
The ETF Tax Dodge - howard941
https://www.bloomberg.com/graphics/2019-etf-tax-dodge-lets-investors-save-big/
======
stochastician
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-...](https://www.bloomberg.com/opinion/articles/2019-03-29/deals-
on-the-train-are-everyone-s-business)

~~~
lconstable613
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/](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](https://www.wsj.com/articles/SB921028092685519084)

~~~
Lazare
> 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_?

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URSpider94
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.

~~~
AnthonyMouse
> 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.

~~~
cheerlessbog
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.

~~~
AnthonyMouse
From the perspective of the government the risk is extremely diversified --
across all taxpayers and all investments. And it remains the case that the
average returns from the stock market exceed the average interest rate on US
government debt.

~~~
cheerlessbog
If you squint, that is a Keynesian argument, since it potentially justifies
government borrowing more money and handing it out for the economy to invest.
It is just a matter of degree - again my point that it is not necessarily a
good idea.

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sokoloff
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.

~~~
icedchai
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._

~~~
sokoloff
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.)

~~~
URSpider94
You may decide that tax ought not to be due when you take one of the houses,
but under the law it IS due. For me to take one of the houses, we would have
to change the ownership structure and there would be a transfer price for
that.

~~~
credit_guy
> change the ownership structure and there would be a transfer price for that

The transfer price in gp’s example would be zero, wouldn’t it.

~~~
URSpider94
Probably not. If the transfer price is zero, then that now becomes my tax
basis in the property. So assuming again that I put in $100k originally, and
now take out one house worth $150k, then sell it, I’m going to pay capital
gains on the full $150k, not just my $50k gain.

What probably happens is that I sell you my share in the holding entity for
$150k, and the entity sells me the house for $150k.

There are cases where you could simply dissolve the entity and distribute the
assets, which would avoid the sale and resulting taxes, in which case you’re
just re-titling it and not selling it.

Tl;dr: this gets complicated really quickly.

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supercanuck
>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...](https://www.justice.gov/jm/criminal-resource-
manual-923-18-usc-371-conspiracy-defraud-us)

~~~
loeg
It's a poor metaphor.

------
doctorpangloss
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
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.

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

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jannotti
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.

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

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

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gok
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?

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

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

~~~
greenyoda
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.

~~~
loeg
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.

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cletus
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.

~~~
cheerlessbog
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.

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cheez
That's brilliant. Love the visualization as well.

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patrickg_zill
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"

