The 2013 Complete Guide To ETF Taxation

IndexUniverse.com

 

2013 Update:Effective Jan. 1, 2013, new capital gains tax rates are applicable to higher-income investors due to the passing of the American Taxpayer Relief Act of 2012. Also effective Jan. 1, 2013 is a new Medicare surcharge tax on investment income applicable to higher-income investors. While these new maximum capital-gains rates are now referenced throughout the paper, for details regarding these changes, see the "2013 Capital Gains Tax Changes" and "New Medicare Surcharge Tax" sections.

Investors spend hours researching funds for expense ratios and spreads, trying to save a few basis points here and there. But often, not enough time is spent researching a fund's structure and the associated tax implications. When shares are eventually sold for a gain, the different tax implications can translate into hundreds or even thousands of basis points.

Investor confusion over tax treatments comes from many sources. Partly, it's because ETF taxation is complicated. Partly, it's because taxes are boring. And partly, it's because ETF issuers provide unclear tax guidance in many prospectuses.

Whatever the reason, we at IndexUniverse think investors deserve better, so we prepared this document to provide complete guidance on how different ETFs are treated by the tax man.

WHAT DRIVES ETF TAXATION
An ETF's taxation is ultimately driven by its underlying holdings. Since funds are structured differently according to how they gain exposure to the underlying asset, an exchange-traded product's tax treatment inherently depends on both the asset class it covers and its particular structure.

A fund's asset class can be classified in one of five categories:equities; fixed income; commodities; currencies; and alternatives.

For tax purposes, exchange-traded products come in one of five structures:open-end funds; unit investment trusts (UITs); grantor trusts; limited partnerships (LPs); and exchange-traded notes (ETNs).

Many commodity and currency funds that hold futures contracts are regulated by the Commodity Futures Trading Commission as commodities pools, but they're classified as limited partnerships for tax purposes by the IRS. Therefore, "limited partnership" will be used to refer to the structure of these funds throughout this paper.

This five-by-five matrix—five asset classes and five fund structures—defines all the potential tax treatments available in the ETF space. In this paper, we'll use asset class as the primary sort, as that is the easiest way to classify and think about funds.

Note:The tax rates we're about to discuss are the maximum long-term and short-term capital gains rates. The rates listed in the tables for each respective asset classes do not include the new Medicare surcharge tax of 3.8 percent applicable to certain investors. Long-term capital gains apply to positions held for longer than one year; short-term capital gains apply to positions held for one year or less.

 


EQUITY AND FIXED-INCOME FUNDS
Equity and fixed-income ETFs currently operate in three different structures:open-end funds, unit investment trust (UITs) or ETNs.


MAXIMUM CAP GAINS TAX RATE
STRUCTURE Long-Term Short-Term
Open End (40 Act) 20% 39.6%
UIT (40 Act) 20% 39.6%
Grantor Trust (33 Act) N/A N/A
Limited Partnership (33 Act) N/A N/A
ETN (33 Act) 20% 39.6%

 

Examples of open-end funds include the Vanguard FTSE Emerging Markets Index ETF (VWO) and the iShares Barclays TIPS Bond Fund (TIP). An example of a UIT is the SPDR S'P 500 Fund (SPY), while the iPath MSCI India Index ETN (INP) is an example of an equity ETN.

Fortunately, all three structures receive the same tax treatment:The long-term capital gains rate is 20 percent if shares are held for more than one year; if shares are held for one year or less, gains are taxed as ordinary income—with a maximum rate of 39.6 percent.

COMMODITY FUNDS
Commodity exchange-traded products (ETPs) come in one of three structures:grantor trusts; limited partnerships; or ETNs. Knowing the structure of commodity funds is crucial, since the tax implications differ dramatically between the various structures.


