This piece examines the tax efficiency of ETFs, focusing on their growth driven by in-kind redemptions and Section 351 exchanges.
Exchange-traded funds (ETFs) have grown to approximately $12 trillion, with around 80% of these assets being equities. A significant factor contributing to the rise of ETFs is their tax efficiency, as detailed in Section 852(b)(6) of the U.S. Internal Revenue Code. This section allows registered investment companies (RICs) to distribute appreciated property, like securities, to shareholders in redemption of their shares without the RIC recognizing gain. ETFs often utilize Section 852(b)(6) through “in-kind” redemptions involving authorized participants (AP)1 to manage or defer the taxation of investment gains at both fund and shareholder levels. This tax efficiency is particularly appealing to high-net-worth individuals and tax-sensitive investors, and has played a crucial role in the substantial shift from mutual funds to ETFs that has been underway for over a decade.
In-kind transactions involve the physical transfer of securities, rather than a portfolio manager buying or selling them for cash. This process is similar to an investor transferring their securities from one brokerage firm to another after opening a new brokerage account. The in-kind process typically begins when a market maker needs shares to facilitate purchases from investors. When this occurs they often collaborate with an AP to create new shares with the fund. This requires the AP to acquire the underlying securities in the ETF and deliver them to the fund in exchange for ETF shares. Conversely, when a market maker accumulates an inventory of ETF shares from investors selling, they can redeem those shares by delivering them to the fund in exchange for the underlying securities, which they then sell in the open market.
The transfer of ETF shares and underlying securities occurs at the closing values that evening, and does not trigger a capital gain or loss because the securities are physically delivered rather than bought or sold for cash. Although ETFs typically do not distribute capital gains, or if they do, they tend to be small (see Exhibit 2), investors will still realize a gain or loss when they sell their ETF shares. As a result, gains are often deferred rather than avoided.
351 exchanges
Section 351 of the U.S. Internal Revenue Code provides further opportunities to optimize taxes. A 351 exchange enables an individual to transfer property (such as investment assets) into a corporation (in this case, a fund) with no immediate tax consequence. This provision has recently been used in ETF fund launches, where individual investors seed a newly created ETF with existing assets and effectively exchange their assets for shares of the ETF. This strategy has recently gained traction among investors (single or group) seeking to diversify their portfolios without triggering an immediate capital gains tax. While Section 351 has been part of the tax code for over a century, its application to individual investment portfolios is a relatively novel development.
The strategy's elegance lies in its ability to pool the portfolios of multiple investors into a newly created ETF of similar strategy. Once within the ETF's structure, assets can be reallocated over time without tax consequences using the in-kind creation and redemption processes. It should be noted that the investor’s cost basis for the new ETF will remain the same as the original cost basis and holding period. The investor will eventually pay taxes on gains when the ETF is sold.
ETFs typically allow investors the flexibility to realize capital gains at their discretion. As a result, ETFs are increasingly becoming the preferred investment structure, significantly reshaping the investment landscape.
The bottom line
Over the past three decades, ETFs have emerged as the preferred investment vehicle due to their unique advantages. The in-kind redemption process, which minimizes capital gains, has been instrumental in driving their growth. This flexibility in capital gains realization is not only attracting a diverse range of investors but also transforming traditional investment strategies. The innovative application of Section 351, allowing for the deferral of capital gains, is also an interesting development. As ETFs continue to evolve in their use, they likely will continue to redefine the investment landscape for both individual and institutional investors alike.