The ETF Tax Dodge
bloomberg.com
bloomberg.com
> 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-...
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
"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.
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?
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.
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.
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.
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.
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.
> 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.
$10 of taxes deferred for 30 years at a modest interest rate of 2% puts an extra $8 in the investor’s pocket that should have gone to the government.
Edit: Though now that you mention it, I think I must've known this at some point in the past: that ETFs had preferential tax treatment. A while back, I moved my most recent investments to ETFs, even for the "same" fund (example: Vanguard Tech VITAX mutual fund vs VGT ETF) ...
Still, how are ETFs treated differently from a stock?
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.
The bank does not get hit with any capital gains due to the lower basis of the fund. The bank has their own basis in the shares that they brought into the fund which when traded for the other shares may trigger its own separate capital gain.
The shares the bank gets back at the end should have price equal to basis by that point I would think.
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.)
The transfer price in gp’s example would be zero, wouldn’t it.
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.
It seems like the question here is how long you can delay taxes on a capital gain. It doesn't seem particularly unfair if you can't always delay capital gains tax as long as you like?
Company starts with $200K, held 50:50 by two shareholders, losslessly buys two house for that, those go to $300K, company losslessly sells one of them for $150K, company pays $20K tax on $50K gain, and then owns a $150K house and $130K in cash. Shareholder B sells their 50% share in the company to shareholder A for $140K cash, realizing a $40K capital gain on their original shares investment [incurring $16K in taxes on the gain in their shares]. Shareholder A now owns all the shares with a basis of $240K for a company value of $280K.
I argue that Shareholder B’s economic interest in a single gain has been taxed twice.
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.
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.
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.
Making it possible to trade stocks without tax consequences may make it easier to better deploy capital, but it would also have a destabilizing effect, because it could make the markets more exposed to emotional reactions and poor information.
Did the person you sold your old car to have to pay an equal amount of sales tax? Because in that case yes.
> Making it possible to trade stocks without tax consequences may make it easier to better deploy capital, but it would also have a destabilizing effect, because it could make the markets more exposed to emotional reactions and poor information.
This sounds like the argument a monopolist makes for why competition is bad.
If you like, but that is not how sales tax works. My point is that taxing economic activity that is not in cash form (such as trading shares) is not generally considered unreasonable. Arguably, by selling my car, I am better deploying economic resources, as the other guy evidently had more use for it than I do.
If we taxed only translation into cash, the largest fortunes would grow the most rapidly of all, as wealthy people have less use for cash, proportionally. That's arguably against the public interest.
Anyway - I am not taking a position - I am observing that it is not illogical to prefer the current system.
It frequently is. In many cases it goes the other way, e.g. if you buy a PC for $1000 and pay sales tax on it, and then you sell it some years later for $200, the buyer often doesn't owe sales tax because you already paid it when the PC was new. And when a business buys a product as inventory they don't pay sales tax on it, because the customer will.
It's generally not a good policy to charge the same tax twice on the same product. But that's not even what we're talking about here:
> My point is that taxing economic activity that is not in cash form (such as trading shares) is not generally considered unreasonable.
My point is that it isn't doing that.
You can't avoid income tax by having your employer buy you a car. The value of the car just becomes taxable income.
Deferring taxes when securities are exchanged isn't doing that, because your tax basis in the new securities would be the same as it was in the original ones. You still owe the tax whenever you want to sell the securities and spend the money.
Doing it this way would also allow you to get rid of a lot of the rules that really do reset the tax basis, like the one that happens to inherited property. The concern there is that property inherited through generations would have a tax basis of nearly zero, so the entire value would be taxable income and that amount of tax would make it uneconomical to ever sell the property, even if continuing to own it was highly inefficient. But if you could exchange it for another investment vehicle of equal value and just transfer the tax basis then that wouldn't be necessary and the government could continue to defer the tax obligation rather than waiving it entirely as they do now.
Perhaps the money should be held in escrow until a sale or death happens, much like tax withholding for wages.
The problem with this is that the "capital" in many of these cases is a family business. You have some auto shop and the company owns the shop with its land and equipment, but it's all needed to continue operating the business, so you can't sell it without shutting down. Meanwhile the business only makes enough to pay the salaries of the owner-employees, who would likewise shut down the business if they weren't getting paid. So the business is worth more than the taxes it owes, but the only way to pay them would be to liquidate the assets and cease operations. The government sensibly prefers to allow the business to continue operating and collect the taxes later.
