(Article from Registered Funds Regulatory Update, January 2022)
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Senate Finance Committee Chair Ron Wyden (D-Oregon) proposed legislation to close current tax loopholes that permit wealthy investors and large corporations to use pass-through entities, such as partnerships, to avoid paying taxes. The Senator’s proposal specifically limits how gains and losses can be allocated, which has significant unintended consequences for mutual funds and ETFs. Under the current federal income tax rules, when a mutual fund or ETF sells an appreciated portfolio security, including to meet redemption requests, the mutual fund or ETF recognizes capital gain that is distributed before year-end to shareholders, who then pay income tax on the gain distributed at year-end. However, in accordance with Section 852(b)(6) of the Internal Revenue Code, mutual funds and ETFs may instead distribute appreciated portfolio securities in-kind to redeeming shareholders without having to recognize a gain on the securities.
This alternative option is routinely used by ETFs. Authorized participants (brokers and dealers) create and redeem ETF shares for shareholders in-kind by providing “baskets” of securities of the ETF in exchange for “creation units” of the ETF, which when redeemed are exchanged for an in-kind distribution of securities equaling the net asset value of the securities redeemed. The proposed legislation would repeal Section 852(b)(6) and require ETFs to recognize gains on appreciated securities distributed to authorized participants in-kind thereby increasing the taxable gain amounts ETFs will distribute to non-redeeming shareholders.
Repealing Section 852(b)(6) may also result in the following additional unintended consequences:
- The vast majority of households that own ETFs have an annual income under $400,000. The proposed legislation could impact more investors than just the “wealthiest households” as originally intended.
- Tax costs associated with short-term trading of ETF shares could be borne by long-term ETF shareholders.
- The ETF industry’s large growth is due in part to the favorable tax treatment provided by Section 852(b)(6). Removing that favorable tax treatment may adversely impact the ETF industry.
Senator Wyden’s stated goal of making wealthy investors and mega-corporations “pay their fair share” may not in reality be achieved by repealing Section 852(b)(6) as it could lead to retail investors paying the ultimate price for such changes. Senator Wyden’s proposed legislation as drafted would be effective for tax years beginning after December 31, 2022.
Press Release, Wyden Unveils Proposal To Close Loopholes Allowing Wealthy Investors, Mega Corporations To Use Partnerships to Avoid Paying Tax (Sept. 10, 2021), available at https://www.finance.senate.gov/chairmans-news/wyden-unveils-proposal-to-close-loopholes-allowing-wealthy-investors-mega-corporations-to-use-partnerships-to-avoid-paying-tax.