Exchange-Traded Products and Taxes

Note: This article originally appeared on Feb. 2, 2011, but in case you missed it, we are refeaturing it today as part of Morningstar.com's ETF Investing Week.

Fueled by increasing popularity, the exchange-traded product space continues to grow at a staggering pace. More often than not, the discussion of ETPs generally pertains to their advantages and disadvantages relative to the traditional open-end mutual funds, and while comparison is certainly warranted in this regard, it may be all too easy for investors to lump all exchange-traded products into one category while doing so. Here, we outline a number of ETP structures and discuss the tax implications of each.

Before we begin, let me note that I am not a registered tax advisor. Each investor will have a unique set of tax circumstances to which I am not able to speak. Please consult your accountant to verify your tax status for this and all investment products.

The Traditional ETF & the ETN
As the number of exchange-traded fund offerings grows, so, too, does the number of funds that provide exposure to any given slice of the market. One of the first distinctions that investors make within the space is between funds that hold their index constituents and those that do not.

An exchange-traded note is an unsecured debt obligation from a backing bank. The vehicle can be viewed as a promissory note and looks to deliver the precise return of its underlying index. ETNs do not hold any of their index constituents; rather, the notes merely track their return. For this reason, ETNs afford investors exceptionally low tracking error. The primary exception to this rule, of course, is the deduction of a management fee. The primary danger associated with the ETN is that it exposes investors to the credit risk of the backing bank.

Unlike ETNs, traditional ETFs do in fact hold a basket of securities.  SPDR S&P 500 (SPY), for example, holds the 500 underlying equity securities of its S&P 500 Index. Because full replication (matching the index exactly) can be unwieldy at times, most funds allow themselves the use of a conservative replication strategy. Funds using this strategy devote less than 100% of total assets to holdings stipulated by the index. They use remaining assets to attempt to match index returns by holding instruments with significantly similar performance. Sampling can lead to tracking error. On the other hand, ETFs are not exposed to the credit risk of a single backing bank as ETNs are.

Investors should understand that an ETF is a look-through vehicle. Holding an ETF, investors can generally expect to pay taxes as if they directly owned the fund's underlying holdings. At most times, absent erratic market activity, a traditional ETF and a mutual fund of the same type should garner similar tax treatment. During times of net redemptions, however, the ETF structure has proved to be generally more tax-efficient. A key advantage over the mutual fund structure is that, in most cases, ETF investors are only taxed for their own investment activities. In contrast, open-end mutual fund investors may be liable for taxable events that took place even before they established the position.

Tax treatment for these ETN and traditional ETF structures is similar in that investors are required to realize capital gains/losses upon liquidation of the position. Liquidation after a one-year holding period subjects investors to long-term capital gains taxes at rates no greater than 15%. Liquidation before one year passes subjects investors to short-term capital gains taxes at ordinary income rates.

Tax treatment between the two structures does, however, differ markedly with regard to distributions. An ETN is technically a debt security, and as such, its distributions are taxed at ordinary income rates, like any taxable bond. That said, distributions here are not common.

As mentioned earlier, ETFs are a pass-through vehicle. Investors here will pay taxes on ETF dividend payments as they would if they owned the basket constituents directly. ETFs holding a basket of U.S. stocks may make dividend payments. As with a direct holding, those dividends are taxable at a maximum rate of 15% only if the underlying position was held for more than 60 days within the 121-day period beginning 60 days before the fund's ex-dividend date. Although uncommon, ETFs holding a basket of bonds may distribute interest income, and as with a direct taxable-bond holding, distributions will be taxed at ordinary income rates.

Summary of ETN Tax Treatment:

• ETNs do not hold index constituents.
• Investor is taxed upon sale.
• Short-term capital gains rates apply when held for less than a year.
• Long-term capital gains rates apply when held for more than a year.
• ETN distributions, while not common, are taxed as interest income.

Summary of Traditional Equity ETF Tax Treatment:

• Traditional ETFs hold index constituents in a capacity stipulated by their prospectuses.
• Investors here are taxed upon sale.
• Short-term capital gains rates apply when held for less than a year.
• Long-term capital gains rates apply when held for more than a year.
• ETFs pass distributions of their holdings through to investors.
• ETFs are flow-through vehicles, so distributions will generally be taxed as if investors owned the fund's holding directly.

Limited Partnerships ETPs
The majority of ETPs structured as limited partnerships tap the commodity futures markets to gain their exposure. Investors here will not receive the traditional Form 1099 to which they are accustomed. Rather, these funds will issue Schedule K-1 tax filings. Of the multitude of such funds, popular examples include:  PowerShares DB Commodity Index Tracking  (DBC),  United States Oil (USO), and  United States Natural Gas (UNG).