MAXIMUM CAP GAINS TAX RATE
STRUCTURE Long-Term Short-Term
Open End (40 Act) N/A N/A
UIT (40 Act) N/A N/A
Grantor Trust (33 Act) 28% 39.6%
Limited Partnership (33 Act)* 27.84%** 27.84%**
ETN (33 Act) 20% 39.6%

*Distributes K-1
**Max rate of blended 60% LT/40% ST

 

 

Commodity Grantor Trusts
Grantor trust structures are used for "physically held" precious metals ETFs, such as the SPDR Gold Shares (GLD), the iShares Silver Trust (SLV) and the ETFS Physical Swiss Gold Shares (SGOL). These and related funds store the physical commodity in question in vaults, giving investors direct exposure to spot returns.

Under current IRS rules, investments in these precious metals ETFs are considered collectibles. Collectibles never qualify for the 20 percent long-term tax rate applied to traditional equity investments; instead, long-term gains are taxed at a maximum rate of 28 percent. If shares are held for one year or less, gains are taxed as ordinary income, again at a maximum rate of 39.6 percent.

Commodity Limited Partnerships
Many ETFs hold futures contracts to gain exposure to commodities, and are structured as limited partnerships, or LPs.

Some commodity funds structured as LPs include the PowerShares DB Commodity Index Tracking Fund (DBC), the United States Natural Gas Fund (UNG) and the iShares S'P GSCI Commodity-Indexed Trust (GSG). There are even ETFs that invest in precious metals futures, which stand in contrast to the physically backed funds mentioned earlier.

Futures-based funds have unique tax implications. Currently, 60 percent of any gains are taxed at the long-term capital gains rate of 20 percent, and the remaining 40 percent is taxed at the investor's ordinary income rate, regardless of how long the shares are held. This comes out to a blended maximum capital gains rate of 27.84 percent.

Limited partnership ETFs are considered pass-through investments, so any gains made by the trust are "marked to market" at the end of each year and passed on to its investors, potentially creating a taxable event. This means that your cost basis adjusts at year-end and you can be subject to pay taxes on gains regardless of whether you sold your shares or not.

For tax reporting, limited partnership ETFs also generate a Schedule K-1 form. This can create uncertainty and annoyance for the average investor not familiar with K-1s when they receive these forms in the mail.

Commodity Exchange-Traded Notes
Commodity ETNs do not hold the physical commodity, nor do they hold futures contracts. They are unsubordinated, unsecured debt notes issued by banks that promise to provide the return of a specific index. This means they carry credit risk:If the bank issuing the note goes bankrupt or defaults, investors can lose their entire investment.

Popular commodity ETNs include the iPath Dow Jones-UBS Commodity Index Total Return ETN (DJP), the Elements Rogers International Commodity Total Return ETN (RJI) and the iPath S'P GSCI Crude Oil Total Return Index ETN (OIL).

Commodity ETNs are currently taxed like equity and/or bond funds. Long-term gains are taxed at 20 percent, while short-term gains are taxed as ordinary income (maximum 39.6 percent). Despite the fact that many of these products track futures-based indexes, they do not generate a K-1.

 


CURRENCY FUNDS
Currency ETPs come in one of four structures:open-end funds; grantor trusts; limited partnerships; or ETNs.


MAXIMUM CAP GAINS TAX RATE
STRUCTURE Long-Term Short-Term
Open End (40 Act) 20% 39.6%
UIT (40 Act) N/A N/A
Grantor Trust (33 Act) 39.6% 39.6%
Limited Partnership (33 Act)* 27.84%** 27.84%**
ETN (33 Act) 39.6% 39.6%

*Distributes K-1
**Max rate of blended 60% LT/40% ST


Currency Open-End Funds
WisdomTree is currently the only issuer to offer currency ETFs structured as open-end funds. Some of its funds include the WisdomTree Dreyfus Chinese Yuan Fund (CYB), the WisdomTree Dreyfus Emerging Currency Fund (CEW) and the WisdomTree Dreyfus Brazilian Real Fund (BZF).

WisdomTree's currency funds do not hold currency notes or futures contracts. Instead, most of their funds hold the bulk of their assets in U.S. Treasury bills and repurchase agreements (repos), while gaining exposure to the reference currencies through forward currency contracts and swaps.

