The ETF Tax Dodge

https://www.bloomberg.com/graphics/2019-etf-tax-dodge-lets-investors-save-big/

by howard941 • 7 years ago

103 83 7 years ago

sokoloff8• 7 years ago

It seems to me that this "tax dodge" means that ETFs work the same way basically every investment in the world works (under US taxation). You invest money in a thing, thing goes up and you hold: you pay no taxes; you sell the thing: you pay taxes on the gain.

Redeeming ETF into and holding shares of the underlying index also acts the same way: you pay taxes on any gains when you eventually sell the underlying shares.

I'm not seeing a "dirty little secret" here. That Fidelity's mutual fund is not able to accomplish the same level of tax efficiency as the SPDR or iShares ETFs reads to me like a flaw in Fidelity's execution, not an illegal dodge on State Street's or Blackrock's side, IMO.

icedchai4• 7 years ago

Except these institutions are not paying taxes on the gain??

Typically, when you sell a stock for more than you paid, you owe tax on the gain. But thanks to a quirk in a Nixon-era tax law, funds can avoid that tax if they use the stock to pay off a withdrawing fund investor.

jayess• 7 years ago

The person who initially invested does. I don't see at all how this is a tax dodge.

vxNsr• 7 years ago

The underlying investors do when they cash out.

gph• 7 years ago

Yes, but the investor will pay more in taxes when they sell the actual ETF. It's more like deferring taxes than avoiding them.

Think of it this way, if the fund paid these taxes when they sell their various holdings, that less tax amount would be baked into the ETF valution, which would carry over to a smaller tax bill when an investor sells their ETF shares and pays taxes.

That's still advantageous in many ways, but I think people in this topic are thinking this is some kind of complete tax avoidance. It isn't.

menage• 7 years ago

Presumably the withdrawing investor also gets the fund's cost basis in the stock, so they'll be on the hook for the fund's capital gains themselves when they sell the stock. (The article didn't explicitly mention it, nor does the relevant statute https://www.law.cornell.edu/uscode/text/26/852#b_6, but that's the standard way that stock transfers work.)

sokoloff8• 7 years ago

Suppose you and I take $100K each and mutually invest 50:50 in something together. Maybe we bought two identical houses for $200K total (or even bought a duplex together). Later on, the houses have gone up in value to $300K, even later I decide that I want out, we look things over and decide that the fair thing is for me to take one of the houses. At the moment that we take that action, no tax is (nor ought to be, IMO) due.

Later, when/if I sell the house, tax is due on the $50K in gains. Just like in the ETF case.

In the alternate treatment seemingly contemplated by the article, we could instead agree to sell one of the houses, jointly pay taxes on $50K in gains, and give me the sum of $150K-taxes, the gains of which I'd pay taxes upon again. You'd also have effectively paid taxes when you hadn't done anything but invest and hold. There's a pretty good argument this is unfair to me (to tax me twice on one gain); there's an almost ironclad argument that it's unfair to you.

It's no surprise that the treatment that is both more reasonable and more profitable is the one that ETFs seek to implement.

(Fees and other weirdnesses around real-estate ignored above for simplicity.)

vmarsy• 7 years ago

Except these institutions are not paying taxes on the gain??

Why should they? They are not people.

When you buy an item for $50 at a store, as a consumer you would pay sales tax on it. But every transaction made from the buying of raw materials up to the time the store sold you the item is done tax free by the businesses, only at the time of sale to the final consumer, a tax is due.

Here ETF is kind of similar, except that the consumer provides the raw materials: A consumer buys the ETF at a share price of $100, and sells it once the ETF reaches $150: $50 should be taxable to the consumer. Instead of it being categorized as "sales tax" it's "income tax" or "LTCG tax", but the principle is the same.

If the institution made money off that transaction, by charging someone a $5 fee for instance, then tax should be paid on those $5 by the institution, but I don't see why amount the fund grew should have an impact. It goes both way obviously, if the consumer buys an ETF a $100 but sells it at $75, the institution should not be able to claim a loss on those $25, but that doesn't seem to be something claimed by the article.

URSpider947• 7 years ago

You could make the same argument about buying into a mutual fund, yet mutual funds have to distribute capital gains every year.

Similarly, if I tried to re-create an index in my own account with individual stocks, I would end up incurring cap gains as I had to add and remove stocks when the index changes.

For whatever reason, we seem to feel like ETF’s deserve different treatment.

AnthonyMouse9• 7 years ago

The real question is why we don't treat other things the way we treat ETFs, which is more efficient.

