“Mutual fund” is the common term for an investment vehicle that pools money from multiple investors and invests in various assets such as stocks and bonds. Most traditional mutual funds, commonly referred to as “open ended” funds, issue shares directly to shareholders and redeem them at the demand of the shareholder at the fund’s net asset value (NAV). Mutual funds register with the SEC under the Investment Company Act of 1940 (the Act).
While an exchange-traded fund (ETF) is similar to a traditional mutual fund in that it pools money into a fund to invest in various assets and can register with the SEC under the Act, it differs in that its shares are traded on a secondary market as opposed to directly between the shareholders and the fund. One or more intermediaries, referred to as authorized participants, seed the fund with cash and/or stocks in exchange for the fund shares and then list those shares on a secondary market to be bought and sold by the prospective fund shareholders.
A traditional mutual fund can be converted to an ETF. The present discussion focuses on the tax implications of doing so. A conversion may be appealing because of the greater tax efficiency of ETFs (discussed below), lower expense ratios, and the fact that a conversion utilizes the scale and performance of an existing fund. Mutual funds’ appetite for converting was further enhanced by the SEC’s approving Rule 6c-11 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, they are not subject to entity-level tax if they distribute their net income and capital gains via dividends to their shareholders. Shareholders with nonqualified taxable accounts ultimately bear the tax burden.
ETFs are often more tax-efficient than traditional mutual funds, however. In the case of a mutual fund, besides the trading that occurs in the normal course of business, other transactions at the fund level can result in an increased tax burden for the shareholders. For instance, a portfolio rebalance and/or change in investment strategy can result in the fund’s recognizing substantial gains. Large redemptions can also cause a mutual fund to recognize gains because it may need to sell securities to raise the cash to meet the redemption request.
The ETF structure can mitigate or even eliminate this tax burden. With respect to redemptions, Sec. 852(b)(6) provides that a RIC that redeems shareholders with “property” instead of cash will not recognize any gain from the disposition of that property. While this provision applies to both traditional mutual funds and ETFs, mutual fund shareholders will almost always prefer a cash redemption, while authorized participants are usually indifferent. With respect to a rebalancing of the portfolio, ETFs can utilize either a redemption basket (of securities) or a creation basket (of securities) between the ETF and the authorized participants. This allows the ETF to avoid recognizing and distributing taxable gains to the shareholders.
The conversion transaction itself
While the conversion of a traditional mutual fund to an ETF has numerous legal and operational hurdles, the details of which are outside the scope of this discussion, the tax structuring is fairly simple. Typically, the fund sponsor will create a shell ETF for purposes of the conversion. This ETF will likely have the same investment objectives, board of directors, and management as the original mutual fund. After the shell ETF is created, the original mutual fund merges into the shell ETF.
If structured properly, the merger will qualify as a tax-free reorganization under Sec. 368(a)(1)(F) (F reorganization). The requirements of an F reorganization, detailed in Regs. Sec. 1.368-2(m), are listed below:
- Immediately after the F reorganization, all the stock of the resulting corporation, including any stock issued before the potential F reorganization, must have been distributed in exchange for the stock of the transferor corporation.
- The same person or persons must own all the stock of the transferor corporation and of the resulting corporation in identical proportions.
- The resulting corporation may not hold any property or have any tax attributes immediately before the F reorganization.
- The transferor corporation must completely liquidate as part of the transaction.
- Immediately following the potential F reorganization, no corporation other than the resulting corporation may hold property that was held by the transferor corporation immediately before the reorganization.
- Immediately following the potential F reorganization, the resulting corporation may not hold property acquired from a corporation other than the transferor corporation.
Given the nature of the conversion of a traditional mutual fund to an ETF, it is likely that the transaction will meet the above requirements. Assuming it does, an F reorganization is considered a “mere change of form” for tax purposes. As such, the fund tax year end, employer identification number, and all tax attributes from the original mutual fund remain.
There are some other ancillary tax implications of the conversion. The mutual fund may want to sell some assets prior to the conversion; this could result in some taxable distributions to shareholders. Also, unlike traditional mutual funds, ETFs generally do not issue fractional shares, so these will be redeemed with cash prior to the conversion and could result in a nominal amount of tax.
Other items to consider
While this item focuses primarily on the tax impact, some nontax aspects of converting a traditional mutual fund to an ETF should also be considered:
- Shareholders may need to set up a brokerage account to hold the ETF shares.
- Unlike traditional mutual funds, ETFs can trade at a premium or discount to NAV, which can create some level of risk to the shareholder. However, the create/redeem process between the ETF and the authorized participants can operate to reduce any premium or discount spreads.
- Approval by the mutual fund’s board of directors may be required to complete this transaction.
Potentially significant benefits
While substantial operational and legal obstacles need to be considered and addressed, the conversion of a traditional mutual fund to an ETF can have significant tax benefits, depending on the nature of the fund’s activities and the makeup of the fund shareholder base.
Paul Bonner is the editor-in-chief of The Tax Adviser.