Tax implications for these funds are similar to equity funds. According to WisdomTree's prospectuses, gains are taxed as long-term capital gains (20 percent) if held for more than one year; if held for one year or less, gains are taxed as ordinary income (maximum 39.6 percent).

 

 

Currency Grantor Trusts
Rydex's CurrencyShares are structured as grantor trusts. Each CurrencyShares product gives investors exposure to spot exchange rates of the underlying currency by holding the foreign currency in bank accounts. The most popular CurrencyShares are currently the Canadian Dollar Trust (FXC), the Swiss Franc Trust (FXF) and the Australian Dollar Trust (FXA).

The taxation of CurrencyShares products is straightforward. All gains from the sale of shares are taxed as ordinary income (maximum 39.6 percent) regardless of how long they are held by the investor.

Currency Limited Partnerships
Similar to commodity LP funds, currency funds that hold futures contracts are structured as LPs. These funds include the PowerShares DB US Dollar Index Bearish and Bullish Funds (NYSEArca:UDN and NYSEArca:UUP, respectively) as well as leveraged currency funds such as the ProShares UltraShort Euro Fund (EUO) and the ProShares UltraShort Yen Fund (YCS).

The tax implications for currency limited partnership ETFs are the same as commodity limited partnership ETFs—gains are subject to the same 60 percent/40 percent blend, regardless of how long the shares are held. They're also marked to market at year-end and are reported on K-1s.

Currency Exchange-Traded Notes
Some uncertainty surrounds the taxation of currency ETNs. Due to an IRS ruling in late 2007—Revenue Ruling 2008-1—gains from currency ETNs are now generally taxed as ordinary income (maximum 39.6 percent), regardless of how long the shares are held by the investor.

However, according to the prospectuses of some currency ETNs, investors might have an option to classify gains as long-term capital gains if a valid election under Section 988 is made before the end of the day that the ETN was purchased.

Also, even though currency ETNs don't pay out any distributions to its shareholders, if a note generates any income throughout the year, investors can be subject to pay taxes on this "phantom income" at year end.

Some currency ETPs structured as exchange-traded notes include the Market Vectors Chinese Renminbi/USD ETN (CNY), the iPath EUR/USD Exchange Rate ETN (ERO) and the PowerShares DB 3X Long US Dollar Index ETN (UUPT).

 



ALTERNATIVE FUNDS
Alternative funds come in one of three structures:open-end funds; limited partnerships; or ETNs.

Alternative funds seek to provide diversification by combining asset classes or investing in nontraditional assets.

MAXIMUM CAP GAINS TAX RATE
STRUCTURE Long-Term Short-Term
Open End (40 Act) 20% 39.6%
UIT (40 Act) N/A N/A
Grantor Trust (33 Act) N/A N/A
Limited Partnership (33 Act)* 27.84%** 27.84%**
ETN (33 Act)*** 20% 39.6%

*Distributes K-1
**Max rate of blended 60% LT/40% ST
***Exception is ticker "ICI"; see explanation below


The tax implications of alternative funds fall in line with the tax implications for equities and commodities with their respective structures. For example, alternative funds structured as open-end funds such as the WisdomTree Managed Futures Strategy Fund (WDTI) and the PowerShares S'P 500 BuyWrite Fund (PBP) are taxed like equity funds. Long-term gains are taxed at 20 percent and short-term gains are taxed as ordinary income (maximum 39.6 percent).

Alternative funds that hold futures contracts like some volatility, commodity and currency funds are structured as LPs. Some examples include the PowerShares DB G10 Currency Harvest Fund (DBV), the iShares Diversified Alternatives Trust (ALT) and the ProShares VIX Short-Term Futures Fund (VIXY). All gains are taxed at the blended 60 percent/40 percent rate, regardless of holding period, creating a maximum blended tax rate of 27.84 percent.

