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Tax Changes Coming to ETFs?

A horrible idea, says Morningstar's Ben Johnson.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. There's some talk in Congress of changing the way exchange-traded funds are taxed. Joining me today to unpack the proposal and discuss its impact on investors is Ben Johnson. Ben is Morningstar's global director of ETF research.

Thanks for being here, Ben.

Ben Johnson: Thanks for having me, Susan.

Dziubinski: Let's start out with a little bit of a primer about how ETFs are taxed today. How does it work?

Johnson: Well, it's important to understand that ETFs are really taxed no differently than traditional mutual funds. So, when ETFs distribute taxable capital gains, investors will have to pay capital gains tax on those taxable capital gains distributions. When ETFs distribute income to their shareholders, they'll have to pay income taxes on those distributions of income. That is no different than traditional open-ended mutual funds. Now, what is different is the frequency, specifically of taxable capital gains distributions that we see coming from ETFs, which tend to be much fewer, much further between, and, when they do happen, much smaller in magnitude than what we've seen from open-ended mutual funds in recent years. And why that is is because ETFs have disproportionately benefited from the ability to push securities out of their portfolios on an in-kind basis. So, they're not selling stocks and bonds; they're handing them over to another market participant when it comes time to meet redemptions or to make necessary adjustments to the portfolio to turn the portfolio over. And because they're not directly selling those underlying securities in the market, they're not unlocking any embedded gains.

Now, mutual funds, when they're either turning over their portfolio or meeting redemption requests, more often than not are going to have to go into the market and sell those securities, realize gains in the process, and pass those gains on to shareholders in the mutual fund, irrespective of whether those fund shareholders were selling or not. 

So, what ETFs have in effect is sort of a tax-deferral mechanism by virtue of the fact that they're able to push securities out in-kind. It's important to note: Mutual funds can do this, too. They have done it, too. They reserve the right to do it. But most mutual fund investors when they go to sell their position in a mutual fund portfolio aren't going to be a big fan of getting a few thousand stocks pushed across the table to them, might not even be logistically feasible. So, largely, for matters of convenience and logistics, this is a very rare occurrence in mutual funds, where it's par for the course, it's very commonplace, in ETFs and explains a huge increment of ETFs' relative tax efficiency over open-ended mutual funds.

Dziubinski: Then, Ben, what's in the proposal? What should change according to the proposal?

Johnson: The Chairman of the Senate Finance Committee, Ron Wyden, has pushed across a more sweeping proposal. But one of the elements of that proposal is aimed specifically at the tax loophole that allows registered investment funds to do exactly what I just described--to get rid of securities from the portfolio on an in-kind basis and avoid any tax consequences as a result, because they're not directly selling them. Now, this would disproportionately affect ETFs for all the reasons that I've described and make them incrementally less tax-efficient than they are today, and their tax efficiency, frankly, has been a primary point of appeal, most notably and most understandably, among investors who are allocating taxable money to them.

Dziubinski: Why is this proposal on the table? What is it trying to achieve?

Johnson: Well, I think this proposal, as I mentioned before, is really just one element of a more sweeping proposal that's aimed at taxing people who to-date either haven't been paying as much tax as they probably should be or any tax at all, so getting swept up in the mix here are ETFs. And I would argue unfavorably so because ETFs are a fundamentally different vehicle. We're not talking about carried interest exemptions here. We're talking about a very democratic vehicle, a vehicle that's owned by investors of all types, of all levels of income, of all levels of assets and irrespective of whether you've got $1 billion invested in an ETF or $1,000 invested in an ETF with taxable money, you are benefiting from the status quo, the way that ETFs operate today from their current tax efficiency vis-à-vis traditional open-ended funds.

Dziubinski: Ben, what do you make of this proposal? Gaze into your crystal ball--how likely do you think it is to really pass?

Johnson: Well, I think this proposal is a terrible, horrible, no good, very bad idea, quite frankly, for all the reasons I've just described, because it's not just large investors that are benefiting from the status quo. It's also frankly a step in the wrong direction. If anything, I would argue that investors should pay the taxes that they owe when they owe them. And as it stands today, that's not the case for investors in open-ended mutual funds, many of whom have been saddled with capital gains taxes over years now, not in accord of their own behavior, but the behavior of investors in the fund around them that in many cases are redeeming their shares for a variety of reasons. So, if anything, I would argue that the fairer treatment would be to treat traditional open-ended mutual funds and ETFs equivalently--again, to have investors pay the taxes that they owe when they owe them, which I think is not only fair but also would put the United States on par with other major fund markets around the world, where that is how fund investors are currently taxed as it stands today.

Dziubinski: Lastly, Ben, if I'm an ETF investor, what does this mean for me today?

Johnson: What it means today is absolutely nothing. The call to action is inaction for the time being. I think there's a very low probability that this ultimately will see the light of day, and I think that probability is very low because it is very unpopular, not just among providers of ETFs but frankly among individual investors. Irrespective of how much money they have allocated to ETFs and taxable accounts today, the fact that they've been able to defer those taxes, haven't been saddled with taxable capital gains, means that they've got more of their money that is compounding to their benefit over a long period of time and then come one day, 20, 30 years down the road when they do ultimately liquidate those positions, at least in theory, the Treasury is going to get more money than they would if they had been taxing them all along the way. So, I don't think it's a good idea. I think for a variety of reasons, most of which I've described, this isn't something that, again, will see the light of day in my mind.

Dziubinski: Well, Ben, thank you for your time today and for your perspective and walking us through the various issues related to the proposal. We appreciate it.

Johnson: I appreciate you having me. Thanks, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.