How ETFs Keep the Taxman at Bay

ETFs are often touted for their tax efficiency, and for good reason. They can be significantly more tax-efficient than conventional mutual funds, making them good candidates for taxable accounts. But what's the secret behind their tax-efficient ways?

First of all, ETFs are tax-efficient because they are index funds. Most index funds keep trading to a minimum, which means there are fewer taxable gains realized, and the few gains that are realized often qualify for the lower long-term capital gains tax rate.

Furthermore, ETFs are shielded from unpredictable and frequent shareholder cash flows that can also trigger tax consequences. That's because individual investors like you and me trade ETFs with each other in the secondary market. Mutual funds don't enjoy that benefit, and inopportune cash flows out of a fund can force a manager to recognize taxable gains.

Finally, the structure of ETFs confers certain powerful tax advantages. To fully understand how this works, we'll have to venture into more technical aspects of ETFs, so bear with me while I describe the inner workings of an ETF.

The Mechanics of ETF Tax Efficiency
Only a few very large investors (called "authorized participants") deal directly with the ETF provider. When an authorized participant (typically large financial institutions or market makers) wants to create or buy ETF shares, it assembles a portfolio of the underlying stocks and delivers it to the provider, who hands over new ETF shares. The same process is carried out in reverse for a redemption. The large investor gives the ETF shares to the provider, and the large investor in return receives the underlying portfolio of stocks.

ETFs use the in-kind redemption process to give the taxman the brush-off. When large investors request in-kind redemptions, the ETF manager can off-load equity shares with the lowest cost basis, thereby sweeping unrealized gains out of the fund.

This structure has proved effective so far. Very few ETFs have made capital gains distributions. Even those ETFs that trade more frequently--such as PowerShares Dynamic Market (PWC), which has experienced turnover as high as 116%--have not distributed a single capital gain. Granted, higher-turnover ETFs are still relatively young. But it's heartening that the in-kind mechanism has worked as it should so far.

Special Tax Situations
It's a mistake to assume that all ETFs are tax-friendly, though. It all depends on what an ETF invests in. For example, ETFs that invest directly in precious metals, such as StreetTracks Gold Shares (GLD) and iShares Silver Trust (SLV), are taxed as "collectibles" rather than securities. That means gains are taxed at a maximum rate of 28% rather than the current 15% for long-term capital gains on securities.

Commodity ETFs and others that use futures contracts to gain exposure to their specified asset class receive dual tax treatment--60% of gains receive the beneficial long-term gains rate (maximum of 15%), while the remaining 40% are treated as short-term capital gains, which are taxed at the shareholder's ordinary income tax rate, which can be twice as much. Similarly, all gains on currency ETFs are taxed at the shareholder's ordinary income tax rate.

The tax-efficient structure of ETFs is also not as relevant for bond ETFs because the bulk of their returns come from interest rather than capital gains, and any interest distribution is taxed at the shareholder's ordinary income tax rate.

Sometimes it's not what an ETF owns but how it's structured that gives rise to tax inefficiency. The vast majority of ETFs are organized as registered investment companies, but a handful of specialized ETFs have adopted other structures. For example, all CurrencyShares ETFs, including CurrencyShares Euro Trust (FXE), are structured as grantor trusts, and US Oil (USO) is structured as a limited partnership. IShares GSCI Commodity Indexed Trust (GSG) is a trust that holds limited liability company interests in a commodity pool. Under each of those structures, shareholders must pay taxes on their share of the fund's income and earnings each year even if those dividends and earnings are not distributed. In other words, shareholders of these funds could wind up owing taxes on income they've never received.

So clearly, not all ETFs are suited for taxable accounts. And it's important to do your homework before you invest so you'll know exactly how an ETF's returns will be taxed.

What about Exchange-Traded Notes?
Since it launched the first iPath ETN in July 2006, Barclay's had pitched ETNs as very tax-friendly vehicles. But ETNs are now in the taxman's cross hairs, and Barclay's interpretation of the tax code may turn out to be overly generous.

On Dec. 7, the IRS ruled that currency ETNs should receive the same tax treatment as other vehicles that offer exposure to single currencies. That's in contrast to Barclay's assertion that shareholders should be taxed only when they sell their ETN shares.

The new ruling applies only to currency ETNs. However, the IRS has asked for comments on how other ETNs should be taxed. Hopefully, the IRS will issue a ruling soon to provide investors much-needed clarity on this issue. In the meantime, investors are left to speculate about how these vehicles will be taxed. If the IRS decides to treat ETNs like other competing vehicles, ETNs will lose a major point in their favor.

 

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