But then that creates another perverse incentive. You've just graduated medical school when you inherit an auto shop. If you sell the shop and use the money to found a medical practice (or just invest it in a major ETF and go work for a hospital), you immediately lose $250K to taxes. If you continue operating the auto shop, you don't, which gives it an advantage it shouldn't have and you end up with a doctor running an auto shop. It creates too much of a preference for not selling the shop. So to solve that we reset the basis. But how is that better than leaving its basis where it is but allowing it to be sold and the low tax basis transferred to the medical practice or the stock purchase?
(edit: basis isn't set to zero, taxable gain is zeroed out by setting basis to FMV)
> how is that better than leaving its basis where it is but allowing it to be sold and the low tax basis transferred [to another investment]?
IMO, that is better from a record-keeping and audit perspective. It is often not possible to determine when or at what basis an asset was acquired, particularly when the original purchaser can no longer be interviewed. It is not a particularly exploitable loophole as you have to die to "take advantage" of it.
In most states, when you sell your car and buy another in a single transaction, you do avoid sales tax on that amount. (This is common in a dealer "trade-in" scenario.)
You pay income tax every year because you consume about that amount of resources every year and the things you want to buy aren't tax deductible. If you didn't, and you have enough money to be worth doing it, there are already a zillion tax shelters that cause taxes to be deferred until you actually want to spend the money on something.
It would reduce inequality to make that available to ordinary people rather than only the super rich, as well as encourage people to have more savings so they have more stability and aren't as impacted by a large sudden expense.
> Taxes are designed to fund the government and also address inequality. You need to be taxed more frequently to address the inequality issue.
Except that you aren't, you just keep the holdings you have already instead, and then everything is worse for everybody. The government ends up with less in the long run, so does the taxpayer, so does the new business looking for investment capital to challenge the incumbents. About the only beneficiaries are the incumbents who retain capital that wouldn't continue to be allocated to them in a more efficient market.
In theory it shouldn't have mattered if you invested in Blockbuster or Netflix because if Blockbuster was doomed then their share price should reflect that already. But in the early 2000s Blockbuster still had a higher market cap, in part because someone who invested in Blockbuster in 1989 but now thinks Netflix has more promise would have to be extra sure before making the exchange since it would cause a lot of taxes to immediately come due. So then they don't, and it becomes harder for the challenger to raise capital and easier for the zombie incumbent to waste resources in its death throes, which is inefficient.
Having the zombie company isn’t inefficient. That company is still deploying its capital to its employees and vendors, paying rent, etc. They are still contributing to the economy.
Also remember companies aren’t making money from stock trades. They already got all the money at the IPO.
Yes, it is. If the price drops, it becomes that much more feasible for an outsider to rescue it with a takeover bid - either way, the company will surely be viable as a going concern. You don't seem to be making a consistent argument here.
It isn't intentional and it doesn't do that. Speculation can already be done with no tax consequences or profitable tax consequences when the thing you're selling to buy something else has had zero or negative value appreciation, and can also be done by borrowing money to speculate with and using the shares you can't sell as collateral for the loan. But that too is less efficient because, although the speculation is happening, now there are a bunch of wasteful transaction costs.
Also, long-term investors shouldn't care about short-term value swings, and short-term investors get what they paid for.
> Having the zombie company isn’t inefficient. That company is still deploying its capital to its employees and vendors, paying rent, etc. They are still contributing to the economy.
When one company is paying people to build technology to reduce carbon emissions and the other is paying people to dig holes and fill them back in for no reason or rearrange the deck chairs on a sinking ship, diverting capital to the second company is most certainly inefficient.
> Also remember companies aren’t making money from stock trades. They already got all the money at the IPO.
The IPO for some companies hasn't happened yet. Moreover, existing companies can sell new shares, and the company's market value is used to assuage creditors and allow existing companies to borrow at lower rates because the creditors know the company could pay the debt by issuing new shares if necessary.
Obvious counterexamples to your logic: ETFs using heartbeats and foreign buyers can buy and sell without tax consequences in the US.
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).
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...
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.
Making capital-gains taxes progressive would address an entirely different set of concerns, and applies a different set of forces onto the market.
I'm not sure how much I like these rules, but either they're both "dodges" or neither is.
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.
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.
They just defer capital gains incurred by fund turnover in an ETF.
note: title was changed from its original posting of "ETF Tax Dodge is Wall Street's Dirty Little Secret"