17(a) and (b), and 6(c) of the 1940 Act. See, e.g., Cambria Inv. Mgmt., L.P., Investment Company Act Release No. 30302 (Dec. 12, 2012). See also David J. Abner, The ETF Handbook 287 (2nd ed. 2016). In connection with Rule 6c-11, the SEC also adopted amendments requiring enhanced disclosures both to the SEC and to the public.
Some of the conditions to come within the scope of Rule 6c-11 include that the ETF be listed on a national securities exchange, issue and redeem creation units from APs, disclose on its public website details of the portfolio holdings forming the basis of the NAV calculation, disseminate an intraday indicative value, and comply with other website disclosures and recordkeeping requirements. 17 C.F.R. § 270.6c-11(c). Leveraged ETFs were specifically excluded from the application of new Rule 6c-11.
17 C.F.R. § 270.6c-11(b)(1). ETFs are also exempted from Section 22 of the 1940 Act, which generally requires that investment companies, principal underwriters and dealers sell a redeemable security to the public at the current public offering price. ETFs are also exempted from Rule 22c-1, which requires that a dealer transact a redeemable security at its NAV. Rule 6c-11 also exempts certain affiliates of an ETF from the application of Section 17(a) of the 1940 Act, which prohibits an affiliated person of an investment company from selling any security or other property to or purchasing any security from the investment company. This rule applies to persons who are affiliates solely because they hold voting power of 5% or more of the ETF’s shares or 5% or more of any investment company that is an affiliated person of the ETF. 17 C.F.R. § 270.6c-11(b)(3)(i) and (ii).
The primary force motiving the growth of ETFs is the overall shift from active management to passive management. In 2019, the AUM of passive U.S. equity funds surpassed that of active U.S. funds.61
John Gittelson, End of Era: Passive Equity Funds Surpass Active in Epic Shift, Bloomberg (Sept. 11, 2019), https://perma.cc/QL5H-RMWL.On January 21, 2020, for example, three of the four ETFs with AUM of greater than $100 billion tracked the S&P 500 and the fourth tracked the U.S. total market index, which tracks the CRSP U.S. Total Market Index. See ETF Finder, ETF.com, https://perma.cc/FR4V-FA8L(visited October 10, 2022) (ETFs selected by AUM).
See, e.g., iShares ESG MSCI U.S.A. ETF (ESGU ticker), iShares by BlackRock, https://perma.cc/4YSW-E4YM(tracking an index of U.S. companies selected and weighted for positive environmental, social, and governance characteristics).
See, e.g., iShares Edge MSCI Min Vol U.S.A. Small-Cap ETF (SMMV ticker), iShares by BlackRock, https://perma.cc/R4EE-ETXJ(tracking an index of U.S.-listed small cap stocks that are selected and weighted to create a low-volatility portfolio).
See, e.g., The Cannabis ETF (THCX ticker), MarketWatch, https://perma.cc/2ZQ7-CEAX(tracking an index of cannabis companies defined as companies deriving at least 50% of their revenues from legal marijuana or hemp industries).
See, e.g., ProShares Pet Care ETF (PAWZ ticker), MarketWatch, https://perma.cc/LA34-8CPQ(tracking a global index of companies providing pet-care products and services). ETFs offer hundreds of different economic exposures to subsets of the global equity market. See List of Equity Indexes, VettaFi, https://perma.cc/C4EW-PU7M.The use of the term “passive” for many of these funds is certainly a misnomer. See, e.g., Adriana Z. Robertson, Passive in Name Only: Delegated Management and “Index” Investing, 36 Yale J. on Reg. 795 (2019) (arguing that index investing is a form of delegated management).
ETFs combine some features of closed-end and mutual funds but mitigate some of the shortcomings of both. Like closed-end funds, retail ETF investors purchase and sell ETF shares through a broker on an exchange and not from the fund itself. Since ETF shares can be purchased or sold throughout the trading day, an ETF investor does not purchase or sell at the end-of-day NAV as in the case of mutual funds.
The price at which an ETF trades is set by the market, and an investor may sell or purchase at a price different from NAV. A well-known shortcoming of closed-end funds is that fund shares can trade at varying premiums or discounts to NAV, which at times can be significant.66
This is a very well-known phenomenon of closed-end funds. See, e.g., Charles M. C. Lee, Andrei Shleifer, and Richard Thaler, Investor Sentiment and the Closed-End Fund Puzzle, 46 J. of Fin. 75 (1991); Martin Cherkes, Closed-End Funds: A Survey, 4 Ann. Rev. of Fin. Econ. 431 (2012).
For example, an investor who believes that the Korean stock market was going to rise could purchase shares of a closed-end fund that invests in Korean stocks. Even if the Korean stock market rises, the investment in the fund could earn a return less than the increase in the Korean stock market if the fund trades at a discount or the discount widens.
Since ETFs are exchange traded, they can be used both in long and short strategies. For instance, if one believes that healthcare stocks would do better than the overall market, one could go long on the iShares U.S. Healthcare ETF and short the SPDR S&P 500 Index. In contrast, it is not generally possible to short mutual funds, and the discounts and premiums in closed-end funds also preclude them from being good candidates for shorting strategies.
The structural innovation of ETFs to overcome the discounts and premiums to NAV of closed-end funds is the role of APs, which are large broker-dealers, such as Merrill Lynch, Morgan Stanley, and Goldman Sachs, authorized by the ETF to create and redeem shares in large baskets denominated “creation units.” ETF shares can generally only be created and redeemed by APs.68
Rule 6c-11 permits non-APs to create and redeem shares on the day of a reorganization, merger, conversion, or liquidation. 17 C.F.R. § 270-6c-11(a)(2) (2019).
For a more detailed overview of the creation and redemption process, see ETF Processing, DTCC Learning Center, https://perma.cc/58DC-YKVW. In-kind creations and redemptions are by far the predominant methods, although some ETFs require cash to create shares, and some pay cash instead of in-kind distributions upon redemption. See SPDR Series Trust, Form 497K, 91–92 (Dec. 18, 2019) (listing creation unit sizes from 10,000 to 500,000 shares for various ETFs and describing whether a fund’s creation units are in-kind or cash). For an overview of the purchase and redemption of creation units of a particular family of funds, see id. at 91–98.
See, e.g., SPDR Series Trust, Form 497K, 91–92 (Dec. 18, 2019) at 97–98 (listing transaction fees for the purchase and redemption of creation units, which range from $250 to $3,000 per transaction).
The creation and redemption process helps to ensure that the market price of an ETF share does not vary substantially from the ETF’s NAV.71
See, e.g., Understanding the ETF creation and redemption mechanism, Charles Schwab (2022), https://perma.cc/3WAP-GSS3.
Id. The AP earns virtually risk-free the $1 difference between the short sale proceeds and the acquisition cost of the ETF shares.
Similarly, if an ETF’s NAV is $9 and the ETF share price is $10, an AP can short the ETF shares for $10, purchase the underlying basket of securities of the ETF for $9, and then create additional ETF shares that can be used to close the short sale, thereby generating a profit of $1.73
Id.
The creation and redemption process gives ETFs certain structural advantages over mutual funds. Since APs pay a fee to create and redeem ETF shares, these costs are shifted from the ETF and its shareholders to the APs and indirectly to the purchasing ETF shareholders. Although the purchasing or selling ETF shareholder bears bid-ask spreads and brokerage fees, many ETFs can now be purchased with no commissions.74
Some fund families, such Vanguard and Fidelity, offer commission-free ETFs for persons with a brokerage account. See, e.g., ETF fees and minimums, Vanguard, https://perma.cc/BE7J-JJ7C (no commission for Vanguard ETFs if purchased in Vanguard brokerage account) and iShares ETFs, Fidelity, https://perma.cc/XMV9-7GEL(no commissions for iShares ETFs if purchased in Fidelity brokerage account). Although these arrangements eliminate brokerage commissions, the investor still bears any bid-asked spread.
ETFs are required to post online a table showing the number of days during the most recently completed calendar year and the most recently completed calendar quarters the ETF traded at a premium or discount. ETFs are also required to post a line graph showing the actual premiums and discounts. 17 C.F.R. § 270.6c-11(c)(1)(ii) and (iii). In situations of market stress, bid-asked spreads can widen, and the ETF share price can diverge significantly from NAV. For example, on April 9, 2020, the iShares iBoxx $ High Yield Corporate Bond ETF traded at a premium of 4.59%; on March 26, 2020, the premium was 3.25%. See iShares iBoxx $ High Yield Corporate Bond ETF, iShares by BlackRock, https://perma.cc/27LK-UHVC. If there is insufficient interest in the ETF, it can become a so-called “zombie” fund, which are generally characterized by low AUM and trading volume. See, e.g., Guillaume Poulin-Goyer, Understanding Zombie ETFs, Investment Executive (Feb. 4, 2020), https://perma.cc/P4T2-F4W8(describing zombie ETFs as funds ‘living dead’ due to their low trading volume and low assets).
When a mutual fund shareholder invests or requests redemption of its shares, any creation and redemption costs are borne by all remaining mutual fund shareholders. These costs include record-keeping, and transaction costs from sales and purchases of assets. Mutual fund shares can generally be purchased and redeemed without any fees,76
Although a mutual fund can levy a front-end or back-end load on purchasing and selling shareholders, such loads are increasingly rare.
For example, the largest mutual fund in the United States is the Vanguard 500 Index Fund Admiral Shares (VFIAX ticker) which requires a minimum investment of $3,000, whereas the ETF of the same fund has a minimum investment of one share. See VFIAX Vanguard 500 Index Fund Admiral Shares, Vanguard (Oct. 10, 2022), https://perma.cc/S757-34ZE. After the initial investment in a fund with a minimum investment requirement, subsequent investments can be of any size.
When a mutual fund experiences net redemptions—redemptions greater than contributions—the fund can be forced to sell assets to obtain cash to pay redeeming shareholders.78
If contributions equal or exceed redemptions, contribution proceeds can be used to pay the redeeming shareholders. Mutual funds often retain a cash balance with which to satisfy redemptions, but these cash balances can be a drag on fund returns. ETFs do not have to retain such balances, because they generally satisfy redemption requests in-kind.
If not all of the underlying assets are liquid, which can occur especially in a bond mutual fund, a run on the fund can cause the fund to first sell the liquid assets to meet redemptions leaving only illiquid and difficult-to-sell assets in the fund. A notable example of this occurred in 2015 when Third Avenue Focused Credit Fund suspended redemptions. See, e.g., Matt Hougan, ETFs Solve Mutual Bond Fund Problem, ETF.com (Dec. 14, 2015), https://perma.cc/FXE7-NVY6.
Unlike mutual funds, ETFs do not have to sell shares to satisfy redemption requests. Rather, ETFs distribute securities in kind. Although the economic effect of selling publicly traded securities and distributing the cash to a redeeming shareholder is identical to distributing those same securities to a redeeming shareholder, a sale of securities is a taxable event for the fund, but an in-kind distribution is tax-free under Section 852(b)(6). Through in-kind redemptions, ETF managers can distribute, tax free, low-basis shares and thereby reduce overhang and future fund-level taxable gains.
Section 852(b)(6) now functions as an enormous tax subsidy for the ETF industry.79
Section 852(b)(6) is listed as a tax expenditure, but one for which projected revenue changes are unavailable. Staff of Joint Comm. on Tax’n, 116th Cong., Estimates of Federal Tax Expenditures for Fiscal Years 2020–2024, JCX-23-20, at 22 (Joint Comm. Print 2020). The Joint Committee of Taxation, however, has estimated that repeal of Section 852(b)(6) would bring in over $200 billion in tax revenue over the next 10 years. Lim & Rubin, supra note 24.
When Congress enacted the predecessor to Subchapter M in the Revenue Act of 1942, it subjected RICs to corporate tax, but because of the deductions for dividends paid, a RIC avoided corporate tax by distributing its gains and income as dividends. Congress did not need to specifically address the treatment of in-kind distributions of property in redemptions because under the General Utilities doctrine such distributions were not taxable.80
Gen. Utils. & Operating Co. v. Helvering, 296 U.S. 200, 206 (1935). Congress extended the same non-recognition rule in the case of liquidations. I.R.C. §§ 336(a), 337(a) (1954) (corporation does not recognize gain or loss on the distribution of property in liquidation or the sale of property within a twelve-month period of adoption of liquidation). Notwithstanding the general non-recognition rules, gain was required to be recognized on the distribution of LIFO inventory and property with liabilities greater than basis, and on the distribution of installment obligations in liquidations. Id. §§ 311(b)–(c), 336. The General Utilities doctrine, originally codified in Section 311(a) of the Internal Revenue Code of 1954, remains in the Code, but it no longer applies to distributions of appreciated property. 26 U.S.C. § 311(b).
I.R.C. § 311(a)(2) (1954) (corporation does not recognize gain or loss on distribution of property in ordinary distribution or redemption); id. at §§ 336(a), 337(a) (1954) (corporation does not recognize gain or loss on the distribution of property in liquidation or the sale of property within 12-month period of adoption of liquidation).
In 1969 Congress began to carve back the General Utilities doctrine with the enactment of former Section 311(d)(1), which required a corporation to recognize gain on the distribution of appreciated property to a shareholder in redemption of its shares.82
Tax Reform Act of 1969, Pub. L. No. 91-172, sec. 905(a), § 311(d)(1), 83 Stat. 487, 713 (amended in 1986).
Clifford L. Porter, Redemption of Stock with Appreciated Property: Section 311(d), 24 Tax Law. 63, 63–64 (1970). The article was The Great Tax-Free Cash-In: The Insurance Companies Are Getting imaginative about the Big Unrealized Capital Gains in Their Investment Portfolios, Forbes, Nov. 1, 1969, at 52. In 1968, the IRS ruled that a corporation would not recognize gain on the distribution of appreciated shares held as investment property in redemption of its shares. The stock was offered pro rata to all shareholders, and shareholders owning 35% of the distributing corporation’s stock accepted the offer.
S. Rep. No. 91-552 at 279 (1969).
The legislative history noted Congress’s concern with avoiding tax on the distribution of appreciated property by a corporation in redemption of its shares, but it is puzzling why Congress did not make all transfers of appreciated property out of corporate solution taxable. This provision applied to both redemptions that were treated as ordinary distributions and sales or exchanges, but notably, it did not apply to ordinary distributions such as dividends or to distributions in complete or partial liquidations.85
H. R. Rep. No. 91-782 at 333 (1969). Certain redemptions were excluded, including complete redemptions of 10%-or-more shareholders, split-offs of 50%-or-more subsidiaries, distributions pursuant to antitrust decrees, redemptions under Section 303, and certain redemption distributions to private foundations. Tax Reform Act of 1969, Pub. L. No. 91-172, sec. 905(a), § 311(d)(2)(A)–(G), 83 Stat. at 714.
In the same legislation, but without any discussion in the legislative history, Congress exempted RICs from the gain recognition requirement if the distribution was “ . . . in redemption of its stock upon the demand of the shareholder.”86
Tax Reform Act of 1969, Pub. L. No. 91-172, sec. 905(a), § 311(d)(2)(G), 83 Stat. at 714.
The IRS has permitted closed-end funds to redeem their shares subject to certain more restrictive circumstances than mutual funds. See infra Part X.C.
See Porter, supra note 83, at 79.
Although Congress may have been concerned in 1969 that taxing in-kind distributions could have subjected RICs to double taxation,89
See Porter, supra note 83, at 79. This observation may not be entirely accurate, because even if distributions were taxable, the recognized gains would not be subject to entity-level tax, provided the RIC distributed the gains as a dividend.
Under the 1940 Act, open-end funds issue “redeemable securities,” which are defined to be a security “under the terms of which the holder, upon its presentation to the issuer . . . is entitled . . . to receive approximately his proportionate share of the issuer’s current net assets, or the cash equivalent thereof.” 15 U.S.C. § 80a-2(a)(32). Details on a fund’s right to pay redemptions in-kind are disclosed in Form N-1A, Item 11(c)(8) and a fund’s formation documents, e.g., articles of incorporation or declaration of trust. N-1A Items 22 and 23 also address redemption rights. Form N-1A is used by open-end funds to register under the 1940 Act and offer their shares under the Securities Act of 1933.
In the Tax Reform Act of 1986, Congress finally eliminated any remaining vestiges of the General Utilities doctrine by requiring a corporation to recognize gain on the distribution of appreciated property in an ordinary distribution, redemption, or complete liquidation.91
I.R.C. § 311(b) (distribution of appreciated property as an ordinary distribution taxable); id. at § 336(a) (distribution of appreciated property in a complete liquidation taxable). Section 311(b) applies to distributions described in Sections 301–07, which includes ordinary distributions (generally treated as dividends) under Section 301 and distributions in redemption of a corporation’s shares that are treated as exchanges under Section 302(a). An important exception to this rule is Section 355, which permits a corporation to distribute stock or securities of a controlled corporation to its shareholders in a spin-off, split-up, or split-off without the recognition of gain or loss. I.R.C. § 355(c). Another exception is for property distributed to an 80%-or-more corporate shareholder in a corporate liquidation. Id. § 337(a).
Compare I.R.C. § 311(d)(2)(E) (1982) (amended 1986), with Tax Reform Act of 1986, Pub. L. 99-514, sec. 631(e)(11), § 852(b), 100 Stat. 2085, 2274 (codified as amended at I.R.C. § 852(b)(6)).
In promulgating rules for investment companies to manage their liquidity risks in 2016, the SEC stated that “most funds often consider redemptions in kind to be a last resort or emergency measure.” Investment Company Liquidity Risk Management Programs, 81 Fed. Reg. 82142, 82210 (Nov. 18, 2016) (codified at 17 C.F.R. pts. 270, 274) [hereinafter SEC Liquidity Management].
VI. The Mutual Fund Relief Valve of Section 852(b)(6) Becomes the ETF Tax Bonanza
TOPOne justification that has been put forth by regulators is that the in-kind redemption rule functions as a sort of relief valve that protects a fund from having to sell assets at “fire sale” prices when faced with significant redemptions.94
Michael S. Piwowar, Comm’r, SEC, Remarks at the 2015 Mutual Funds and Investment Management Conference (Mar. 16, 2015). See also SEC Liquidity Management, supra note 93.
To assure smaller investors that they will not receive in-kind distributions, most mutual funds have committed to pay certain redeeming shareholders in cash. Under Rule 18f-1, originally adopted in 1971, an open-end fund may elect to commit to pay all redemption requests in cash limited to the lesser of $250,000 or 1% of the NAV of the fund for each shareholder during any ninety-day period.95
17 C.F.R. § 270.18f-1(a) (2017). The irrevocable election is filed on Form N-18F-1 and must be disclosed in either the prospectus or statement of additional information. It is also required to be disclosed on Form N-1A, Item 23(d).
See Vikas Agarwal, Honglin Ren, Ke Shen, and Haibei Zhao, Redemption in Kind and Mutual Fund Liquidity Management, Rev. of Fin. Stud. (forthcoming) (finding that from 1997 to 2017, approximately 70% of funds permitted in-kind redemptions).
When assets are contributed to an ETF, the APs will almost always recognize gain or loss, because the APs will not be in control of the ETF,97
To contribute appreciated property tax free to a corporation, the transferor(s) must be in control of the corporation immediately after the exchange. I.R.C. § 351(a). Control is defined to be at least 80% of the combined voting power of all classes of voting stock. I.R.C. § 368(c).
I.R.C. § 852(b)(6) (Section 311(b), which requires a corporation to recognize gain on the distribution of appreciated property, does not apply to a RIC in a redemption of its shares).
The ETF could only recognize the losses if they were not subject to the wash sales limitation of Section 1091.
Treas. Reg. § 1.1012-1(c) (default rule for basis of stock sold is FIFO, but specific identification permitted).
For example, at the end of March 31, 2021, the iShares Russell Mid-Cap ETF had $1.132 billion of capital loss carryforwards and $9.944 billion of unrealized gains, BlackRock, iShares 2021 Annual Report 127 (2021), and it realized $1.354 billion of gains from in-kind distributions, id. at 105. It is not clear why a RIC cannot use an NOL but can carryover a capital loss. I.R.C. § 852(b)(2)(B) (stating that no NOL deduction is permitted in computing investment company taxable income).
The combination of the managerial realization and specific identification options coupled with the exemption of Section 852(b)(6) has resulted in equity ETFs distributing virtually no capital gains dividends over the last decade despite record economic gains and significant portfolio adjustments.102
The largest and oldest ETF, SPDR S&P 500 ETF, has never made a capital gains distribution in 24 years. Zachary Mider, Rachel Evans, Carolina Wilson, and Tom Langerman, Hop In, Hop Out, Make Taxes Disappear, Bloomberg Businessweek, Apr. 1, 2019, at 26, 27.
The returns were obtained using an S&P 500 Return Calculator using starting month and ending month of January, starting year of 2011, and ending year of 2020. The returns were with dividends reinvested. See S&P 500 Return Calculator, with Dividend Reinvestment, DQYDJ, https://perma.cc/J5RT-8WAR.
Eighty of the companies were removed because of mergers and acquisitions. List of S&P 500 Companies, Wikipedia (Oct. 4, 2022), https://perma.cc/LG8F-YXDA;see also Adriana Z. Robertson, The (Mis)Uses of the S&P 500, 2 U. Chi. Bus. L. Rev. 137, 160–63, 64 (finding that constituents of S&P 500 “change substantially over time”).
Equity ETFs and mutual funds typically distribute ordinary dividends, which consist of a fund’s investment income after expenses, such as dividends, short-term capital gains, interest, and securities lending fees. To the extent that the dividends received by a fund are qualified dividends, the fund shareholders may treat the corresponding portion as qualified dividends.105
I.R.C. § 854(b)(1)(B) (qualified dividends). The fund shareholder must also satisfy the holding period rules in Section 246(c) to treat any dividend as a qualified dividend. I.R.C. § 1(h)(11)(B)(iii) (dividend is qualified dividend only if holding period rules of Section 246(c) are satisfied, with 45 days replaced by 60 days and 91-day period replaced by 121-day period). Qualified dividends are dividends received from U.S. corporations and certain foreign corporations. I.R.C. § 1(h)(11)(B)(i).
The quantum of the tax benefits of Section 852(b)(6) is easily observed in the fund-level disclosure of a fund’s taxable gains and the realized but not recognized gains on in-kind distributions. A fund’s statement of operations breaks out the realized gain and losses, including those arising from in-kind redemptions. The annual reports also provide a fund’s built-in gains and losses. These reports demonstrate that the tax benefits of Section 852(b)(6) are staggering.
Annex 1 lists the largest (by AUM) twenty-five equity ETFs as of August 15, 2021, from etf.com. These twenty-five funds realized $208 billion of gains from in-kind redemptions for the most recently ended fiscal year, but they distributed $0 of capital gains.
Even while distributing $817 billion via in-kind redemptions, these funds still had cumulatively $1.25 trillion of unrealized gains. It seems that significant positive returns across U.S. equity markets prevented most of the funds from being able to use Section 852(b)(6) to eliminate fund-level built-in gains, although five funds had net built-in losses. The funds with built-in losses realized $48 billion of gains in in-kind redemptions, which is about 25% of the total realized gains from in-kind redemptions of the twenty-five funds.
Many mutual funds that followed comparable investment strategies to these ETFs, but that could not avail themselves of the benefits of Section 852(b)(6), had significant taxable capital gain distributions. Consequently, the after-tax returns to the taxable mutual fund shareholders were less than the after-tax returns to the taxable ETF shareholders.
It is unquestionable that Section 852(b)(6) has imbued ETFs with a significant tax advantage over mutual funds. According to one academic study covering the period from 1993–2017, ETFs distribute annually only 0.1% of capital gains compared to 3.44% for active mutual funds and 1.76% for index mutual funds.106
Moussawi, supra note 12, at 4, 5.
Ben Johnson and Alex Bryan, Measuring ETFs’ Tax Efficiency Versus Mutual Funds, Morningstar (Aug. 7, 2019), https://perma.cc/JL4E-E659.
These differences arise even for funds with the same sponsor. For example, the investment advisor Blackrock offers the ETF iShares Russell 1000 ETF (fund ticker “IWB”) and the mutual fund iShares Russell 1000 Large-Cap Indx Inv A (fund ticker “BRGAX”, Class K), both of which aim to replicate the return of the Russell 1000 index.108
The Russell 1000 tracks the returns of the highest ranking 1,000 stocks, on a capitalization-weighted basis, of the Russell 3000, which aims to track the return of the entire U.S. stock market. FTSE Russell, 2019 Russell US Indexes Reconstitution 4 (2019), https://perma.cc/D2LC-HQ49.
The following table shows that the annual pre-tax returns ending in 2020 of both funds were virtually identical, with most of the difference being attributable to the difference in expense ratios of seven basis points (0.15% for IWB and 0.08% for BRGAX).109
The difference between the two returns were, in four of the five years, actually a bit less than the difference in the expense ratios.
Annual Returns (%)
BRGAX (K Class) | |
2016 |
11.92 |
2017 |
21.60 |
2018 |
-4.85 |
2019 |
31.28 |
2020 |
20.84 |
IWB | |
2016 |
11.91 |
2017 |
21.52 |
2018 |
-4.91 |
2019 |
31.26 |
2020 |
20.8 |
BRGAX (K Class) - IWB | |
2016 |
0.01 |
2017 |
0.08 |
2018 |
0.06 |
2019 |
0.02 |
2020 |
0.04 |
2016 |
2017 |
2018 |
2019 |
2020 |
|
---|---|---|---|---|---|
BRGAX (K Class) |
11.92 |
21.60 |
-4.85 |
31.28 |
20.84 |
IWB |
11.91 |
21.52 |
-4.91 |
31.26 |
20.8 |
BRGAX (K Class) - IWB |
0.01 |
0.08 |
0.06 |
0.02 |
0.04 |
The difference in the recognized gains was mostly likely due to portfolio changes or gains realized to pay redeeming shareholders. Since both IWB and BRGAX track the same index, they must adjust their portfolios when the index changes. In 2018, 2019, and 2020, the Russell 1000 added fifty-five, forty-seven, and fifty-four companies and deleted thirty-six, twenty-one, and forty-three companies, respectively, from the index, which in turn required portfolio changes by BRGAX and IWB.110
FSTE Russell, 2019 Russell US Indexes Reconstitution, 4, https://perma.cc/KW8K-V6M4.Additions generally are not taxable events.
