A proposal from a powerful Senate Democrat to change the tax treatment for in-kind redemptions used by exchange-traded funds and mutual funds has asset managers concerned.
Sen. Ron Wyden, D-Ore., chairman of the Senate Finance Committee, released draft legislation on Sept. 10 aimed at closing "loopholes" he says are used by wealthy investors and corporations. The proposal includes a provision to repeal a section of the tax code that allows regulated investment companies — which ETFs and mutual funds are considered — to avoid recognizing gains when distributing appreciated assets to their shareholders.
"Because fund managers decide which securities to distribute, they distribute assets with unrealized gains and thereby significantly reduce the future tax burdens of their current and future shareholders," a 2017 paper from Fordham University Law Professor Jeffrey Colon said. Mr. Wyden cited the paper in a summary of his draft legislation. "Many ETFs have morphed into investment vehicles that offer better after-tax returns than IRAs funded with after-tax contributions," Mr. Colon said in the paper.
When an ETF seeks to offload appreciated securities for rebalancing or redemption purposes, it can avoid paying capital gains taxes on the securities by asking an accommodating party, such as a broker or bank, to buy shares in the fund and then exchange those shares for the appreciated securities. The tax rule used in this instance was written more than 20 years before ETFs came into existence.