[ad_1]
A “mutual fund” is a generic term for an investment vehicle that pools money from multiple investors and invests in a variety of assets, such as stocks and bonds. Most traditional mutual funds, commonly known as “open-ended” funds, issue shares directly to shareholders and redeem them at the shareholder’s request at the fund’s net asset value (NAV). Mutual funds are registered with the SEC under the Investment Company Act of 1940 (the Act).
Exchange Traded Funds (ETFs) are similar to traditional mutual funds in that they combine a variety of assets into a fund and are required to be registered with the SEC, but differ in that the shares are traded on a secondary basis. As opposed to a direct market between shareholders and the fund. One or more intermediaries, referred to as authorized participants, exchange the fund’s cash and/or shares for shares of the fund and list those shares to be bought and sold by the fund’s shareholders in the secondary market.
A traditional mutual fund can be converted into an ETF. The current discussion focuses on the tax implications of doing so. A conversion can be attractive because of ETFs’ high tax efficiency (discussed below), low expense ratios, and the fact that the conversion leverages the balance and performance of existing funds. The demand for mutual fund exchanges increased further with the adoption of Rule 6c-11 by the SEC in 2019, which reduced the time and cost of launching an ETF.
Tax efficiency of ETFs
Both traditional mutual funds and ETFs that are domestic corporations—if they are registered with the SEC under the Act and meet certain diversification, income, and distribution requirements—are taxed as regulated investment companies (RICs) under Subchapter M of the Internal Revenue Code. Under these rules, if they distribute their net income and capital gains to their shareholders as dividends, they will not be taxed at the corporate level. Shareholders with non-qualified taxable accounts will ultimately bear the tax burden.
ETFs are often more tax-efficient than traditional mutual funds. In the case of mutual funds, in addition to transactions occurring in the ordinary course of business, other transactions at the fund level may increase the tax burden on shareholders. For example, a portfolio rebalancing and/or a change in investment strategy may result in the fund realizing higher returns. Large redemptions can cause a mutual fund to realize a profit because it needs to sell securities to collect the cash to meet the redemption request.
An ETF structure can reduce or eliminate this tax burden. Regarding redemptions, Sec. 852(b)(6) provides that a RIC that redeems shareholders with “property” instead of cash does not recognize gain from the use of the property. While this provision applies to both traditional mutual funds and ETFs, mutual fund shareholders always choose cash redemptions, while authorized participants are indifferent. For portfolio rebalancing, ETFs can use a redemption basket (securities) or a creation basket (securities) between the ETF and its authorized participants. This allows the ETF to avoid recognizing and distributing taxable gains to shareholders.
The conversion itself
While converting a traditional mutual fund into an ETF has many legal and procedural hurdles, the details of which are beyond the scope of this discussion, the tax arrangement is simple. Typically, the fund’s sponsor creates a shell ETF for conversion purposes. This ETF may have the same investment objectives, board of directors and management as the original mutual fund. After the shell ETF is created, the underlying mutual fund is merged into the shell ETF.
If properly structured, the merger would qualify as a tax-free reorganization under Sec. 368(a)(1)(F) (reorganization of F). F reorganization requirements, outlined in Regs. Sec. 1.368-2(m), listed below:
- Immediately after F’s reorganization, all stock of the resulting corporation, including any stock issued prior to F’s reorganization, must be distributed to the stock of the transferee corporation.
- The same person or persons must own the stock of the transferor corporation and the resulting corporation in the same proportion.
- The resulting corporation cannot hold any assets or have any tax attributes prior to the F reorganization.
- The transferor corporation must be fully liquidated as part of the transaction.
- Following F’s reorganization, no corporation other than the resulting corporation may hold property held by the transferor corporation prior to the reorganization.
- Following an F reorganization, the resulting corporation may not hold any assets from the corporation other than the transferring corporation.
Given the nature of the conversion of a traditional mutual fund into an ETF, the transaction may meet the above criteria. In that case, F’s reorganization is considered a “simple change of form” for tax purposes. As such, the fund’s tax year end, employer identification number, and all other tax attributes of the original mutual fund remain.
There are some other ancillary tax implications of the change. You may want to sell some assets before the mutual fund is converted; This may result in some taxable distributions to shareholders. Also, unlike traditional mutual funds, ETFs generally do not issue fractional shares, so these are returned in cash before conversion and may result in an unknown amount of tax.
Other things to consider
While this item focuses primarily on the tax implications, there are also some non-tax aspects of converting a traditional mutual fund to an ETF to consider:
- Shareholders may need to establish a brokerage account to hold ETF shares.
- Unlike traditional mutual funds, ETFs can trade at a premium or discount to NAV, which can create some upside for a shareholder. However, the creation/contribution process between the ETF and its authorized participants can work to reduce any premium or discount distributions.
- Approval of the mutual fund’s board of directors may be required to complete this transaction.
Potential benefits
While practical and legal hurdles must be considered and addressed, converting a traditional mutual fund to an ETF can have significant tax benefits, depending on the nature of the fund’s operations and the fund’s shareholders.
EditorNotes
Paul Bonner He is the editor-in-chief. The tax advisor.
[ad_2]
Source link