If shares are depreciated, the fund can generally recognize any losses, subject to the wash sales limitation of Section 1091. These losses can be netted against gains in determining a fund’s net capital gains and investment income. If a fund has a net capital loss, it can be carried over indefinitely and used against gains in subsequent years, subject to certain limitations. I.R.C. § 1212(a)(3).
As of March 31, 2021, IWB had $613 million of capital loss carryovers compared to net assets of $27 billion.
But how can an ETF that holds appreciated assets and must make portfolio adjustments do so without recognizing gain? For instance, Annex 1 shows that of the top twenty-five equity ETFs, twenty had net built-in gains. Possible explanations are that the portfolio changes were only of securities whose net built-in losses were greater than the net built-in gains, or that the ETF had sufficient capital loss carryovers to offset any realized gains.113
Annex 1 shows that 100% of the top 25 equity ETFs had capital loss carryovers, and the total capital loss carryovers were $133 billion.
The most likely explanation is that ETF fund managers are relying on heartbeat trades, a mechanism that exploits Section 852(b)(6) to ensure that portfolio adjustments, whether arising from mergers, index changes, or a manager’s decision to alter the portfolio, can be done without the recognition of gain. Heartbeat trades have become a tax pathology built on Section 852(b)(6).
VII. Exploiting Section 852(b)(6): Heartbeat Trades and Capital Structure Arbitrage
TOPImagine that you own a diversified portfolio of shares of ten different companies worth $10 million, and one of the companies, whose shares are significantly appreciated and worth $1 million, is on the verge of being acquired in a taxable transaction. Shortly before the acquisition closes, a bank offers to exchange the $1 million of appreciated shares of the target company in your portfolio for $1 million of additional shares of the remaining nine companies in your portfolio in the same proportion as your portfolio. Immediately after the exchange, you would be in the same position as if you had received $1 million of cash from the acquisition of the appreciated shares and reinvested proportionately the $1 million in additional shares of the remaining nine companies in your portfolio.
For an individual investor, this exchange would clearly be a taxable exchange under Section 1001, because the appreciated shares are being exchanged for non-like-kind assets—the shares of the remaining companies in the portfolio.114
I.R.C. § 1001(c) (generally requiring realized gain and loss on the sale or exchange of property to be recognized); Treas. Reg. § 1.1001-1(a) (gain or loss is realized from the exchange of property for other property differing materially).
For detailed analysis of how Vanguard used heartbeat trades to eliminate the gain on $1 billion of shares of Monsanto on the eve of its taxable acquisition by Bayer, see Zachary R. Mider, Annie Massa, and Christopher Cannon, Vanguard Patented a Way to Avoid Taxes on Mutual Funds, Bloomberg (May 1, 2019), https://perma.cc/9G8N-ESYV.
The term “heartbeat trade” was coined by financial journalist Elizabeth Kashner in a series of articles published in 2017 and 2018.116
Kashner, supra note 18.
Mider, supra note 102, at 26.
A procedure to detect heartbeat trades based on inflows and outflows is set out in Moussawi, supra note 12, at 47.
There are various scenarios for which a fund might employ heartbeat trades. For instance, a fund may need to dispose of appreciated securities because a portfolio company may be on the verge of being acquired in a taxable transaction, the constituent shares of a fund’s tracking index could be slated to change, or a particular strategy followed by the fund, such as momentum, minimum volatility, value, or size, requires periodic readjustment or rebalancing of its portfolio.119
The S&P 500 index, for example, is generally rebalanced quarterly and reconstituted annually in September. See S&P Dow Jones Indices, S&P U.S. Indices Methodology 26 (Mar. 2020); see also BlackRock ETFs Get Billions Via Trades Hinting at Tax Avoidance, Bloomberg (June 24, 2021), https://perma.cc/T82K-7FAY.
A rebalancing of an equity index can consist of adding entirely new shares, increasing positions in current shares, deleting entire positions in current shares, and reducing positions in current shares.
If shares in an ETF’s portfolio have declined or the ETF has had significant inflows and outflows and has been able to distribute appreciated assets, the ETF may not hold significantly appreciated assets. If, however, the market has appreciated and the ETF has not experienced significant inflows and outflows, the ETF may own significantly appreciated assets. As shown in Annex 1, even with the ability to distribute tax free appreciated securities using Section 852(b)(6), twenty of the top twenty-five equity ETFs still hold significantly appreciated assets.121
The twenty funds had built-in gains of $1.271 trillion. The remaining five funds had total built-in losses of only $20.5 billion.
To avoid taxable gains when making portfolio changes, the ETF works with APs to structure related inflow and outflow trades to remove the appreciated securities from the fund tax-free via in-kind redemptions.122
See Kashner, Players, supra note 18 (finding that creation and redemption trades come from “ETF trading desks at capital market firms.”). Kashner also notes that although an asset manager or sponsor could invest in one of its portfolio managers and do the same trade, it is prohibited from doing so under the self-dealing rules of Section 17 of the 1940 Act.
See Kashner, Heartbeat, supra note 18 If some of the shares that the ETF wishes to dispose of have built-in losses, the ETF could sell those in the market to generate fund-level losses to use against future gains.
If these two nominally separate transactions are respected for tax purposes, the distributions of the unwanted securities would be tax-free under Section 852(b)(6), and the fund would have been able to make tax-free fund-level portfolio adjustments.124
The AP would recognize any gain or loss on the contribution of the creation portfolio, as the transaction would not qualify under Section 351. The AP would recognize gain or loss on the difference between the value of the ETF shares at the time of contribution and the value of the securities received in the in-kind distribution. I.R.C. § 1001(c) (generally requiring realized gain and loss on the sale or exchange of property to be recognized); Treas. Reg. § 1.1001-1(a) (gain or loss is realized from the exchange of property for other property differing materially). The exchange of the ETF shares for the custom portfolio would be treated as a sale or exchange under Section 302(a)(5). I.R.C. § 302(a)(5) (redemption by publicly offered RIC treated as sale or exchange). An ETF would satisfy the definition of publicly offered RIC since its shares are regularly traded on an established securities market. I.R.C. § 67(c)(2)(B)(i)(II).
The ability to carry out heartbeat trades is dependent on the ETF being able to distribute a non-pro rata selection of its portfolio in redemption of its shares. In promulgating Rule 6c-11 in 2019, the SEC specifically permitted ETFs to distribute securities via a custom basket, which is defined to be “a basket that is composed of a non-representative selection of the [ETF’s] portfolio holdings.”125
17 C.F.R. § 270-6c-11(a)(1)(A) (2019). A basket consists of the securities or other asset for which an ETF issues creation units (shares) or for which it redeems creation units. Id.
Id.
Prior to 2012, the SEC did not impose limitations on the use of custom baskets by ETFs, but in 2012, the exemptive orders on which ETFs relied generally required that ETF redemption baskets be a pro rata slice of an ETF’s portfolio holdings, with certain exceptions.127
Exchange-Traded Funds, 83 Fed. Reg. 37332, 37355 (proposed Jul. 31, 2018). This change in SEC practice created a disparity between ETFs that were able to use custom baskets and those that were not.
Rule 6c-11, supra note 10, at 57,184. See, e.g., The Dreyfus Corp., Application for an Order under Section 6(c) of the Investment Company Act of 1940 (Form 40-APP/A) (Sep. 28, 2016).
Rule 6c-11, supra note 10, at 57184.
The SEC had limited the use of custom baskets because of its concern that ETFs could potentially harm shareholders either through APs cherry-picking certain securities in a redemption transaction or dumping unwanted securities into ETFs in a contribution transaction.130
Exchange-Traded Funds, 83 Fed. Reg. at 37355 (proposed Jul. 31, 2018).
Id.
Id.
Recognizing the potential benefits to ETFs and their shareholders of employing custom baskets, but also being cognizant of the potential for abuses, the SEC now permits virtually unfettered use of custom baskets. However, ETFs using these custom baskets must adopt and implement detailed written procedures that “set forth detailed parameters for the construction and acceptance of custom baskets that are in the best interest of the [ETF] and its shareholders . . . .”133
17 C.F.R. § 270-6c-11(c)(3)(i) (2019). The ETF must also specify the titles or roles of the ETF’s investment adviser’s employees who are required to review compliance with the specified parameters. 17 C.F.R. § 270-6c-11(c)(3)(ii) (2019).
17 C.F.R. § 270-6c-11(a)(2) (2019).
It is not readily obvious how an AP is compensated for tying up its capital for the duration of the related creation and redemption trades since all transactions between the AP and ETF are done at NAV. The AP must be able to hedge any financial exposure and earn a profit to cover its capital and hedging costs. An AP would not enter into the heartbeat trade without being able to hedge its price risks and cover its capital and execution costs.
Kashner dissects one particular heartbeat trade and demonstrates how the AP and its trading desks can profit on heartbeat rebalance transactions.135
Kashner, The Heartbeat of ETF Tax Efficiency Part Three: Trade Forensics, supra note 18.
In the transaction analyzed by Kashner, for the appreciated shares included in the redemption basket, the AP and its trading desk profited by shorting the shares in the redemption basket at the volume weighted average price (VWAP) and receiving the shares in the redemption basket at their closing prices.136
Id. at 14. The shares received are delivered to close the short sales.
Id.
The costs of these trades may be substantial, especially for an ETF that follows a strategy or an index that requires frequent rebalancing. In the trade analyzed by Kashner, the total profits of the parties working with the ETF were approximately six basis points, which is approximately twenty-four basis points annualized if the ETF rebalances quarterly.138
Id.
See, e.g., Dimensional ETF Trust, Registration Statement (Form N-1A) 30–36 (June 25, 2020) (discussing of creation and redemption process, including the use of custom baskets, but not discussing potential costs to ETFs). For tax-exempt investors, these trades may not be beneficial.
The prior subsection discussed how ETFs have employed highly structured heartbeat redemption transactions to ensure that virtually no equity ETF pays any capital gains taxes on portfolio adjustments. Individual investors, however, holding identical securities cannot make the same in-kind portfolio adjustments via heartbeat trades without recognizing gains and losses. Mutual funds also generally cannot use heartbeat trades to offload tax free appreciated securities via in-kind redemptions.
Given the significant benefits of Section 852(b)(6) for long-term taxable investors, creative planners have devised structures that permit ETFs to leverage Section 852(b)(6) and siphon off capital gains from related mutual funds through the Section 852(b)(6) redemption mechanism. The most well-known capital structure arbitrage is that employed by Vanguard.140
Vanguard applied for and was granted exemptive relief under Section 6(c) of the 1940 Act for exemptions under various sections of the 1940 Act, including Section 2(a)(32) (definition of redeemable security), Section 18(f)(1) and (i) (prohibition against issuing senior securities), 22(d) (prohibition against dealers selling redeemable security except at a price described in the prospectus), and Section 17(a)(1) and (a)(2) (prohibition of selling to or buying from an affiliate). See Vanguard Index Funds, Investment Company Act Release No. 24680, 65 Fed. Reg. 61005, 61007 (Oct. 13, 2000); Vanguard Index Funds, Investment Company Act Release No. 24789, 65 Fed. Reg. 79439 (Dec. 19, 2000).
Vanguard structures most of its ETFs as a separate share class of their related mutual funds.141
As of July 2, 2021, Vanguard has eighty-two ETFs, sixty-two equity ETFs, and twenty fixed income ETFs. See Discover Vanguard ETFs, Vanguard (Oct. 4, 2022), https://perma.cc/7ZRL-D85A.
The mutual fund ticker for the Admiral class shares is VTSAX, and VTI for the ETF shares. The fund has six classes of shares, five classes of mutual fund shares, and one class of ETF shares. The various mutual fund shares vary by their investment fees and investment minimums.
Structuring ETFs as a mutual fund share class provides potential benefits for both ETF and mutual fund shareholders. Since the ETFs will be part of a larger single asset base, the management expenses will be smaller than if an additional fund had to be created.143
U.S. Patent No. 6,879,964 B2 col. 3 (issued Apr. 12, 2005) [hereinafter Vanguard Patent]; Ben Johnson, Vanguard’s Unique ETF Structure Presents Unique Tax Risks, Morningstar (Jan. 15, 2020), https://perma.cc/44LP-FPC7.
Vanguard Patent, supra note 143, at col. 3.
Id. at cols. 3 and 4.
Perhaps the largest benefit of the dual class structure is the ability for the fund to distribute low-basis assets to APs when they redeem their ETF shares.146
Id.
Annex 1 lists the largest Vanguard equity ETFs and the percentage of common stock the ETF shares represent. The smallest is the Vanguard Total International Stock Fund at 7.71%, and the largest is the Vanguard Information Technology ETF at 87.65%. The mean and median percentages are around 49%.
The dual-class structure presents some possible tax risks to ETF shareholders that would not be present if the ETF and mutual fund shareholders invested in separate funds. Large redemptions from mutual fund shareholders could cause the fund to have to liquidate appreciated positions to pay the redeeming shareholders, and any taxable gains would be shared among both mutual fund and ETF shareholders.147
Johnson, supra note 143 (describing the risk of mass exodus on mutual fund shareholders).
Id.
Id.
A large exit of mutual fund shareholders would probably only occur if the market dropped significantly. In such case, however, the amount of overhang and potential tax liability would also decline.
The dual class structure also facilitates converting mutual fund shares to ETF shares. Since both share classes are issued by the same corporation, any exchange of mutual fund shares for ETF shares is tax-free under Section 1036, which permits a shareholder to exchange common stock of a corporation for common stock of the same corporation.151
In its prospectuses, Vanguard touts this option privilege. See Vanguard U.S. Stock ETFs, Prospectuses (Form 497K) (Apr. 29, 2021), https://perma.cc/XL2Y-F9C2.This is a one-way privilege, and ETF shareholders may not exchange their shares for mutual fund shares. See Vanguard Index Funds, Investment Company Act Release No. 24680, 65 Fed. Reg. 61005, 61007–61008 (Oct. 13, 2000).
Vanguard filed a patent for this structure in 2001, which was granted in 2005.152
Vanguard Patent, supra note 143.
Yale, supra note 16, at 407 n.53. The patent will expire in May 2023. See Adrian D. Garcia, Vanguard’s special ETF patent expires next year. Does it matter? Financial Times (Apr. 12, 2022).
A sponsor considering adding an ETF share class to its mutual funds must apply for exemptive relief from Section 18(f)(1) and (i) of the 1940 Act. Section 18(f)(1) prohibits issuance of a class of senior security, which includes a stock class having priority over other classes in distribution of assets or payment of dividends. Section 18(i) requires that all investment company shares have equal voting rights. The SEC rejected applying Rule 6(c)-11 to share class ETFs on the grounds that share class ETFs may give rise to differing costs to the underlying portfolio, but these costs are shared by all shareholders. The SEC acknowledged that by not doing so it was potentially creating an uneven playing field, but it opted to continue to require a fund wishing to offer a share class ETF to seek exemptive relief. Rule 6c-11 at 57, 196.
The combination of the dual class structure and heartbeat trades has been a tax boon for these Vanguard funds and their shareholders. A 2019 article in Bloomberg Businessweek detailed that since Vanguard added ETF share classes to some of its mutual funds and engaged in heartbeat trades, the funds stopped distributing any capital gains to any of their shareholders.155
Mider et al., supra note 18.
Id.
The article further highlights a massive heartbeat trade carried out by Vanguard Total Stock Market Index fund in connection with the taxable acquisition of Monsanto Co. by Bayer in 2018. On the verge of the acquisition, an AP purchased $1 billion of the ETF VTI shares and two days later, it redeemed the same amount, which represented most of the $1.3 billion of Monsanto shares owned by the fund.157
Id.
Id.
Vanguard, with its dual class capital structure overlaid with heartbeat trades, is the posterchild of the tax infirmities of Section 852(b)(6). For long-term Vanguard equity ETF shareholders, ETFs potentially offer indefinite deferral of fund-level capital gains, even gains arising from portfolio adjustments in rebalancing trades. The dual class structure enables Vanguard mutual fund shareholders to also enjoy the same tax deferral as its associated ETF shareholders. It is certain that other fund families will consider adopting a similar capital structure to extend the benefit of heartbeat trades and in-kind redemptions to their mutual fund shareholders.159
Eaton Vance has developed a similar offering, NextShares, which is an exchange traded managed fund. Like an ETF, a retail investor buys and sells on an exchange, but the price received or paid is not the market price at the time of sale but the next determined NAV plus or minus a trading cost. Note, no assets leave or are contributed to the fund in the case of retail trades. Like ETFs, APs can create and redeem shares in exchange for a contribution basket, which is a slightly narrower portion of the fund’s portfolio. For a discussion, see Yale, supra note 16, at 428–32.
This Part illustrates how Section 852(b)(6) is exploited by ETFs and APs. The basic redemption and creation mechanism, coupled with the option to realize and carry over losses, reduces fund-level built-in gains and current and future realized gains. Any remaining built-in gain or overhang of an ETF is merely a tax mirage, as custom baskets and heartbeat trades are available to eliminate gains that are about to be realized in connection with index rebalancing, taxable mergers, or other portfolio adjustments. The coup de grâce is adding ETFs as a share class to affiliated mutual funds so that mutual fund shareholders can also share in the in-kind redemption tax spoils.
These tax gambits drive a wedge between the after-tax returns of ETFs and other investment vehicles such as mutual funds without an ETF share class, partnerships, and directly managed accounts. Although these trades satisfy the statutory requirements of Section 852(b)(6), i.e., they are distributions in redemption of a fund’s stock, whether the form and purported tax results of these transactions should be respected is discussed next.
In interpreting statutory tax provisions, courts have developed a panoply of common law doctrines that can be applied to recast the tax treatment of a transaction or series of transactions. These include the substance over form, business purpose, and step transaction doctrines, and they play an especially vital role in the interpretation of U.S. corporate tax provisions.160
The cases, administrative guidance, and commentary on the substance over form doctrine and its corollaries are voluminous. See, e.g., Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts ¶ 4.3.1. (3rd ed. 2021); Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations and Shareholders ¶ 12.02[2][a] (7th ed. 2021).
Although these doctrines are pervasive and regularly applied to transactions by courts, regulators, and tax planners, determining whether they will or should be applied is often far from certain.161
See Bittker & Lokken, supra note 160 (“Unfortunately, it is almost impossible to distill useful generalizations from the welter of substance-over-form cases. The facts of the cases are usually complicated, and it is rarely clear which facts are crucial to the decision and which are irrelevant.”).
Under the substance over form doctrine, the U.S. tax rules are applied to the economic substance of a transaction rather than to its form.162
United States v. Phellis, 257 U.S. 156, 168 (1921) (“We recognize the importance of regarding matters of substance and disregarding forms in applying the provisions of the Sixteenth Amendment and income tax laws enacted thereunder.”).
Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d. Cir. 1968) (listing relevant factors to determine whether debt instrument in form should be treated as equity).
Davant v. Comm’r, 366 F.2d 874, 880 (5th Cir. 1966).
Spicer Acct. Inc. v. United States, 918 F.2d 90, 92–93 (9th Cir. 1990) (distributions to shareholder of S corporation were wages for employment tax purposes).
One variation of the substance over form doctrine is the step transaction doctrine under which ostensibly separate transactions are disregarded or stepped together, and the transaction is taxed in accordance with the resulting aggregated or recharacterized transaction. Courts and the IRS have developed various formulations of the step transaction doctrine that determine when it will be applied: the end result test, the mutual interdependence test, and the binding commitment test. When these tests should be applied, however, is often difficult to determine.166
Martin D. Ginsburg et al., Mergers, Acquisitions, and Buyouts ¶ 608.3.1 (2015) (“[I]t often will be difficult to determine with a high degree of certainty whether a series of related transactions will be stepped together in some fashion for tax purposes.”). New York State Bar Association, Report on the Role of the Step Transaction Doctrine in Section 355 Stock Distributions: Control Requirement and North-South Transactions 6 (Nov. 5, 2013) [hereinafter “NYSBA Step Transaction”] (“Neither the courts nor the Services have clear guidelines for determining which test should apply in a particular situation. Moreover, the boundaries between the tests themselves are not clear, and as a result, they have been applied inconsistently.”).
The binding commitment test is the narrowest formulation of the step transaction doctrine, and it steps together transactions only when there is a legally binding commitment to complete another step or series of steps after a first step is taken.167
See, e.g., Comm’r v. Gordon, 391 U.S. 83, 96 (1968) (refusing to step together the distribution of stock rights representing together 100% of the corporation where the two distributions were separated by almost two years because there was no binding commitment to make the subsequent distribution of 43%); Intermountain Lumber Co. v. Comm’r, 65 T.C. 1025, 1033 (concluding that transfer of property to wholly owned corporation did not satisfy control test of Section 368(c) because transferor had entered into binding agreement to sell 50% of the shares).
See Am. Bantam Car Co. v. Comm’r, 11 T.C. 397, 406 (1947), aff’d 177 F.2d 1235 (5th Cir. 1949), cert. denied, 339 U.S. 920 (1950).
Penrod v. Comm’r, 88 T.C. 1415, 1429 (1987).
As discussed above, heartbeat trades are highly structured, coordinated transactions between APs and ETFs. An ETF communicates with an AP and divulges the names and sizes of the securities positions that the ETF desires to dispose of tax-free via a heartbeat trade. Based on these communications, the AP then acquires a direct position170
The contribution can be securities, cash, or a combination thereof.
If both the AP contribution and redemption transactions were stepped together, heartbeat trades would be treated as an exchange between the ETF and AP of one portfolio of securities or cash (the contribution portfolio) for a portfolio of different securities (the redemption portfolio). Recast as an exchange of non-identical securities, the heartbeat trade would be taxable to both the AP and ETF.171
An AP would be indifferent between an exchange for shares of the ETF or for shares of the custom basket since both transactions would be taxable.
Since there appears to be no explicit binding commitment between the AP and ETF to redeem the AP with the custom basket following the AP’s contribution, the binding commitment test would likely not apply. When courts apply the end result and interdependence tests, they examine the parties’ intent and the time between the initial and subsequent transactions.172
Ginsburg, supra note 166, at ¶¶ 608.3.2.1. and 608.3.2.2.
Without the initial significant contribution by an AP, the ETF would not be able to subsequently distribute via redemption the undesired securities, because the value of shares that are typically redeemed on a given day would be insufficient. Furthermore, it is clear that the AP would not make the outsized initial contribution without planning on requesting redemption of the ETF shares received shortly thereafter. The two transaction legs of a heartbeat trade are clearly related and arguably should be stepped together.173
See also Hodaszy, Section 852(b)(6) Loophole, supra note 26, at 594–98 (stating without significant discussion that heartbeat trades should be treated as taxable exchanges between APs and ETF applying step transaction principles).
Another pillar of the tax common law, especially for corporate transactions, is the business purpose doctrine, under which the form of a transaction will not be respected if there is no business purpose other than tax avoidance.174
The business purpose doctrine is a fundamental requirement for reorganizations. Treas. Reg. §§ 1.368-1(b) (reorganization must be required by business exigencies); 1.368-1(c) (transaction structured as reorganization having no business or corporate purpose is not a plan of reorganization).
293 U.S. 465 (1935).
Putting aside, then, the question of motive in respect of taxation altogether, and fixing the character of the proceeding by what actually occurred, what do we find? Simply an operation having no business or corporate purpose—a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of a preconceived plan, not to reorganize a business or any part of a business, but to transfer a parcel of corporate shares to the petitioner.176
293 U.S. at 469.
Since Gregory, the business purpose enquiry has often been employed as one prong of the economic substance or sham transaction doctrine. Under this approach, a transaction can be treated as a sham and disregarded if either the transaction has no real potential for profits apart from its tax benefits or the taxpayer had no non-tax motives and no legitimate business purpose for entering into the transaction.177
See, e.g., Wells Fargo & Co. v. United States, 957 F.3d 840, 847 (8th Cir. 2020); United Parcel Service of America, Inc. v. Comm’r, 254 F.3d 1014, 1019 (11th Cir. 2001) (restructuring of insurance business by placing it in Bermuda corporation owned by the same shareholders as UPS found to be simply an altered form of bona fide business that had real economic effects and a business purpose).
I.R.C. § 7701(o) (transaction has economic substance only if the transaction changes the taxpayer’s economic position, and the taxpayer has a substantial non-tax (business) purpose for entering into the transaction). Section 7701(o) potentially applies to post-March 31, 2010 transactions. See I.R.S. Notice 2010-62, 2010-40 C.B. 411.
Two cases in the early 2000s, IES Industries, Inc. v. United States179
IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir. 2001), rev’g IES Indus., Inc. v. United States, No. C97-206, 1999 WL 973538, at *2 (N.D. Iowa Sept. 22, 1999).
Compaq Computer Corp. v. Comm’r, 277 F.3d 778 (5th Cir. 2001), rev’g Compaq Computer Corp. v. Comm’r, 113 T.C. 214, 214 (T.C. 1999).
ADRs are publicly traded securities that represent shares of a foreign corporation held in trust by a U.S. bank.
A share trades cum dividend if the purchaser would be entitled to a declared dividend, since the purchaser would be the record date owner. A shares trades ex dividend if the purchaser would not be entitled to the declared dividend since the trade would settle after the record date.
The ADRs were owned by tax-exempt entities, which could not benefit from any foreign withholding tax levied on the dividends: $1 of dividend subject to a 15% withholding tax would be worth $0.85 to the tax-exempt owner. The tax-exempt entity would loan the ADRs to a third party that would sell them cum dividend to the U.S. corporation and then simultaneously repurchase them ex-dividend from the U.S. corporation.183
The purchase legs were made with special, next-day settlement, while the sales legs were made via the standard five-day settlement. Compaq, 133 T.C. at 217. The Compaq trades were broken up into 46 transactions of around 450,000 ADRs and completed in a little over an hour. Thus, Compaq was exposed to market risk for approximately 2-3 minutes. Compaq, 277 F.3d at 780. In the case of IES, the trades took place within hours of each other, sometimes on foreign exchanges, and sometimes when the U.S. market was closed. IES, 253 F.3d at 352.
Compaq had recognized a long-term capital gain of $231 million, and IES had a recognized long-term capital gain in excess of $82 million. Compaq, 113 T.C. at 214; IES, 253 F.3d at 353.
Compaq, 133 T.C. at 223. This is an instance where the price of the $1 of foreign dividends was not $1 but $0.85. Presumably the marginal purchaser could not otherwise use the foreign tax credits.
