Treasury Officials Call New Tax Alpha ETFs ‘Too Good to Be True’

Turns out there is such a thing as being too tax-efficient. 

Treasury Department officials are reportedly voicing their concerns over several new Wall Street tax strategies that are saving investors from potentially paying billions of dollars in capital gains tax. The officials called some of the new funds “too good to be true” and even “abusive” at an event on Tuesday, per a Bloomberg report, including the increasingly popular 351 conversions that seed new exchange-traded funds with appreciated stocks. The comments come amidst a boom in so-called “tax alpha” strategies and mark the latest salvo in an ongoing debate over the controversial products that are quietly transforming ETF investing.  

“I’m surprised it’s taken them this long,” said Jeffrey Colon, a tax law professor at Fordham University. “The Treasury hasn’t shown its hand on next steps, but promoters and sponsors of abusive ETF strategies are now on notice.” 

Collateral Damage Control

One of the main issues is that 351 launches transform a routine tool into a tax-avoidance mechanism, said Amrita Nandakumar, president of Vident Asset Management. 

“Any potential crackdown by the Treasury could create collateral damage and compliance issues for well-intentioned managers who simply wanted to modernize their long-term investment structures through legitimate conversions,” she said. The new funds could also invite unnecessary scrutiny of the in-kind mechanism, which allows investors to exchange a basket of securities for shares of an ETF. “Ruining a clean conversion path for asset managers is bad enough, but threatening the regulatory standing of the in-kind process is far worse.” 

The 351 conversions are growing rapidly, especially for high-net-worth individuals. Per a separate Bloomberg report: 

• Some 105 ETFs have been created through 351 exchanges, more than half in the past year. 
• The funds helped defer at least $6.5 billion in embedded capital gains. 

“Recent public commentary has raised questions,” the Investment Company Institute said in a recent public letter. “We believe IRS and Treasury guidance for such transactions would bring needed certainty.” The Treasury Department and IRS did not respond to requests for comment. 

Tax Tail Wagging the Dog. So much of tax alpha investing seems to be marketed toward the tax side first and foremost, said Shang Chou, cofounder of Dishmi Capital. “What we tell our clients and the folks we work with is that should not be the case. Investment rationale, economic substance: That’s what it’s all about,” he said. 

Similarly, he doesn’t recommend clients “contort” their assets to achieve eventual tax benefits when those strategies could come with higher costs and regulatory risks. “Not to mention, it could just simply not be a great investment to make.”