The ETF Tax Dodge(bloomberg.com)
bloomberg.com
The ETF Tax Dodge
https://www.bloomberg.com/graphics/2019-etf-tax-dodge-lets-investors-save-big/
88 comments
With respect to Matt Levine, the exact opposite is true. ETFs were a tax dodge that became embedded in the system. To get technical, Congress enacted §311(b) exemptions in 1986, exempting gain recognition for in-kind distributions for Subchapter M companies as §852(b)(6). At the time, mutual funds rarely distributed property in kind. The first ETF appeared in 1993, and the spectacular tax advantage is a big reason for its success. Given their popularity, ETFs are also given regulatory exemptive relief from parts of the '33 and '40 Acts. I'd argue this is like frequent flyer miles -- the IRS basically gave up on collecting them as taxable income because everyone thought of them as free.
Credential - I'm a lawyer and value investor @ https://lembascapital.com/ and I spend a great deal of time looking at fund structures.
PS Other smart mutual funds began distributing in kind once they realized this tax structure was sufficiently embedded. See e.g. Sequoia Fund, the famous value investing mutual fund (at least pre Valeant) - https://www.wsj.com/articles/SB921028092685519084
Credential - I'm a lawyer and value investor @ https://lembascapital.com/ and I spend a great deal of time looking at fund structures.
PS Other smart mutual funds began distributing in kind once they realized this tax structure was sufficiently embedded. See e.g. Sequoia Fund, the famous value investing mutual fund (at least pre Valeant) - https://www.wsj.com/articles/SB921028092685519084
> With respect to Matt Levine, the exact opposite is true.
You may want to re-read what he wrote then, because you're literally just restating what he said. He even covered the history of the tax break, noting, as you did, that the law changed decades before the first ETF appeared in 1993.
Levine is explicitly saying that this whole thing came about by accident decades ago but today it has become "embedded in the system", and everyone, up to and including the regulators, believes that the point of an ETF is to be tax efficient, so they're going to let them be tax efficient, even if that requires some legal gymnastics.
> I'd argue this is like frequent flyer miles -- the IRS basically gave up on collecting them as taxable income because everyone thought of them as free.
Exactly. What exactly do you think you're disagreeing with Levine about?
You may want to re-read what he wrote then, because you're literally just restating what he said. He even covered the history of the tax break, noting, as you did, that the law changed decades before the first ETF appeared in 1993.
Levine is explicitly saying that this whole thing came about by accident decades ago but today it has become "embedded in the system", and everyone, up to and including the regulators, believes that the point of an ETF is to be tax efficient, so they're going to let them be tax efficient, even if that requires some legal gymnastics.
> I'd argue this is like frequent flyer miles -- the IRS basically gave up on collecting them as taxable income because everyone thought of them as free.
Exactly. What exactly do you think you're disagreeing with Levine about?
It doesn't seem like you and Matt Levine are disagreeing about anything material. Just over whether it should be called a "dodge" or not. It's just a rule. It's almost exactly like the rule for real estate like-kind exchanges (at least in the effect it ends up having - you can swap the asset you're in without the frictional cap gains tax).
I didn't read the Levine article as stating where ETFs games from, rather where they are today.
"I'd argue this is like frequent flyer miles -- the IRS basically gave up on collecting them as taxable income because everyone thought of them as free."
Isn't that what Levine is also arguing? Realpolitik as tax law.
"I'd argue this is like frequent flyer miles -- the IRS basically gave up on collecting them as taxable income because everyone thought of them as free."
Isn't that what Levine is also arguing? Realpolitik as tax law.
From a UK perspective seems strange that any investment company would it self owe CT tax individual US shares don't.
And the USA does have REIT's as a model.
And large chunks of the capital invested in the USA in the 19th century was by UK investment trusts which don't pay capital gains - the owner of the shares does.
And the USA does have REIT's as a model.
And large chunks of the capital invested in the USA in the 19th century was by UK investment trusts which don't pay capital gains - the owner of the shares does.
People are missing the point. This is not a tax dodge in the sense that you never pay the taxes. It’s a tax dodge in the sense that you postpone paying taxes in the year when they are due (which is the most common kind of tax dodge).
It’s absolutely correct that the ETF shareholders will pay the tax one way or another, either now on an annual cap gains distribution, or when they sell the shares later. It is NOT double taxation, because you either pay now or later, not both.
The issue is that the government cares deeply that you pay taxes in the year that you incur them. The US government, as you may know, has massive debt, and so getting the tax later costs it money in interest payments. They care about this so much that if you owe a lot in taxes, you actually have to pay them in quarterly installments, so the Feds don’t have to wait a whole year to get your money.
Since ETF’s are buy-and-hold investments, it could literally be decades before you actually send in a check for taxes that would ordinarily be due today.
It’s absolutely correct that the ETF shareholders will pay the tax one way or another, either now on an annual cap gains distribution, or when they sell the shares later. It is NOT double taxation, because you either pay now or later, not both.
The issue is that the government cares deeply that you pay taxes in the year that you incur them. The US government, as you may know, has massive debt, and so getting the tax later costs it money in interest payments. They care about this so much that if you owe a lot in taxes, you actually have to pay them in quarterly installments, so the Feds don’t have to wait a whole year to get your money.
Since ETF’s are buy-and-hold investments, it could literally be decades before you actually send in a check for taxes that would ordinarily be due today.
> The issue is that the government cares deeply that you pay taxes in the year that you incur them. The US government, as you may know, has massive debt, and so getting the tax later costs it money in interest payments. They care about this so much that if you owe a lot in taxes, you actually have to pay them in quarterly installments, so the Feds don’t have to wait a whole year to get your money.