Held in a traditional brokerage account, investors here will be required to pay capital gains taxes each year in which there is a nonrealized gain, regardless of sale. Of these gains, 60% are taxed at long-term rates while the remaining 40% are taxed at short-term rates. Gains of funds that turn to swaps and/or options to procure commodity exposure may not be subject the 60/40 rule. It is important to note that these funds typically do not distribute realized capital gains, so investors may need to pay capital gains taxes out-of-pocket. Additionally, futures-based ETPs margin their futures positions with cash or cash equivalents, held as collateral. Generally, funds will hold T-bills, and despite how low rates have fallen in recent years, the holding will generate interest that investors must recognize in their tax filings.

These tax implications (and the extra paperwork they necessitate) may lead some to consider holding LPs in a tax-deferred account, such as an IRA. Because an IRA is not subject to capital gains taxes until withdrawal, the 60/40 rule doesn't apply. The account structure allows investors to defer taxes on interest income until withdrawal as well.

An IRS clause known as Unrelated Business Taxable Income, or UBTI, can render an IRA taxable if distributions exceed a set threshold. UBTI is far more likely to affect master limited partnerships, generally pipeline companies that engage in business activities to generate income, than futures-based ETPs. Futures-based ETPs generate income passively. On this basis, such funds are not subject to UBTI, so long as they maintain their current business practices.

Summary of LP ETP Tax Treatment:

• ETPs structured as limited partnerships primarily hold futures contracts, though most allow themselves the use of swaps and options.
• Investors here face capital gains taxes every year regardless of sale.
• 60% of futures-related gains are taxed at long-term rates, 40% at short-term rates.
• These funds do not distribute realized gains, so investors may need to pay out-of-pocket.
• Investors must realize interest income produced by cash withheld as collateral.
• UBTI is currently a nonissue.

Grantor Trust ETPs
Much of the growing popularity in the ETP space may be attributed to vehicles structured as grantor trusts that deliver direct exposure to physical precious metals. There are a number of these types of funds. You may recognize some of the more popular offerings in the space, such as  SPDR Gold Shares (GLD),  iShares Gold Trust (IAU), and  iShares Silver Trust (SLV). As of this writing, ETPs structured as grantor trusts all back their shares with holdings of physical bullion. Accordingly, the look-through nature of the ETP wrapper requires that they be taxed as collectibles. Currently, collectibles are taxed at ordinary income rates, at a maximum rate of 28%.

Summary of Grantor Trust ETP Tax Treatment:

• Currently, all grantor trust ETPs hold physical metals.
• Investors are taxed upon sale.
• Investors' positions are taxed as collectibles: ordinary income at a max rate of 28%.
• The fund makes no distributions.

Leveraged and Inverse ETFs
Leveraged and inverse offerings serve as a shining example of how the common perception of the straightforward and efficient tax structure of ETFs may not always apply. In 2008, a number of these funds made extremely large distributions to investors holding them in taxable accounts. Adding insult to injury, these were considered short-term capital gains by the IRS.

These leveraged products are generally less tax-efficient than their traditional counterparts in large part because of the lack of the in-kind creation/redemption process that allows ETFs to outperform mutual funds in this area. Because leveraged and inverse products rely on custom swap-contracts to gain their exposure, they deal in cash for creations and redemptions. While in-kind redemptions do not generate taxable events, cash-redemptions do. If a fund of this type were to go into net redemptions, effectively shrinking, it might need to sell its derivative holdings, creating a substantial tax burden for its shareholders. Such an event would not affect new shareholders, but investors who held the position during periods of gains would likely see a taxable event much sooner than they had expected.

As is the case with funds that hold futures, investors should understand the tax implications associated with the exotic derivatives held by leveraged and inverse offerings. The swaps that these funds use are taxed at short-term capital gains rates regardless of the holding period, creating the potential for a sizable tax setback. While this shouldn't disqualify leveraged and inverse offerings from investor use, it certainly warrants caution. These funds afford retail investors access to hedging and speculative opportunities that would otherwise be inaccessible, and while they lack the tax efficiency of their traditional cousins, they shouldn't perform any worse than similar mutual funds in this regard.

Summary of Leveraged and Inverse ETP Tax Treatment:

• These funds hold swaps and options, backed by a cash withholding.
• Interest income from the cash withholding is taxed as ordinary income.
• All gains are taxed at short term rates.
• Investors here face taxes each year, regardless of sale.
• Funds facing net redemptions may make extremely sizable taxable distributions.

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