Tax Proposals May Affect Exchange Traded Funds Morgan lewis

The recently proposed tax legislation, if passed, would fundamentally change the taxation of exchange-traded funds. This LawFlash discusses the potential consequences of such legislation on industry participants, including retail investors.

On September 10, 2021, U.S. Senate Finance Committee Chairman Ron Wyden (D-Oregon) released tax bill (Wyden’s project) focused primarily on eliminating perceived opportunities for corporate tax abuse. However, the Wyden Draft also included provisions that affect exchange-traded funds (ETFs) registered under the Investment Company Act of 1940 (’40 Act) imposed as regulated investment companies (RICs) and ETFs. subject to the rules applicable to listed partnerships (PTP). ) (often referred to more broadly as “exchange traded products” or “ETPs”). Subsequently, on September 15, the House Ways and Means Committee announced the completion of its markup of the draft tax legislation (Draft Ways and Means) that may inadvertently affect FTEs treated as “dealers” for US federal income tax purposes.

It is currently unclear whether any of the provisions of the Wyden Project or the Ways and Means Project will become law.


Over the past 15 years or so, there has been a significant amount of commentary and misunderstanding regarding Section 852 (b) (6) of the Internal Revenue Code of 1986, as amended (the Code), which is unique to the taxation of RICs. As a reminder, RICs are corporations for tax purposes. Under current law, companies are generally required to recognize the gain on the distribution of valued property to their shareholders. However, RICs that issue redeemable securities, which include most Law 40 ETFs, are exempt from this rule when they distribute valued assets following a shareholder redemption request. Specifically, section 852 (b) (6) allows an RIC to distribute valued property to a shareholder without recognizing a gain. Notably, although section 852 (b) (6) may prevent a RIC from recognizing a capital gain, and therefore prevent additional taxable distributions to shareholders of the RIC, section 852 (b) (6) does not result in no increase in the tax base in RIC shares and therefore does not prevent non-redeeming shareholders from recognizing a gain on the subsequent sale of their shares. The changes proposed in Wyden’s draft would repeal section 852 (b) (6), requiring RICs to recognize any gain on in-kind distributions of valued property. If passed, the proposed changes would come into effect for taxation years that begin after December 31, 2022.

Although the elimination of Section 852 (b) (6) would technically affect all registered investment firms seeking to qualify as RICs, including mutual funds, “business development companies” or “BDC” and certain closed-end funds that have received IRS approval to use subsection 852 (b) (6)) – this proposed change is expected to primarily affect ETFs. Many ETFs rely heavily on in-kind distributions of securities as a key part of implementing their investment strategy, and section 852 (b) (6) is a fundamental aspect of how ETFs work. by accepting contributions in kind and making contributions in kind. redemptions. Since RICs are required to distribute their income and earnings annually to avoid tax at the entity level, a repeal of section 852 (b) (6) would likely result in an ETF that generates earnings from the distribution of securities valued in accordance with redemption requests to sell securities on the market in order to generate the necessary liquidity to meet its annual distribution needs. Such sales can generate additional capital gains, further increasing the distribution requirements of the ETF. The resulting additional distributions would generally be taxable to non-redeeming shareholders, although the gains would be generated by redemption requests from redeeming shareholders. The repeal of section 852 (b) (6) may also result in additional transaction costs for ETFs related to the sale of securities in the market, these additional costs being borne by non-redeeming shareholders. Additionally, the need to meet increased annual distribution requirements can make it difficult for index ETFs to properly track their underlying indices.

In particular, this proposal only appears in the Wyden Draft. The Ways and Means outline would not repeal section 852 (b) (6).


Another proposal in the Wyden Draft that has the potential to disrupt the ETF industry is the PTP provision. This provision would eliminate a means by which PTPs can be treated as partnerships rather than taxable “C corporations”. If enacted, the provision would result in many PTPs being treated as C corporations and thus subjecting them to entity-level tax. The current law generally treats all PTPs, including Master Limited Partnerships (MLPs), commodity / futures based PTPs, and real estate PTPs, among others, as C corporations, unless certain exemptions are made. respected. Such exemption applies if 90% or more of the gross income of a TPP consists of “qualifying income” within the meaning of Article 7704 (d) of the Code and of the Treasury regulations thereunder ( exemption from qualifying income).[1]

Wyden’s plan would eliminate the qualifying income exemption, which would require many TPPs to be subject to entity-level tax as C corporations for tax years beginning after December 31, 2022. Proposed changes do not appear to affect other exemptions that allow certain PTPs to avoid being treated as a corporation. Since ETFs cannot, in practice, match other exemptions, they rely on the qualifying income exemption. The summary section by section of the Wyden Draft states that “[PTPs] often have hundreds of thousands of partners and it is nearly impossible for the IRS to properly administer these entities. In addition, these entities do not pay corporate tax and thus erode the corporate tax base.

On the other hand, the Ways and Means outline proposes to broaden the types of “eligible income” authorized by the exemption from eligible income to include certain income from the production of electricity or thermal energy and from certain renewable energies. among other sources of energy. Therefore, there does not appear to be a consensus between the Wyden Draft and the Ways and Means Draft on the changes to the qualifying income exemption.


Many fixed investment ETPs (holding metals, currencies, commodities, cryptocurrency) and mutual funds (often holding baskets of undiversified securities) are treated as the “dealers” described in Articles 671 to 679 of the Code. Contributions to a grantor trust and distributions from a grantor trust to its shareholders (technically “grantors”) are generally not tax recognition events, as the shareholders are considered to be the owners of a pro rata party. of the underlying assets of the trusts, and the grantor trusts are indeed not taken into account for tax purposes. Consequently, a contribution or a distribution to a shareholder is ignored as a transaction between the shareholder and himself.

A die proposed changes in the Ways and Means project may unintentionally alter the functioning of these trusts. Specifically, section 1062 of the newly proposed Code would override the otherwise applicable treatment of transferor trusts in determining whether “a transfer of ownership between a trust and the [sic] person who is the deemed owner of the trust (or part of it) ”is treated as a“ sale or exchange ”. There does not appear to be any indication that this proposal is intended to affect the operation of fixed investment ETPs; rather, it seems intended to deal with certain estate and tax planning transactions that do not apply to investment funds structured as grantor trusts. However, as drafted, the proposal applies to “any transfer”, which could be interpreted to encompass in-kind distributions and in-kind contributions commonly used by closed-end investment trusts without subjecting trusts. or their shareholders to the recognition of the gain. Therefore, the proposal, if adopted in its current form and interpreted to apply to closed-end investment trusts, could fundamentally change the taxation and operation of such trusts.

Morgan Lewis will continue to monitor the Wyden Draft and the Ways and Means Draft as they move forward in the reconciliation process, as well as any similar proposals, and will keep you informed of their potential ramifications if adopted.

[1] “Qualifying income” generally includes interest, dividends, rents from real estate, gain from the sale or other disposition of real estate, income and gain from the operation and production of real estate. certain mineral and natural resources, the gain from the sale or disposal of a fixed asset or Code property of Article 1231, and in the case of a partnership whose main activity is the purchase and the sale of commodities, income and gains derived from commodities (not described in Article 1221 (a) (1) of the Code) or from futures, options or futures contracts with at l ‘regard to these commodities (including currency transactions of a commodity pool). [View source.]

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