Treasury and IRS Comment on ETFs and Section 351: Broader Implications for Taxpayers

At the July 21 meeting of the Wall Street Tax Association, Treasury and IRS officials discussed several tax strategies that have recently drawn their attention:

• Section 351 transactions,
• Redemptions in-kind,
• Swaps, and
• Straddles and other tax strategies.

Many of these areas are not unique to the exchange-traded fund (ETF) industry and may be relevant to investment advisers, fund sponsors, family offices, private funds, and others employing similar transactions and restructurings.

It’s important to note Treasury and the IRS emphasized they are still in the information gathering stage, and their comments do not constitute formal guidance or stated enforcement priorities. However, the discussion provides insight into the types of transactions currently receiving their attention.

What Types of Transactions and Strategies Are Treasury and IRS Discussing?

The broader focus appears to be whether certain tax results align with the underlying economics of a transaction or primarily reflect the pursuit of tax benefits. Examples discussed include:

• Certain tax-deferred ETF seedings followed by post-seeding redemptions in-kind that appear to raise diversification or strategy related concerns
• Certain redemptions in-kind of ETF nonqualifying assets
• Certain box spread strategies intended to replicate Treasury bill returns, while potentially converting income character from interest income to capital gain
• Certain strategies intended to avoid recognizing income from underlying ETF holdings through redemption in-kind transactions
• Certain selective use of swaps, straddles, and foreign currency elections that result in recognizing capital gains and ordinary losses

Relevant Tax Provisions

• Sec. 351 generally allows property to be contributed to a corporation without immediate gain recognition.
• Sec. 852(b)(6) generally allows a Regulated Investment Company (RIC), which is how most ETFs are taxed, to distribute securities in kind without requiring capital gain distribution.

Treasury and the IRS did not suggest these provisions are problematic on their own. Rather, the discussion focused on certain fact patterns involving the interaction of these provisions and the resulting tax outcomes.

Common Themes

• Whether or not combinations of tax provisions can produce results that are inconsistent with the policy objectives underlying those provisions.
• Whether or not certain transactions can produce tax benefits that appear disproportionate to the underlying economic results, including whether certain transactions can alter the timing or character of gain or loss recognition.

These are not new considerations. The IRS has long focused on transactions that defer gain recognition, accelerate loss recognition, or change the character of income or loss in ways that may not align with the underlying economics of a transaction. In certain circumstances, judicial and statutory tax doctrines, including economic substance, focus on whether a transaction has meaningful nontax effects and a valid business purpose beyond the tax benefits obtained.

Takeaway

For now, nothing has changed. Treasury and the IRS continue to gather information, while industry groups actively engage with regulators. Although much of the discussion has centered on ETFs, many of the concepts involve broadly applicable tax provisions and may extend well beyond the ETF industry.

Contact Andreana Shengelya, Jay Laurila or a member of your service team to discuss this topic further.

In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.