In both cases, the taxpayers incurred other fees and expenses, and deducted those as well.
The government prevailed in Tax Court against Compaq and in the Iowa District Court against IES. Both lower courts focused on the issue of determining whether the taxpayers had a reasonable possibility of making a pre-tax profit from the transactions. In IES, the Iowa District Court found that the structured trades did not change IES’s economic position and were “solely shaped by tax avoidance consideration, had no other practical economic effect, and [were] properly disregarded for tax purposes.”187
IES, 1999 WL 973538 at *2.
In Compaq, the Tax Court found that the ADR trades lacked economic substance because there was no reasonable possibility of a pre-tax profit. In determining whether there was the possibility of pre-tax profit, the Tax Court rejected including the foreign withholding taxes as additional income and instead analyzed the transaction on a cash flow basis, concluding that the transaction had a net economic loss.188
Compaq, 133 T.C. at 223.
Id. at 224 (noting that the ADR trades were executed at a price determined by agent of the seller of the transaction, were divided into 23 purchase and resale cross-trades within an hour on the floor of the exchange and were executed with non-standard settlement to prevent risk of breaking up the trades).
Both cases, however, were reversed on appeal. In Compaq, the Fifth Circuit Court of Appeals treated the foreign withholding taxes as income from the transactions and found that Compaq had a reasonable possibility of earning a pre-tax profit. This is because the difference between the purchase and sales price was 85% of the dividend, while Compaq received 100% of the dividend, after including the foreign withholding tax.190
There were associated fees and expenses with the transaction. In Compaq, the fees and expenses were about $1.5 million. Compaq, 133 T.C. at 223.
This represents a pre-tax profit of $1.9 million less approximately $640,000 of U.S. taxes.
In IES, the Eighth Circuit Court of Appeals similarly held that the transactions were not shams and should not be disregarded for tax purposes. The court found that the economic benefit to IES was the gross amount of the dividend, and since the price paid exceeded the selling price by the net amount of the dividend, IES made a profit.192
IES, 253 F.3d at 354.
Id. The same circuit court distinguished IES in 2020 in the context of a structured trust advantage repackaged securities transaction (STARS) in Wells Fargo & Co. v. United States, 957 F.3d 840, 847 (8th Cir. 2020). The STARS transaction also involved the treatment of foreign taxes, and the court in Wells Fargo concluded that they were a pre-tax expense rather than a post-tax expense as in IES.
Although the principal issue in determining whether IES and Compaq had the possibility of pretax profit was whether pretax profit should be calculated after the foreign withholding taxes but before U.S. tax or whether both taxes should be treated similarly, and this issue is not present in the case of heartbeat trades, it is possible that an AP may be able to demonstrate that it had a reasonable expectation of economic profit in contributing capital to an ETF and then redeeming the ETF shares received two days or so afterwards. An AP may potentially realize profits on the difference between the cost of the contribution portfolio, to the extent it consists of shares, and the value of the ETF shares received. The AP may also be able to profit from disposing of the shares of the custom basket received from the ETF when the AP redeems.194
See Kashner, The Heartbeat of ETF Tax Efficiency Part Three: Trade Forensics, supra note 18.
Given that an ETF will generally only distribute appreciated assets, it should be able to demonstrate a pretax profit and a change in economic position, since its portfolio will change. Similarly, an ETF may be able to argue that it has a business purpose in engaging in heartbeat trades. For instance, it may be cheaper for the ETF to dispose of the shares of a custom basket through an in-kind distribution instead of selling them on the open market. Also, if the value of the shares of the custom basket is significant, a sale would generate cash that would either have to be reinvested or distributed, which could affect the ETF’s tracking error or generate increased administrative costs and fees. Against this potential benefit, however, the ETF should net costs to the ETF from the AP’s trading activity with respect to the shares distributed in the custom basket.195
ETF registration statements mention custom portfolios, but they do not address any potential costs to the ETF. See, e.g., Dimensional ETF Trust, Registration Statement (Form N-1A) 30–36 (June 25, 2020) (discussing creation and redemption process, including the use of custom baskets, but not discussing potential costs to ETF).
Even if the contribution and redemption transactions are related, and assuming they have insufficient business purposes, it is not clear that they will always be stepped together. In various rulings, the IRS has qualified the application of the step transaction doctrine to related transactions by examining whether the transactions are inconsistent with the purpose and intent of the applicable code provisions.196
See, e.g., Rev. Rul. 2017-9, I.R.B. 1244, and Rev. Rul. 79-250, 1979-2 C.B. 156, modified by Rev. Rul. 96-29, 1996-1 C.B. 50.
In Revenue Ruling 2017-9,197
Rev. Rul. 2017-9, I.R.B. 1244.
The purpose of the south transfer in the ruling is to permit distributing to satisfy the active trade or business test of Section 355(b)(1)(A).
If the two legs of the North-South transaction were stepped together, the transaction could be recast as if parent had transferred property to distributing in exchange for a portion of the shares of controlled that are subsequently received via a spinoff.199
For example, if parent contributed $25 to distributing, and the value of the shares of controlled were $100, parent would be treated as purchasing 25% of the shares of controlled for cash (or other property) and receiving the remaining 75% via distribution. If the two legs are respected as separate transactions, the south transfer would be tax-free under Section 351, and the north spin-off would be tax-free under Section 355, assuming that all of its requirements were otherwise satisfied.
If the property were appreciated, gain would be recognized under Section 1001(c), but any loss would be disallowed or deferred under Section 267(a) or (f).
In determining whether the North-South transactions should be stepped together, the IRS stated that it would examine the “scope and intent underlying each of the implicated provisions of the Code.”201
Rev. Rul. 2017-9, I.R.B. 1244.
Id.
Applying these criteria, the IRS held that each leg should be given independent significance. The south contribution would be respected because it is generally permissible to transfer assets tax-free within the same corporate group to enable a subsequent distribution to qualify under Section 355(b).203
The ruling cited Rev. Rul. 78-442, 1978-2 C.B. 143 (357(c) gain in a Section 351 transfer does not violate the requirement that no gain or loss is recognized if an active trade or business acquired within five years); Rev. Rul. 74-79, 1974-1 C.B. 81 (tax-free liquidation of subsidiary with active trade or business enabled parent to meet active trade or business requirement); and Rev. Rul. 78-330, 1978-2 C.B. 147 (cancellation of debt between a parent and subsidiary prior to the merger of the subsidiary into a related subsidiary so that no gain would be recognized under Section 357(c)(1)(B) would be respected as having independent economic significance “because it resulted in a genuine alteration of a previous bona fide business relationship.”).
Given that the south contribution was respected as a separate transaction, the ruling concluded that Section 355 should apply to the north transaction since “each step provides for continued ownership in modified corporate form [and] the steps do not resemble a sale, and none of the interests are liquidated or otherwise redeemed.”204
Rev. Rul. 2017-9, I.R.B. 1244.
Id.
In Revenue Ruling 2003-51, the IRS had previously applied a similar purposive analysis to multiple related dropdowns under Section 351 and permitted each transaction to be analyzed separately.206
Rev. Rul. 2003-51, 2003-1 C.B. 938.
Had the two transfers been stepped together, the requirements of Section 351 would not have been satisfied because the transferor in the initial dropdown would not have had control of the corporation immediately after the exchange.207
Control is defined as 80% or more of the voting power of all classes of voting stock and 80% or more of the total number of shares of all other classes of stock. I.R.C. § 368(c).
Rev. Rul. 2003-51, 2003-1 C.B. 938.
The purposive approach employed in these rulings perhaps supports an argument that even if the separate legs of the heartbeat trades are clearly related and could otherwise be stepped together and recharacterized as a taxable exchange between the AP and an ETF under traditional step transaction doctrines, the separate legs should be respected. The difficulty in applying a purposive approach, however, is to determine the underlying intent or purpose of a particular Code section.
Section 852(b)(6) exempts a fund from recognizing gain when it distributes appreciated property in redemption of its shares, which occurs in the second leg of a heartbeat trade but also when an AP requests redemption to take advantage of pricing discrepancies between the creation portfolio and NAV. One could argue that since the statute does not impose any restrictions on redemptions by investment companies, an investment company should never recognize gain when distributing appreciated property. The dearth of legislative history and the fact that Section 852(b)(6) predates the first ETF by more than twenty years makes it difficult to extract any definitive purpose or intent from Section 852(b)(6). When the predecessor to Section 852(b)(6) was enacted, however, in-kind distributions by RICs were uncommon and almost certainly not undertaken in connection to related contributions. Consequently, redemptions related to contributions may fall outside of Section 852(b)(6).
In Esmark v. Commissioner,209
90 T.C. 171 (1988), aff’d 866 F.2d 1318 (7th Cir. 1989).
Id at 175.
The primary reason for the tender offer/redemption structure was that Esmark would not recognize gain on the distribution of the Vickers shares, and its shareholders would realize the highest end value for their Esmark shares.211
Id. at 176.
Id. at 187.
Mobil was the successful bidder for the Vickers shares, agreeing to acquire Vickers via a tender offer/redemption transaction. Mobil completed the tender offer for 11.9 million shares, and on the same day and pursuant to an exchange agreement, Esmark redeemed Mobil’s shares for 97.5% of the Vickers stock.
In 1980, when the transaction was completed, the distribution of appreciated stock was generally taxable to the distributing corporation,213
I.R.C. § 311(d)(1) (1982).
I.R.C. § 311(d)(2)(B)(i)–(iii) (1982). The corporation whose stock was distributed had to be engaged in at least one trade or business and not have received property tax free from the parent company that constitutes a substantial part of its assets within the previous five years. Id.
I.R.C. § 311(d)(2)(E) (1982).
The IRS advanced various substance-over-form arguments for treating the redemption as a taxable disposition by Esmark of the Vickers shares, all of which were rejected by the Tax Court. The IRS argued under assignment of income principles that the transaction should be recast as a sale by Esmark to Mobil for cash, with Mobil being obligated to transfer the cash to the redeeming shareholders and Mobil transferring back to Esmark the shares as proof of payment. The Tax Court rejected this argument because the right to share in the proceeds of the deemed sale was not measured by each shareholder’s stake in Esmark, but by how many shares of Esmark each shareholder was willing to tender.216
90 T.C. at 188. The Tax Court also rejected the IRS’s argument that Mobil did not possess the attributes of ownership on the grounds that the tendering shareholders surrendered all incidents of ownership when the tender offer closed and therefore had no right to receive any distributions of corporate assets. Id. at 194. Similarly, responding to the argument that Mobil purchased Vickers for cash and was a conduit for the transfer of the same cash from Esmark to its shareholders, the Tax Court found Esmark could not bind its shareholders to retain or sell their stock, and Esmark was under no obligation to purchase its shares from the public, and therefore Mobil’s purchase of Esmark stock should be respected and Mobil could not be treated as a conduit. Id.
In response to the IRS’s argument that Mobil’s ownership of Esmark was too transitory to be respected, the Tax Court, relying on its decision in Standard Linen Service, Inc., v. Commissioner,217
33 T.C. 1 (1959).
90 T.C. at 189.
Finally, the Tax Court rejected application of the step transaction doctrine, which in this case, the IRS argued, would treat the transaction as a sale of the Vickers shares to Mobil for cash followed by a self-tender offer by Esmark.219
90 T.C. at 196.
Id.
Id.
Given that the provision addressed in Esmark was virtually identical to the predecessor of Section 852(b)(6), would a challenge to heartbeat trades on a substance over form basis suffer the same result as in Esmark? There are some significant differences between heartbeat trades and the tender offer/redemption transaction in Esmark. Most important, in a heartbeat trade there is no other purpose to the trade than to remove the appreciated shares; whereas in Esmark, the Tax Court noted that Esmark had two goals: to sell the Vickers energy business and to change its capital structure by reducing the shares outstanding.222
In the case of a heartbeat trade, it could be possible to argue that the goal of the transaction is to both sell shares and change the ETF’s portfolio.
Under Section 1259, if a taxpayer owns an appreciated financial position, which includes any position with respect to stock, and there is a constructive sale of the position, the taxpayer must recognize gain as if the appreciated financial position were sold for its fair market value on the date of the constructive sale.223
I.R.C. § 1259(a)(1) (taxpayer must recognize gain on constructive sale of appreciated financial position); id. at (b)(1) (appreciated financial position means any position with respect to stock with a built-in gain).
Id. §§ 1259(c)(1)(C) (entering into a short forward contract on the same property is constructive sale); (c)(1)(E) (constructive sale includes transactions that have substantially the same effect as forward sale).
A forward contract is a contract to deliver property in the future for a price agreed upon today.225
Id. § 1259(d)(1) (defining “forward contract” as “a contract to deliver a substantially fixed amount of property . . . for a substantially fixed price”).
In the case of a heartbeat trade, there is no explicit forward contract between the AP and ETF, but the related contribution and redemption legs function similarly to a pre-paid forward contract in which the AP is prepaying the forward price for the appreciated securities with the contribution leg and receiving the appreciated securities via the redemption leg two days later.
Since, however, there is no explicit obligation to distribute the exact securities comprising the redemption custom basket, it could be argued that the securities are not being delivered pursuant to a forward contract on those securities. Furthermore, given the lack of regulations under Section 1259, it is unlikely that the IRS could treat a heartbeat trade as a constructive sale.
Heartbeat trades are highly structured transactions between APs and ETF sponsors: the AP contribution leg of one custom basket of shares or other property is integrally tied to the subsequent ETF redemption leg consisting of appreciated shares that the ETF no longer wishes to hold. There is ample basis to step together the two transactions under either the end-result test or mutual interdependence test and to treat the transactions in accordance with their substance: a taxable exchange of shares or property between the AP and ETF.
The prior discussion has shown, however, the uncertainty of the application of the various pillars of the substance over form doctrine—business purpose and step transaction—even to highly structured transactions, such those in Compaq and Esmark. Thus, barring a court revisiting the rationale of these decisions, there is authority to treat heartbeat trades as separate transactions.
Furthermore, since Section 852(b)(6) is not limited in any way by its terms, it may not violate the purpose of the statute to redeem an AP with a custom basket of shares even though the AP had contributed other shares or property as part of a related transaction. Finally, since an AP arguably changes its economic position by contributing property to an ETF and is exposed to market risk, existing jurisprudence may support a position that the separate legs of the heartbeat trade should be respected.
Given the increasing importance of ETFs in U.S. capital markets, the tax policy issues raised by allowing ETFs to make tax-free portfolio adjustments via heartbeat trades, thereby permitting their shareholders to defer all tax on their funds’ capital gains, should be addressed by Congress instead of by application of common law tax principles. As discussed in the next Part, it is certain that creative tax planners will continue to expand the use of Section 852(b)(6), which may provide the necessary impetus for Congress to overhaul Section 852(b)(6).
IX. Section 852(b)(6) Needs to be Reformed
TOPIt could be argued that since Subchapter M is intended to be a pass-through regime with no entity-level taxation, there is not the same need to protect the tax base of investment companies as there is for C corporations. Since the unrealized gains and losses of an investment company’s assets are reflected in NAV, an argument could be made to ignore any built-in gains that leave an investment company when it distributes appreciated property, because those gains will eventually be taxed at the shareholder level. The combination of Section 852(b)(6) and heartbeat trades ensures this result for equity ETFs, but not for mutual funds and individual investors.
This argument should be rejected on various grounds. If realized fund-level gains should not be taxed until a shareholder disposes of her shares, the same argument should therefore also apply to any income earned and reinvested by an investment company, including dividends, interest, short-term capital gains, and realized capital gains, which are also reflected in NAV.226
A bill to exempt taxable mutual fund investors from current taxation on reinvested capital gains dividends from RICs has been periodically introduced in Congress. See, e.g., Generate Retirement Ownership through Long-Term Holding Act of 2009, H.R. 3429, 111th Cong. (2009).
The current system has created a tax divide between equity ETFs and other investment companies, such as mutual funds and closed-end funds, which generally cannot readily avail themselves of the benefits of Section 852(b)(6) and heartbeat trades. A shareholder of a mutual fund that follows the same investment strategy or tracks the same index as an ETF will generally have lower after-tax returns than the ETF shareholder, even though they are both subject to the same tax regime of Subchapter M and have the same economic exposure.227
See Moussawi, supra note 12, at 4 (finding that ETFs have 0.65% lower tax burdens than large-cap and small-cap index funds).
Mutual funds can, in theory, use Section 852(b)(6) to obtain the same tax benefits as ETFs, without having a distinct ETF share class like certain Vanguard funds.228
See supra Part VII.D.
15 U.S.C. §§ 80a-2(a)(32), 80a-5(a)(1) (defining “redeemable security,” which entitles holders to receive proportionate share of issuer’s net assets or cash equivalent, and “open-end company”). The SEC has interpreted this provision “as giving the issuer the option of redeeming its securities in cash or in kind.” Election by Open-End Investment Companies to Make Only Cash Redemptions, Investment Company Act release 6561, 36 Fed. Reg. 11919 (June 23, 1971) (adopting Rule 18f-1 and Form N-18F-1). Under a rule adopted in 2016 in connection with revisions aimed at improving fund liquidity risk management, the SEC requires that a fund that engages in or reserves the right to engage in redemptions in kind must establish policies and procedures regarding how and when it will engage in such redemptions in kind. 17 C.F.R. § 270.22e-4(b)(1)(v) (2021). The same rules amended Form N-1A, the registration statement for open-end management investment companies, to require a fund to state the methods that a fund typically expects to use to meet redemption requests, including the ability to redeem in kind. SEC Liquidity Management, supra note 93, at 82210 (amending Form N1-A by adding new paragraph (c)(8) under Item 11).
17 C.F.R. § 270.18(f)-1 (2022). The election is made on Form N-18F-1.
Even though mutual funds are permitted to make in-kind redemptions, they are still rare.231
Redemptions in kind by mutual funds are often considered to be “a last resort or emergency measure.” SEC Liquidity Management, supra note 93, at 82210. For the period from 1997 to 2017, a team of researchers has found that around 70% of the U.S. equity funds reserved the right to pay redemptions in kind, and 13.1% of the funds that reserved this right actually engaged in in kind redemptions at least once. Vikas Agarwal et al., supra note 96 (manuscript at 3–4). The same researchers found that the in-kind redemption transactions were economically significant: the mean and median dollar amounts were $153 million and $70 million. Id.
Paul M. Miller and Christopher D. Carlson, Can the Tax Efficiencies of ETF Redemptions In-Kind Be Replicated for Mutual Funds, 27 Invest. Law. 1, 3 (Feb. 2020).
Id. at 4.
The ability of a mutual fund to redeem in kind could provide mutual fund shareholders with some of the tax benefits that inure to ETF shareholders, such as decreased cost of selling securities, and of course, the potential to distribute low basis shares and reduce fund overhang. The SEC has indicated that the new obligations for a fund to establish policies and procedures for in-kind redemptions would address these issues as well as address how a fund would select securities to use in an in-kind redemption and whether it plans to redeem securities on a pro rata or non-pro rata basis. The concern with non-pro rata redemptions is that the securities are properly valued so that shareholders are not diluted.234
SEC Liquidity Management, supra note 93, at 82210
Because mutual funds must issue and redeem shares at day end NAV, it may be difficult to structure trades that would be profitable for a mutual fund investor. For plain vanilla redemptions, it may be difficult to find sufficient investors willing to receive shares in kind upon redemption from a fund. This makes it difficult for a fund to whittle down built-in gains through everyday redemptions. For heartbeat trades, if part of the strategy involves shorting the shares of the redeeming fund, it is generally not possible to short shares of a mutual fund. The investor would pay NAV to purchase the shares and receive NAV upon redeeming the shares. Thus, it would be difficult to be able to compensate an investor doing an integrated contribution and redemption trade.
One possible candidate to carry out in-kind redemptions is an affiliated person of the mutual fund.235
An affiliated person of an investment company includes any 5%-or-more shareholder (by vote), any person under common control, and any investment adviser. 15 U.S.C. § 80a-2(a)(3).
15 U.S.C. § 80a-17(a)(1)–(2).
15 U.S.C. § 80a-17(b). The SEC has issued various exemptive orders permitting in-kind redemptions by affiliated persons. See, e.g., GE Institutional Funds, SEC No-Action Letter, 2005 WL 3601654 (Dec. 21, 2005).
Signature Financial Group, SEC No-Action Letter, 1999 WL 1261284 (Dec. 28, 1999). The letter also required that the redemption be consistent with the fund’s policies in the prospectus and statement of additional information and neither the affiliated shareholder nor any other party with the ability and pecuniary incentive to influence the redemption selects or influences the distributed securities. Id. at *7. Finally, the redemption must be approved by the fund’s board, either after a finding that the affiliated shareholder will not be favored over any other shareholder and the redemption is in the best interest of the distributing fund or that it is undertaken pursuant to certain procedures adopted by the board. Id. at *7–*8.
Id. at *5, *8 n.23.
17 C.F.R. § 270.22e-4(b)(1)(v) (2021).
By using the option to distribute low basis shares, realizing fund-level losses, and employing heartbeat trades, U.S. equity ETFs have largely eliminated any fund-level recognized gains. Furthermore, once Vanguard’s patent expires, any mutual fund sponsor will be able to create a separate ETF share class in its mutual funds, which can then be used as a conduit to remove unrealized gains from the mutual funds when the ETF shares are redeemed. This will benefit both ETF and mutual fund shareholders. There is no evidence, other than silent inaction, that Congress intended Section 852(b)(6) to be exploited like this.
Since heartbeat trades have become commercially commonplace, creative tax advisors will eventually consider employing Section 852(b)(6) as a capital gains eliminator. One possible strategy would be to use an ETF to acquire securities or other property with a built-in gain in a tax-free transaction and then distribute them in redemption of a shareholder’s interest. This would eliminate the gain in the securities or property and allow the new acquirer a fair market value basis in the securities or property, while the sellers could continue to defer any gains until a sale of the ETF shares.
Although such acquisitions can potentially be accomplished via tax-free reorganizations, special reorganization rules apply to investment companies, and regulatory limitations aimed at RICs acquiring property with built-in gain may also apply. Furthermore, the diversification rules of Subchapter M and the 1940 Act may impose some limits on the ability of an investment company to acquire another company via a tax-free reorganization. These rules are sketched out below.
1. Reorganizations and ETFs
Assume that an owner of a C corporation that holds appreciated assets wishes to diversify her economic exposure but does not wish to sell the shares of the corporation or the underlying assets in a taxable sale. An ETF could acquire either the assets or shares of the corporation in a tax-free reorganization in exchange for shares of the ETF. The ETF could thereafter distribute the assets or shares via a heartbeat trade, and the acquirer would have a fair market value basis in the distributed property.
There are two basic methods for a corporation to acquire appreciated property tax-free: a transfer to a controlled corporation pursuant to Section 351 or an acquisition that constitutes a reorganization under Section 368.241
Another is via a distribution pursuant to Section 355, such as a split-off or spin-off.
I.R.C. §§ 351(a) and 368(c) (defining control).
An investment company is a RIC, REIT, or a corporation more than 80% of whose assets are held for investment and are stock or securities or interests in RICs or REITs. Treas. Reg. § 1.351-1(c)(1)(i)-(ii). Other investments assets, such as options and foreign currency, are treated as stock and securities. See I.R.C. § 351(e)(1)(B). Section 721(b) incorporates these rules to partnerships.
I.R.C. § 351(e). A transfer by two or more persons of nonidentical assets generally results in diversification. Treas. Reg. § 1.351-1(c)(5). A transfer by a single transferor generally does not result in diversification unless it is part of a plan to achieve diversification, such as a planned transfer of the securities received or corporate assets to an investment company. If the transferor transfers a diversified portfolio of stock and securities, as defined in Section 368(a)(2)(F)(ii), to a corporation, the transfer will not result in diversification. Treas. Reg. § 1.351-1(c)(6)(i).
Congress limits the use of RICs and other investment companies in corporate reorganizations.245
See I.R.C. § 368(a)(2)(F). For an acquisition of stock or assets to be tax-free for shareholders and corporations, it must fall under one of the statutory reorganization provisions in Sections 368(a)(1) and (2).
An investment company, including an ETF or mutual fund, can generally be a party to a reorganization,246
Under Section 368(a)(2)(F)(i), if two or more parties to purported reorganization are investment companies, the transaction is not a reorganization unless the companies are RICs, REITs, or diversified investment companies. An investment company is considered to be diversified if not more than 25% of the value of its total assets is invested in the stock and securities of any one issuer and not more than 50% of the value of its total assets is invested in the stock and securities of 5 or fewer issuers. I.R.C. § 368(a)(2)(F)(ii). For these purposes, cash and government securities are excluded. Id. § 368(a)(2)(F)(iv).
An investment company includes RICs, REITs, and any corporation 50% or more of the value of which consists of stock and securities and 80% or more of the value of whose total assets are assets held for investment. I.R.C. § 368(a)(2)(F)(iii). There is a look-through rule for subsidiaries, which are defined to be companies where the parent owns 50% or more of the vote and 50% of the value of the outstanding shares. Id. For these purposes, cash and government securities are excluded. Id.§ 368(a)(2)(F)(iv).
Satisfaction of the statutory reorganization requirements is not necessarily sufficient for a transaction to be treated as a reorganization. A transaction must also satisfy the business purpose test, and the continuity of shareholder interest and continuity of business enterprise requirements.248
Treas. Reg. § 1.368-1(b).
See, e.g., Rev. Rul. 72-405, 1972-2 C.B. 271 (forward triangular merger followed by liquidation is asset acquisition); and Rev. Rul. 67-274, 1967-2 C.B. 141 (stock acquisition followed by liquidation is treated as asset acquisition). Certain post-acquisition distributions are protected against recharacterization. See Treas. Reg. § 1.368-2(k).
If a RIC acquires property from a C corporation that is not an undiversified investment company in a reorganization, such as a merger or “C” reorganization, under Section 337(d) regulations, the RIC will be taxed on any net recognized built-in gains for five years following the acquisition of the property under the rules of Section 1374.250
The regulations treat the acquisition of property by a RIC or REIT from a C corporation or the qualification of a C corporation as a RIC as a conversion transaction. Treas. Reg. § 1.337(d)-7(a)(2)(ii). Once property of a C corporation becomes property of a RIC in a conversion transaction, it is subject to the rules of Section 1374. Treas. Reg. § 1.337(d)-7(b)(1). These rules apply to net built-in gains recognized during the recognition period, which is the five-year period beginning on the date the RIC acquires the property. Treas. Reg. § 1.337(d)-7(b)(2)(iii). These rules do not apply if the C corporation makes an election to treat the transfer to the RIC as a deemed sale of assets. See Treas. Reg. § 1.337(d)-7(c).