If you own Stock A and it has appreciated significantly over the years, but now you think Stock B is a better choice, the fact that trading one for the other is a tax realization event may cause you to not do it. This doesn't get the government any revenue this year, and it costs the government revenue in the future if you were right that Stock B is now the better choice, because you'll have less taxable appreciation when you finally do cash out during your retirement. It also makes the economy less efficient in general by locking up capital in whatever people invested in years ago.

travisp• 7 years ago

You could make the same argument about buying into a mutual fund, yet mutual funds have to distribute capital gains every year.

This is sort of true, but no longer completely true -- because of ETFs. For example, Vanguard uses ETFs that connect with their Mutual Funds in such a way that it has virtually eliminated capital gains distributions on the majority of its index mutual funds. They are now taxed more similarly to ETFs.

Similarly, if I tried to re-create an index in my own account with individual stocks, I would end up incurring cap gains as I had to add and remove stocks when the index changes.

However, if you did this with your own stocks, you could also take capital losses, which mutual funds cannot do (they cannot distribute capital losses to you), and you could also just decide to hold onto the individual stocks indefinitely. At a small percentage of your portfolio, it would probably not significantly effect performance (some evidence even suggests that stock portfolios that never sold stocks when dropped from the indexes even outperformed the indexes!).

Even worse, in a mutual fund, you can actually buy into already existing capital gains that you never even profited from. For instance, if a mutual fund had a lot of gains in 2017, you buy in at the end of 2017, and then the mutual fund realizes those gains, you would receive those distributions and pay taxes, which seems pretty unfair to pay capital gains taxes on.

There's a lot of nuance and oddities in how all of these taxes work, but it certainly seems far from clear that the way ETFs "dodge" (defer) capital gains taxes until you sell the asset is unfair. To me, mutual funds seem to be the weird tax structure, not ETFs, which at least have a clear and predictable capital gains cost (your sale price minus your purchase price).

patrickg_zill• 7 years ago

should be... "One of Wall Street's Dirty Little Secrets"

note: title was changed from its original posting of "ETF Tax Dodge is Wall Street's Dirty Little Secret"

cheez• 7 years ago

That's brilliant. Love the visualization as well.

cletus• 7 years ago

I'm willing to join in the outrage at Wall Street (a|im)morality but this one doesn't particular bother me. Let me explain why.

So imagine an S&P 500 ETF went from a $10B valuation to $15B in 5 years. Lots of transactions took place as the index gets rebalanced. Companies leave the index. Others take their place. No tax is paid by the fund. You're tempted to be outraged. Let's say that the offset tax amounts to $1B for simplicity.

But consider: someone invested $10k in that fund and held for 5 years. They sell and owe taxes on $5k.

If the ETF had been paying taxes that $15B would be $14B and the seller would owe taxes on $4k instead of $5k.

In Australia, when you hold a company and it, say, pays dividends. It typically pays corporate taxes on that. As a stockholder you not only receive that dividend but you receive a credit for taxes paid (called "franking credits"). If the dividend is fully franked (meaning the full corporate tax rate was paid) then you might receive a $700 dividend and $300 (30% of the gross $1000 dividend) in franking credits. When you do your taxes, if your tax rate is higher than 30% you pay the difference. If it's less you'll get a refund.

This is to avoid double taxation, basically. In the US, you don't have this. Earn income through a company, it pays taxes, it pays a dividend and you pay taxes again. This was the whole reason for the (misguided) passthrough entity tax break with the Trump tax cuts. It would be a lot easier if US dividends were just taxed at source and they came with a tax credit that could be applied to, say, US tax liabilities.

So, you can view heartbeat trades as simply a way of avoiding double taxation. It's at least debatable. After all, if you invest in a company you only pay taxes when you sell on the gain (dividends notwithstanding) so this is really just treating ETFs the same way.

cheerlessbog6• 7 years ago

It's only double taxation if you arbitrarily consider the transfer of the dividend from the company to yourself to be a non taxable event. Until that point the money isn't "yours" in the full normal sense. If I buy 1% of Exxon I don't have the legal right to extract 1% of its income.

Another argument for "double" taxation : corporations are artificial entities created by law with significant privileges, such as shielding owners from direct liability in most cases. That's a privilege society extends and it is arguable reasonable that it is subject to a different tax regime than capital which is owned directly by the individual.

loeg6• 7 years ago

Heatbeats don't avoid double taxation.

They just defer capital gains incurred by fund turnover in an ETF.

supercanuck• 7 years ago

Imagine that a grocer got a tax deduction every time someone returned a box of cornflakes to his store. Heartbeats are when the grocer asks a friend to buy all the boxes and return them, just to pocket more deductions. Fund managers and bankers say the trades are perfectly legal...

