January 4, 2010

Exotic ETFs Come with Peculiar Tax Consequences

Exchange traded fund investors might be forgiven for thinking that the much vaunted "tax efficiency" of ETFs will unburden them of all but the most superficial annual tax obligations. While mutual funds must sell assets to accommodate large redemptions and can thereby incur capital gains liabilities, ETFs manage withdrawals using the "create/redeem" process, in which the ETF delivers shares of the underlying securities to institutional investors in exchange for shares of the ETF. Because the fund can deliver the lowest cost-basis shares, it can constantly step up its cost basis and thus escape any long term capital gains liability.

This advantage--most ETFs report no long-term capital gains even when identical mutual funds do--is real, significant, and a valid reason for buying shares in an ETF instead of a mutual fund. What some investors fail to appreciate, however, is that the holdings of the more exotic ETFs--specifically those that own precious metals, commodity or currency futures, or other types of derivatives--are treated differently for tax purposes from the stocks and bonds owned by the more plain vanilla ETFs. As always, it pays to read the fine print, and those who do may be in for some rather unexpected news.

(It is important to remember that every investor's tax situation is different, and not to rely on tax advice except that given by a professional. Tax rules can and do change significantly, and the tax consequences of owning any particular ETF can vary.)

With gold prices setting record highs, many investors have purchased shares in precious metals ETFs that either own bullion, such as the mammoth SPDR Gold Trust (GLD), iShares Silver Trust (SLV), or ETFS Physical Swiss Gold Shares (SGOL). It is tempting to assume that any gains from trading in these ETFs will be treated by the Internal Revenue Service in the same way that gains from shares of IBM or Microsoft would be. Not so. Bullion-owning ETFs are structured legally as a grantor trust, and owners of their shares are deemed to be the direct owners of a pro-rata share of the actual bullion--not shareholders in a corporation that owns gold. Furthermore, the IRS treats gold, silver, and platinum as "collectibles," not as an investment asset, and taxes short-term gains as ordinary income and long-term gains at up to 28%, far above the 15% rate for long-term capital gains on stocks and bonds.

ETFs that hold futures and other derivative contracts based on commodities and currencies, such as PowerShares DB Precious Metals Fund (DBP) or ProShares Ultrashort DJ-UBS Crude Oil (SCO), are taxed according to a different set of rules. Like bullion-owning ETFs, gains and losses experienced by these ETFs flow directly to shareholders. Owners receive a K-1 form detailing their share of the fund's realized gains or losses as well as the mark-to-market gains or losses from current holdings. Gains are treated like this: 60% of any capital gain during the year is taxed at the long-term rate, and 40% of the gain at the short-term rate. There will also be interest income from the fund's cash holdings. Maddeningly, losses incurred are treated as passive losses, and cannot be used to offset income from other sources, only future gains from the same fund. (Some funds, like PowerShares DB Base Metals Fund (DBB) hold foreign futures contracts or other assets that are treated differently for tax purposes.)

As should be obvious, accounting for each investor's pro-rata gains and losses--especially for those who trade into and out of positions within a day--is an accounting nightmare. Some funds simplify the process by allocating gains and losses for a particular month to shareholders of record on the last trading day of the preceding month. As ProShares helpfully points out on its website: "this means even if you sell your shares before the end of the second month, you will be treated as continuing to hold the shares through that second month. Therefore it is possible that you may be allocated income, gain, loss and deductions that were realized after you sold your shares."

The tax treatment of exchange traded notes (ETNs)--and several ETNs offer exposure to commodities and currencies--is refreshingly simple. They are treated as prepaid contracts, and any gain is subject to normal long- or short-term capital gains taxation.

In general, it pays to understand the tax consequences of any ETF before buying it, but be prepared to dig through a fund's prospectus to find it.

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S&P Senior Financial Writer Vaughan Scully can be reached at vaughan_scully@standardandpoors.com. Send him your ideas for ETF story topics.

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