This regulation does not apply to the acquisition of stock of a C corporation, for example, in a B reorganization.
Net recognized built-in gain is any gain recognized for the five years following the acquisition of property from a C corporation, but only to the extent of any built-in gain at the time of acquisition.252
I.R.C. §§ 1374(d)(1) (defining net unrealized built-in gain) and 1374(d)(3) (limiting recognized built-in gain to the gain at the beginning of the S corporation’s first taxable year).
Distributions that are related to the reorganization, however, could cause the reorganization to be reclassified under the step transaction doctrine.
2. Acquisitions and the Diversification Tests
If a RIC acquires stock or assets of a C corporation in a reorganization, the RIC must ensure that it does not run afoul of the gross income test of Subchapter M and the diversification requirements of Subchapter M and the 1940 Act. Under Section 851(b)(2), to qualify as a RIC, 90% of a corporation’s gross income must be passive income, such as dividends, interest (both taxable and tax-exempt), and gains from the sale of stock and securities.254
I.R.C. § 852(b)(2)(A). Also included are gains realized from foreign currencies, and derivatives based on stock or securities such as options, forwards, and futures. Id.
Using a C corporation, including a foreign corporation, to block bad income is a common structuring technique for RICs and REITs. See Willard B. Taylor, “Blockers,” “Stoppers,” and the Entity Classification Rules, 64 Tax Law. 1 (2010).
Subchapter M imposes relatively loose diversification requirements. A RIC must satisfy two diversification tests, the 50% test and the 25% test, both of which are determined quarterly.256
I.R.C. §§ 852(b)(3) and (d). Although the statutory requirements appear to be clear-cut, this is an area of some uncertainty. The treatment of swap positions, for example, is unclear. This is especially relevant for new ETFs that offer single stock exposure. See, e.g., Direxion Shares ETF Trust, Registration Statement (Form N-1A) (Feb. 17, 2022), https://perma.cc/45TY-ASZH.For a detailed discussion of the diversification requirement, see Susan A. Johnston & James R. Brown, Jr., Taxation of Regulated Investment Companies and Their Shareholders ¶ 2.07 (2021).
I.R.C. § 851(b)(3)(A)(ii).
I.R.C. § 851(b)(3)(A)(i)–(ii).
Under the 25% test, not more than 25% of a RIC’s total assets can be invested in the securities of any one issuer, the securities of two of more issuers controlled by the RIC and engaged in the same trade or business, or the securities of one or more qualified publicly traded partnerships.259
I.R.C. § 851(b)(3)(B)(i)–(iii).
I.R.C. § 851(c)(2).
I.R.C. § 851(c)(1)–(3).
Thus, a RIC can also acquire and hold all of the shares of another corporation, provided that the value of the shares is less than 25% of the RIC’s total assets and the RIC holds the requisite 50% of good assets. A RIC may acquire and hold assets, but the income they produce will not count towards the 90% gross income test, and the assets cannot constitute more than 50% of the RIC’s assets.
The 1940 Act also imposes diversification requirements on investment companies that are management companies262
The 1940 regulates “investment companies,” including “management companies.” 15 U.S.C. § 80a-3 (defines investment company); 15 U.S.C. § 80a-4 (classifies investment companies as either “face-amount certificate company”, “unit investment trust”, or “management company”). A management company is furthered classified as either an “open-end” or “closed-end” company. 15 U.S.C. § 80a-5(a)(1)–(2).
15 U.S.C. § 80a-5(b)(1)–(2).
15 U.S.C. § 80a-5(b)(1).
15 U.S.C. § 80a-13(a)(1). For an example of a request to shareholders to change from a diversified to non-diversified management company, see, e.g., Vanguard, Joint Special Meeting of Shareholders (Form DEF 14A) (Oct. 19, 2020), https://perma.cc/MF5U-KMF9.Among the reasons given for the change was that various indices tracked by these funds, e.g. the Russell 1000 Growth Index, had become concentrated in their top holdings, and the fund could no longer hold the underlying shares and still be considered diversified under the 1940 Act. Id. at 3, 4.
This Part has sketched out some of the rules applicable to investment companies acquiring shares or assets of another company.266
There are additional mechanisms for an ETF to acquire shares of a company tax-free, such as, for example, via a qualifying Section 355 spin-off or split-off. The ETF could then distribute the acquired shares tax free to a redeeming shareholder under Section 852(b)(6), and an acquiring shareholder would receive the shares with a fair market value basis.
X. Section 852(b)(6) Should Be Reformed
TOPThrough distributions of low basis stock, heartbeat trades, and capital structure arbitrage, Section 852(b)(6) has turned equity ETFs into capital gain deferral machines—no shareholder-level tax is incurred until the shares are sold. This significant tax benefit accounts for the meteoric rise in equity ETF assets over the last twenty years and has created a caste system for various investment vehicles, with ETFs on the top and mutual funds and individual investors on the bottom. Furthermore, investing via an ETF can be more tax advantageous than investing directly, since an ETF can make tax-free portfolio adjustments, but individual investors cannot.
Since Subchapter M often fails to match a shareholder’s economic and taxable income and loss, taxable mutual fund shareholders can consequently be temporarily over-taxed or under-taxed.267
See infra Part III.
ETF shareholders can still benefit from fund-level capital losses, which can offset any recognized capital gains.
If Section 852(b)(6) is not amended, and the IRS does not limit tax-free heartbeat trades or capital structure arbitrage, it is certain that equity ETFs will continue to displace mutual funds and even displace direct investment by taxable investors.269
A new challenger to ETFs may be direct indexing, which is a custom basket of stocks assembled by a portfolio manager or advisor. This strategy allows an investor to assemble a diversified portfolio that is adjusted to reflect a particular investment strategy, such as ESG or certain factor exposures. Since the shares are owned directly by the investor, the investor can selectively realize losses and defer gains on individual securities, which may increase an investor’s after-tax returns, even when compared with ETFs. See Ben Johnson & Susan Dziubinski, Should You Follow Vanguard Into Direct Indexing?, Morningstar (Aug. 9, 2021), https://perma.cc/NX5T-X83K.Direct investing generally requires a significant minimum investment and there are fees to acquire the portfolio, but Vanguard, Blackrock, and J.P. Morgan have purchased direct-investing firms, and the minimums and costs will certainly decline. See, e.g., Vanguard to offer direct indexing capabilities through acquisition of Just Invest, Vanguard (Jul. 13, 2021), https://perma.cc/V7QD-L9WT.Even with direct investing, however, portfolio adjustments will generally be taxable.
See Colon, Oil and Water, supra note 51, at 778–88. See generally Matthew P. Fink, The Rise of Mutual Funds (2008).
As ETFs continue to attract more assets, more taxable shareholders will benefit from the deferral of capital gains, and ETFs will be able to continue making unlimited tax-free portfolio adjustments. The benefit of deferring capital gains increases as an investor’s gains increase. Thus, Section 852(b)(6) operates as an unjustifiable tax subsidy for wealthier investors.271
Moussawi, supra note 12, at 33–35, 66 tbl. IX, has found an “overwhelming trend” of high-net-worth clients from 2000 through 2017 shifting into ETFs, especially after the 2012 increase in capital gains tax rates. Households owning ETFs also have significantly higher mean and median total assets, financial assets, and net worth than U.S. households generally. See Inv. Co. Inst. and Strategic Bus. Insights, A Close Look at ETF Households (Sept. 2018), https://perma.cc/58ZC-2CL6(finding that ETF households’ mean and median financial assets are $1,006,100 and $401,700 versus $272,700 and $37,700 for all households).
Given the high likelihood that creative tax advisors will find new ways to exploit Section 852(b)(6), the status quo will not be tenable. A fundamental goal of Subchapter M is to roughly equalize the tax treatment of investing directly in publicly traded securities and investing indirectly via a RIC. The use of Section 852(b)(6) by ETFs heaps tax benefits on their shareholders and drives a wedge between the tax treatment of ETF shareholders and direct investors and mutual fund shareholders.
Barring a wholesale revision of the taxation of public investment companies and their shareholders, an overhaul of Subchapter M, or the taxation of publicly traded assets, the simplest and soundest approach to address heartbeat trades, capital structure arbitrage, and the elimination of fund-level gains through the ETF creation and redemption process is to repeal Section 852(b)(6) and require ETFs, like all other corporations, to recognize gain on the distribution of appreciated property. This was the proposal put forth by Senator Wyden in 2021.272
Staff of S. Finance Comm., 117th Cong., Discussion Draft on Wyden Pass-through Reform, Section by Section Summary (Sept. 10, 2021), https://perma.cc/JTE5-GS2S.
Eliminating Section 852(b)(6) would remove the competitive tax advantage that ETFs have over mutual funds, direct investors, and investors in publicly traded partnerships. Since it would also apply to mutual funds, it would eliminate the benefit of heartbeat trades, whether carried out by a standalone ETF or an ETF that is part of a mutual fund, such as the current Vanguard ETFs. Additionally, the Joint Committee on Taxation has reportedly estimated that repeal of Section 852(b)(6) would raise significant tax revenue.273
The Joint Committee on Taxation has reportedly estimated that repeal of Section 852(b)(6) would raise $200 billion over the next ten years. See Lim & Rubin, supra note 24.
Repealing Section 852(b)(6) could lessen the attractiveness of ETFs for taxable investors as redemptions using appreciated property that are currently tax-free at the fund level would have to be recognized and distributed to the fund’s shareholders. It is important to emphasize that tax-exempt investors, such as pension plans, endowments, foreign investors, ETFs held in IRAs and Roth IRAs, and ETFs held by taxpayers subject to mark-to-market tax accounting would not be affected by this proposal. A fair question is whether repeal of Section 852(b)(6) would make ETFs prohibitively tax inefficient for taxable investors. The answer is an emphatic no.
Since a manager will have the option to select which securities to distribute, the ETF manager can control the gain recognized on in-kind redemptions; she can distribute high basis securities if she does not want to recognize gain or low basis securities if she wishes to recognize gain. A manager might wish to recognize gain if the fund has recognized losses to offset the gains or the manager wishes to reduce any fund overhang. Conversely, a fund manager can selectively realize losses and use those losses against current or future gains. A mutual fund manager must make similar decisions when a fund has net redemptions, and the manager must choose which positions to sell. The mutual fund manager must also decide whether to engage in tax loss harvesting to accumulate losses that can be used against future gains.
Furthermore, the amount of gain that can be recognized on in-kind distributions is limited by the total unrecognized gains in a fund’s portfolio of securities. To the extent that the overall returns in the market or the portion of the market tracked by an ETF are flat or negative, a fund may have little or no gains. If a fund’s returns are volatile and there are continual contributions and redemptions, a manager will have more opportunity to distribute securities with little or no gain since the securities that were purchased when the market was higher can be distributed when the market has moved lower.
If, however, a fund manager defers gains by distributing high basis securities, and the overall returns of the fund have been positive, overhang may increase, making it more likely that gains will be recognized on future in-kind distributions. As can occur with mutual funds, taxable shareholders could be taxed on gains that arose before they purchased their shares. This could temporarily increase the disconnect between a taxable shareholder’s economic returns and taxable returns. In such a case, it may be better for individual, long-term taxable investors to consider migrating away from ETFs and instead invest in mutual funds or direct indexing.
For investors whose income level permits them to invest in an IRA or Roth IRA, the optimal move may be to invest in ETFs through these tax-favored investment vehicles or through their 401(k) plan.274
In 2021, a single individual can contribute up to $6,000 annually to an IRA or Roth IRA. If the person is 50 or over, the annual limit is $7,000. Once the individual’s modified adjusted income (MAGI) is over $125,000, the maximum contribution is phased out and is $0 once MAGI is $140,000 or greater. For married persons filing jointly, the MAGI limitation is $198,000, and is phased out completely at $208,000. Thus, a married couple could contribute annually up to $12,000. See I.R.C. §§ 219 (IRA limitation) and 408A (Roth IRA limitation). For a participant to invest in an ETF via a 401(k), the retirement plan would have to offer a brokerage option.
The finance literature has addressed this issue in great detail. See, e.g., Daniel Bergstresser and James M. Poterba, Asset Allocation and Asset Location: Household Evidence from the Survey of Consumer Finances, 88 J. of Pub. Econ. 1893 (2004) and Robert Dammon, Chester S. Spatt, and Harold H. Zhang, Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing, 59 J. of Fin. 999 (2004). Recent entrants into the automatic investment advisor space, such as Betterment, also stress the importance of tax-efficient asset location. See Boris Khentov, Rukun Vaidya, and Lisa Huang, Asset Location Methodology, Betterment (Sept. 26, 2016) https://perma.cc/6TFL-AS6R.
ETFs held by a trader fund that has made the mark-to-market election under Section 475(f) would recognize ordinary gain or loss on any ETF position held at the end of the year. See I.R.C. § 475(f). If a distribution were made at year end, the NAV of the fund would drop by the amount of the distribution and thus any dividend income would be offset by the reduced gain or increased loss of the value of the ETF.
It is important to emphasize that eliminating Section 852(b)(6) would not lessen the attractiveness of ETFs for tax-exempt investors, such as foreigner investors, pension plans, endowments, sovereign wealth funds, and retirement plans such as IRAs and 401(k) plans. Although this is ultimately an empirical question, given that foreigners, nonprofits, and retirement plans own 75% of U.S. corporate stock, there should still be more than sufficient investor demand for ETFs to continue to be a viable investment vehicle.277
Steven M. Rosenthal and Theo Burke, Who Owns US Stock? Foreigners and Rich Americans, Tax Pol’y Ctr. (Oct. 20, 2020), https://perma.cc/SC45-785E(finding that in 2019, tax-exempt investors, including foreigners, own 75% of U.S. corporate stock).
If Section 852(b)(6) is repealed, the treatment of realized losses on in-kind distributions should be revisited. Currently, a corporation cannot recognize a loss when distributing property as either a dividend or in redemption of its shares.278
I.R.C. § 311(a)(2).
I.R.C. § 336(a). The ability to recognize a loss in a liquidation is subject to various limitations. See I.R.C. § 336(d).
It is not clear why Congress, when it repealed the last vestiges of the General Utilities doctrine in 1986, did not permit corporations to recognize losses on the distribution of property. One possible reason is the concern that a corporation could manipulate the price of the distributed property.280
Bittker & Eustice, supra note 160, at ¶ 8.21[2] (7th ed. 2021).
Taxing in-kind distributions of appreciated property is not necessarily inconsistent with Subchapter M, which implements conduit taxation by treating RICs as taxable entities but permits distributions to be fully deductible. One consequence to taxing in-kind distributions of appreciated property is that if a fund recognized additional gains from in-kind redemptions, it would have to distribute additional dividends to avoid entity-level tax.
One concern is whether taxing in-kind distributions could lead to a capital-depleting cascade. Since a RIC must distribute its investment income and net capital gains to avoid entity-level tax, a fund that recognized gains on in-kind distributions would be required to increase its distributions to avoid entity-level taxation. To ensure that it has sufficient cash to distribute at year end, a fund may have to either sell assets or borrow. These sales could generate additional gains, which in turn would require additional dividends to be paid to avoid entity-level taxation, which could force additional sales of assets, and so forth. A combination of taxable redemptions and asset sales could result in a fund’s capital being depleted.
For various reasons, this scenario is unlikely. If distributions of appreciated property were taxable, a manager could distribute high-basis assets to avoid recognizing gains or low-basis assets to increase gains recognized. Similarly, if a fund needed to sell assets to generate cash, the manager could sell high-basis assets to reduce gains recognized or generate losses or sell low-basis assets to recognize gains. In the face of significant redemptions, a mutual fund manager faces these same decisions. Finally, if a fund experiences significant redemptions, it could be because of poor fund performance or a general market downturn. In either case, the fund is unlikely to own significantly appreciated assets.
A related justification that has been put forth by regulators is that the in-kind redemption rule for mutual funds functions as a sort of relief valve that protects a fund from having to sell assets at “fire sale” prices when faced with significant redemptions.281
Michael S. Piwowar, Comm’r, SEC, Remarks at the 2015 Mutual Funds and Investment Management Conference (Mar. 16, 2015). See also SEC Liquidity Management, supra note 93, at 82210 (“[M]ost funds often consider redemptions in kind to be a last resort or emergency measure . . . .”)
In-kind distributions of assets, however, raise additional issues both for redeeming and remaining shareholders. An in-kind distribution paid to a large redeeming institutional shareholder may benefit remaining shareholders because the cost of selling the shares can be shifted to the redeeming shareholder.282
Letter from Barbara Novick, Vice Chairman, Blackrock, to Brent Fields, Sec’y, SEC, at 11 (Jan. 13, 2016), https://perma.cc/5ZJ6-PEQD.
For a detailed disclosure of some of the potential hardships that could befall shareholders who are redeemed in kind, see, e.g., Dodge & Cox, Dodge & Cox Funds Prospectus 52 (May 1, 2020), https://perma.cc/S8QH-TZSX.Managers of open-end funds confront the same issue when making cash redemptions and deciding which assets to sell. See SEC Liquidity Management, supra note 93, at 82150. Since money market funds are considered by investors to be cash equivalents, and value impairments such as “breaking the buck” could cause substantial harm to the financial system, the SEC has promulgated rules that permit money market funds to make in-kind redemptions, suspend redemptions during emergencies, and impose liquidity fees if the percentage of liquid assets falls below a specified minimum. See., e.g., Vanguard, Vanguard Money Market Funds Prospectus 39–40 (Dec. 17, 2021), https://perma.cc/BG5F-XQE8.
17 C.F.R. § 270.22e-4.
A significant market decline could cause mutual fund shareholders to request redemptions en masse, which could force a manager to sell assets and thereby generate gains. This, in turn, would require a fund to increase its distributions, and a fund could see its capital decline precisely at the moment that it could be the most valuable as asset prices have declined.285
If a fund earns taxable income without a corresponding amount of cash, which can occur when the fund invests in debt instruments that generate a significant original issue discount, a fund could have to liquidate assets to generate the cash to satisfy the distribution requirement or be forced to borrow. In the throes of a financial crisis, borrowing can be impossible, and a fund would therefore have to sell assets to generate the cash to satisfy the distribution requirement. Sales of assets during a financial crisis could exacerbate the crisis.
The SEC issued an order on March 23, 2020, that permits funds to borrow from the firm that manages the portfolio and from other funds in the same family. Order Under Sections 6(c), 12(d)(1)(J), 17(b), 17(d) and 38(a) of the Investment Company Act of 1940 and Rule 17d-1 Thereunder Granting Exemptions from Specified Provisions of the Investment Company Act and Certain Rules Thereunder, Investment Company Act Release No. 33821, 85 Fed. Reg. 17374 (Mar. 23, 2020).
Via a series of revenue procedures, the IRS has permitted a RIC to make distributions payable in stock, cash, or some combination thereof, which enables the RIC to avoid distributing cash to satisfy the minimum distribution requirements and avoid entity-level taxation.287
Rev. Proc. 2009-15, 2009-4 I.R.B. 356 (effective for distributions declared on or after Jan. 1, 2008). Rev. Proc. 2010-12, 2010-3 I.R.B. 302 extended these provisions to cover distributions declared on or before Dec. 31, 2012. The IRS had earlier extended this treatment to REITs. See Rev. Proc. 2008-68, 2008-52 I.R.B. 1373. Once the prior revenue procedures were no longer effective, taxpayers requested private letter rulings to receive the desired treatment. To obviate the need for requesting a ruling, the IRS issued Rev. Proc. 2017-45, 2017 I.R.B. 216, effective for distributions declared on or after Aug. 11, 2017.
Under Revenue Procedure 2021-53,288
Rev. Proc. 2021-53, 2021-51 I.R.B. 887 is effective for distributions on or after November 1, 2021, and on or before June 30, 2022. It followed Rev. Proc. 2020-19, 2020-22 I.R.B. 87, which was effective for distributions on or after Apr. 1, 2020, and on or before Dec. 31, 2020.
Although stock dividends are generally not taxable under Section 305(a), because of the option to receive cash or stock the stock dividend would be treated as a distribution of property under Section 301. I.R.C. § 305(b)(1).
Rev. Proc. 2021-53, 2021-51 I.R.B. 887 § 3. Under Rev. Proc. 2017-45, the cash limitation percentage was 20%. One commentator has suggested that the original 20% number was approximately equal to the taxes due on the entire distribution using a federal rate of 15% and a state rate of 5%. Using the highest rate for capital gains under current law, 23.8%, for the federal tax rate and 5% for the state rate, if a taxpayer received 10% of the distribution in cash, the 10% cash distribution could be significantly less than the tax due on the entire distribution. Presumably, such taxpayers would satisfy their tax obligations out of other funds. Richard W. Bailine, A Rare and Valuable Look at Section 305, 35 J. Corp. Tax’n 28, 29 (Nov./Dec, 2008). For RICs, given that 90% or more of RIC shareholders typically elect to reinvest their distributions in additional stock and therefore pay the tax out of other funds, the concern that a taxpayer would not have sufficient cash to satisfy their tax obligations is minor.
Under Section 305(b)(1), if a distribution is payable in stock or cash, the entire distribution is taxable. Since it is possible that a particular shareholder can receive the entire distribution in cash, the distribution is therefore taxable in its entirety, even though the RIC will distribute a maximum of only 10% of the total distribution in cash. In contrast, if the RIC distributed a dividend consisting of 10% in cash and 90% in stock, the stock portion would not be taxable. See Treas. Reg. § 1.305-1(b), Ex. 1 (dividend of two shares for each share owned where shareholder could elect to receive cash for one share is a taxable dividend only to the extent of one share; the distribution of the other share is a non-taxable distribution under Section 305(a)).
For instance, if a fund offered to distribute a total amount of cash equal to 10% of the dividend and all shareholders elect to receive cash, each shareholder would receive 10% cash and 90% stock, but the shareholder would have a taxable inclusion of 100%. See Rev. Proc. 2009-15, 2009-4 I.R.B. 356 § 4(b).
These revenue procedures offer a mechanism by which a fund could mitigate the potential capital depleting effects of significant fund-level gains: the fund could pay the required dividend distributions as stock dividends with a shareholder-level election to take a portion of the dividends in the form of cash.293
Although the minimum cash amount has varied between 10% and 20% in the revenue procedures, under the IRS’s interpretation of Section 305(b)(2) and the accompanying regulations, it appears that there is no minimum cash amount required in order to have the cash and stock distribution treated as a taxable distribution in its entirety.
A potential objection is that the cash received by a shareholder would be insufficient to pay his federal and state tax obligations. This should not be a concern for a few reasons. The amount of the shortfall will depend on the character of a fund’s income. If the fund’s income consists solely of ordinary income or short-term capital gains, the federal top rate could be as high as 40.8%, or 23.8% in the case of net capital gains.294
40.8% is the sum of the highest federal rate on ordinary income including short-term capital gains, 37%, and the 3.8% tax on net investment income under Section 1411. The highest rate on net capital gains,20%, plus the 3.8% tax on investment income, yields 23.8%.
Over 90% of the total dividends paid by all mutual funds are reinvested. Factbook, supra note 1, at 238 tbl. 29.
Treas. Reg. § 1.305-1(b)(2) (stock received by RIC shareholder with election to receive cash or stock is equal to amount of cash that could have been received); Treas. Reg. § 1.301-1(h)(1) (basis of property received in a Section 301 distribution is its fair market value).
Repealing Section 852(b)(6) would eliminate the tax advantage of ETFs over mutual funds and individual investors. Depending how ETF managers manage fund tax liabilities, ETFs could become less tax-efficient and less attractive investment vehicles for long-term taxable investors. Such investors may therefore be advised to migrate to mutual funds or direct indexing. Given the substantial holdings of U.S. securities of tax-exempt investors, however, there should be sufficient demand for ETF shares that would permit APs to maintain the market price-NAV parity of ETF shares.
For those investors that use ETFs as part of active trading strategies, the repeal of Section 852(b)(6) may not adversely affect them because they may be able to trade around any ETF distributions; if their tax burdens increase, it may just be part of the cost of intraday liquidity.
If Congress considers the costs of a full repeal of Section 852(b)(6) to outweigh the benefits, another approach would be to retain Section 852(b)(6) but limit its scope to prevent more extreme abuses, such as heartbeat trades and capital structure arbitrage. In private letter rulings, the IRS has permitted closed-end funds to benefit from Section 852(b)(6), but these rulings have imposed extra-statutory requirements on the distributions.297
See, e.g., I.R.S. Priv. Ltr. Rul. 2003-34-1014 (Jul. 1, 2003). The IRS has issued six rulings to closed-end funds seeking to use Section 852(b)(6) in connection with self-tender offers. See Johnston & Brown, supra note 256, at ¶ 3.06[2][c] n.704. Since closed-end funds do not issue redeemable securities, in the absence of a letter ruling, in-kind redemptions using appreciated securities would not be exempt under Section 852(b)(6) and would be taxable under Section 311(b).
The letter rulings typically contain a representation that the fund will distribute a pro rata share of each security excluding: (a) unregistered securities, (b) foreign securities that cannot be held by non-nationals, (c) derivative contracts, (d) cash or cash equivalents, (e) fractional shares, and (f) cash distributions for fractional shares and odd lots. Id.
Id.
Modifying Section 852(b)(6) to limit it solely to proportionate distributions would ensure that distributions of custom portfolios in heartbeat trades would be taxable, but ordinary pro rata redemption distributions would continue to be tax-free. In essence, when an ETF changes its portfolio by making non-proportional distributions, the distribution would be taxable in its entirety. The distribution exceptions in the letter rulings should not apply to prevent gains from being recognized, even if certain assets are not distributed. Although it may not be possible to distribute, for example, derivative contracts or unregistered securities, a fund should have to recognize gain on a proportional amount of any undistributed property to prevent avoidance of the proportional distribution requirement by investing in derivatives instead of holding the underlying securities.300
Since all of an ETF’s assets are marked to market daily in computing NAV, the value of the undistributed assets is known. If there is a need to draft exceptions, for example, for distributions of cash, these exceptions should be narrowly drafted to prevent a fund from changing its portfolio composition without the recognition of gain.
