Tax Risks of an ETF

As a general rule, exchange-traded funds (ETFs) are tax efficient, but there are exceptions and therefore investors need to understand how taxes apply to the different types of ETFs.

ETFs create tax efficiency by using in-kind exchanges with authorized participants (APs). Instead of the fund manager needing to sell stocks to cover redemptions, as they do in a mutual fund, the manager of an ETF uses an exchange of an ETF unit for the actual stocks within the fund. This creates a scenario where the capital gains on the stocks are actually paid by the AP, and not the fund. Thus, you will not receive capital gains distributions at the end of the year.

However, once you move away from index ETFs, there are additional taxation issues that can potentially occur. For example, actively managed ETFs may not do all of their selling via an in-kind exchange. They can incur capital gains which would then need to be distributed to fund holders.

Tax exposures to different ETF types

There are two main types of ETFs that may have negative tax benefits:

• If the ETF is of the international variety, it may not have the ability to do in-kind exchanges. Some countries do not allow for in-kind redemption, thus creating capital gain issues.
• If the ETF uses derivatives to accomplish its objective, then there will be capital gains distributions. You cannot do in-kind exchanges for these types of instruments, so they must be bought and sold on the regular market. Funds that typically use derivatives are leveraged funds and inverse funds

Other tax considerations

Finally, commodity ETFs have very different tax implications depending on how the fund is structured. There are three types of fund structures:

1. Grantor trusts
2. Limited partnerships (LPs)
3. Exchange-traded notes (ETNs)

Each of these structures have different tax rules. For example, if you are in a grantor trust for a precious metal, you are taxed as if it were a collectible. Investors should consult their tax professional for tax guidance and questions.

Want to launch an ETF?

If you too are looking to launch an ETF, then download our guide below. We will walk you through everything you need to know to get started, including the differences between ETFs and other product offerings, startup costs, necessary service providers, and how to gain assets via distribution.

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How we help

If you are ready to launch an ETF, then contact us today to get started.

Year-over-year, the most well-known global wealth and asset managers continue to choose ACA Foreside to help expand and support their product line up of ETFs. In 2023, our specialists partnered with more than half of the ETF launches in the U.S., and we support 1,000+ ETFs distributed across 275 managers. 

We work with asset management firms throughout the world to facilitate compliance and product distribution through legal underwriting, registered rep licensing and chaperoning, and DTCC/NSCC fund sponsorship. We have experience working with all types of pooled investment vehicles, such as traditional mutual funds, ETFs, alternative products, closed-end interval funds, and private placements.

Once launched, we can further support you with our broad range of advisory, managed services, and regulatory technology solutions, to help you grow and protect your business, while also addressing your compliance, ESG, investment performance, and cybersecurity challenges.