Treasury Asked to Clarify Fast-Growing ETF Tax-Busting Strategy

The Investment Company Institute has asked the US Treasury Department for guidance on a fast-growing ETF strategy that allows investors to sidestep immediate capital-gains taxes, as uncertainty grows over how regulators view the practice.

The industry group — which represents more than $45 trillion across various fund structures run by the likes of BlackRock Inc. and Vanguard Group, among many others — has filed a comment letter to Treasury seeking clarity around so-called 351 conversions. These transactions allow investors to move concentrated stock positions or entire portfolios into ETFs without immediately triggering capital-gains taxes.

ICI said it has had two meetings with Treasury officials, who at one stage discussed “shutting this down in some form or another,” according to Mike Horn, the group’s deputy general counsel. As part of those discussions, Treasury considered labeling certain conversions a “transaction of interest,” a designation for deals that the Internal Revenue Service and Treasury see as having tax-avoidance potential. ICI added that the Treasury is still assessing 351 conversions and it may be that no action is forthcoming in the end.

“It’s a little risky because when we ask for guidance, we can’t control what we get,” Horn said as part of a panel at the ICI ETF Conference in Nashville. “A lot of our members who are seeing this and are saying ‘there’s a lot of variation, we want to know the rules, just tell us the rules.’”

A Treasury representative didn’t immediately respond to a request for comment. Bloomberg News reported earlier this year that the Treasury was in early discussions about increasing scrutiny of the practice.

The conversion tactic, one of a growing roster of strategies in Wall Street’s flourishing tax-optimization complex, helps investors rebalance a portfolio of appreciated assets without immediately triggering a liability for capital gains. An exchange-traded fund is seeded with the securities, and then makes use of a famous ETF industry loophole to swap them out for fresh assets.

While some portfolios retain their assets and focus after a 351 conversion into an ETF, others use the process to significantly alter holdings without incurring a taxable gain. Bloomberg News reported last July that in one case, an ETF swapped about 40% of its portfolio — two tech stocks — within days of listing, replacing them with an S&P 500-tracking fund.

In the meetings with the Treasury, both parties agreed that investors should not contribute securities to an ETF with no intent to hold them post-conversion, Horn said. ICI emphasized the non-tax benefits of 351 conversions and the competitive fee structure among reasons not to shut down the practice.

“Yes, some transactions are problematic, but the practice itself has legitimate, non-tax reasons. Therefore, don’t shut down the entire industry. Instead, target the abusive cases,” Horn said. “I think that message was heard and understood.”