However, adoption of the requirement that puts a floor on the amount of basis of securities that would have to be distributed would not prevent an ETF from continuing to be able to reduce fund-level gains tax free. Even if the ETF had to distribute a minimum amount of basis each time it distributed securities, each redemption could take with it a proportionate amount of the fund’s remaining gains. In the case of an ETF with a significant number of sizable redemptions during the year, a manager could distribute low-basis securities and reduce a fund’s built-in gains without changing the portfolio.
Assume, for instance, a fund has an aggregate basis of $100 in its securities and distributes 5% of its securities in redemption of its shares. Under the approach of the closed-end private letter rulings, the basis of the distributed securities could be no less than 4% of $100, or $4. This puts a floor on the basis of the distributed securities, which ensures that a distribution can, roughly, only remove a proportionate amount of unrealized gain from the fund. But this limitation would not prevent redemptions from removing built-in gains tax free.
Assume that in the above example, the ETF’s securities (basis of $100) have a FMV of $200, and the fund has $100 of built-in gain. If an AP redeemed 10% of the ETF’s shares, and the ETF distributed securities with a FMV of $20 (10% of $200) and a basis of $10 (10% of $100), the ETF would hold securities with built-in gain of $90 ($180 FMV – $90 basis) or 10% less than the original built-in gain.301
If the manager distributed securities with a basis of $20, for example, the built-in gain would remain at $100 ($180 – $80).
Now assume that an AP contributed securities worth $180 and a basis of $180. AUM would increase to $360 ($180 + $180), total inside basis would be $270 ($90 + $180), but built-in gains would remain at $90 ($360 – $270). A short time later with NAV unchanged, an AP redeems $180 of shares, and the manager distributes $180 of the securities with a basis of $135 (50% of $270), leaving the ETF with securities with a built-in gain of $45 ($180 – $135). Thus, with no change in NAV, the $180 contribution and distribution would permit the ETF to remove 50% of the built-in gain for the remaining shareholders.
This example illustrates that even adopting a rule that mandates that an ETF distribute securities with a basis at least equal to the proportion of the securities distributed would not prevent an ETF from being able to reduce built-in gain. Although the pro rata distribution requirement would limit an ETF’s ability to make tax-free portfolio adjustments employing heartbeat trades,302
If Congress opted to pursue this approach, it would be vital to ensure that any exceptions to the pro rata distribution requirement would be drafted narrowly. One idea would be to require an ETF to mark-to-market a pro rata portion of any position that was not distributed.
In this example, the AP contributed $180 of basis and then removed $135 of basis, which reduced built-in gain by $45.
Another approach that could be employed in connection with the proportional distribution requirement is to require funds that distribute appreciated property to reduce the basis of their remaining appreciated securities by any realized but unrecognized gain in proportion to the basis of the remaining securities.304
Professor Hodaszy, Section 852(b)(6) Tax Avoidance, supra note 26, at 537, 599–605, and Section 852(b)(6) Loophole, supra note 26, at 74–86, has advocated such an approach. He models his proposal on Section 362(c), which addresses the treatment of non-shareholder contributions to capital. Section 362(c) requires a corporation to take a zero basis in the contributed property and to reduce the basis of the corporation’s property by the contributed cash. I.R.C. § 362(c)(2).
Hodaszy, Section 852(b)(6) Tax Avoidance, supra note 26, at 602–603.
Id. at 604 n.296. Professor Hodaszy does not state how unrecognized losses on distributed securities should be treated. If the goal is to preserve all unrecognized gains or losses at the fund level, the basis of the remaining securities should arguably be increased by unrecognized losses. Also, Professor Hodaszy does not detail how the basis reduction rule would work for such assets as cash and derivatives.
Without addressing heartbeat trades, however, it is highly doubtful whether an ETF would ever recognize the deferred gain in a taxable sale.307
Professor Hodaszy has subsequently recognized this. See Hodaszy, Section 852(b)(6) Loophole, supra note 26, at 81 (recognizing that the “abusive practice of heartbeat trades would need to be shut down, for the basis-reduction rule to work”).
To the extent that gains are eventually recognized either upon a sale of securities or when an asset’s basis falls below zero, this proposal could exacerbate the overhang problem if a manager were to only distribute high basis securities leaving low basis securities and greater built-in gain in a fund. Since gains would be deferred, it could further drive a wedge between a taxable shareholder’s taxable income and her economic income. Finally, as an ETF’s overhang increases significantly, taxable shareholders may avoid purchasing shares of the ETF.
Eliminating or amending Section 852(b)(6) to limit its scope leaves intact the basic structure of Subchapter M. Although repeal of Section 852(b)(6) may be the best tax policy alternative as it would treat distributions of publicly traded and easy to value securities identically to the sale of securities followed by a distribution of cash, such a change could make ETFs less tax-efficient for taxable investors and potentially limit the growth of ETFs. Congress could decide that repeal of Section 852(b)(6) is not the best path forward.
Less sweeping alternatives, such as limiting Section 852(b)(6) to proportional distributions and requiring funds to reduce basis by unrecognized gains, would eliminate the advantages of heartbeat trades and eventually require funds to recognize gains that escape tax under Section 852(b)(6). These alternatives, however, would permit an ETF to continue to defer gains until either it sells appreciated securities or has used up all of the basis in a security. An ETF’s overhang could therefore become quite significant if an ETF manager opted to not sell appreciated positions, which could cause taxable investors to avoid investing in the ETF.
Another potential path that has been suggested is to revise Subchapter M to incorporate certain partnership principles that may better match taxable income or loss of the entity to the owners who have economically benefitted from the income or borne the losses than the principles embodied in current Subchapter M.308
See Colon, supra note 26, at 49–66 and Stephen D. Fisher, RICs and the Retail Investor: A Marriage of Convenience or Necessity?, 66 Tax Law. 331, 388 (2013).
See, e.g., Invesco DB Multi-Sector Commodity Trust and Invesco DB Agriculture Fund, Prospectus Supplement No. 1, 75–88 (Aug. 27, 2021) [hereinafter Invesco Trust Prospectus] (describing U.S. tax consequences to investing in fund and the special rules for publicly traded partnerships). RICs that primarily hold stocks and securities are currently not eligible to be taxed as partnerships. I.R.C. § 7704(c)(3) (providing that qualifying income exception is not available to any partnership that would be a RIC if it were a U.S. corporation).
The basic goals of such a regime should be to match an owner’s economic and taxable gains and losses and to prevent tax-free portfolio adjustments by the underlying investment entity. A detailed discussion of these rules is beyond the scope of this article, but the following discussion highlights their basic operation and some of the administrative challenges that adopting these provisions would raise.310
For a detailed discussion of how these rules are implemented and modified by natural resources publicly traded partnerships, see Deborah Fields, Holly Belanger, Robert Swiech, and Eric Lee, Triangles in a World of Squares: A Primer on Significant U.S. Federal Income Tax Issues for Natural Resources Publicly Traded Partnerships (Part I), Taxes, Dec. 2009; Deborah Fields, Holly Belanger, and Eric Lee, Triangles in a World of Squares: A Primer on Significant U.S. Federal Income Tax Issues for Natural Resources Publicly Traded Partnerships (Part III—Bringing in the Public and Management and Partnership Allocations), Taxes, May 2010; Deborah Fields, Holly Belanger, and Eric Lee, Triangles in a World of Squares: A Primer on Significant U.S. Federal Income Tax Issues for Natural Resources Publicly Traded Partnerships (Part IV—Secondary Offerings and the Impact of Public Trading), Taxes, Oct. 2010. See also Colon, supra note 26, at 49–66.
Under Subchapter M, overhang is created when a fund has unrealized gains, and a shareholder enters the fund by acquiring fund shares at NAV. The tax policy concern raised by overhang is that when the gains are realized and ultimately taxed to the year-end shareholders, those shareholders are not necessarily the shareholders who have benefited from the economic gains.311
See supra Part III.
Treas. Reg. § 1.704-1(b)(2)(iv)(f)(5)(v)(i)-(ii) (describing situations in which is it permissible to adjust capital accounts, such as the contribution of property or money, the liquidation of a partner’s interest, or the distribution of property or money to a retiring or continuing partner). Certain partnerships that hold publicly traded stock and securities, such as hedge funds, are allowed to adjust capital accounts in the absence of these events. These adjustments are referred to as reverse 704(c) allocations. Publicly traded partnerships often adopt certain conventions to mitigate the complexity of making these adjustments. See, e.g., Invesco Trust Prospectus, supra note 9, at 79–80 (describing monthly reverse 704(c) convention and basing revaluations not on FMV of the assets, as required by regulations, but the average price of the shares during the month in which a creation or redemption takes place).
For a discussion of some of the issues that arise in making reverse 704(c) adjustments, see Colon, supra note 26, at 53–57 and the sources cited therein. Some commentators have noted that issues can also arise regarding when exactly income is earned by a fund. See Yale, supra note 16 at 438. When a partner contributes property with a built-in gain to the partnership, the partnership is required to allocate that pre-contribution gain to the contributing partner when it is realized or the property is distributed to another partner within seven years. I.R.C. § 704(c)(1)(A) and (B).
To prevent a partner who purchases her interest in the partnership from another partner from being taxed on the economic gains of other partners, the partnership can treat the purchasing partner as if she purchased a pro-rata share of each partnership asset.314
I.R.C. § 743(b). To make such adjustments, the partnership would have to have made an election under Section 754. Publicly traded partnerships generally make this election. See, e.g., Invesco Trust Prospectus, supra note 3099, at 80 (describing Section 754 election and consequences under Section 743 and noting that fund applies certain conventions to reduce complexity of calculations and administrative costs).
Treas. Reg. § 1.743-1(f) (“[A] transferee’s basis adjustment is determined without regard to any prior transferee’s basis adjustment.”). One commentator has argued that reverse 704(c) adjustments would result in different allocations of taxable gain depending on when they bought into a fund, which would result in the shares not being fungible. Yale, supra note 16, at 438. If, however, a fund has made a Section 754 election and it adjusts the basis of partnership property for the purchaser upon a transfer of an interest, the shares should be fungible for a purchaser—it would not matter whether a purchaser acquired a share with large or small book-tax difference since the purchaser would have the same Section 743 basis adjustment.
One potentially significant impediment to implementing such a regime is that it is necessary for the entity to know each owner’s transactions in the shares of the entity. In the United States, many publicly traded ownership interests are not held directly, but are in the name of brokers or other third parties.316
See Invesco Trust Prospectus, supra note 3099, at 81 (noting the need to obtain secondary market transaction information for all shareholders to make the Section 743 basis adjustments).
Under Subchapter M currently, a RIC determines its investment company income and net capital gains yearly. The shareholders of record when these amounts are distributed are taxed on these amounts. The distributed capital gains may represent earnings that accrued in prior years, and the shareholders receiving capital gains distributions may not have benefited from them. This treatment follows the basic rules for corporate distributions.
However, publicly traded partnerships generally follow the partnership rules with certain modifications. They determine taxable income and loss monthly and allocate it among the shareholders in proportion to the number of shares owned at the previous month’s end.317
See Invesco Trust Prospectus, supra note 3099, at 79–80 (noting that a shareholder who redeems shares during a month may be allocated income, gain, loss, and deduction realized after the date of the redemption and that monthly allocation may be consistent with IRS regulations requiring daily allocations of tax items between buyers and sellers of partnership interest under Section 706).
In considering whether to adopt Subchapter K principles for RICs, Congress would have to address the treatment of distributions for redeeming shareholders. When a partnership distributes cash in redemption of an ownership interest, a partner does not recognize gain until they receive a cash distribution in excess of basis.318
I.R.C. §§ 731(a) (gain not recognized to partner except if cash distributed exceeds basis of partnership interest); and 733 (basis reduced by money distributed to partner). Partners have a unitary basis in their partnership interests.
In a redemption by a shareholder in a RIC, a shareholder determines gain or loss on a share-by-share basis.
If a partnership has a Section 754 election in effect and a partner realizes gain on the distribution of cash, the partnership can increase the basis of its property by the amount of gain recognized.320
I.R.C. § 734(b)(1)(A) (basis of partnership property increased by any gain recognized under Section 731(a)(1)). If a loss is recognized, the partnership decreases the basis of its property. Id. § 734(b)(2)(A).
The treatment of distributions of property other than cash raises additional policy and administrative challenges. Distributions of property by a partnership are generally tax free, but they are treated differently depending on whether the distribution is a liquidation of a partner’s interest or a non-liquidating distribution.321
If the only property distributed is cash, unrealized receivables, or inventory in liquidation of a partner’s interest, and the basis of such property is less than the basis of the partner’s interest in the partnership, the partner will recognize loss. I.R.C. § 731(a)(2). In certain circumstances, the distribution of marketable securities is treated as a distribution of cash, but this rule does not apply to investment partnerships. I.R.C. §§ 731(c)(1) and (c)(3)(A)(iii).
In a non-liquidating distribution of property, a partner generally takes a carryover basis in the property and reduces his basis in his partnership interest.322
I.R.C. §§ 732(a)(1) (basis of property distributed to partner in non-liquidating distribution is the same as the partnership basis in the property but limited to partner’s basis in partnership); and 733 (basis of partnership interest reduced by basis of property distributed). If a partner’s basis is less than the basis of the property distributed, the property will take a basis equal to the partner’s basis in her partnership interest immediately before the distribution. Id. § 732(a)(2).
I.R.C. § 732(b) (basis of property distributed in liquidation is equal to partner’s basis in partnership interest immediately before the distribution). The rules for allocating the basis among the distributed property are found in Section 732(b).
Id. § 734(a)–(c).
Adopting these rules for RICs would not, however, address the issues raised by Section 852(b)(6) generally and heartbeat trades in particular, as RICs could continue to distribute property tax-free to their shareholders in either a liquidating or non-liquidating distribution. In the case of a liquidating distribution, a redeeming shareholder would take a basis in the property equal to the basis in her redeemed interest; the property distributed could have a built-in gain or loss in the hands of the liquidated partner.
In the case of a non-liquidating distribution, neither the shareholder nor the RIC would recognize gain, but since the redeeming shareholder would generally take a carryover basis in any property received, any built-in gain in the distributed property would ultimately be taxed to the redeeming shareholder.325
Under Section 732(a)(2), if the basis of the property distributed were greater than the partner’s outside basis, the basis of the property distributed would be stepped down to the partner’s outside basis, and the partnership would increase the basis of its remaining property by the difference in the property’s basis and the partner’s basis in her partnership interest. See also id. § 734(b)(1)(B) (the same rules, applicable to liquidating distributions).
This assumes that the appreciated property was not contributed by another partner. See id. § 704(c)(1)(B).
One commentator has argued that if appreciated property were distributed to an AP and the tax burden from the sale of the property were shifted from an ETF to a redeeming AP, the redemption-contribution mechanism used to maintain the parity between share price and NAV could fall apart.327
Hodaszy, Section 852(b)(6) Loophole, supra note 26, at 85.
To illustrate, assume that an ETF has two shareholders, AP1 and S2. AP1 has a basis of 100 and S2 has a basis of 50 in the ETF shares. Both interests are worth 100. If the ETF makes a non-liquidating distribution to AP1 of property with a basis of 50 and a FMV of 75, AP1 would have a carryover basis of 50 in the property with a built-in gain of 25 and a basis of 50 in her remaining interest now worth 25. Although the distributed property has a built-in gain of 25, that gain is exactly offset by the unrealized loss in the retained ETF interest. Since APs are certainly dealers in securities, under Section 475(a) they are subject to mark-to-market treatment on their securities. Thus, they can sell both positions and offset the gains and losses or retain one or both of them, but all gains and losses from both positions will be recognized at year end.
Current partnership rules permit tax-free distributions of property, both pro rata distributions and non-pro rata distributions under Section 852(b)(6). For instance, a partner could contribute unappreciated securities328
Special rules apply to contributions of appreciated property that is distributed to another partner. See I.R.C. § 704(c)(1)(B).
If a partnership had a Section 754 election in effect, when property is distributed and other partners have Section 743 basis adjustments with respect to the distributed property, those adjustments would have to be allocated to other property. See Treas. Reg. § 1.743-1(g)(2). These adjustments would certainly impose significant administrative costs if partnership interests are turned over frequently, and the partnership frequently distributes property. Importantly, this ensures that the gains remain at the partnership level.
In sum, adoption of partnership principles could significantly reduce the problem with overhang, albeit with an increase in administrative complexity at the fund level. Given the treatment of distributions of partnership property, however, current partnership principles would be insufficient to prevent heartbeat trades and prevent a fund from making tax-free portfolio adjustments. These partnership rules could be modified, for example, by treating distributions of appreciated securities as a taxable event. Alternatively, Congress could opt to live with the limitations of Subchapter M and overhang but focus on eliminating Section 852(b)(6).
The ability of ETFs to distribute tax free appreciated securities and make tax-free portfolio adjustments using the exemption of Section 852(b)(6) should be curtailed. The exploitation of this rule as a mechanism to allow ETFs to reduce unrealized gain via distributions of appreciated property both in ordinary redemptions and in heartbeat trades was certainly not contemplated by Congress when it enacted the provision in 1969. Congress should either repeal Section 852(b)(6) or limit it to pro rata distributions of an ETF’s portfolio and concomitantly require ETFs to reduce the basis of their securities by any gains realized when distributing property in redemption of their shares.
Annex 1:
Realized Gains on In-Kind Redemptions and Capital Gains Distributions for the Largest (by AUM) Equity ETFs (June 15, 2021)
Source: etf.com

- 1Inv. Co. Inst., 2021 Investment Company Fact Book 33 at II (61st ed. 2021) [hereinafter Factbook], https://perma.cc/3ZLY-KZGX;id. at 41 fig. 2.2. Investment companies also include closed-end funds and unit investment trusts (UITs), which held about 0.9% and 0.2%, respectively, of investment company assets. Id. Many early ETFs were organized as UITs. Two of these early UITs, SPDR S&P 500 ETF Trust (SPY) and PowerShares QQQ Trust, Series 1 (QQQ), still represent a significant portion of total ETF trading volume and net assets. Exchange-Traded Funds, 83 Fed. Reg. 37332, 37336 (proposed Jul. 31, 2018). This article does not address UITs. For a history of the development of index funds, including ETFs, see Robin Wigglesworth, Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever (2021).
- 2Factbook, supra note 1, at 43 fig. 2.4.
- 3Id. at 47 fig. 2.7.
- 4Id. at 40 fig. 2.1.
- 5Id. at 41 fig. 2.2 (ETF assets); id. at 40 fig. 2.1 (number of ETFs). In contrast, the number of mutual funds grew from 7,970 to 9,027, and the assets held by mutual funds grew from $6.8 billion to $23.9 billion over the same period. Id. at 40 fig. 2.1 (number of mutual funds); id. at 41 fig. 2.2 (mutual fund assets).
- 6Lewis Braham, DFA’s Plan to Launch 3 ETFs Marks the End of an Era, Barron’s (Oct. 2, 2020), https://perma.cc/3SY4-3G6P. TheETFs were converted from mutual funds.
- 7See, e.g., Claire Ballentine, If Your Mutual Fund Becomes an ETF, Here’s Why, Bloomberg (Apr. 1, 2021), https://perma.cc/FY68-DQ6M;Brian Cheung, ‘Floodgates’ open on mutual funds converting into ETFs, Yahoo Fin. (Aug. 13, 2021), https://perma.cc/3RTU-LKMB.Heather Bell, JP Morgan to Convert 4 Mutual Funds, ETF.com (Aug. 11, 2021), https://perma.cc/RF6H-4F7M.
- 8Investment companies are subject to the provisions of the Investment Company Act of 1940 [hereinafter the 1940 Act], and regulated investment companies are subject to the provisions of Subchapter M of the Internal Revenue Code. Certain ETFs, which invest in commodities, currencies, and futures, are not subject to the 1940 Act. As of 2021, these ETFs held assets of $82 billion of the $4.4 trillion total ETF assets. Factbook, supra note 1, at 84 fig. 4.2.
- 9A fund may not offer to exchange its securities for anything other than its NAV without SEC approval. 15 U.S.C. § 80a-11 (2021); 17 C.F.R. § 270-22c-1(a) (2021) (requiring redemption or purchase price to be at the current NAV which is next computed after the redemption or purchase request).
- 10Exchange Traded Funds, 84 Fed. Reg. 57162, 57166 (Oct. 24, 2019) (codified at 17 C.F.R. pts. 210, 232, 239, 270, 274) [hereinafter Rule 6c-11].
- 11Precidian ETFs Trust, Investment Company Act Release Nos. 33440, 84 Fed. Reg. 14690 (Apr. 8, 2019) (notice) and 33477 (May 20, 2019) (order) and related application. Prior to the Precidian order, ETFs disclosed daily their portfolio components. In contrast, the Precidian ActiveShares ETFs are not required to disclose their portfolio components. Precidian discloses portfolio prices every second.
- 12See, e.g., Rabih Moussawi, Ke Shen, and Raisa Velthuis, The Role of Taxes in the Rise of ETFs (Sept. 22, 2022) (working paper), https://perma.cc/5BSX-BUZA(concluding that migration of flows from active mutual funds to ETFs is driven primarily by tax considerations); Ben Johnson & Alex Bryan, Measuring ETFs’ Tax Efficiency Versus Mutual Funds, Morningstar (Aug. 7, 2019), https://perma.cc/FPZ6-BVV8.
- 13The committee that selects stocks comprising the S&P 500 typically replaces 25 to 30 companies per year or 5% or 6% of the index. David Blitzer, Inside the S&P 500: Selecting Stocks, S&P IndexologyBlog (July 9, 2013), https://perma.cc/C8PY-WUEP.Other indices may have a slightly higher turnover. In contrast, many equity mutual funds have annual turnover exceeding 100%.
- 14An ETF investor will be taxed on distributions received from an ETF attributable to dividends, short-term capital gains, or interest.
- 15Capital gains dividends, which are dividends consisting of a fund’s net capital gains, are generally distributed at year-end.
- 16Ethan Yale, Mutual Fund Tax Overhang, 38 Va. Tax Rev. 397 (2018).
- 17Moussawi et al., supra note 12.
- 18Elisabeth Kashner, The Heartbeat of ETF Tax Efficiency [hereinafter Heartbeat), Factset (Dec. 18, 2017), https://perma.cc/3EDP-7B3N;Elisabeth Kashner, The Heartbeat of ETF Tax Efficiency Part Two: Knowing the Players [hereinafter Players], Factset (March 22, 2018), https://perma.cc/5LCA-9NUL;Elisabeth Kashner, The Heartbeat of ETF Tax Efficiency Part Three: Trade Forensics, Factset (Apr. 5, 2018) https://perma.cc/VC5L-9MZ7;Zachary Mider, Rachel Evans, Carolina Wilson, and Christopher Cannon, The ETF Tax Dodge is Wall Street’s ‘Dirty Little Secret’, Bloomberg (March 29, 2019), https://perma.cc/98C9-JHPE.
- 19Sam Potter, BlackRock ETFs Get Billions Via Trades Hinting at Tax Avoidance, Bloomberg (Jun. 24, 2021), https://perma.cc/P6MZ-ULY8(describing $13.5 billion inflows into five funds in suspected heartbeat trades due to rebalancing of FTSE Russell indices).
- 20Rule 6c-11, 84 Fed. Reg. 57162, 57184–57189; 17 C.F.R. § 270.6c-11(a)(1) (defining custom basket). Custom baskets and heartbeat trades are discussed infra at Part VII.A. and B.
- 21See infra at Part VII.D.
- 22Mider et al., supra note 18.
- 23Contributions to an after-tax IRA are not deductible, and hence must be made with after-tax dollars. Any realized earnings are exempt from current taxation, but withdrawals in excess of the amount contributed are treated as ordinary income. Thus, an investor in a tax-efficient ETF would currently recognize their share of the fund’s ordinary dividends, but it would recognize long-term capital gains upon exiting the investment. Holding the same investment in an after-tax IRA, the investor would not be taxed currently on dividends but would recognize ordinary income upon withdrawing the investment gains. Furthermore, if the shares of the ETFs are held at death, the shareholder’s heirs will receive them with a stepped-up basis, which eliminates any unrealized capital gains. IRAs are not eligible for a stepped basis at death.
- 24A preliminary estimate by the Joint Committee on Taxation is that repealing Section 852(b)(6) would raise $206 billion over the next 10 years. Dawn Lim & Richard Rubin, Democratic Tax Proposal Takes Aim at ETFs, Wall St. J. (Sept. 15, 2021), https://perma.cc/EE4D-ZX83.
- 25Staff of S. Finance Comm., 117th Cong., Discussion Draft on Wyden Pass-through Reform, Section-by-Section Summary (Sept. 10, 2021), https://perma.cc/JTE5-GS2S.
- 26The taxation of U.S. investment companies has begun to attract the attention of legal scholars over the last decade due to the growth in ETF assets under management and the salience of the Section 852(b)(6) tax subsidy. See, e.g., Samuel D. Brunson, Mutual Funds, Fairness, and the Income Gap, 65 Ala. L. Rev. 139, 160 (2013) (recommending that investors be able to exclude up to ten percent of their dividend income from mutual funds from the investors’ taxable income); John C. Coates IV, Reforming the Taxation and Regulation of Mutual Funds: A Comparative Legal and Economic Analysis, 1 J. Legal Analysis 591, 614–18 (2009) (discussing a wide array of mutual fund reforms); Jeffrey M. Colon, The Great ETF Tax Swindle: The Taxation of In-kind Redemptions, 122 Penn St. L. Rev. 1 (2017); Steven Z. Hodaszy, Tax-Efficient Structure or Tax Shelter? Curbing ETFs’ Use of Section 852(b)(6) for Tax Avoidance, 70 Tax Law. 537, 599–605 (2017) [hereinafter Hodaszy, Section 852(b)(6) Tax Shelter] (arguing that ETFs should be required to reduce the basis of their remaining securities by the unrecognized gain of distributed securities) and Steven Hodaszy, ETFs Use Section 852(b)(6) for Tax Avoidance, Not Just Tax Deferral: So Why is this Loophole Still Open, 75 Tax Law. 489 (2022) [hereinafter Hodaszy, Section 852(b)(6) Loophole] (same); Lee A. Sheppard, ETFs as Tax Shelters, 130 Tax Notes 1235, 1240 (2011) (critiquing § 852(b)(6)) and Lee A. Sheppard, ETFs as Tax Dialysis Machines, 165 Tax Notes Federal 909 (Nov. 11, 2019); Shawn P. Travis, The Accelerated and Uneconomic Bearing of Tax Burdens by Mutual Fund Shareholders, 55 Tax Law. 819, 853–57 (2002) (detailing scenarios under which Subchapter M can result in acceleration of tax for fund shareholders and arguing that fund shareholders should not be taxed on reinvested capital gains but only when shares are sold, or non-capital gain dividends are received).
