The Advisor's Professional Library

ETF Taxation

March 4, 2013

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What is an exchange-traded fund (ETF)?

Overview

In promulgating a proposed rule under the Investment Company Act of 1940, the SEC described exchange-traded funds (ETFs) as “offer[ing] public investors an undivided interest in a pool of securities and other assets.” They “are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on an exchange through a broker-dealer. ETFs therefore possess characteristics of traditional mutual funds, which issue redeemable shares, and of closed-end investment companies, which generally issue shares that trade at negotiated market prices on a national securities exchange and are not redeemable.”[1]

The first ETFs in the early 1990s generally held baskets of securities that mirrored broad-based stock market indexes, such as the S&P 500. That has changed, however. According to the SEC, “Many of the newer ETFs are based on more specialized indexes, including indexes that are designed specifically for a particular ETF, bond indexes, and international indexes. . . . ETFs are held today in increasing amounts by institutional investors (including mutual funds) and other investors as part of sophisticated trading and hedging strategies. Shares of ETFs can be bought and held (sometimes as a core component of a portfolio), or they can be traded frequently as part of an active trading strategy.”[2]

ETFs are thought to have certain benefits compared to traditional mutual funds, including “lower expense ratios and certain tax efficiencies” and “allow[ing] investors to buy and sell shares at intra-day market prices.” Investors can also “sell ETF shares short, write options on them, and set market, limit, and stop-loss orders on them.”[3] ETF shares can be purchased on margin.

Exchange-traded funds are promoted as being more tax-efficient than mutual funds, in large part because the turnover in portfolio securities is likely to be lower. In addition, as the SEC noted, ”[b]ecause an exchange-traded fund typically redeems creation units of exchange-traded shares by delivering securities in the ‘redemption basket,’ an exchange-traded fund generally does not have to sell securities (and thus possibly realize capital gains) in order to pay redemptions in cash.”[4] Although exchange-traded funds may thus produce fewer, and smaller, capital gain distributions than some mutual funds, that does not mean that such funds never make capital gain distributions, or that the amount of a distribution will always be smaller than a capital gain distribution from a mutual fund.


[1] .Exchange-Traded Funds, Proposed Rule, RIN 3235-AJ60, 73 Fed. Reg. 14618, 14619 (3-18-2008).
[2] .Exchange-Traded Funds, Proposed Rule, 73 Fed. Reg. 14618, 14619 (3-18-2008).
[3] .Exchange-Traded Funds, Proposed Rule, 73 Fed. Reg. 14618, 14620 (3-18-2008).
[4] .Concept Release: Actively Managed Exchange-Traded Funds, 66 Fed. Reg. 57514 (11-15-2001).


How do ETFs operate?

The SEC described the operation of ETFs as follows:

Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares (‘ETF shares’) at net asset value (’NAV’). Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks called “creation units.” A financial institution that purchases a creation unit of ETF shares first deposits with the ETF a “purchase basket” of certain securities and other assets identified by the ETF that day, and then receives the creation unit in return for those assets. The basket generally reflects the contents of the ETF’s portfolio and is equal in value to the aggregate NAV of the ETF shares in the creation unit. After purchasing a creation unit, the financial institution may hold the ETF shares, or sell some or all in secondary market transactions.[1]

ETFs must register offerings and sales of shares under the securities laws, and, “as with any listed security, investors may trade ETF shares at market prices. ETF shares purchased in secondary market transactions are not redeemable from the ETF except in creation units.”[2]

Redemption of ETF shares mirrors the purchase process:

The financial institution acquires (through purchases . . . the number of ETF shares that comprise a creation unit, and redeems the creation unit from the ETF in exchange for a “redemption basket” of securities and other assets. An investor holding fewer ETF shares than the amount needed to constitute a creation unit (most retail investors) may dispose of those ETF shares by selling them on the secondary market. The investor receives market price for the ETF shares, which may be higher or lower than the NAV of the shares, and pays customary brokerage commissions on the sale.[3]


[1] .Exchange-Traded Funds, Proposed Rule, 73 Fed. Reg. 14618, 14620 (3-18-2008).
[2] .Exchange-Traded Funds, Proposed Rule, 73 Fed. Reg. 14618, 14620 (3-18-2008).
[3] .Exchange-Traded Funds, Proposed Rule, 73 Fed. Reg. 14618, 14620 (3-18-2008).