Alternative funds structured as ETNs currently have the same tax implications as equity ETNs, with the exception of the iPath Optimized Currency Carry ETN (ICI). ICI is considered a currency ETN for tax purposes, with gains that generally get taxed as ordinary income regardless of how long shares are held.

TAXATION OF DISTRIBUTIONS
Besides taxes on capital gains incurred from selling shares of ETPs, investors are also subject to pay taxes on periodic distributions paid out to shareholders throughout the year. These distributions can be from dividends paid out from the underlying stock holdings, interest from bond holdings, return of capital (ROC) or capital gains—which come in two forms:long-term gains and short-term gains.

Dividend payments from ETFs are usually paid out monthly, quarterly, semiannually or annually. There are two kinds of dividends that investors should be aware of:qualified dividends and nonqualified dividends.

Qualified dividends are dividends paid out from a U.S. company whose shares have been held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. Importantly, this refers to the shares held by the ETF itself, and not the holding period of investors in the ETF.

Effective Jan. 1, 2013, qualified dividends are taxed at a maximum rate of 20 percent, compared with nonqualified dividends, which are taxed as ordinary income. Many of the dividends paid out to shareholders in domestic equity ETFs are qualified dividends.

 

 

Investors should keep in mind that while monthly distributions from bond ETFs are often called "dividends," interest from the underlying bond holdings aren't considered qualified dividends and are taxed as ordinary income.

Similarly, interest-yielding currency funds such as the CurrencyShares Australian Dollar Trust (FXA) are also taxed as ordinary income. Some currency funds, such as WisdomTree's funds, can pay out distributions as income from its Treasury holdings and short-term and long-term gains from its holdings in forward currency contracts.

Funds can also pay out distributions in excess of the fund's earnings and profits, called return of capital (ROC). ROC is generally nontaxable and reduces the investor's cost basis by the amount of the distribution. While any fund can potentially pay out ROC distributions, it's more prevalent in REIT and master limited partnership funds, such as the Alerian Master Limited Partnership Fund (AMLP).

Fortunately for investors, all of this is generally broken down in the 1099-DIV at year-end. The 1099-DIV will first show "Total Ordinary Dividends," which includes both qualified and nonqualified dividends, as well as any short-term capital gains. Qualified dividends that are subject to the beneficial 20 percent tax rate are further separated under the "Qualified Dividends" heading.

Any long-term capital gains that qualify for the 20 percent rate are separated as well, listed under the heading "Total Capital Gains Distributions." ROC distributions should be included in the "Nondividend Distributions" section on the 1099-DIV.

2013 CAPITAL GAINS TAX CHANGES
Effective Jan. 1, 2013, due to the passing of the American Taxpayer Relief Act of 2012, singles with a taxable income over $400,000 and married filing jointly with a taxable income over $450,000 are now subject to higher capital-gains tax rates.

For investors in this higher tax bracket, long-term capital gains rates have increased from 15 to 20 percent, while short-term capital-gains rates increased from 35 to 39.6 percent. Qualified dividends are also now taxed at this new 20 percent rate, while interest income from bond funds will continue to be subject to ordinary income rates, or a maximum of 39.6 percent.

For all other filers with a taxable income equal to or less than the $400,000/$450,000 threshold, all rates on capital gains and qualified dividends remain the same as in 2012 (excluding the Medicare tax, which is a separate tax with a different income threshold), with maximum long-term capital gains and qualified dividends still taxed at a 15 percent rate, and maximum short-term rates taxed at 35 percent.

NEW MEDICARE SURCHARGE TAX
Effective Jan. 1, 2013, due to the passing of the Patient Protection and Affordable Care Act, singles with an adjusted gross income (AGI) over $200,000 and married filing jointly with an AGI over $250,000 are now subject to an additional 3.8 percent Medicare surcharge tax on investment income, which includes all capital gains, interest and dividends.

