A Democratic leader in the US Senate has proposed ending a significant advantage of investing in exchange-traded funds, more commonly known as ETFs.
In recent years, many investors have shifted away from mutual funds and toward ETFs due to the tax efficiency of the latter. But Ron Wyden, chairman of the Senate Finance Committee, recently unveiled draft legislation that reportedly would end that tax advantage by eliminating a system that currently allows tax deferrals on capital gains associated with ETFs.
Under the new system, large and small investors will have to pay taxes on capital gains associated with ETFs much sooner. Bloomberg reported that such a change could “change the entire US financial landscape.”
The ETF’s current tax advantage can be traced back to law dating back to the Nixon administration, Bloomberg reports. It exempts regulated investment firms from recognizing taxable gains on assets when the company pays shareholders “in kind”.
This means that under current law, if a company pays investors who have withdrawn in securities like shares — not cash — the gains can be deferred. As reported by Bloomberg:
“ETFs are structured so that money flows in and out via facilitators known as approved participants, and the fund’s redemptions are usually done in kind. This means that if there are sufficient withdrawals, the ETF can avoid recognizing taxable gains entirely. Rather From paying tax on fund gains each year, investors usually don’t pay anything until they sell their ETFs.”
As a result of the current law, “ETFs have become machines for deferring big capital gains,” Jeffrey Colon, a professor at Fordham Law School, told the Wall Street Journal.
However, under Wyden’s new proposal, ETFs would end up passing capital gains to millions of investors each year. (Wyden said this week that retirement accounts would be exempt, Bloomberg reports.)
Jeremy Senderovich — a partner at law firm Vedder Price, which represents several ETFs — told Bloomberg that because ETFs are fleeting vehicles, any tax increase under the proposal would flow directly to shareholders, “not all of them are dirty rich.” .
However, before you call your broker in a panic, know that some experts say the proposal is a long way off from actually becoming law. Ben Johnson, director of global ETF research at Morningstar, told Bloomberg:
“The industry is going to fight back hard. It’s hard for me to see this gain popular support – largely because it’s a global advantage, so all investors, big and small and in the middle, who invest taxable money benefit from the tax efficiency of ETFs.”
Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click on links in our Stories.