How is this legal, this seems to me to be fraud?? If this was small town grocer and John Doe, how would this not be rolled up into a defrauding the government?

https://www.justice.gov/jm/criminal-resource-manual-923-18-u...

loeg6• 7 years ago

It's a poor metaphor.

OscarCunningham• 7 years ago

But don't investors eventually pay the tax when they sell the ETF?

lixtra• 7 years ago

Yes, but meanwhile the deferred taxes compound. The question is wether rebalancing an ETF should trigger taxes or not.

doctorpangloss• 7 years ago

Taxes have an outsize impact on markets.

People shouldn’t really care about the difference between 15 versus 25 percentage point taxes if they feel they’re timing the market right. But if you look at a chart of redemptions and CG taxes (check Wikipedia), it turns out a 5-9 percentage point decrease occurs around 9-40x increases in redemptions during the low tax period. This is basically why you observe Republican (i.e. low tax) administrations experience traditionally low stock market prices—everyone is selling and turning their imaginary paper into cash!

Capital gains taxes are essentially the free shipping of equities. They totally distort people’s behavior disproportionate to their impact on returns, most of all by discouraging normal (retail) investors from selling when their gut tells them to, and then they bear most of the losses. Obviously a more equitable scheme would make capital gains taxes progressive instead of time based.

Just to make it clear about the article, if you made ETFs pay the taxes we’d get even more correlation and asset inflation. The best example of that is the cryptocurrency market.

ISL• 7 years ago

To address the timing problem, one could make capital-gains taxes time-independent, or smoothly-varying with time.

Making capital-gains taxes progressive would address an entirely different set of concerns, and applies a different set of forces onto the market.

loeg6• 7 years ago

Cap gains are taxed in progressive brackets on an annual basis.

stochastician• 7 years ago

Matt Levine has an excellent explanation of why this isn't as big of a deal as it seems (read down to Heartbeats) [1]

On the other hand I am not convinced that one should look at the transaction in isolation here. My view of the situation is not only that “an ETF is a mutual fund that doesn’t pay taxes,” but also that everyone accepts that. There just seems to be broad agreement among investors and regulators and policymakers that an ETF is supposed to be tax-efficient, that ETF investors get to defer capital gains until they sell their shares. (Again: This is a very widely advertised benefit of ETFs. 7 ) Some ETFs ran into a bit of a technical problem that might have required them to pay taxes, and so they developed a very technical solution that fixed it. The fact that the solution is a little shammy-looking would be a problem if everyone expected them to pay the taxes, but since people don’t expect that, any old solution will do.

[1] https://www.bloomberg.com/opinion/articles/2019-03-29/deals-...

lconstable613• 7 years ago

With respect to Matt Levine, the exact opposite is true. ETFs were a tax dodge that became embedded in the system. To get technical, Congress enacted §311(b) exemptions in 1986, exempting gain recognition for in-kind distributions for Subchapter M companies as §852(b)(6). At the time, mutual funds rarely distributed property in kind. The first ETF appeared in 1993, and the spectacular tax advantage is a big reason for its success. Given their popularity, ETFs are also given regulatory exemptive relief from parts of the '33 and '40 Acts. I'd argue this is like frequent flyer miles -- the IRS basically gave up on collecting them as taxable income because everyone thought of them as free.

Credential - I'm a lawyer and value investor @ https://lembascapital.com/ and I spend a great deal of time looking at fund structures.

PS Other smart mutual funds began distributing in kind once they realized this tax structure was sufficiently embedded. See e.g. Sequoia Fund, the famous value investing mutual fund (at least pre Valeant) - https://www.wsj.com/articles/SB921028092685519084

benj111• 7 years ago

I didn't read the Levine article as stating where ETFs games from, rather where they are today.

"I'd argue this is like frequent flyer miles -- the IRS basically gave up on collecting them as taxable income because everyone thought of them as free."

Isn't that what Levine is also arguing? Realpolitik as tax law.

jannotti2• 7 years ago

It doesn't seem like you and Matt Levine are disagreeing about anything material. Just over whether it should be called a "dodge" or not. It's just a rule. It's almost exactly like the rule for real estate like-kind exchanges (at least in the effect it ends up having - you can swap the asset you're in without the frictional cap gains tax).

Lazare• 7 years ago

With respect to Matt Levine, the exact opposite is true.

You may want to re-read what he wrote then, because you're literally just restating what he said. He even covered the history of the tax break, noting, as you did, that the law changed decades before the first ETF appeared in 1993.

Levine is explicitly saying that this whole thing came about by accident decades ago but today it has become "embedded in the system", and everyone, up to and including the regulators, believes that the point of an ETF is to be tax efficient, so they're going to let them be tax efficient, even if that requires some legal gymnastics.