This new tax will be levied on the lesser of net investment income or modified adjusted gross income (MAGI) in excess of $200,000 single/$250,000 joint. Therefore, for investors in the highest tax brackets, their "true" tax rates on long-term capital gains and qualified dividends can reach 23.8 percent (20 percent capital gains plus 3.8 percent Medicare tax).

CHOOSING THE RIGHT FUND FOR YOU
There are many reasons besides tax implications for choosing between funds. This paper does not try to address those issues. But knowing the tax implications of different choices can certainly help investors make a decision, especially with commodity and currency funds. We call out a few examples below.

 



Commodity Funds
From a tax perspective, the time period that you expect to own that asset can make a difference. For short-term holders in higher tax brackets, for example, LPs offer a strong tax benefit, since 60 percent of any gains are taxed at the low 20 percent tax rate, regardless of holding period. In other structures, short-term gains are taxed as ordinary income, with rates up to 39.6 percent.

On the flip side, long-term investors might gain an advantage with ETNs because they are subject to 20 percent long-term gains, compared with the 60/40 blend of partnerships, which comes out to a blended maximum of 27.84 percent. The Catch-22 is that ETNs come with credit risk of the counterparty.

Then there are tax reporting differences. The tax structure associated with LPs can be challenging for investors who are accustomed to 1099s when they receive K-1s in the mail. For investors looking to simplify their taxes without K-1s, grantor trusts and ETNs might look more appealing.

Currency Funds
While CurrencyShares offers the "purest" way to gain exposure to a currency through an exchange-traded product, any distributed income or gains from selling shares are taxed as ordinary income, so investors don't get any long-term capital gains tax advantages.

WisdomTree's open-end funds might have a tax advantage for long-term investors, but, for better or worse, funds using forward contracts don't always perfectly follow spot exchange rates of the underlying currency.

Similar to commodities, currency limited partnership ETFs can be beneficial for short-term traders because of the blended maximum 27.84 percent rate even if shares are held for less than one year. But investors need to deal with K-1 forms, and shares are marked to market if they're held over into a new calendar year.

As always, the choice comes down to the individual. Nonetheless, it pays to have a full understanding of the potential tax treatments so you can make an informed decision.

Max LT/ST Capital Gains Rates (Taxable Income Equal to or Less than $400K Single/$450K Joint)
Equity ' Fixed Income Commodity Currency Alternative
FUND STRUCTURE
Open End (40's Act) 15/35 N/A 15/35 15/35
UIT (40's Act) 15/35 N/A N/A N/A
Grantor Trust (33 Act) N/A 28/35 35/35 N/A
Limited Partnership (33 Act) N/A 23/23* 23/23* 23/23*
ETN (33 Act) 15/35 15/35 35/35 15/35

*Max blended rate of 60% LT/40% ST
NOTE:These rates are NOT inclusive of the 3.8% Medicare surcharge tax or any additional taxes applicable from the phaseout of itemized deductions and personal exemptions.


Max LT/ST Capital Gains Rates (Taxable Income Greater than $400K Single/$450K Joint)
Equity ' Fixed Income Commodity Currency Alternative
FUND STRUCTURE
Open End (40's Act) 20/39.6 N/A 20/39.6 20/39.6
UIT (40's Act) 20/39.6 N/A N/A N/A
Grantor Trust (33 Act) N/A 28/39.6 39.6/39.6 N/A
Limited Partnership (33 Act) N/A 27.84/27.84* 27.84/27.84* 27.84/27.84*
ETN (33 Act) 20/39.6 20/39.6 39.6/39.6 20/39.6

*Max blended rate of 60% LT/40% ST
NOTE:These rates are NOT inclusive of the 3.8% Medicare surcharge tax or any additional taxes applicable from the phaseout of itemized deductions and personal exemptions.



Disclaimer: We are not professional tax advisors. This article is for informational purposes only and not intended to be tax advice. Tax rules can change. Individuals should always consult with a professional tax advisor for details about the tax implications of investment products and their personal taxes.

Permalink | ' Copyright 2013 IndexUniverse LLC. All rights reserved
View Comments