On September 10, 2021, Senate Finance Committee Chairman Ron Wyden of Oregon released a discussion draft proposing changes to the taxation of partnerships and the taxation of regulated investment companies, including including mutual funds and exchange-traded funds (ETFs) – which would have significant impacts on the world of investment funds.1 Much of what is included in the proposed legislation would impose more rigid structures on how a partnership’s income, gains and losses can be distributed among its partners. This alert, which is the first in a series, deals with the impact of the proposed changes on regulated investment firms.

Mutual funds and ETFs are two types of regulated investment companies that are subject to the same federal tax rules. Under these rules, when a mutual fund or an ETF sells popular portfolio securities, including to deal with redemptions, it recognizes the capital gain that is distributed before the end of the year to shareholders, who must then pay tax on the distributed gain at the end of the year. Alternatively, under Section 852 (b) (6) of the Internal Revenue Code of 1986, as amended (the Code), mutual funds and ETFs may instead distribute portfolio securities appreciated in kind. to shareholders when they buy back their shares without recognizing a gain on the shares.2 Unlike mutual funds, which generally do not distribute portfolio securities appreciated in kind when redeeming shares, ETFs regularly distribute securities in kind to shareholders; and due to Article 852 (b) (6) of the Code, ETFs do not recognize gains on appreciated securities included in the distribution. Senator Wyden’s draft discussion proposes to repeal subsection 852 (b) (6), which would cause mutual funds and ETFs to account for the gain on valued securities distributed to shareholders in kind, increasing thus the amount of taxable gain that the ETFs will distribute to shareholders.

The shareholders of a UCI buy their shares directly from the UCI and, when they no longer want them, sell them back to the UCI as part of a repurchase transaction. Like the purchase price, this sale (or redemption) price of their shares is equal to the value of the share of the shares in the FCP’s assets (called net asset value or net asset value). In contrast, most shareholders of an ETF (retail shareholders) buy and sell their shares on the stock exchange, where the price is a market price on the stock exchange.

There is a second category of ETF shareholders, which are stockbrokers (called authorized participants), who deal directly with the ETF to create and redeem shares of the ETF. Authorized participants bring in baskets of in-kind securities to the ETF in exchange for aggregations of shares (called creation units), and when they redeem their shares, they receive an in-kind distribution of securities of equal value. to the net asset value of the redeemed creation units. The activities of participants authorized to acquire securities to buy creation units and to acquire ETF shares in the market to buy back creation units establish what is known as the “ETF arbitrage mechanism”, which causes the market price of ETF shares to closely follow the shares. NAV.

The ETF arbitrage mechanism ensures that ETFs regularly sell valued securities, without currently recognizing any taxable gain that must be distributed to shareholders. It is this last point that is central to the proposed repeal of subsection 852 (b) (6).

Senator Wyden’s talking points accompanying the draft proposal assert that in-kind redemptions generally cause ETFs to make smaller taxable capital gains distributions to their shareholders than mutual funds. Senator Wyden also asserts that ETF stocks can appreciate even more, and with less frequent recognition of fund-level gains, than mutual fund stocks. An ETF shareholder, however, does not avoid paying taxes on the gain, he simply defers the recognition and payment of taxes on the gain until he sells the shares.

While one of the results of repealing subsection 852 (b) (6) would cause ETFs to recognize more taxable gains than they currently do, there could be other unintended consequences.

  • Twelve million US households own ETFs, and 92% of those households have an annual income of less than $ 400,000. In fact, the median household income of ETF investors is $ 125,000 per year.3 Thus, the proposed tax will affect many U.S. investors with annual income well below $ 400,000, even though the administration’s stated goal has been limited to generating income from households with an annual income of $ 400,000. $ or more.4

  • Section 852 (b) (6) plays an important role in mitigating the systemic risk potentially posed by a “rush” on mutual funds and ETFs, and the United States Securities and Exchange Commission, as administrator of federal securities laws, has recognized the potential for in-kind redemptions to mitigate this systemic risk in various rules, including recently enacted rules 6c-11 and 22e-4 under the Companies Act investment of 1940. In this regard, the repeal of Section 852 (b) (6) may be exactly what the doctor did not order at a time when Congress and the administration seek to reduce the systemic risk in the financial system.

  • If subsection 852 (b) (6) were repealed, many of the tax costs associated with short-term trading of ETF shares by authorized participants will be borne by long-term ETF shareholders. In addition, the ETF arbitrage mechanism will be burdened by the increase in tax costs, as these tax costs may be passed on by ETFs to authorized participants in the form of transaction fees, which will result in the trading of ETF shares. wider bid-ask spreads and discounts on net asset value. Ultimately, retail shareholders will pay these costs in the form of wider bid-ask spreads and market prices below NAV (that is to say., a discount on NAV).

  • The ETF industry today is an 8 trillion dollar industry,5 which employs a proportional number of people, in part thanks to retail investors recognizing the favorable tax treatment applied by Article 852 (b) (6) to the ETF structure. However, the repeal of section 852 (b) (6) could have a negative impact on the sector.

The repeal of section 852 (b) (6) should be included in the budget reconciliation legislation being drafted by the Senate finance committee. President Wyden’s stated policy for the proposal is to “close loopholes that allow wealthy investors and mega-corporations to use flow-through entities, mostly partnerships, to avoid paying their fair share of taxes.” As noted above, in attempting to achieve this goal, the proposal may create unintended consequences, especially for retail investors, which outweigh any perceived benefit from the repeal of Section 852 (b). (6).


1 Staff of S. Comm. on Finance, 117th Cong., Wyden Pass-through Reform Discussion Draft (Comm. Print 2021).

2 Subsection 852 (b) (6) is an exception to the general rule that the distribution of property by a corporation to its shareholders results in the recognition of a gain by the corporation in respect of the distributed property. This provision helps registered funds avoid adverse tax consequences to their remaining shareholders when a significant shareholder redeems their fund shares, as it allows the fund to meet the redemption request using a non-taxable in-kind distribution of securities instead. than to sell securities and recognize a gain that would later be distributed and taxed to shareholders back home.

3 Investment Company Institute, 2021 INVESTMENT COMPANY FACT BOOK, Chapter 4.

4 Compare Wyden Discussion Draft, above note 1, at note 36 (citing a review of the law, which claims that section 852 (b) (6) “unfairly benefits wealthy ETF owners”).

5 Michael Wursthorn, ETF Assets Reach $ 9 Trillion, WALL ST. J., August 13, 2021, at B1, B10


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