- 27The 1940 Act regulates “investment companies.” 15 U.S.C. § 80a-3(a)(1) (defining investment company to mean any issuer that holds itself out as being engaged primarily in the business of investing or trading in securities). The investment companies that are subject to the provisions of the 1940 Act are face-amount certificate companies, unit investment trusts, and management companies. 15 U.S.C. § 80a-4(1)-(3). To elect to be a RIC, a company must be a U.S. corporation that is registered under the 1940 Act as a management company, which includes open-end funds and closed-end funds. 15 U.S.C. § 5(a)(1)–(2). Unit investment trusts, business development companies, and certain common trust funds also can qualify as RICs, but they are not discussed further in this Article. I.R.C. § 851(a)(1) and (2).
- 28To be a RIC, an investment company elects RIC status and must derive at least 90% of its gross income as passive income, e.g., dividends, interest, and gains from the sale of stock or securities, and satisfy certain asset diversification requirements. I.R.C. § 851(b)(2) (defining gross income test); id. § 851(b)(3) (defining diversification test). The 1940 Act also imposes diversification tests on investment companies. 15 U.S.C. § 80a-5(b)(1)–(2). An investment company that fails either the income or asset tests may still qualify as a RIC if it makes certain disclosures and undertakes steps to remediate the failure. I.R.C. § 851(d)(3) (failure to satisfy asset tests) and 851(i) (failure to satisfy gross income test).
- 29An open-end mutual fund is one that issues “redeemable securities,” which entitle the holder to receive from the issuer his proportionate share of the issuer’s current net assets, or the cash equivalent thereof. 15 U.S.C. §§ 80a-2(a)(32) and 80a-5(a)(1) (defining redeemable security and open-end company, respectively).
- 3015 U.S.C. § 80a-5(a)(2) (defining closed-end company to be any management company that is not an open-end company). A closed-end fund can also raise capital via rights offerings and distribute capital via tender offers.
- 3117 C.F.R. § 270.6c-11(a)(1) (defining ETF). If certain conditions are satisfied, an ETF will be deemed to issue “redeemable securities” under Section 2(a)(32) of the 1940 Act. 17 C.F.R. § 270.6c-11(b)(1). ETFs organized as UITs do not fall within the purview of Rule 6c-11 but operate pursuant to exemptive orders.
- 32I.R.C. § 852(b)(1) and (3)(A) (imposition of corporate tax on investment company taxable income and net capital gains over capital gain dividends); I.R.C. § 852(b)(2)(D) (deduction for dividends paid against investment company income excluding net capital gains and tax-exempt interest dividends). Investment company taxable income is regular corporate taxable income but with certain adjustments, such as the exclusion of net capital gain, the disallowance of a deduction for any net operating loss (NOL), and the disallowance of the dividends received deduction. Id. § 852(b)(2). Investment company taxable income does not include tax-exempt interest.
- 33To the extent that a RIC does not distribute or is not deemed to distribute its investment company income or its net capital gains, it will be subject to corporate tax. Furthermore, to retain the benefits of Subchapter M, a RIC is generally required to distribute or be deemed to distribute annually at least 90% of its investment company taxable income and 90% of its tax-exempt interest income, computed without regard to the deduction for dividends. I.R.C. § 852(a)(1)(A)–(B). If a RIC does not satisfy the distribution requirements, it will be taxed as a regular C corporation.
- 34I.R.C. § 854(b)(1)(B) (qualified dividends); id. § 854(a) (treating capital gain dividend not as dividend for purposes of Sections 1(h)(11) and 243); id. § 852(b)(3)(B) (treating capital gain dividend as long-term capital gain); id. § 852(b)(5)(B) (treating exempt-interest dividend as tax-exempt interest under Section 103).
- 35See id. § 853(a)(1).
- 36When short-term capital gains are distributed to foreign shareholders, however, they retain their character as capital gains. See id. § 871(k)(2)(D) (exempting foreign persons from tax on short-term capital gain dividends distributed by a RIC). See Jeffrey M. Colon, Foreign Investors in U.S. Mutual Funds: The Trouble with Treaties, 35 Va. Tax Rev. 483 (2016).
- 37I.R.C. § 66(a)(1). These investment expenses also do not offset favorably taxed net capital gains or qualified dividend income. See Rev. Rul. 2005-31, 2005-1 C.B. 1084. For individuals, prior to 2018, such expenses would have been deductible under Section 212, but subject to the two percent floor for miscellaneous itemized deductions of Section 67(a). Under Section 68(g), which prohibits any miscellaneous itemized deduction until post-2025 taxable years, none of these expenses are deductible.
- 38A RIC can indefinitely carry over a capital loss. I.R.C. § 1212(a)(3)(A). Net operating losses, in contrast, cannot be carried over to reduce a RIC’s income in a subsequent year. Id. § 852(b)(2)(B). But since a loss reduces a fund’s NAV, it also reduces a shareholder’s gain or increases loss upon a sale of the RIC shares. Id. § 852(b)(2)(B).
- 39Other separate entity tax principles reflected in Subchapter M include taxing RICs on their retained income and gains at corporate rates, taxing shareholders on contributions of property to RICs, treating RICs as corporations for reorganizations and contributions, and requiring RICs to maintain earnings and profits accounts for retained earnings.
- 40An open-end fund may not offer to exchange its securities for anything other than its NAV without SEC approval. 15 U.S.C. § 80a-11; 17 C.F.R. § 270-22c-1(a) (requiring redemption or purchase price to be at the current NAV which is next computed after the redemption or purchase request).
- 41Since stock of an investment company is generally a capital asset, any gain or loss recognized on the sale or exchange of the stock will be capital, and the seller’s holding period will generally determine whether it is short-term or long-term. Redemptions of shares of publicly offered RICs are treated as sales or exchanges. I.R.C. § 302(b)(5).
If a shareholder has received an actual or deemed capital gains distribution and holds the RIC share for six months or less, any loss recognized on the sale or exchange is long-term loss to the extent of the capital gain dividend. I.R.C. § 852(b)(4)(A). This rule prevents a shareholder from purchasing a share shortly before a capital gain distribution and then selling it and realizing a short-term loss. Since a fund’s NAV declines by the amount of the distribution, the long-term capital gain distribution would approximate the short-term capital loss if the shares were sold shortly after the distribution. For taxable investors in the highest tax brackets, the loss would offset income taxed at 40.3%, while the long-term gain would be taxed at 23.8%. A similar rule disallows any loss on the sale of stock of a RIC held six months or less to the extent of any tax-exempt interest dividend. I.R.C. § 852(b)(4)(B).
- 42One exception is if a RIC does not distribute all of its capital gains, in which case it is taxed on undistributed net capital gains. I.R.C. § 852(b)(3)(A). The RIC may designate an amount of undistributed capital gains, and the RIC’s shareholders at year end will include that amount in income. They are treated as having paid their share of the RIC’s taxes and can increase their share basis by the difference between the designated amount and tax paid. I.R.C. § 852(b)(3)(D).
- 43For a detailed examination of tax overhang, see Yale, supra note 16.
- 44NAV was $30 ($60 assets/two shares) when S2 invested. After distribution of the $20 of realized gains, the NAV drops to $20 ($60 – $20)/two shares.
- 45See, e.g., Debbie Carlson, Brace Yourself for a Large Tax Hit from Mutual-Fund Payouts, MarketWatch (Dec. 13, 2021), https://perma.cc/DG5L-F5A9;Tom Herman, A Tax Trap Many Fund Investors Fall Into, Wall St. J. (Oct. 22, 2019), https://perma.cc/W3BX-BETZ;and Christine Benz, The Lowdown on Mutual Fund Capital Gains 2019 Edition, Morningstar (Nov. 14, 2019), https://perma.cc/W4NB-TKU3.Even the funds of sponsors that have a reputation for focusing on tax efficiency, such as Vanguard, can generate significant tax liabilities in the absence of economic gains. See Jason Zweig, The Huge Tax Bills That Came Out of Nowhere at Vanguard, Wall St. J. (Jan. 21, 2022), https://perma.cc/8KMH-ERES(noting that certain Vanguard target date funds reported distributing 15% of total assets as capital gains).
- 46See, e.g., Distributions by Fidelity Mutual Funds, Fidelity, https://perma.cc/TP92-XBT8.
- 47See, e.g., Michael Barclay, Neil D. Pearson, and Michael S. Weisbach, Open End Mutual Funds and Capital Gains Taxes, 49 J. of Fin. Econ. 3 (1998) (finding evidence that managers reduce overhang to attract new investors); Daniel Bergstresser & James Poterba, Do After-Tax Returns Affect Mutual Fund Inflows, 63 J. of Fin. Econ. 381 (2002).
- 48Yale, supra note 16.
- 49Bergstresser and Poterba found that an increase of 10% in a fund’s overhang decreased new money net inflows by between 1.7% and 2.3%. Bergstresser & Poterba, supra note 47, at 406 tbl. 10.
- 50Barclay, et al., supra note 47, at 30, 33.
- 51For a discussion of the issue of co-investment by taxable and tax-exempt shareholders in mutual funds, see Jeffrey M. Colon, Oil and Water: Mixing Taxable and Tax-Exempt Shareholders in Mutual Funds, 45 Loy. U. Chi. L. J. 773 (2014).
- 52Barclay, et al., supra note 47, at 30, 33. Tax-exempt shareholders may benefit, however, if any increased AUM reduces per‑share administrative costs.
- 53Clemens Sialm & Laura Starks, Mutual Fund Tax Clienteles, 67 J. Fin. 1397 (2012).
- 54Id.
- 55These conflicts and the failure to manage them were laid bare at the end of 2021 when Vanguard lowered its minimum investment for its institutional target retirement funds. Tax-exempt corporate retirement funds moved from the standard funds to the institutional funds, which required the standard funds to sell appreciated assets to pay the redeeming shareholders. The sales generated significant tax liabilities for taxable shareholders. See Zweig, supra note 45.
- 56The first ETF was listed in Canada. See David Berman, The Canadian Investment Idea that Busted a Mutual-fund Monopoly, The Globe and Mail (Feb 19, 2017), https://perma.cc/KG3S-TH6R.The first U.S. ETF, the Standard & Poor’s Depository Receipts or SPDRs, was approved by the SEC in 1993. See Frances Denmark, Happy 20th Birthday, ETFs: A Look Back at Nate Most and His Novel Idea, Institutional Investor (July 3, 2013), https://perma.cc/A3TU-BWUZand The ETF Story Podcast, Bloomberg (2018), https://perma.cc/3X4U-L2VB.See also Wigglesworth, supra note 1 at 166–83 (detailing the birth of SPDRs).
- 57See, e.g., Martin Small et al., Four Big Trends to Drive ETF Growth, Blackrock (May 2018), https://perma.cc/8DZ2-RZUJ.
- 58Rule 6c-11, supra note 10, at 37, 333–37, 334. An ETF would typically request exemptive relief under Sections 2(a)(32), 5(a)(1), 22(d) and (e), 12(d)(1), 17(a) and (b), and 6(c) of the 1940 Act. See, e.g., Cambria Inv. Mgmt., L.P., Investment Company Act Release No. 30302 (Dec. 12, 2012). See also David J. Abner, The ETF Handbook 287 (2nd ed. 2016). In connection with Rule 6c-11, the SEC also adopted amendments requiring enhanced disclosures both to the SEC and to the public.
- 59Some of the conditions to come within the scope of Rule 6c-11 include that the ETF be listed on a national securities exchange, issue and redeem creation units from APs, disclose on its public website details of the portfolio holdings forming the basis of the NAV calculation, disseminate an intraday indicative value, and comply with other website disclosures and recordkeeping requirements. 17 C.F.R. § 270.6c-11(c). Leveraged ETFs were specifically excluded from the application of new Rule 6c-11.
- 6017 C.F.R. § 270.6c-11(b)(1). ETFs are also exempted from Section 22 of the 1940 Act, which generally requires that investment companies, principal underwriters and dealers sell a redeemable security to the public at the current public offering price. ETFs are also exempted from Rule 22c-1, which requires that a dealer transact a redeemable security at its NAV. Rule 6c-11 also exempts certain affiliates of an ETF from the application of Section 17(a) of the 1940 Act, which prohibits an affiliated person of an investment company from selling any security or other property to or purchasing any security from the investment company. This rule applies to persons who are affiliates solely because they hold voting power of 5% or more of the ETF’s shares or 5% or more of any investment company that is an affiliated person of the ETF. 17 C.F.R. § 270.6c-11(b)(3)(i) and (ii).
- 61John Gittelson, End of Era: Passive Equity Funds Surpass Active in Epic Shift, Bloomberg (Sept. 11, 2019), https://perma.cc/QL5H-RMWL.On January 21, 2020, for example, three of the four ETFs with AUM of greater than $100 billion tracked the S&P 500 and the fourth tracked the U.S. total market index, which tracks the CRSP U.S. Total Market Index. See ETF Finder, ETF.com, https://perma.cc/FR4V-FA8L(visited October 10, 2022) (ETFs selected by AUM).
- 62See, e.g., iShares ESG MSCI U.S.A. ETF (ESGU ticker), iShares by BlackRock, https://perma.cc/4YSW-E4YM(tracking an index of U.S. companies selected and weighted for positive environmental, social, and governance characteristics).
- 63See, e.g., iShares Edge MSCI Min Vol U.S.A. Small-Cap ETF (SMMV ticker), iShares by BlackRock, https://perma.cc/R4EE-ETXJ(tracking an index of U.S.-listed small cap stocks that are selected and weighted to create a low-volatility portfolio).
- 64See, e.g., The Cannabis ETF (THCX ticker), MarketWatch, https://perma.cc/2ZQ7-CEAX(tracking an index of cannabis companies defined as companies deriving at least 50% of their revenues from legal marijuana or hemp industries).
- 65See, e.g., ProShares Pet Care ETF (PAWZ ticker), MarketWatch, https://perma.cc/LA34-8CPQ(tracking a global index of companies providing pet-care products and services). ETFs offer hundreds of different economic exposures to subsets of the global equity market. See List of Equity Indexes, VettaFi, https://perma.cc/C4EW-PU7M.The use of the term “passive” for many of these funds is certainly a misnomer. See, e.g., Adriana Z. Robertson, Passive in Name Only: Delegated Management and “Index” Investing, 36 Yale J. on Reg. 795 (2019) (arguing that index investing is a form of delegated management).
- 66This is a very well-known phenomenon of closed-end funds. See, e.g., Charles M. C. Lee, Andrei Shleifer, and Richard Thaler, Investor Sentiment and the Closed-End Fund Puzzle, 46 J. of Fin. 75 (1991); Martin Cherkes, Closed-End Funds: A Survey, 4 Ann. Rev. of Fin. Econ. 431 (2012).
- 67For example, an investor who believes that the Korean stock market was going to rise could purchase shares of a closed-end fund that invests in Korean stocks. Even if the Korean stock market rises, the investment in the fund could earn a return less than the increase in the Korean stock market if the fund trades at a discount or the discount widens.
- 68Rule 6c-11 permits non-APs to create and redeem shares on the day of a reorganization, merger, conversion, or liquidation. 17 C.F.R. § 270-6c-11(a)(2) (2019).
- 69For a more detailed overview of the creation and redemption process, see ETF Processing, DTCC Learning Center, https://perma.cc/58DC-YKVW. In-kind creations and redemptions are by far the predominant methods, although some ETFs require cash to create shares, and some pay cash instead of in-kind distributions upon redemption. See SPDR Series Trust, Form 497K, 91–92 (Dec. 18, 2019) (listing creation unit sizes from 10,000 to 500,000 shares for various ETFs and describing whether a fund’s creation units are in-kind or cash). For an overview of the purchase and redemption of creation units of a particular family of funds, see id. at 91–98.
- 70See, e.g., SPDR Series Trust, Form 497K, 91–92 (Dec. 18, 2019) at 97–98 (listing transaction fees for the purchase and redemption of creation units, which range from $250 to $3,000 per transaction).
- 71See, e.g., Understanding the ETF creation and redemption mechanism, Charles Schwab (2022), https://perma.cc/3WAP-GSS3.
- 72Id. The AP earns virtually risk-free the $1 difference between the short sale proceeds and the acquisition cost of the ETF shares.
- 73Id.
- 74Some fund families, such Vanguard and Fidelity, offer commission-free ETFs for persons with a brokerage account. See, e.g., ETF fees and minimums, Vanguard, https://perma.cc/BE7J-JJ7C (no commission for Vanguard ETFs if purchased in Vanguard brokerage account) and iShares ETFs, Fidelity, https://perma.cc/XMV9-7GEL(no commissions for iShares ETFs if purchased in Fidelity brokerage account). Although these arrangements eliminate brokerage commissions, the investor still bears any bid-asked spread.
- 75ETFs are required to post online a table showing the number of days during the most recently completed calendar year and the most recently completed calendar quarters the ETF traded at a premium or discount. ETFs are also required to post a line graph showing the actual premiums and discounts. 17 C.F.R. § 270.6c-11(c)(1)(ii) and (iii). In situations of market stress, bid-asked spreads can widen, and the ETF share price can diverge significantly from NAV. For example, on April 9, 2020, the iShares iBoxx $ High Yield Corporate Bond ETF traded at a premium of 4.59%; on March 26, 2020, the premium was 3.25%. See iShares iBoxx $ High Yield Corporate Bond ETF, iShares by BlackRock, https://perma.cc/27LK-UHVC. If there is insufficient interest in the ETF, it can become a so-called “zombie” fund, which are generally characterized by low AUM and trading volume. See, e.g., Guillaume Poulin-Goyer, Understanding Zombie ETFs, Investment Executive (Feb. 4, 2020), https://perma.cc/P4T2-F4W8(describing zombie ETFs as funds ‘living dead’ due to their low trading volume and low assets).
- 76Although a mutual fund can levy a front-end or back-end load on purchasing and selling shareholders, such loads are increasingly rare.
- 77For example, the largest mutual fund in the United States is the Vanguard 500 Index Fund Admiral Shares (VFIAX ticker) which requires a minimum investment of $3,000, whereas the ETF of the same fund has a minimum investment of one share. See VFIAX Vanguard 500 Index Fund Admiral Shares, Vanguard (Oct. 10, 2022), https://perma.cc/S757-34ZE. After the initial investment in a fund with a minimum investment requirement, subsequent investments can be of any size.
- 78If contributions equal or exceed redemptions, contribution proceeds can be used to pay the redeeming shareholders. Mutual funds often retain a cash balance with which to satisfy redemptions, but these cash balances can be a drag on fund returns. ETFs do not have to retain such balances, because they generally satisfy redemption requests in-kind.
If not all of the underlying assets are liquid, which can occur especially in a bond mutual fund, a run on the fund can cause the fund to first sell the liquid assets to meet redemptions leaving only illiquid and difficult-to-sell assets in the fund. A notable example of this occurred in 2015 when Third Avenue Focused Credit Fund suspended redemptions. See, e.g., Matt Hougan, ETFs Solve Mutual Bond Fund Problem, ETF.com (Dec. 14, 2015), https://perma.cc/FXE7-NVY6.
- 79Section 852(b)(6) is listed as a tax expenditure, but one for which projected revenue changes are unavailable. Staff of Joint Comm. on Tax’n, 116th Cong., Estimates of Federal Tax Expenditures for Fiscal Years 2020–2024, JCX-23-20, at 22 (Joint Comm. Print 2020). The Joint Committee of Taxation, however, has estimated that repeal of Section 852(b)(6) would bring in over $200 billion in tax revenue over the next 10 years. Lim & Rubin, supra note 24.
- 80Gen. Utils. & Operating Co. v. Helvering, 296 U.S. 200, 206 (1935). Congress extended the same non-recognition rule in the case of liquidations. I.R.C. §§ 336(a), 337(a) (1954) (corporation does not recognize gain or loss on the distribution of property in liquidation or the sale of property within a twelve-month period of adoption of liquidation). Notwithstanding the general non-recognition rules, gain was required to be recognized on the distribution of LIFO inventory and property with liabilities greater than basis, and on the distribution of installment obligations in liquidations. Id. §§ 311(b)–(c), 336. The General Utilities doctrine, originally codified in Section 311(a) of the Internal Revenue Code of 1954, remains in the Code, but it no longer applies to distributions of appreciated property. 26 U.S.C. § 311(b).
- 81I.R.C. § 311(a)(2) (1954) (corporation does not recognize gain or loss on distribution of property in ordinary distribution or redemption); id. at §§ 336(a), 337(a) (1954) (corporation does not recognize gain or loss on the distribution of property in liquidation or the sale of property within 12-month period of adoption of liquidation).
- 82Tax Reform Act of 1969, Pub. L. No. 91-172, sec. 905(a), § 311(d)(1), 83 Stat. 487, 713 (amended in 1986).
- 83Clifford L. Porter, Redemption of Stock with Appreciated Property: Section 311(d), 24 Tax Law. 63, 63–64 (1970). The article was The Great Tax-Free Cash-In: The Insurance Companies Are Getting imaginative about the Big Unrealized Capital Gains in Their Investment Portfolios, Forbes, Nov. 1, 1969, at 52. In 1968, the IRS ruled that a corporation would not recognize gain on the distribution of appreciated shares held as investment property in redemption of its shares. The stock was offered pro rata to all shareholders, and shareholders owning 35% of the distributing corporation’s stock accepted the offer.
- 84S. Rep. No. 91-552 at 279 (1969).
- 85H. R. Rep. No. 91-782 at 333 (1969). Certain redemptions were excluded, including complete redemptions of 10%-or-more shareholders, split-offs of 50%-or-more subsidiaries, distributions pursuant to antitrust decrees, redemptions under Section 303, and certain redemption distributions to private foundations. Tax Reform Act of 1969, Pub. L. No. 91-172, sec. 905(a), § 311(d)(2)(A)–(G), 83 Stat. at 714.
- 86Tax Reform Act of 1969, Pub. L. No. 91-172, sec. 905(a), § 311(d)(2)(G), 83 Stat. at 714.
- 87The IRS has permitted closed-end funds to redeem their shares subject to certain more restrictive circumstances than mutual funds. See infra Part X.C.
- 88See Porter, supra note 83, at 79.
- 89See Porter, supra note 83, at 79. This observation may not be entirely accurate, because even if distributions were taxable, the recognized gains would not be subject to entity-level tax, provided the RIC distributed the gains as a dividend.
- 90Under the 1940 Act, open-end funds issue “redeemable securities,” which are defined to be a security “under the terms of which the holder, upon its presentation to the issuer . . . is entitled . . . to receive approximately his proportionate share of the issuer’s current net assets, or the cash equivalent thereof.” 15 U.S.C. § 80a-2(a)(32). Details on a fund’s right to pay redemptions in-kind are disclosed in Form N-1A, Item 11(c)(8) and a fund’s formation documents, e.g., articles of incorporation or declaration of trust. N-1A Items 22 and 23 also address redemption rights. Form N-1A is used by open-end funds to register under the 1940 Act and offer their shares under the Securities Act of 1933.
- 91I.R.C. § 311(b) (distribution of appreciated property as an ordinary distribution taxable); id. at § 336(a) (distribution of appreciated property in a complete liquidation taxable). Section 311(b) applies to distributions described in Sections 301–07, which includes ordinary distributions (generally treated as dividends) under Section 301 and distributions in redemption of a corporation’s shares that are treated as exchanges under Section 302(a). An important exception to this rule is Section 355, which permits a corporation to distribute stock or securities of a controlled corporation to its shareholders in a spin-off, split-up, or split-off without the recognition of gain or loss. I.R.C. § 355(c). Another exception is for property distributed to an 80%-or-more corporate shareholder in a corporate liquidation. Id. § 337(a).
- 92Compare I.R.C. § 311(d)(2)(E) (1982) (amended 1986), with Tax Reform Act of 1986, Pub. L. 99-514, sec. 631(e)(11), § 852(b), 100 Stat. 2085, 2274 (codified as amended at I.R.C. § 852(b)(6)).
- 93In promulgating rules for investment companies to manage their liquidity risks in 2016, the SEC stated that “most funds often consider redemptions in kind to be a last resort or emergency measure.” Investment Company Liquidity Risk Management Programs, 81 Fed. Reg. 82142, 82210 (Nov. 18, 2016) (codified at 17 C.F.R. pts. 270, 274) [hereinafter SEC Liquidity Management].
- 94Michael S. Piwowar, Comm’r, SEC, Remarks at the 2015 Mutual Funds and Investment Management Conference (Mar. 16, 2015). See also SEC Liquidity Management, supra note 93.
- 9517 C.F.R. § 270.18f-1(a) (2017). The irrevocable election is filed on Form N-18F-1 and must be disclosed in either the prospectus or statement of additional information. It is also required to be disclosed on Form N-1A, Item 23(d).
- 96See Vikas Agarwal, Honglin Ren, Ke Shen, and Haibei Zhao, Redemption in Kind and Mutual Fund Liquidity Management, Rev. of Fin. Stud. (forthcoming) (finding that from 1997 to 2017, approximately 70% of funds permitted in-kind redemptions).
- 97To contribute appreciated property tax free to a corporation, the transferor(s) must be in control of the corporation immediately after the exchange. I.R.C. § 351(a). Control is defined to be at least 80% of the combined voting power of all classes of voting stock. I.R.C. § 368(c).
- 98I.R.C. § 852(b)(6) (Section 311(b), which requires a corporation to recognize gain on the distribution of appreciated property, does not apply to a RIC in a redemption of its shares).
- 99The ETF could only recognize the losses if they were not subject to the wash sales limitation of Section 1091.
- 100Treas. Reg. § 1.1012-1(c) (default rule for basis of stock sold is FIFO, but specific identification permitted).
- 101For example, at the end of March 31, 2021, the iShares Russell Mid-Cap ETF had $1.132 billion of capital loss carryforwards and $9.944 billion of unrealized gains, BlackRock, iShares 2021 Annual Report 127 (2021), and it realized $1.354 billion of gains from in-kind distributions, id. at 105. It is not clear why a RIC cannot use an NOL but can carryover a capital loss. I.R.C. § 852(b)(2)(B) (stating that no NOL deduction is permitted in computing investment company taxable income).
