Will a New Bill Make Investing in ETFs Less Attractive?

A Democratic leader in the U.S. Senate has proposed ending a major perk of investing in exchange-traded funds, more commonly known as ETFs.

In recent years, many investors have shifted away from mutual funds and toward ETFs because of the latter’s tax efficiency. But Senate Finance Committee Chair Ron Wyden, D-Ore., recently unveiled draft legislation that, reports say, would end that tax advantage by repealing a system that currently allows for the deferral of taxes on capital gains linked to ETFs.

Under the new system, investors big and small would be forced to pay taxes on ETF-related capital gains much sooner. Bloomberg reports that such a change could “potentially alter the entire U.S. fund landscape.”

The current ETF tax advantage can be traced back to a law that dates to the Nixon administration, Bloomberg reports. It exempts regulated investment companies from recognizing taxable gains on assets when a company pays out shareholders “in-kind.”

That means that under current law, if the company pays withdrawing investors in securities like stocks — rather than in cash — the gains can be deferred. As Bloomberg reports:

“ETFs are structured so that money flows in and out via facilitators known as authorized participants, and redemptions for a fund almost always take place in-kind. That means that if there are enough withdrawals, an ETF can avoid recognizing taxable gains entirely. Rather than paying a tax on a fund’s gains each year, investors usually don’t pay anything until they sell their ETF.”

Jeffrey Colon, a professor at Fordham University School of Law, tells The Wall Street Journal that as a result of the existing law, “ETFs have become big capital gains deferral machines.”

However, under Wyden’s new proposal, ETFs would end up passing on capital gains to their millions of investors each year. (Wyden said this week that retirement accounts would be exempt, Bloomberg reports.)

Jeremy Senderowicz — a partner at law firm Vedder Price, which represents several ETF firms — told Bloomberg that because ETFs are pass-through vehicles, any increased tax under the proposal would flow directly to shareholders, “not all of whom are filthy rich.”

However, before calling your broker in a panic, know that some experts are saying the proposal is a long shot to actually become law. Ben Johnson, director of global ETF research at Morningstar, told Bloomberg:

“The industry will push back hard. It’s hard for me to see this getting popular support — in large part because it’s a benefit that is universal, so all investors, large, small and in-between, that are investing taxable money benefit from ETFs’ tax efficiency.”