I'd argue this is like frequent flyer miles -- the IRS basically gave up on collecting them as taxable income because everyone thought of them as free.

Exactly. What exactly do you think you're disagreeing with Levine about?

walshemj• 7 years ago

From a UK perspective seems strange that any investment company would it self owe CT tax individual US shares don't.

And the USA does have REIT's as a model.

And large chunks of the capital invested in the USA in the 19th century was by UK investment trusts which don't pay capital gains - the owner of the shares does.

gok• 7 years ago

How would ETFs (and passive investment systems in general) work without this trick? If there were no tax free way to do rebalancing, how could you really track the exchange?

loeg6• 7 years ago

Mutual funds do this by distributing capital gains to investors annually. Yes, that would be one reason they might lag the index.

URSpider947• 7 years ago

People are missing the point. This is not a tax dodge in the sense that you never pay the taxes. It’s a tax dodge in the sense that you postpone paying taxes in the year when they are due (which is the most common kind of tax dodge).

It’s absolutely correct that the ETF shareholders will pay the tax one way or another, either now on an annual cap gains distribution, or when they sell the shares later. It is NOT double taxation, because you either pay now or later, not both.

The issue is that the government cares deeply that you pay taxes in the year that you incur them. The US government, as you may know, has massive debt, and so getting the tax later costs it money in interest payments. They care about this so much that if you owe a lot in taxes, you actually have to pay them in quarterly installments, so the Feds don’t have to wait a whole year to get your money.

Since ETF’s are buy-and-hold investments, it could literally be decades before you actually send in a check for taxes that would ordinarily be due today.

AnthonyMouse9• 7 years ago

The issue is that the government cares deeply that you pay taxes in the year that you incur them. The US government, as you may know, has massive debt, and so getting the tax later costs it money in interest payments. They care about this so much that if you owe a lot in taxes, you actually have to pay them in quarterly installments, so the Feds don’t have to wait a whole year to get your money.

Which is very silly, because the government pays a lower interest rate on its debt than the average returns from the stock market. So the government would actually come out ahead to carry more debt now and allow you to accrue more taxable appreciation, because the tax paid on the market gains from the money not paid in tax until later are more than the interest the government has to pay on its debt in the meantime.

cheerlessbog6• 7 years ago

I may equally lose that money. There's a reason that government debt pays less. The sooner they get their money, the less time it is exposed to that risk.

zAy0LfpBZLC8mAC2• 7 years ago

They care about this so much that if you owe a lot in taxes, you actually have to pay them in quarterly installments, so the Feds don’t have to wait a whole year to get your money.

That's really not about interest, but about credit risk. If a tax payer goes broke, they don't want to lose a whole year of taxes.

wutbrodo• 7 years ago

The time value of money (and thus interest) is in part by driven by the risk of the future payout not happening, so these aren't really separate phenomena.

Retric• 7 years ago

Time value of money, delaying taxes lowers them.

cameldrv• 7 years ago

This type of deferral does end up being a tax dodge if the ETF is inherited. As of 2018, you get to leave up to 11 million to your heirs tax free, AND they get a free step up in cost basis.

intopieces• 7 years ago

If ETFs are able to dodge taxes that mutual funds cannot, why do people still invest in mutual funds? Different risks?

greenyoda• 7 years ago

One disadvantage of an ETF is that you have to pay a brokerage commission each time you trade it. Many mutual funds have no fees for buying/selling shares. If you have a savings strategy like automatically investing a percentage of every paycheck, the commissions on ETF trades could add up quickly.

loeg6• 7 years ago

Brokerage commissions are $0 for Vanguard ETFs in a Vanguard brokerage or Fidelity ETFs in a Fidelity brokerage, etc. This isn't a real downside unless you want to trade ETFs in a brokerage account unaffiliated with the ETF.

loeg6• 7 years ago

ETFs only trade interday; mutual funds only trade end of day. It can be more convenient to automatically invest some portion of your pay in a mutual fund than an ETF. (Also, Vanguard mutual funds are shares classes of their ETFs, so they have the same tax benefit ETFs do here.)

twiceaday• 7 years ago

You can buy fractional shares of mutual funds. Vanguard only lets you auto-invest on a schedule into mutual funds. Mutual funds trade once a day, at the end of the day, for the intra-day-valume-based average cost so you are not timing the hour.

jannotti2• 7 years ago

When all is said and done, this ends up seeming like pretty much the exact same treatment that "like-kind exchange" gives to Real Estate. In both cases you're allowed to swap an asset without capital gains at the swap time (but your basis stays at the low old price, so you eventually will).

I'm not sure how much I like these rules, but either they're both "dodges" or neither is.

The ETF Tax Dodge

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