- 102The largest and oldest ETF, SPDR S&P 500 ETF, has never made a capital gains distribution in 24 years. Zachary Mider, Rachel Evans, Carolina Wilson, and Tom Langerman, Hop In, Hop Out, Make Taxes Disappear, Bloomberg Businessweek, Apr. 1, 2019, at 26, 27.
- 103The returns were obtained using an S&P 500 Return Calculator using starting month and ending month of January, starting year of 2011, and ending year of 2020. The returns were with dividends reinvested. See S&P 500 Return Calculator, with Dividend Reinvestment, DQYDJ, https://perma.cc/J5RT-8WAR.
- 104Eighty of the companies were removed because of mergers and acquisitions. List of S&P 500 Companies, Wikipedia (Oct. 4, 2022), https://perma.cc/LG8F-YXDA;see also Adriana Z. Robertson, The (Mis)Uses of the S&P 500, 2 U. Chi. Bus. L. Rev. 137, 160–63, 64 (finding that constituents of S&P 500 “change substantially over time”).
- 105I.R.C. § 854(b)(1)(B) (qualified dividends). The fund shareholder must also satisfy the holding period rules in Section 246(c) to treat any dividend as a qualified dividend. I.R.C. § 1(h)(11)(B)(iii) (dividend is qualified dividend only if holding period rules of Section 246(c) are satisfied, with 45 days replaced by 60 days and 91-day period replaced by 121-day period). Qualified dividends are dividends received from U.S. corporations and certain foreign corporations. I.R.C. § 1(h)(11)(B)(i).
- 106Moussawi, supra note 12, at 4, 5.
- 107Ben Johnson and Alex Bryan, Measuring ETFs’ Tax Efficiency Versus Mutual Funds, Morningstar (Aug. 7, 2019), https://perma.cc/JL4E-E659.
- 108The Russell 1000 tracks the returns of the highest ranking 1,000 stocks, on a capitalization-weighted basis, of the Russell 3000, which aims to track the return of the entire U.S. stock market. FTSE Russell, 2019 Russell US Indexes Reconstitution 4 (2019), https://perma.cc/D2LC-HQ49.
- 109The difference between the two returns were, in four of the five years, actually a bit less than the difference in the expense ratios.
- 110FSTE Russell, 2019 Russell US Indexes Reconstitution, 4, https://perma.cc/KW8K-V6M4.Additions generally are not taxable events.
- 111If shares are depreciated, the fund can generally recognize any losses, subject to the wash sales limitation of Section 1091. These losses can be netted against gains in determining a fund’s net capital gains and investment income. If a fund has a net capital loss, it can be carried over indefinitely and used against gains in subsequent years, subject to certain limitations. I.R.C. § 1212(a)(3).
- 112As of March 31, 2021, IWB had $613 million of capital loss carryovers compared to net assets of $27 billion.
- 113Annex 1 shows that 100% of the top 25 equity ETFs had capital loss carryovers, and the total capital loss carryovers were $133 billion.
- 114I.R.C. § 1001(c) (generally requiring realized gain and loss on the sale or exchange of property to be recognized); Treas. Reg. § 1.1001-1(a) (gain or loss is realized from the exchange of property for other property differing materially).
- 115For detailed analysis of how Vanguard used heartbeat trades to eliminate the gain on $1 billion of shares of Monsanto on the eve of its taxable acquisition by Bayer, see Zachary R. Mider, Annie Massa, and Christopher Cannon, Vanguard Patented a Way to Avoid Taxes on Mutual Funds, Bloomberg (May 1, 2019), https://perma.cc/9G8N-ESYV.
- 116Kashner, supra note 18.
- 117Mider, supra note 102, at 26.
- 118A procedure to detect heartbeat trades based on inflows and outflows is set out in Moussawi, supra note 12, at 47.
- 119The S&P 500 index, for example, is generally rebalanced quarterly and reconstituted annually in September. See S&P Dow Jones Indices, S&P U.S. Indices Methodology 26 (Mar. 2020); see also BlackRock ETFs Get Billions Via Trades Hinting at Tax Avoidance, Bloomberg (June 24, 2021), https://perma.cc/T82K-7FAY.
- 120A rebalancing of an equity index can consist of adding entirely new shares, increasing positions in current shares, deleting entire positions in current shares, and reducing positions in current shares.
- 121The twenty funds had built-in gains of $1.271 trillion. The remaining five funds had total built-in losses of only $20.5 billion.
- 122See Kashner, Players, supra note 18 (finding that creation and redemption trades come from “ETF trading desks at capital market firms.”). Kashner also notes that although an asset manager or sponsor could invest in one of its portfolio managers and do the same trade, it is prohibited from doing so under the self-dealing rules of Section 17 of the 1940 Act.
- 123See Kashner, Heartbeat, supra note 18 If some of the shares that the ETF wishes to dispose of have built-in losses, the ETF could sell those in the market to generate fund-level losses to use against future gains.
- 124The AP would recognize any gain or loss on the contribution of the creation portfolio, as the transaction would not qualify under Section 351. The AP would recognize gain or loss on the difference between the value of the ETF shares at the time of contribution and the value of the securities received in the in-kind distribution. I.R.C. § 1001(c) (generally requiring realized gain and loss on the sale or exchange of property to be recognized); Treas. Reg. § 1.1001-1(a) (gain or loss is realized from the exchange of property for other property differing materially). The exchange of the ETF shares for the custom portfolio would be treated as a sale or exchange under Section 302(a)(5). I.R.C. § 302(a)(5) (redemption by publicly offered RIC treated as sale or exchange). An ETF would satisfy the definition of publicly offered RIC since its shares are regularly traded on an established securities market. I.R.C. § 67(c)(2)(B)(i)(II).
- 12517 C.F.R. § 270-6c-11(a)(1)(A) (2019). A basket consists of the securities or other asset for which an ETF issues creation units (shares) or for which it redeems creation units. Id.
- 126Id.
- 127Exchange-Traded Funds, 83 Fed. Reg. 37332, 37355 (proposed Jul. 31, 2018). This change in SEC practice created a disparity between ETFs that were able to use custom baskets and those that were not.
- 128Rule 6c-11, supra note 10, at 57,184. See, e.g., The Dreyfus Corp., Application for an Order under Section 6(c) of the Investment Company Act of 1940 (Form 40-APP/A) (Sep. 28, 2016).
- 129Rule 6c-11, supra note 10, at 57184.
- 130Exchange-Traded Funds, 83 Fed. Reg. at 37355 (proposed Jul. 31, 2018).
- 131Id.
- 132Id.
- 13317 C.F.R. § 270-6c-11(c)(3)(i) (2019). The ETF must also specify the titles or roles of the ETF’s investment adviser’s employees who are required to review compliance with the specified parameters. 17 C.F.R. § 270-6c-11(c)(3)(ii) (2019).
- 13417 C.F.R. § 270-6c-11(a)(2) (2019).
- 135Kashner, The Heartbeat of ETF Tax Efficiency Part Three: Trade Forensics, supra note 18.
- 136Id. at 14. The shares received are delivered to close the short sales.
- 137Id.
- 138Id.
- 139See, e.g., Dimensional ETF Trust, Registration Statement (Form N-1A) 30–36 (June 25, 2020) (discussing of creation and redemption process, including the use of custom baskets, but not discussing potential costs to ETFs). For tax-exempt investors, these trades may not be beneficial.
- 140Vanguard applied for and was granted exemptive relief under Section 6(c) of the 1940 Act for exemptions under various sections of the 1940 Act, including Section 2(a)(32) (definition of redeemable security), Section 18(f)(1) and (i) (prohibition against issuing senior securities), 22(d) (prohibition against dealers selling redeemable security except at a price described in the prospectus), and Section 17(a)(1) and (a)(2) (prohibition of selling to or buying from an affiliate). See Vanguard Index Funds, Investment Company Act Release No. 24680, 65 Fed. Reg. 61005, 61007 (Oct. 13, 2000); Vanguard Index Funds, Investment Company Act Release No. 24789, 65 Fed. Reg. 79439 (Dec. 19, 2000).
- 141As of July 2, 2021, Vanguard has eighty-two ETFs, sixty-two equity ETFs, and twenty fixed income ETFs. See Discover Vanguard ETFs, Vanguard (Oct. 4, 2022), https://perma.cc/7ZRL-D85A.
- 142The mutual fund ticker for the Admiral class shares is VTSAX, and VTI for the ETF shares. The fund has six classes of shares, five classes of mutual fund shares, and one class of ETF shares. The various mutual fund shares vary by their investment fees and investment minimums.
- 143U.S. Patent No. 6,879,964 B2 col. 3 (issued Apr. 12, 2005) [hereinafter Vanguard Patent]; Ben Johnson, Vanguard’s Unique ETF Structure Presents Unique Tax Risks, Morningstar (Jan. 15, 2020), https://perma.cc/44LP-FPC7.
- 144Vanguard Patent, supra note 143, at col. 3.
- 145Id. at cols. 3 and 4.
- 146Id.
- 147Johnson, supra note 143 (describing the risk of mass exodus on mutual fund shareholders).
- 148Id.
- 149Id.
- 150A large exit of mutual fund shareholders would probably only occur if the market dropped significantly. In such case, however, the amount of overhang and potential tax liability would also decline.
- 151In its prospectuses, Vanguard touts this option privilege. See Vanguard U.S. Stock ETFs, Prospectuses (Form 497K) (Apr. 29, 2021), https://perma.cc/XL2Y-F9C2.This is a one-way privilege, and ETF shareholders may not exchange their shares for mutual fund shares. See Vanguard Index Funds, Investment Company Act Release No. 24680, 65 Fed. Reg. 61005, 61007–61008 (Oct. 13, 2000).
- 152Vanguard Patent, supra note 143.
- 153Yale, supra note 16, at 407 n.53. The patent will expire in May 2023. See Adrian D. Garcia, Vanguard’s special ETF patent expires next year. Does it matter? Financial Times (Apr. 12, 2022).
- 154A sponsor considering adding an ETF share class to its mutual funds must apply for exemptive relief from Section 18(f)(1) and (i) of the 1940 Act. Section 18(f)(1) prohibits issuance of a class of senior security, which includes a stock class having priority over other classes in distribution of assets or payment of dividends. Section 18(i) requires that all investment company shares have equal voting rights. The SEC rejected applying Rule 6(c)-11 to share class ETFs on the grounds that share class ETFs may give rise to differing costs to the underlying portfolio, but these costs are shared by all shareholders. The SEC acknowledged that by not doing so it was potentially creating an uneven playing field, but it opted to continue to require a fund wishing to offer a share class ETF to seek exemptive relief. Rule 6c-11 at 57, 196.
- 155Mider et al., supra note 18.
- 156Id.
- 157Id.
- 158Id.
- 159Eaton Vance has developed a similar offering, NextShares, which is an exchange traded managed fund. Like an ETF, a retail investor buys and sells on an exchange, but the price received or paid is not the market price at the time of sale but the next determined NAV plus or minus a trading cost. Note, no assets leave or are contributed to the fund in the case of retail trades. Like ETFs, APs can create and redeem shares in exchange for a contribution basket, which is a slightly narrower portion of the fund’s portfolio. For a discussion, see Yale, supra note 16, at 428–32.
- 160The cases, administrative guidance, and commentary on the substance over form doctrine and its corollaries are voluminous. See, e.g., Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts ¶ 4.3.1. (3rd ed. 2021); Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations and Shareholders ¶ 12.02[2][a] (7th ed. 2021).
- 161See Bittker & Lokken, supra note 160 (“Unfortunately, it is almost impossible to distill useful generalizations from the welter of substance-over-form cases. The facts of the cases are usually complicated, and it is rarely clear which facts are crucial to the decision and which are irrelevant.”).
- 162United States v. Phellis, 257 U.S. 156, 168 (1921) (“We recognize the importance of regarding matters of substance and disregarding forms in applying the provisions of the Sixteenth Amendment and income tax laws enacted thereunder.”).
- 163Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d. Cir. 1968) (listing relevant factors to determine whether debt instrument in form should be treated as equity).
- 164Davant v. Comm’r, 366 F.2d 874, 880 (5th Cir. 1966).
- 165Spicer Acct. Inc. v. United States, 918 F.2d 90, 92–93 (9th Cir. 1990) (distributions to shareholder of S corporation were wages for employment tax purposes).
- 166Martin D. Ginsburg et al., Mergers, Acquisitions, and Buyouts ¶ 608.3.1 (2015) (“[I]t often will be difficult to determine with a high degree of certainty whether a series of related transactions will be stepped together in some fashion for tax purposes.”). New York State Bar Association, Report on the Role of the Step Transaction Doctrine in Section 355 Stock Distributions: Control Requirement and North-South Transactions 6 (Nov. 5, 2013) [hereinafter “NYSBA Step Transaction”] (“Neither the courts nor the Services have clear guidelines for determining which test should apply in a particular situation. Moreover, the boundaries between the tests themselves are not clear, and as a result, they have been applied inconsistently.”).
- 167See, e.g., Comm’r v. Gordon, 391 U.S. 83, 96 (1968) (refusing to step together the distribution of stock rights representing together 100% of the corporation where the two distributions were separated by almost two years because there was no binding commitment to make the subsequent distribution of 43%); Intermountain Lumber Co. v. Comm’r, 65 T.C. 1025, 1033 (concluding that transfer of property to wholly owned corporation did not satisfy control test of Section 368(c) because transferor had entered into binding agreement to sell 50% of the shares).
- 168See Am. Bantam Car Co. v. Comm’r, 11 T.C. 397, 406 (1947), aff’d 177 F.2d 1235 (5th Cir. 1949), cert. denied, 339 U.S. 920 (1950).
- 169Penrod v. Comm’r, 88 T.C. 1415, 1429 (1987).
- 170The contribution can be securities, cash, or a combination thereof.
- 171An AP would be indifferent between an exchange for shares of the ETF or for shares of the custom basket since both transactions would be taxable.
- 172Ginsburg, supra note 166, at ¶¶ 608.3.2.1. and 608.3.2.2.
- 173See also Hodaszy, Section 852(b)(6) Loophole, supra note 26, at 594–98 (stating without significant discussion that heartbeat trades should be treated as taxable exchanges between APs and ETF applying step transaction principles).
- 174The business purpose doctrine is a fundamental requirement for reorganizations. Treas. Reg. §§ 1.368-1(b) (reorganization must be required by business exigencies); 1.368-1(c) (transaction structured as reorganization having no business or corporate purpose is not a plan of reorganization).
- 175293 U.S. 465 (1935).
- 176293 U.S. at 469.
- 177See, e.g., Wells Fargo & Co. v. United States, 957 F.3d 840, 847 (8th Cir. 2020); United Parcel Service of America, Inc. v. Comm’r, 254 F.3d 1014, 1019 (11th Cir. 2001) (restructuring of insurance business by placing it in Bermuda corporation owned by the same shareholders as UPS found to be simply an altered form of bona fide business that had real economic effects and a business purpose).
- 178I.R.C. § 7701(o) (transaction has economic substance only if the transaction changes the taxpayer’s economic position, and the taxpayer has a substantial non-tax (business) purpose for entering into the transaction). Section 7701(o) potentially applies to post-March 31, 2010 transactions. See I.R.S. Notice 2010-62, 2010-40 C.B. 411.
- 179IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir. 2001), rev’g IES Indus., Inc. v. United States, No. C97-206, 1999 WL 973538, at *2 (N.D. Iowa Sept. 22, 1999).
- 180Compaq Computer Corp. v. Comm’r, 277 F.3d 778 (5th Cir. 2001), rev’g Compaq Computer Corp. v. Comm’r, 113 T.C. 214, 214 (T.C. 1999).
- 181ADRs are publicly traded securities that represent shares of a foreign corporation held in trust by a U.S. bank.
- 182A share trades cum dividend if the purchaser would be entitled to a declared dividend, since the purchaser would be the record date owner. A shares trades ex dividend if the purchaser would not be entitled to the declared dividend since the trade would settle after the record date.
- 183The purchase legs were made with special, next-day settlement, while the sales legs were made via the standard five-day settlement. Compaq, 133 T.C. at 217. The Compaq trades were broken up into 46 transactions of around 450,000 ADRs and completed in a little over an hour. Thus, Compaq was exposed to market risk for approximately 2-3 minutes. Compaq, 277 F.3d at 780. In the case of IES, the trades took place within hours of each other, sometimes on foreign exchanges, and sometimes when the U.S. market was closed. IES, 253 F.3d at 352.
- 184Compaq had recognized a long-term capital gain of $231 million, and IES had a recognized long-term capital gain in excess of $82 million. Compaq, 113 T.C. at 214; IES, 253 F.3d at 353.
- 185Compaq, 133 T.C. at 223. This is an instance where the price of the $1 of foreign dividends was not $1 but $0.85. Presumably the marginal purchaser could not otherwise use the foreign tax credits.
- 186In both cases, the taxpayers incurred other fees and expenses, and deducted those as well.
- 187IES, 1999 WL 973538 at *2.
- 188Compaq, 133 T.C. at 223.
- 189Id. at 224 (noting that the ADR trades were executed at a price determined by agent of the seller of the transaction, were divided into 23 purchase and resale cross-trades within an hour on the floor of the exchange and were executed with non-standard settlement to prevent risk of breaking up the trades).
- 190There were associated fees and expenses with the transaction. In Compaq, the fees and expenses were about $1.5 million. Compaq, 133 T.C. at 223.
- 191This represents a pre-tax profit of $1.9 million less approximately $640,000 of U.S. taxes.
- 192IES, 253 F.3d at 354.
- 193Id. The same circuit court distinguished IES in 2020 in the context of a structured trust advantage repackaged securities transaction (STARS) in Wells Fargo & Co. v. United States, 957 F.3d 840, 847 (8th Cir. 2020). The STARS transaction also involved the treatment of foreign taxes, and the court in Wells Fargo concluded that they were a pre-tax expense rather than a post-tax expense as in IES.
- 194See Kashner, The Heartbeat of ETF Tax Efficiency Part Three: Trade Forensics, supra note 18.
- 195ETF registration statements mention custom portfolios, but they do not address any potential costs to the ETF. See, e.g., Dimensional ETF Trust, Registration Statement (Form N-1A) 30–36 (June 25, 2020) (discussing creation and redemption process, including the use of custom baskets, but not discussing potential costs to ETF).
- 196See, e.g., Rev. Rul. 2017-9, I.R.B. 1244, and Rev. Rul. 79-250, 1979-2 C.B. 156, modified by Rev. Rul. 96-29, 1996-1 C.B. 50.
- 197Rev. Rul. 2017-9, I.R.B. 1244.
- 198The purpose of the south transfer in the ruling is to permit distributing to satisfy the active trade or business test of Section 355(b)(1)(A).
- 199For example, if parent contributed $25 to distributing, and the value of the shares of controlled were $100, parent would be treated as purchasing 25% of the shares of controlled for cash (or other property) and receiving the remaining 75% via distribution. If the two legs are respected as separate transactions, the south transfer would be tax-free under Section 351, and the north spin-off would be tax-free under Section 355, assuming that all of its requirements were otherwise satisfied.
- 200If the property were appreciated, gain would be recognized under Section 1001(c), but any loss would be disallowed or deferred under Section 267(a) or (f).
- 201Rev. Rul. 2017-9, I.R.B. 1244.
- 202Id.
- 203The ruling cited Rev. Rul. 78-442, 1978-2 C.B. 143 (357(c) gain in a Section 351 transfer does not violate the requirement that no gain or loss is recognized if an active trade or business acquired within five years); Rev. Rul. 74-79, 1974-1 C.B. 81 (tax-free liquidation of subsidiary with active trade or business enabled parent to meet active trade or business requirement); and Rev. Rul. 78-330, 1978-2 C.B. 147 (cancellation of debt between a parent and subsidiary prior to the merger of the subsidiary into a related subsidiary so that no gain would be recognized under Section 357(c)(1)(B) would be respected as having independent economic significance “because it resulted in a genuine alteration of a previous bona fide business relationship.”).
- 204Rev. Rul. 2017-9, I.R.B. 1244.
- 205Id.
- 206Rev. Rul. 2003-51, 2003-1 C.B. 938.
- 207Control is defined as 80% or more of the voting power of all classes of voting stock and 80% or more of the total number of shares of all other classes of stock. I.R.C. § 368(c).
- 208Rev. Rul. 2003-51, 2003-1 C.B. 938.
- 20990 T.C. 171 (1988), aff’d 866 F.2d 1318 (7th Cir. 1989).
- 210Id at 175.
- 211Id. at 176.
- 212Id. at 187.
- 213I.R.C. § 311(d)(1) (1982).
- 214I.R.C. § 311(d)(2)(B)(i)–(iii) (1982). The corporation whose stock was distributed had to be engaged in at least one trade or business and not have received property tax free from the parent company that constitutes a substantial part of its assets within the previous five years. Id.
- 215I.R.C. § 311(d)(2)(E) (1982).
- 21690 T.C. at 188. The Tax Court also rejected the IRS’s argument that Mobil did not possess the attributes of ownership on the grounds that the tendering shareholders surrendered all incidents of ownership when the tender offer closed and therefore had no right to receive any distributions of corporate assets. Id. at 194. Similarly, responding to the argument that Mobil purchased Vickers for cash and was a conduit for the transfer of the same cash from Esmark to its shareholders, the Tax Court found Esmark could not bind its shareholders to retain or sell their stock, and Esmark was under no obligation to purchase its shares from the public, and therefore Mobil’s purchase of Esmark stock should be respected and Mobil could not be treated as a conduit. Id.
- 21733 T.C. 1 (1959).
- 21890 T.C. at 189.
- 21990 T.C. at 196.
- 220Id.
- 221Id.
- 222In the case of a heartbeat trade, it could be possible to argue that the goal of the transaction is to both sell shares and change the ETF’s portfolio.
- 223I.R.C. § 1259(a)(1) (taxpayer must recognize gain on constructive sale of appreciated financial position); id. at (b)(1) (appreciated financial position means any position with respect to stock with a built-in gain).
- 224Id. §§ 1259(c)(1)(C) (entering into a short forward contract on the same property is constructive sale); (c)(1)(E) (constructive sale includes transactions that have substantially the same effect as forward sale).
- 225Id. § 1259(d)(1) (defining “forward contract” as “a contract to deliver a substantially fixed amount of property . . . for a substantially fixed price”).
- 226A bill to exempt taxable mutual fund investors from current taxation on reinvested capital gains dividends from RICs has been periodically introduced in Congress. See, e.g., Generate Retirement Ownership through Long-Term Holding Act of 2009, H.R. 3429, 111th Cong. (2009).
- 227See Moussawi, supra note 12, at 4 (finding that ETFs have 0.65% lower tax burdens than large-cap and small-cap index funds).
- 228See supra Part VII.D.
- 22915 U.S.C. §§ 80a-2(a)(32), 80a-5(a)(1) (defining “redeemable security,” which entitles holders to receive proportionate share of issuer’s net assets or cash equivalent, and “open-end company”). The SEC has interpreted this provision “as giving the issuer the option of redeeming its securities in cash or in kind.” Election by Open-End Investment Companies to Make Only Cash Redemptions, Investment Company Act release 6561, 36 Fed. Reg. 11919 (June 23, 1971) (adopting Rule 18f-1 and Form N-18F-1). Under a rule adopted in 2016 in connection with revisions aimed at improving fund liquidity risk management, the SEC requires that a fund that engages in or reserves the right to engage in redemptions in kind must establish policies and procedures regarding how and when it will engage in such redemptions in kind. 17 C.F.R. § 270.22e-4(b)(1)(v) (2021). The same rules amended Form N-1A, the registration statement for open-end management investment companies, to require a fund to state the methods that a fund typically expects to use to meet redemption requests, including the ability to redeem in kind. SEC Liquidity Management, supra note 93, at 82210 (amending Form N1-A by adding new paragraph (c)(8) under Item 11).
- 23017 C.F.R. § 270.18(f)-1 (2022). The election is made on Form N-18F-1.
- 231Redemptions in kind by mutual funds are often considered to be “a last resort or emergency measure.” SEC Liquidity Management, supra note 93, at 82210. For the period from 1997 to 2017, a team of researchers has found that around 70% of the U.S. equity funds reserved the right to pay redemptions in kind, and 13.1% of the funds that reserved this right actually engaged in in kind redemptions at least once. Vikas Agarwal et al., supra note 96 (manuscript at 3–4). The same researchers found that the in-kind redemption transactions were economically significant: the mean and median dollar amounts were $153 million and $70 million. Id.
- 232Paul M. Miller and Christopher D. Carlson, Can the Tax Efficiencies of ETF Redemptions In-Kind Be Replicated for Mutual Funds, 27 Invest. Law. 1, 3 (Feb. 2020).
- 233Id. at 4.
- 234SEC Liquidity Management, supra note 93, at 82210
- 235An affiliated person of an investment company includes any 5%-or-more shareholder (by vote), any person under common control, and any investment adviser. 15 U.S.C. § 80a-2(a)(3).
- 23615 U.S.C. § 80a-17(a)(1)–(2).
- 23715 U.S.C. § 80a-17(b). The SEC has issued various exemptive orders permitting in-kind redemptions by affiliated persons. See, e.g., GE Institutional Funds, SEC No-Action Letter, 2005 WL 3601654 (Dec. 21, 2005).
- 238Signature Financial Group, SEC No-Action Letter, 1999 WL 1261284 (Dec. 28, 1999). The letter also required that the redemption be consistent with the fund’s policies in the prospectus and statement of additional information and neither the affiliated shareholder nor any other party with the ability and pecuniary incentive to influence the redemption selects or influences the distributed securities. Id. at *7. Finally, the redemption must be approved by the fund’s board, either after a finding that the affiliated shareholder will not be favored over any other shareholder and the redemption is in the best interest of the distributing fund or that it is undertaken pursuant to certain procedures adopted by the board. Id. at *7–*8.
- 239Id. at *5, *8 n.23.
- 24017 C.F.R. § 270.22e-4(b)(1)(v) (2021).
- 241Another is via a distribution pursuant to Section 355, such as a split-off or spin-off.
- 242I.R.C. §§ 351(a) and 368(c) (defining control).