How are ETFs taxed?

ETF shares represent undivided interests in the assets held by the fund. ETFs are “organized either as open-end investment companies or unit investment trusts.”[1] ETFs organized as unit investment trusts generally qualify for tax treatment as regulated investment companies for tax purposes. 

Exchange-Traded Funds Invested in Metals. In a memorandum prepared by the Office of Chief Counsel of the IRS, which was made public only as the result of a court order, the IRS advised that the sale of an interest in an ETF that directly invests in metal (“physically-backed metal ETF”) is treated as the sale of a “collectible”, such that any gain from the sale of the interest is subject to the maximum capital gain rate of 28%.[2] The Service reasoned that in the case of a physically-backed metal ETF that is treated as a trust, the investor is treated as owning an undivided beneficial interest in the collectible held by the trust. Accordingly, if the investor sells an interest in the ETF or the trust sells a portion of the collectible, the investor is treated as having sold all or a portion of his or her share of the collectible held by the trust, and any gain from the sale of the trust interest or sale of the collectible by the trust is treated as collectible gain and, therefore, is subject to the maximum capital gain rate of 28%. However, if a physically-backed metal ETF is not structured as a trust, or if the ETF does not directly invest in the metal, then the above rule does not apply. The Service cautions that the structure of each physically backed metal ETF should be considered to determine the tax consequences of an investment in that ETF.


[1] .Exchange-Traded Funds, Proposed Rule, 73 Fed. Reg. 14618, 14619 (3-18-2008), Footnote 8.
[2] .Office of Chief Counsel IRS Memorandum by TaJuana Nelson Hyde, Assistant Branch Chief (May 2, 2008), “Exchange-Traded Funds Invested in Metal (Wall Street Journal Article).”


What are the exceptions to the general rules for how ETFs are taxed?

As in just about everything, there are exceptions to the general tax rules for ETFs. A good way to think about these exceptions is to know the tax rules for the sector. ETFs that fit into certain sectors follow the tax rules for the sector rather than the general tax rules. Currencies, futures, and metals are the sectors that receive special tax treatment.

Currencies

Most currency ETFs are in the form of grantor trusts. This means the profit from the trust creates a tax liability for the ETF shareholder, which is taxed as ordinary income. They do not receive any special treatment, such as long-term capital gains, even if you hold the ETF for several years. Since currency ETFs trade in currency pairs, the taxing authorities assume that these trades take place over short periods.

Futures ETFs

These funds trade commodities, stocks, Treasury bonds, and currencies. For example, PowerShares DB Agriculture (AMEX:DBA) invests in futures contracts of the agricultural commodities - corn, wheat, soybeans, and sugar - not the underlying commodities. Gains and losses on the futures within the ETF are treated for tax purposes as 60 percent long-term and 40 percent short-term regardless of how long the contracts were held by the ETF. Further, ETFs that trade futures follow market-to-market rules at year-end. This means that unrealized gains at the end of the year are taxed as though they were sold.

Metals ETFs

If you trade or invest in gold, silver, or platinum bullion, the IRS considers it a "collectible" for tax purposes. The same applies to ETFs that trade or hold gold, silver, or platinum. As a collectible, if your gain is short-term, then it is taxed as ordinary income. If your gain is earned for more than one year, then you are taxed at either of two capital gains rates, depending on your tax bracket. This means that you cannot take advantage of normal capital gains tax rates on investments in ETFs that invest in gold, silver, or platinum. Your ETF provider will inform you what is considered short-term and what is considered long-term gains or losses.

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