New tax proposals designed to raid companies and the wealthy to finance US government spending plans could have a significant impact on the country’s ETF industry and private investors.
Draft legislation published on 10 September by Senate finance committee chairman Ron Wyden would see a tax levied on in-kind redemptions which would remove the tax efficiency of US-listed ETFs that is often touted as one of the industry’s key selling points.
This tax advantage dates back to the Richard Nixon era and exempts regulated investment companies (RICs) from being taxed on gains if shareholders are paid out “in-kind”. In practice, this means payments have to be made in securities such as bonds or equities rather than cash.
Because capital flows in and out of ETFs via authorised participants and there are normally enough withdrawals, virtually all redemptions are carried out in-kind meaning investors usually avoid paying any tax on gains until they sell their ETF.
At present, some ETF managers engage in an activity called heartbeat trades. This process involves pumping cash into an ETF and quickly withdrawing it which increases the amount of withdrawals and allows an ETF to shed securities whose values have increased without realising a taxable gain.
According to data from Morningstar, only five percent of the nearly 1,400 ETFs from the 12 largest US issuers had taxable distributions at the end of 2020.
The proposed change to the way ETFs are taxed would be expected to raise $205bn in revenue over ten years. It featured alongside suggested amendments to the tax reporting requirements around business partnerships, with the measures designed to help finance the Democrat Party’s $3.5trn social spending plan.
If enacted, the closure of the roughly 40-year-old tax loophole would take effect from 31 December, however, there is likely to be significant opposition to the proposals from members of the Republican party and ETF industry participants.In a statement last Tuesday, Wyden said: “This particular proposal simply applies the same rules already in place for corporations to RICs, so wealthy investors can no longer avoid all tax on their gains.
“We are only talking about the taxable accounts of the wealthiest investors.”
Although Wyden said any changes will exempt retirement accounts entirely, Todd Rosenbluth, head of ETF and mutual fund research at CFRA, highlighted the potential impact on regular investors.
“While the proposal if passed is likely harm many middle-class Americans that have been loyal shareholders of ETFs as long as it remains under consideration there is a risk,” Rosenbluth said.
Rosenbluth added withdrawing the current tax advantages would remove one of the main use cases currently cited for choosing ETFs over other structures.
“Tax efficiency along with transparency, liquidity and low costs is a key reason many retail investors have chosen to purchase an ETF.”
Athanasios Psarofagis, ETF analyst at Bloomberg Intelligence, agreed, adding that while the introduction of the Senate’s proposal was “very unlikely”, it would see US ETFs cede some of the edge they currently have over mutual funds and direct indexing.
“Any possible change might be a long shot but maybe they may make mutual funds the same as ETFs. It is funny because mutual funds are allowed to do in-kind redemptions but rarely do. It is not as easy operationally for them.
“This is odd timing considering the Securities and Exchange Commission (SEC) rule passed two years ago allowing all to use custom baskets making them all more tax efficient via the heartbeats so all of that will go away.
“On the flip side, assume they did kill ETF efficiency, this would kill any type of mutual fund to ETF conversions and the Vanguard share class advantage. And probably makes direct indexing a viable choice now.”
Despite these concerns, both Rosenbluth and Psarofagis expect the US ETF industry to continue its growth, regardless of the outcome of the Senate’s proposals. No equivalent in-kind tax advantage exists in Europe, yet the industry has once again broken its record for annual flows with ease.