New congressional draft legislation seeks to end tax efficiency of all ETFs

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Amid the deluge of headlines in the past few days about congressional proposals to boost taxes on companies and the wealthy is one that would affect regular investors — and potentially alter the entire U.S. fund landscape.

Draft legislation released by Senate Finance Committee Chairman Ron Wyden of Oregon on Friday featured a repeal of a key tax advantage for the $6.8 trillion U.S. exchange-traded fund industry. The move was tucked in along with a series of proposals to tighten tax reporting requirements around business partnerships, and wasn’t highlighted in Wyden’s accompanying press release.

The initiative would at a stroke end a system of deferred taxes on capital gains linked to ETFs, bringing forward the tax burden for investors of all stripes. That will make it all the tougher to win inclusion in the final version of tax hikes that Democrats are now assembling to help pay for a social-spending package that’s been penciled in at $3.5 trillion.

“The industry will push back hard” at the proposal, said Ben Johnson, director of global ETF research at Morningstar. “It’s hard for me to see this getting popular support — in large part because it’s a benefit that is universal, so all investors, large, small and in-between, that are investing taxable money benefit from ETFs’ tax efficiency.”

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The measure would bring in $205 billion over a decade, according to preliminary figures from the Joint Committee on Taxation. It would take effect in tax years beginning after Dec. 31, 2022. Wyden said in a statement Tuesday that, “This proposal exempts retirement accounts entirely.”

Wyden’s proposal was made before his committee delivers its draft of tax measures for inclusion in the budget-reconciliation bill that will form the bulk of President Joe Biden’s economic agenda.

The effort would address an advantage for ETFs that stems from a law dating back to the Nixon administration. The law exempts so-called regulated investment companies, or RICs, from recognizing a taxable gain on assets if shareholders are paid out “in kind.” In other words, if withdrawing investors are paid in securities like stocks rather than in cash.

ETFs are structured so that money flows in and out via facilitators known as authorized participants, and redemptions for a fund almost always take place in-kind. That means that if there are enough withdrawals, an ETF can avoid recognizing taxable gains entirely. Rather than paying a tax on a fund’s gains each year, investors usually don’t pay anything until they sell their ETF.

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