Why the Treasury Is Cracking Down on 351 Conversion ETFs

The latest tax-management fad is getting a reality check.

ETF investors have increasingly taken advantage of Section 351 of the US tax code over the past several years, allowing them to move appreciated assets into a new vehicle without immediately paying capital gains taxes (provided the new fund meets certain requirements).

Now, the Treasury may finally be taking aim at certain so-called “351 conversions” that it says don’t jibe with tax law. The department on Monday limited one such transaction involving an ETF and flagged several others. The move signaled the government’s willingness to crack down on some of the funds that fall into this category.

“Investors purportedly avoid recognition of the built-in gains in their securities while effectively exchanging those securities for an indirect interest in an ETF with a materially different portfolio,” the Treasury’s statement reads. “In these transactions, [Sections] 351, 721 and 852(b)(6) are being applied … to achieve a result that these provisions were not intended to produce.”

Laying Down the Law

The Treasury had previously signaled its disapproval of 351 conversions — officials called them “too good to be true” at a recent industry event — but until now, no regulatory actions had been taken. Funds that use the strategy now number over 120, with more than half of those launching in the past year alone. Guidance on the subject was much-needed, said Shang Chou, co-founder of the multi-family office Dishmi Capital. “This is a positive thing. There are now clear[er] guidelines on where investors should be standing,” he said. “Going in there with a plan to skirt out on the capital gains tax to get diversification with this pre-planned idea to dispose of those assets — that’s going to be a no-go going forward.” That said, the department’s language seems to leave a window for what Chou called “well-behaved 351s” — that is, funds that make use of assets already aligned with the ETF’s core strategy.

The trend is real: The MIG Core ETF, for example, took assets from the Hot Pocket empire earlier this year and put them into the ETF structure. “I would contrast that with ETF firms looking to launch S&P 500-tracking ETFs and willing to take in diversified baskets,” Chou said.

Not Over Yet: The underlying principle behind the Internal Revenue Service’s actions is economic substance over tax gains, Chou said. “You shouldn’t be contorting your balance sheet in weird ways just to avoid or defer taxes. That makes no sense,” he added.

The government will also seek public comment on the transactions it targeted, as well as asking about others that it said should be regulated similarly, with the comment period closing at the end of October.