ETFs as Tax Dialysis Machines


Professor Jeffrey Colon was cited in a Tax Notes Federal article by Lee Sheppard, for his opinion on ETFs and for questioning the SEC’s rationale for permitting arbitrage in ETF units.

ETFs are exchange-listed, tradable alternatives to open-end mutual funds. Most function like index funds. No actual fund need exist; some ETFs are derivatives. ETFs trade on the New York Stock Exchange and Nasdaq. Mutual fund shares can only be redeemed at specific times, whereas ETF units can be bought and sold whenever markets are open. There is now $4 trillion invested in ETFs.

If an ETF is an investment company — that is, it invests in securities and is listed on a U.S. exchange — it has to register with the SEC under the Investment Company Act of 1940 (15 U.S.C. section 80-3(a)). If it is also organized as a corporation, it may elect to be treated as a regulated investment company under the tax law. RICs are corporations that are nominally taxable but wash out their income with distributions (section 852(a)).

The SEC doesn’t enforce the tax law. Here’s what we said eight years ago: The SEC likes to think that basket exchanges keep ETFs honest by ensuring that ETF units trade at prices close to NAV. In this view, arbitrageurs who pounce on differentials serve a valuable price discovery function. That may or may not be true, but these exchanges clearly are a tax shelter and should be shut down. Then price discovery can proceed without being goosed by the tax law.

“These transactions permit current and future fund shareholders to inappropriately defer tax on their economic gains and give ETFs and other mutual funds with ETF share classes a significant tax advantage over other investment vehicles,” Jeffrey Colon of Fordham University School of Law wrote. More to the point, for unit holders, in- kind redemptions essentially turn ETFs into IRAs. (Colon, “The Great ETF Tax Swindle: The Taxation of In-Kind Redemptions,” 122 Penn St. L. Rev. 1 (Fall 2017)).

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