Democratic tax proposal takes aim at ETFs

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A top Senate Democrat has been circulating a proposal that would hit the rapidly growing world of exchange-traded funds. Big money managers are bracing for a fight.

Senate Finance Committee Chairman Ron Wyden’s proposal aims to tax ETFs’ use of "in-kind" transactions that currently avoids triggering capital-gains taxes. With such in-kind transactions, ETFs—bundles of securities that trade on exchanges—transfer appreciated stock, bonds or other assets to Wall Street intermediaries instead of cash.

By closing a decades-old tax regulation loophole, the proposal stands to eliminate one of the ETF industry’s key selling points: tax efficiency. This proposed change has spurred a rush to mobilize among the largest asset managers, some of whom have built their businesses around the ETF industry.

"ETFs have become big capital gains deferral machines," said Jeffrey Colon, a professor at Fordham University School of Law who has researched this topic.

ETFs are able to avoid taxes with in-kind transactions thanks to a tax exemption intended for mutual funds, created long before ETFs existed.

"The ability of these funds to do in-kind redemptions of appreciated property is being weaponized and used in a way that Congress surely couldn’t have intended," he said.

The impact of the proposal would largely fall on ETFs rather than mutual funds, which largely distribute assets to investors in cash.

Over the past decade, ETFs have boomed in popularity, with assets of such U.S. registered funds quintupling to $5.4 trillion by the end of 2020, according to the Investment Company Institute. Investors have turned to ETFs because of their low fees, tax benefits, easy trading and broad market exposure.

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The proposal would result in funds passing on capital gains to millions of investors in the funds.

Asset managers are scrambling to respond.

"If the proposal appears to be going somewhere, it’s going to be Defcon 1 for the ETF industry," said Jeremy Senderowicz, a partner at law firm Vedder Price PC, which represents several ETF firms.

The proposal has yet to make its way into any formal legislative plan. It is part of a slew of suggestions Oregon’s Mr. Wyden shared with House and Senate Democrats for discussion as they look to fund an ambitious spending agenda if other tax proposals lose political support.

On Wednesday, the House Ways and Means Committee voted 24-19 to advance a plan that would generate more than $2 trillion that would go toward expanding Medicare, increasing renewable-energy tax breaks and creating a national paid-leave program, among other items. Rep. Stephanie Murphy (D., Fla.) joined Republicans in opposition.

The changes targeting in-kind transactions by funds are expected to generate just over $200 billion over a decade, according to preliminary estimates by the Joint Committee on Taxation that were shared with Sen. Wyden’s office.

Industry lobby groups from ICI to Securities Industry and Financial Markets Association are strategizing on how to topple the proposal. ICI is soliciting feedback from firms.

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Among key ICI statistics starting to circulate and become echoed by various lobbyists and executives is that nearly 12 million U.S. households own ETFs, and the median income of these households is $125,000. That is well below the income level Democrats are targeting for tax increases.

Some asset managers are saying that the proposal would unintentionally saddle long-term investors with a higher tax bill than short-term traders.

BlackRock Inc. said it was looking into the proposal. "We would be concerned about policies that would raise costs and reduce returns for long-term investors and retirement savers, and are carefully reviewing Sen. Wyden’s proposal to better understand how it will impact millions of long-term investors," said a spokesman.

The in-kind trades that this proposal targets are a vital part of the multitrillion-dollar industry. Every day, banks buy baskets of instruments to exchange for shares of ETFs, or vice versa, keeping ETF prices in line with their underlying investments.

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In some cases, fund managers will engineer in-kind trades to help manage tax burdens of the fund while also rebalancing the funds so they track indexes. A fund manager could instruct a bank to steer big inflows in and out of a fund. These flows resemble spikes and troughs in an electrocardiogram and are known in the industry as heartbeat trades. In the process, the ETFs shed shares that might otherwise trigger a taxable gain.

These trades—which can be outsize and visible—were among the issues that prompted Sen. Wyden’s office to pay closer attention to the tax advantages of ETFs in the past two years.

A spokeswoman for Sen. Wyden said that the proposed rule would affect those that invest in ETFs through taxable brokerages, while those in tax-sheltered accounts such as individual retirement accounts wouldn’t be affected.

Invesco Ltd. , a large ETF manager, in a statement said the firm "strongly disagrees with the premise of the proposed legislation.

"Portraying ETFs as an investment for the ‘wealthy’ goes against the nature of the vehicle’s potential benefits and those who are ‘wealthy’ would likely just shift their assets into other platforms or investment vehicles," the company said.

In a statement, Sen. Wyden said "The big-picture point here is that pass-through and partnership taxation are a mess." He added, " As the Senate Democratic caucus continues to look at the menu of tax policy I’ve put forward, this package of loophole closers will be an important part of our conversation."

Vanguard Group declined to comment on the proposal, but said "the ability of mutual funds and ETFs to transact securities in-kind is a longstanding practice that improves outcomes for millions of investors." For the majority of its U.S. ETFs, Vanguard uses a unique structure in which the firm’s ETFs are share classes of mutual funds.

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In these cases, Vanguard’s ETFs can transfer appreciated stocks out of the mutual fund they are tied to in exchanges that don’t incur tax consequences for investors. This means that taxation of in-kind trades would affect both Vanguard’s ETFs and mutual funds.

Executives at Vanguard over the years had questioned whether the favorable tax treatment of in-kind trades would last, said a person familiar with the matter.

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