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Home > Law > DePaul Law Review > Vol. 75 > Iss. 3

 

Abstract

ETFs have begun to challenge mutual funds as the dominant

U.S. public pooled asset vehicle. Their constant liquidity, exposure

to an ever-widening range of investment strategies, and highly

touted tax efficiency have driven the explosive growth in the assets

under management of ETFs over the last fifteen years. The tax

efficiency is due to Section 852(b)(6), which permits ETFs to

distribute appreciated property tax free and eliminate all fund-level

taxable gains even while making portfolio adjustments, which

mutual funds cannot do.

Fund sponsors have developed various strategies to exploit the

benefits of Section 852(b)(6), with the newest being the launch of

ETF swap funds. This strategy allows wealthy investors to

contribute appreciated securities tax free to an ETF, diversify their

economic risks tax free, avoid future tax on fund-level capital gains,

and if the ETF shares are held until death, eliminate income tax on

any unrealized gains.

ETF swap funds rely on a 1996 regulation permitting tax-free

transfers of diversified portfolios to investment companies, which

was promulgated when ETFs were in their infancy. It is certain the

regulation’s drafters did not anticipate that securities transferred

tax free to an investment company under Section 351 could be

immediately distributed tax free under Section 852(b)(6).

Senator Wyden’s recent legislative proposal to eliminate ETF

swap funds, while necessary, addresses only one aspect of a larger

problem: the expanding scope of Section 852(b)(6), which is the

foundation of a variety of strategies that permit investors to not only

defer tax inappropriately but to convert ordinary income into

capital gains. This Article argues that Congress should not only

prevent the tax-free transfer of appreciated securities to ETF swap

funds but also revisit the scope of Section 852(b)(6). Without such

reform, our income tax system risks being converted into a

consumption tax for investment gains.

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