- 243An investment company is a RIC, REIT, or a corporation more than 80% of whose assets are held for investment and are stock or securities or interests in RICs or REITs. Treas. Reg. § 1.351-1(c)(1)(i)-(ii). Other investments assets, such as options and foreign currency, are treated as stock and securities. See I.R.C. § 351(e)(1)(B). Section 721(b) incorporates these rules to partnerships.
- 244I.R.C. § 351(e). A transfer by two or more persons of nonidentical assets generally results in diversification. Treas. Reg. § 1.351-1(c)(5). A transfer by a single transferor generally does not result in diversification unless it is part of a plan to achieve diversification, such as a planned transfer of the securities received or corporate assets to an investment company. If the transferor transfers a diversified portfolio of stock and securities, as defined in Section 368(a)(2)(F)(ii), to a corporation, the transfer will not result in diversification. Treas. Reg. § 1.351-1(c)(6)(i).
- 245See I.R.C. § 368(a)(2)(F). For an acquisition of stock or assets to be tax-free for shareholders and corporations, it must fall under one of the statutory reorganization provisions in Sections 368(a)(1) and (2).
- 246Under Section 368(a)(2)(F)(i), if two or more parties to purported reorganization are investment companies, the transaction is not a reorganization unless the companies are RICs, REITs, or diversified investment companies. An investment company is considered to be diversified if not more than 25% of the value of its total assets is invested in the stock and securities of any one issuer and not more than 50% of the value of its total assets is invested in the stock and securities of 5 or fewer issuers. I.R.C. § 368(a)(2)(F)(ii). For these purposes, cash and government securities are excluded. Id. § 368(a)(2)(F)(iv).
- 247An investment company includes RICs, REITs, and any corporation 50% or more of the value of which consists of stock and securities and 80% or more of the value of whose total assets are assets held for investment. I.R.C. § 368(a)(2)(F)(iii). There is a look-through rule for subsidiaries, which are defined to be companies where the parent owns 50% or more of the vote and 50% of the value of the outstanding shares. Id. For these purposes, cash and government securities are excluded. Id.§ 368(a)(2)(F)(iv).
- 248Treas. Reg. § 1.368-1(b).
- 249See, e.g., Rev. Rul. 72-405, 1972-2 C.B. 271 (forward triangular merger followed by liquidation is asset acquisition); and Rev. Rul. 67-274, 1967-2 C.B. 141 (stock acquisition followed by liquidation is treated as asset acquisition). Certain post-acquisition distributions are protected against recharacterization. See Treas. Reg. § 1.368-2(k).
- 250The regulations treat the acquisition of property by a RIC or REIT from a C corporation or the qualification of a C corporation as a RIC as a conversion transaction. Treas. Reg. § 1.337(d)-7(a)(2)(ii). Once property of a C corporation becomes property of a RIC in a conversion transaction, it is subject to the rules of Section 1374. Treas. Reg. § 1.337(d)-7(b)(1). These rules apply to net built-in gains recognized during the recognition period, which is the five-year period beginning on the date the RIC acquires the property. Treas. Reg. § 1.337(d)-7(b)(2)(iii). These rules do not apply if the C corporation makes an election to treat the transfer to the RIC as a deemed sale of assets. See Treas. Reg. § 1.337(d)-7(c).
- 251This regulation does not apply to the acquisition of stock of a C corporation, for example, in a B reorganization.
- 252I.R.C. §§ 1374(d)(1) (defining net unrealized built-in gain) and 1374(d)(3) (limiting recognized built-in gain to the gain at the beginning of the S corporation’s first taxable year).
- 253Distributions that are related to the reorganization, however, could cause the reorganization to be reclassified under the step transaction doctrine.
- 254I.R.C. § 852(b)(2)(A). Also included are gains realized from foreign currencies, and derivatives based on stock or securities such as options, forwards, and futures. Id.
- 255Using a C corporation, including a foreign corporation, to block bad income is a common structuring technique for RICs and REITs. See Willard B. Taylor, “Blockers,” “Stoppers,” and the Entity Classification Rules, 64 Tax Law. 1 (2010).
- 256I.R.C. §§ 852(b)(3) and (d). Although the statutory requirements appear to be clear-cut, this is an area of some uncertainty. The treatment of swap positions, for example, is unclear. This is especially relevant for new ETFs that offer single stock exposure. See, e.g., Direxion Shares ETF Trust, Registration Statement (Form N-1A) (Feb. 17, 2022), https://perma.cc/45TY-ASZH.For a detailed discussion of the diversification requirement, see Susan A. Johnston & James R. Brown, Jr., Taxation of Regulated Investment Companies and Their Shareholders ¶ 2.07 (2021).
- 257I.R.C. § 851(b)(3)(A)(ii).
- 258I.R.C. § 851(b)(3)(A)(i)–(ii).
- 259I.R.C. § 851(b)(3)(B)(i)–(iii).
- 260I.R.C. § 851(c)(2).
- 261I.R.C. § 851(c)(1)–(3).
- 262The 1940 regulates “investment companies,” including “management companies.” 15 U.S.C. § 80a-3 (defines investment company); 15 U.S.C. § 80a-4 (classifies investment companies as either “face-amount certificate company”, “unit investment trust”, or “management company”). A management company is furthered classified as either an “open-end” or “closed-end” company. 15 U.S.C. § 80a-5(a)(1)–(2).
- 26315 U.S.C. § 80a-5(b)(1)–(2).
- 26415 U.S.C. § 80a-5(b)(1).
- 26515 U.S.C. § 80a-13(a)(1). For an example of a request to shareholders to change from a diversified to non-diversified management company, see, e.g., Vanguard, Joint Special Meeting of Shareholders (Form DEF 14A) (Oct. 19, 2020), https://perma.cc/MF5U-KMF9.Among the reasons given for the change was that various indices tracked by these funds, e.g. the Russell 1000 Growth Index, had become concentrated in their top holdings, and the fund could no longer hold the underlying shares and still be considered diversified under the 1940 Act. Id. at 3, 4.
- 266There are additional mechanisms for an ETF to acquire shares of a company tax-free, such as, for example, via a qualifying Section 355 spin-off or split-off. The ETF could then distribute the acquired shares tax free to a redeeming shareholder under Section 852(b)(6), and an acquiring shareholder would receive the shares with a fair market value basis.
- 267See infra Part III.
- 268ETF shareholders can still benefit from fund-level capital losses, which can offset any recognized capital gains.
- 269A new challenger to ETFs may be direct indexing, which is a custom basket of stocks assembled by a portfolio manager or advisor. This strategy allows an investor to assemble a diversified portfolio that is adjusted to reflect a particular investment strategy, such as ESG or certain factor exposures. Since the shares are owned directly by the investor, the investor can selectively realize losses and defer gains on individual securities, which may increase an investor’s after-tax returns, even when compared with ETFs. See Ben Johnson & Susan Dziubinski, Should You Follow Vanguard Into Direct Indexing?, Morningstar (Aug. 9, 2021), https://perma.cc/NX5T-X83K.Direct investing generally requires a significant minimum investment and there are fees to acquire the portfolio, but Vanguard, Blackrock, and J.P. Morgan have purchased direct-investing firms, and the minimums and costs will certainly decline. See, e.g., Vanguard to offer direct indexing capabilities through acquisition of Just Invest, Vanguard (Jul. 13, 2021), https://perma.cc/V7QD-L9WT.Even with direct investing, however, portfolio adjustments will generally be taxable.
- 270See Colon, Oil and Water, supra note 51, at 778–88. See generally Matthew P. Fink, The Rise of Mutual Funds (2008).
- 271Moussawi, supra note 12, at 33–35, 66 tbl. IX, has found an “overwhelming trend” of high-net-worth clients from 2000 through 2017 shifting into ETFs, especially after the 2012 increase in capital gains tax rates. Households owning ETFs also have significantly higher mean and median total assets, financial assets, and net worth than U.S. households generally. See Inv. Co. Inst. and Strategic Bus. Insights, A Close Look at ETF Households (Sept. 2018), https://perma.cc/58ZC-2CL6(finding that ETF households’ mean and median financial assets are $1,006,100 and $401,700 versus $272,700 and $37,700 for all households).
- 272Staff of S. Finance Comm., 117th Cong., Discussion Draft on Wyden Pass-through Reform, Section by Section Summary (Sept. 10, 2021), https://perma.cc/JTE5-GS2S.
- 273The Joint Committee on Taxation has reportedly estimated that repeal of Section 852(b)(6) would raise $200 billion over the next ten years. See Lim & Rubin, supra note 24.
- 274In 2021, a single individual can contribute up to $6,000 annually to an IRA or Roth IRA. If the person is 50 or over, the annual limit is $7,000. Once the individual’s modified adjusted income (MAGI) is over $125,000, the maximum contribution is phased out and is $0 once MAGI is $140,000 or greater. For married persons filing jointly, the MAGI limitation is $198,000, and is phased out completely at $208,000. Thus, a married couple could contribute annually up to $12,000. See I.R.C. §§ 219 (IRA limitation) and 408A (Roth IRA limitation). For a participant to invest in an ETF via a 401(k), the retirement plan would have to offer a brokerage option.
- 275The finance literature has addressed this issue in great detail. See, e.g., Daniel Bergstresser and James M. Poterba, Asset Allocation and Asset Location: Household Evidence from the Survey of Consumer Finances, 88 J. of Pub. Econ. 1893 (2004) and Robert Dammon, Chester S. Spatt, and Harold H. Zhang, Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing, 59 J. of Fin. 999 (2004). Recent entrants into the automatic investment advisor space, such as Betterment, also stress the importance of tax-efficient asset location. See Boris Khentov, Rukun Vaidya, and Lisa Huang, Asset Location Methodology, Betterment (Sept. 26, 2016) https://perma.cc/6TFL-AS6R.
- 276ETFs held by a trader fund that has made the mark-to-market election under Section 475(f) would recognize ordinary gain or loss on any ETF position held at the end of the year. See I.R.C. § 475(f). If a distribution were made at year end, the NAV of the fund would drop by the amount of the distribution and thus any dividend income would be offset by the reduced gain or increased loss of the value of the ETF.
- 277Steven M. Rosenthal and Theo Burke, Who Owns US Stock? Foreigners and Rich Americans, Tax Pol’y Ctr. (Oct. 20, 2020), https://perma.cc/SC45-785E(finding that in 2019, tax-exempt investors, including foreigners, own 75% of U.S. corporate stock).
- 278I.R.C. § 311(a)(2).
- 279I.R.C. § 336(a). The ability to recognize a loss in a liquidation is subject to various limitations. See I.R.C. § 336(d).
- 280Bittker & Eustice, supra note 160, at ¶ 8.21[2] (7th ed. 2021).
- 281Michael S. Piwowar, Comm’r, SEC, Remarks at the 2015 Mutual Funds and Investment Management Conference (Mar. 16, 2015). See also SEC Liquidity Management, supra note 93, at 82210 (“[M]ost funds often consider redemptions in kind to be a last resort or emergency measure . . . .”)
- 282Letter from Barbara Novick, Vice Chairman, Blackrock, to Brent Fields, Sec’y, SEC, at 11 (Jan. 13, 2016), https://perma.cc/5ZJ6-PEQD.
- 283For a detailed disclosure of some of the potential hardships that could befall shareholders who are redeemed in kind, see, e.g., Dodge & Cox, Dodge & Cox Funds Prospectus 52 (May 1, 2020), https://perma.cc/S8QH-TZSX.Managers of open-end funds confront the same issue when making cash redemptions and deciding which assets to sell. See SEC Liquidity Management, supra note 93, at 82150. Since money market funds are considered by investors to be cash equivalents, and value impairments such as “breaking the buck” could cause substantial harm to the financial system, the SEC has promulgated rules that permit money market funds to make in-kind redemptions, suspend redemptions during emergencies, and impose liquidity fees if the percentage of liquid assets falls below a specified minimum. See., e.g., Vanguard, Vanguard Money Market Funds Prospectus 39–40 (Dec. 17, 2021), https://perma.cc/BG5F-XQE8.
- 28417 C.F.R. § 270.22e-4.
- 285If a fund earns taxable income without a corresponding amount of cash, which can occur when the fund invests in debt instruments that generate a significant original issue discount, a fund could have to liquidate assets to generate the cash to satisfy the distribution requirement or be forced to borrow. In the throes of a financial crisis, borrowing can be impossible, and a fund would therefore have to sell assets to generate the cash to satisfy the distribution requirement. Sales of assets during a financial crisis could exacerbate the crisis.
- 286The SEC issued an order on March 23, 2020, that permits funds to borrow from the firm that manages the portfolio and from other funds in the same family. Order Under Sections 6(c), 12(d)(1)(J), 17(b), 17(d) and 38(a) of the Investment Company Act of 1940 and Rule 17d-1 Thereunder Granting Exemptions from Specified Provisions of the Investment Company Act and Certain Rules Thereunder, Investment Company Act Release No. 33821, 85 Fed. Reg. 17374 (Mar. 23, 2020).
- 287Rev. Proc. 2009-15, 2009-4 I.R.B. 356 (effective for distributions declared on or after Jan. 1, 2008). Rev. Proc. 2010-12, 2010-3 I.R.B. 302 extended these provisions to cover distributions declared on or before Dec. 31, 2012. The IRS had earlier extended this treatment to REITs. See Rev. Proc. 2008-68, 2008-52 I.R.B. 1373. Once the prior revenue procedures were no longer effective, taxpayers requested private letter rulings to receive the desired treatment. To obviate the need for requesting a ruling, the IRS issued Rev. Proc. 2017-45, 2017 I.R.B. 216, effective for distributions declared on or after Aug. 11, 2017.
- 288Rev. Proc. 2021-53, 2021-51 I.R.B. 887 is effective for distributions on or after November 1, 2021, and on or before June 30, 2022. It followed Rev. Proc. 2020-19, 2020-22 I.R.B. 87, which was effective for distributions on or after Apr. 1, 2020, and on or before Dec. 31, 2020.
- 289Although stock dividends are generally not taxable under Section 305(a), because of the option to receive cash or stock the stock dividend would be treated as a distribution of property under Section 301. I.R.C. § 305(b)(1).
- 290Rev. Proc. 2021-53, 2021-51 I.R.B. 887 § 3. Under Rev. Proc. 2017-45, the cash limitation percentage was 20%. One commentator has suggested that the original 20% number was approximately equal to the taxes due on the entire distribution using a federal rate of 15% and a state rate of 5%. Using the highest rate for capital gains under current law, 23.8%, for the federal tax rate and 5% for the state rate, if a taxpayer received 10% of the distribution in cash, the 10% cash distribution could be significantly less than the tax due on the entire distribution. Presumably, such taxpayers would satisfy their tax obligations out of other funds. Richard W. Bailine, A Rare and Valuable Look at Section 305, 35 J. Corp. Tax’n 28, 29 (Nov./Dec, 2008). For RICs, given that 90% or more of RIC shareholders typically elect to reinvest their distributions in additional stock and therefore pay the tax out of other funds, the concern that a taxpayer would not have sufficient cash to satisfy their tax obligations is minor.
- 291Under Section 305(b)(1), if a distribution is payable in stock or cash, the entire distribution is taxable. Since it is possible that a particular shareholder can receive the entire distribution in cash, the distribution is therefore taxable in its entirety, even though the RIC will distribute a maximum of only 10% of the total distribution in cash. In contrast, if the RIC distributed a dividend consisting of 10% in cash and 90% in stock, the stock portion would not be taxable. See Treas. Reg. § 1.305-1(b), Ex. 1 (dividend of two shares for each share owned where shareholder could elect to receive cash for one share is a taxable dividend only to the extent of one share; the distribution of the other share is a non-taxable distribution under Section 305(a)).
- 292For instance, if a fund offered to distribute a total amount of cash equal to 10% of the dividend and all shareholders elect to receive cash, each shareholder would receive 10% cash and 90% stock, but the shareholder would have a taxable inclusion of 100%. See Rev. Proc. 2009-15, 2009-4 I.R.B. 356 § 4(b).
- 293Although the minimum cash amount has varied between 10% and 20% in the revenue procedures, under the IRS’s interpretation of Section 305(b)(2) and the accompanying regulations, it appears that there is no minimum cash amount required in order to have the cash and stock distribution treated as a taxable distribution in its entirety.
- 29440.8% is the sum of the highest federal rate on ordinary income including short-term capital gains, 37%, and the 3.8% tax on net investment income under Section 1411. The highest rate on net capital gains,20%, plus the 3.8% tax on investment income, yields 23.8%.
- 295Over 90% of the total dividends paid by all mutual funds are reinvested. Factbook, supra note 1, at 238 tbl. 29.
- 296Treas. Reg. § 1.305-1(b)(2) (stock received by RIC shareholder with election to receive cash or stock is equal to amount of cash that could have been received); Treas. Reg. § 1.301-1(h)(1) (basis of property received in a Section 301 distribution is its fair market value).
- 297See, e.g., I.R.S. Priv. Ltr. Rul. 2003-34-1014 (Jul. 1, 2003). The IRS has issued six rulings to closed-end funds seeking to use Section 852(b)(6) in connection with self-tender offers. See Johnston & Brown, supra note 256, at ¶ 3.06[2][c] n.704. Since closed-end funds do not issue redeemable securities, in the absence of a letter ruling, in-kind redemptions using appreciated securities would not be exempt under Section 852(b)(6) and would be taxable under Section 311(b).
- 298The letter rulings typically contain a representation that the fund will distribute a pro rata share of each security excluding: (a) unregistered securities, (b) foreign securities that cannot be held by non-nationals, (c) derivative contracts, (d) cash or cash equivalents, (e) fractional shares, and (f) cash distributions for fractional shares and odd lots. Id.
- 299Id.
- 300Since all of an ETF’s assets are marked to market daily in computing NAV, the value of the undistributed assets is known. If there is a need to draft exceptions, for example, for distributions of cash, these exceptions should be narrowly drafted to prevent a fund from changing its portfolio composition without the recognition of gain.
- 301If the manager distributed securities with a basis of $20, for example, the built-in gain would remain at $100 ($180 – $80).
- 302If Congress opted to pursue this approach, it would be vital to ensure that any exceptions to the pro rata distribution requirement would be drafted narrowly. One idea would be to require an ETF to mark-to-market a pro rata portion of any position that was not distributed.
- 303In this example, the AP contributed $180 of basis and then removed $135 of basis, which reduced built-in gain by $45.
- 304Professor Hodaszy, Section 852(b)(6) Tax Avoidance, supra note 26, at 537, 599–605, and Section 852(b)(6) Loophole, supra note 26, at 74–86, has advocated such an approach. He models his proposal on Section 362(c), which addresses the treatment of non-shareholder contributions to capital. Section 362(c) requires a corporation to take a zero basis in the contributed property and to reduce the basis of the corporation’s property by the contributed cash. I.R.C. § 362(c)(2).
- 305Hodaszy, Section 852(b)(6) Tax Avoidance, supra note 26, at 602–603.
- 306Id. at 604 n.296. Professor Hodaszy does not state how unrecognized losses on distributed securities should be treated. If the goal is to preserve all unrecognized gains or losses at the fund level, the basis of the remaining securities should arguably be increased by unrecognized losses. Also, Professor Hodaszy does not detail how the basis reduction rule would work for such assets as cash and derivatives.
- 307Professor Hodaszy has subsequently recognized this. See Hodaszy, Section 852(b)(6) Loophole, supra note 26, at 81 (recognizing that the “abusive practice of heartbeat trades would need to be shut down, for the basis-reduction rule to work”).
- 308See Colon, supra note 26, at 49–66 and Stephen D. Fisher, RICs and the Retail Investor: A Marriage of Convenience or Necessity?, 66 Tax Law. 331, 388 (2013).
- 309See, e.g., Invesco DB Multi-Sector Commodity Trust and Invesco DB Agriculture Fund, Prospectus Supplement No. 1, 75–88 (Aug. 27, 2021) [hereinafter Invesco Trust Prospectus] (describing U.S. tax consequences to investing in fund and the special rules for publicly traded partnerships). RICs that primarily hold stocks and securities are currently not eligible to be taxed as partnerships. I.R.C. § 7704(c)(3) (providing that qualifying income exception is not available to any partnership that would be a RIC if it were a U.S. corporation).
- 310For a detailed discussion of how these rules are implemented and modified by natural resources publicly traded partnerships, see Deborah Fields, Holly Belanger, Robert Swiech, and Eric Lee, Triangles in a World of Squares: A Primer on Significant U.S. Federal Income Tax Issues for Natural Resources Publicly Traded Partnerships (Part I), Taxes, Dec. 2009; Deborah Fields, Holly Belanger, and Eric Lee, Triangles in a World of Squares: A Primer on Significant U.S. Federal Income Tax Issues for Natural Resources Publicly Traded Partnerships (Part III—Bringing in the Public and Management and Partnership Allocations), Taxes, May 2010; Deborah Fields, Holly Belanger, and Eric Lee, Triangles in a World of Squares: A Primer on Significant U.S. Federal Income Tax Issues for Natural Resources Publicly Traded Partnerships (Part IV—Secondary Offerings and the Impact of Public Trading), Taxes, Oct. 2010. See also Colon, supra note 26, at 49–66.
- 311See supra Part III.
- 312Treas. Reg. § 1.704-1(b)(2)(iv)(f)(5)(v)(i)-(ii) (describing situations in which is it permissible to adjust capital accounts, such as the contribution of property or money, the liquidation of a partner’s interest, or the distribution of property or money to a retiring or continuing partner). Certain partnerships that hold publicly traded stock and securities, such as hedge funds, are allowed to adjust capital accounts in the absence of these events. These adjustments are referred to as reverse 704(c) allocations. Publicly traded partnerships often adopt certain conventions to mitigate the complexity of making these adjustments. See, e.g., Invesco Trust Prospectus, supra note 9, at 79–80 (describing monthly reverse 704(c) convention and basing revaluations not on FMV of the assets, as required by regulations, but the average price of the shares during the month in which a creation or redemption takes place).
- 313For a discussion of some of the issues that arise in making reverse 704(c) adjustments, see Colon, supra note 26, at 53–57 and the sources cited therein. Some commentators have noted that issues can also arise regarding when exactly income is earned by a fund. See Yale, supra note 16 at 438. When a partner contributes property with a built-in gain to the partnership, the partnership is required to allocate that pre-contribution gain to the contributing partner when it is realized or the property is distributed to another partner within seven years. I.R.C. § 704(c)(1)(A) and (B).
- 314I.R.C. § 743(b). To make such adjustments, the partnership would have to have made an election under Section 754. Publicly traded partnerships generally make this election. See, e.g., Invesco Trust Prospectus, supra note 3099, at 80 (describing Section 754 election and consequences under Section 743 and noting that fund applies certain conventions to reduce complexity of calculations and administrative costs).
- 315Treas. Reg. § 1.743-1(f) (“[A] transferee’s basis adjustment is determined without regard to any prior transferee’s basis adjustment.”). One commentator has argued that reverse 704(c) adjustments would result in different allocations of taxable gain depending on when they bought into a fund, which would result in the shares not being fungible. Yale, supra note 16, at 438. If, however, a fund has made a Section 754 election and it adjusts the basis of partnership property for the purchaser upon a transfer of an interest, the shares should be fungible for a purchaser—it would not matter whether a purchaser acquired a share with large or small book-tax difference since the purchaser would have the same Section 743 basis adjustment.
- 316See Invesco Trust Prospectus, supra note 3099, at 81 (noting the need to obtain secondary market transaction information for all shareholders to make the Section 743 basis adjustments).
- 317See Invesco Trust Prospectus, supra note 3099, at 79–80 (noting that a shareholder who redeems shares during a month may be allocated income, gain, loss, and deduction realized after the date of the redemption and that monthly allocation may be consistent with IRS regulations requiring daily allocations of tax items between buyers and sellers of partnership interest under Section 706).
- 318I.R.C. §§ 731(a) (gain not recognized to partner except if cash distributed exceeds basis of partnership interest); and 733 (basis reduced by money distributed to partner). Partners have a unitary basis in their partnership interests.
- 319In a redemption by a shareholder in a RIC, a shareholder determines gain or loss on a share-by-share basis.
- 320I.R.C. § 734(b)(1)(A) (basis of partnership property increased by any gain recognized under Section 731(a)(1)). If a loss is recognized, the partnership decreases the basis of its property. Id. § 734(b)(2)(A).
- 321If the only property distributed is cash, unrealized receivables, or inventory in liquidation of a partner’s interest, and the basis of such property is less than the basis of the partner’s interest in the partnership, the partner will recognize loss. I.R.C. § 731(a)(2). In certain circumstances, the distribution of marketable securities is treated as a distribution of cash, but this rule does not apply to investment partnerships. I.R.C. §§ 731(c)(1) and (c)(3)(A)(iii).
- 322I.R.C. §§ 732(a)(1) (basis of property distributed to partner in non-liquidating distribution is the same as the partnership basis in the property but limited to partner’s basis in partnership); and 733 (basis of partnership interest reduced by basis of property distributed). If a partner’s basis is less than the basis of the property distributed, the property will take a basis equal to the partner’s basis in her partnership interest immediately before the distribution. Id. § 732(a)(2).
- 323I.R.C. § 732(b) (basis of property distributed in liquidation is equal to partner’s basis in partnership interest immediately before the distribution). The rules for allocating the basis among the distributed property are found in Section 732(b).
- 324Id. § 734(a)–(c).
- 325Under Section 732(a)(2), if the basis of the property distributed were greater than the partner’s outside basis, the basis of the property distributed would be stepped down to the partner’s outside basis, and the partnership would increase the basis of its remaining property by the difference in the property’s basis and the partner’s basis in her partnership interest. See also id. § 734(b)(1)(B) (the same rules, applicable to liquidating distributions).
- 326This assumes that the appreciated property was not contributed by another partner. See id. § 704(c)(1)(B).
- 327Hodaszy, Section 852(b)(6) Loophole, supra note 26, at 85.
- 328Special rules apply to contributions of appreciated property that is distributed to another partner. See I.R.C. § 704(c)(1)(B).
- 329If a partnership had a Section 754 election in effect, when property is distributed and other partners have Section 743 basis adjustments with respect to the distributed property, those adjustments would have to be allocated to other property. See Treas. Reg. § 1.743-1(g)(2). These adjustments would certainly impose significant administrative costs if partnership interests are turned over frequently, and the partnership frequently distributes property. Importantly, this ensures that the gains remain at the partnership level.