The ETF industry was shaken up this week as a key Democratic senator proposed to repeal a tax advantage that’s been a driving force behind the investment vehicle’s popularity over the past decade.
What Happened
As Senate Democrats discussed President Joe Biden’s sweeping $3.5 trillion reconciliation bill and how to pay for it, Senate Finance Committee Chairman and Oregon Sen. Ron Wyden submitted a series of proposals to be considered for inclusion.. Wyden said he aims to close the loopholes in the current tax system that allows the rich to “pick and choose when, and whether, to pay tax” on their investments.
One such loopholes, according to Wyden, is the tax exemption for the so-called in-kind transactions commonly used by ETFs, which allows most shareholders to not pay any capital-gain taxes until they sell the fund. Repeal of such tax advantages would generate over $200 billion in additional tax income over a decade, preliminary congressional estimates show.
Wyden’s proposal to remove the tax exemption of in-kind transactions could be devastating for the $6.8 trillion ETF industry. As soon as the draft was released, fund companies and industry lobby groups came out in defense, arguing that the tax advantages of ETFs benefited not only the rich, but also millions of regular investors in America.
Putting aside the question whether it’s fair for ETF investors to pay less tax, here is an explanation of how the break works. The first thing to understand is how ETF investors dodge taxes paid by mutual-fund investors.
How Mutual Funds Pay Taxes
If you own an actively managed mutual fund and the portfolio manager decides to sell stockholdings that have appreciated in value, the fund will generate taxable capital gains. By law, the fund must distribute those gains to all shareholders, including you.
What’s more, if another shareholder in the same fund decides to sell his or her shares, the fund manager may also need to sell some stocks to raise cash and meet the redemption request. If those stocks have risen in prices since they were bought, the gains will again be distributed to all the remaining investors, again including you.
These capital-gain distributions typically occur near the end of each year, and you pay taxes on them if you hold the mutual fund in a taxable account.
How ETFs Pay (Or Not Pay) Taxes
Unlike mutual funds, where investors buy shares from the fund companies, ETFs are essentially a bundle of securities trading on the public market just like stocks.
If any ETF investors want to exit the fund, they can simply sell their shares to another investor on the exchange. Since the underlying stocks still remain in the fund––just held by a different person now––there will be no stock selling and capital gains for the ETF.
Sometimes, there are not enough buyers to meet the selling demand and the sellers will need to redeem the shares, or remove them from the market.
Even in this case, the unique ETF structure allows the funds to deliver the basket of underlying stocks––instead of cash––to the so-called authorized participants, who will then pay investors cash. The authorized participants––often market makers or large financial institutions––can later choose to resell those stocks whenever they want.
The transactions between ETFs and authorized participants are considered “in-kind” and according to current laws, they’re exempt from tax payments: Since the ETF shares are exchanged for the equivalent value of stocks, there is technically no capital gains.
This process gives ETFs the perfect tool to shed their holdings that have accumulated the most gains without tax consequences. By doing this, many ETFs can avoid recognizing taxable gains almost entirely––if there are enough redemptions.
All this means ETF investors only need to pay capital-gain taxes when they sell their own shares, while mutual-fund investors have to pay for the gains passed onto them each year even if they hold their shares for decades.
Why It Matters
The ETF industry has seen exponential growth over the past decade, taking in trillions of dollars in new assets as mutual funds continued to see outflows. While ETFs have many advantages such as lower fees, full transparency, and better liquidity, one of their key selling points has been tax efficiency.
If the tax benefits of ETFs are taken away, fund managers say, wealthier investors could just shift their assets into other platforms or investment vehicles, so Wyden’s proposal won’t achieve the tax revenue it expected. On the other hand, retail investors, who have grown particularly fond of ETFs, would be burdened with larger tax bills and might eventually leave the market.
“The provision as currently drafted in Chairman Wyden’s bill wouldn’t close a ‘loophole,’ as he suggests, but would instead result in U.S. households receiving additional tax bills,” wrote Eric J. Pan, president and CEO of the Investment Company Institute in a statement Wednesday.