Which is very silly, because the government pays a lower interest rate on its debt than the average returns from the stock market. So the government would actually come out ahead to carry more debt now and allow you to accrue more taxable appreciation, because the tax paid on the market gains from the money not paid in tax until later are more than the interest the government has to pay on its debt in the meantime.
Which is very silly, because the government pays a lower interest rate on its debt than the average returns from the stock market. So the government would actually come out ahead to carry more debt now and allow you to accrue more taxable appreciation, because the tax paid on the market gains from the money not paid in tax until later are more than the interest the government has to pay on its debt in the meantime.
I may equally lose that money. There's a reason that government debt pays less. The sooner they get their money, the less time it is exposed to that risk.
From the perspective of the government the risk is extremely diversified -- across all taxpayers and all investments. And it remains the case that the average returns from the stock market exceed the average interest rate on US government debt.
If you squint, that is a Keynesian argument, since it potentially justifies government borrowing more money and handing it out for the economy to invest. It is just a matter of degree - again my point that it is not necessarily a good idea.
Time value of money, delaying taxes lowers them.
> They care about this so much that if you owe a lot in taxes, you actually have to pay them in quarterly installments, so the Feds don’t have to wait a whole year to get your money.
That's really not about interest, but about credit risk. If a tax payer goes broke, they don't want to lose a whole year of taxes.
That's really not about interest, but about credit risk. If a tax payer goes broke, they don't want to lose a whole year of taxes.
The time value of money (and thus interest) is in part by driven by the risk of the future payout not happening, so these aren't really separate phenomena.
But the interest the state is paying is not driven very much by the credit risk from individual tax payers.
This type of deferral does end up being a tax dodge if the ETF is inherited. As of 2018, you get to leave up to 11 million to your heirs tax free, AND they get a free step up in cost basis.
It seems to me that this "tax dodge" means that ETFs work the same way basically every investment in the world works (under US taxation). You invest money in a thing, thing goes up and you hold: you pay no taxes; you sell the thing: you pay taxes on the gain.
Redeeming ETF into and holding shares of the underlying index also acts the same way: you pay taxes on any gains when you eventually sell the underlying shares.
I'm not seeing a "dirty little secret" here. That Fidelity's mutual fund is not able to accomplish the same level of tax efficiency as the SPDR or iShares ETFs reads to me like a flaw in Fidelity's execution, not an illegal dodge on State Street's or Blackrock's side, IMO.
Redeeming ETF into and holding shares of the underlying index also acts the same way: you pay taxes on any gains when you eventually sell the underlying shares.
I'm not seeing a "dirty little secret" here. That Fidelity's mutual fund is not able to accomplish the same level of tax efficiency as the SPDR or iShares ETFs reads to me like a flaw in Fidelity's execution, not an illegal dodge on State Street's or Blackrock's side, IMO.
Except these institutions are not paying taxes on the gain??
> Typically, when you sell a stock for more than you paid, you owe tax on the gain. But thanks to a quirk in a Nixon-era tax law, funds can avoid that tax if they use the stock to pay off a withdrawing fund investor.
> Typically, when you sell a stock for more than you paid, you owe tax on the gain. But thanks to a quirk in a Nixon-era tax law, funds can avoid that tax if they use the stock to pay off a withdrawing fund investor.
Suppose you and I take $100K each and mutually invest 50:50 in something together. Maybe we bought two identical houses for $200K total (or even bought a duplex together). Later on, the houses have gone up in value to $300K, even later I decide that I want out, we look things over and decide that the fair thing is for me to take one of the houses. At the moment that we take that action, no tax is (nor ought to be, IMO) due.
Later, when/if I sell the house, tax is due on the $50K in gains. Just like in the ETF case.
In the alternate treatment seemingly contemplated by the article, we could instead agree to sell one of the houses, jointly pay taxes on $50K in gains, and give me the sum of $150K-taxes, the gains of which I'd pay taxes upon again. You'd also have effectively paid taxes when you hadn't done anything but invest and hold. There's a pretty good argument this is unfair to me (to tax me twice on one gain); there's an almost ironclad argument that it's unfair to you.
It's no surprise that the treatment that is both more reasonable and more profitable is the one that ETFs seek to implement.
(Fees and other weirdnesses around real-estate ignored above for simplicity.)
Later, when/if I sell the house, tax is due on the $50K in gains. Just like in the ETF case.
In the alternate treatment seemingly contemplated by the article, we could instead agree to sell one of the houses, jointly pay taxes on $50K in gains, and give me the sum of $150K-taxes, the gains of which I'd pay taxes upon again. You'd also have effectively paid taxes when you hadn't done anything but invest and hold. There's a pretty good argument this is unfair to me (to tax me twice on one gain); there's an almost ironclad argument that it's unfair to you.
It's no surprise that the treatment that is both more reasonable and more profitable is the one that ETFs seek to implement.
(Fees and other weirdnesses around real-estate ignored above for simplicity.)
You may decide that tax ought not to be due when you take one of the houses, but under the law it IS due. For me to take one of the houses, we would have to change the ownership structure and there would be a transfer price for that.
That's very much facts and circumstances dependent. As an example, if we individually purchase the property and form a partnership with that property (rather than the cash), a subsequent distribution of that property is not federally taxable (pub 541). Similarly, ownership changes relating to a divorce are generally not currently taxable.
> change the ownership structure and there would be a transfer price for that
The transfer price in gp’s example would be zero, wouldn’t it.
The transfer price in gp’s example would be zero, wouldn’t it.
Probably not. If the transfer price is zero, then that now becomes my tax basis in the property. So assuming again that I put in $100k originally, and now take out one house worth $150k, then sell it, I’m going to pay capital gains on the full $150k, not just my $50k gain.
What probably happens is that I sell you my share in the holding entity for $150k, and the entity sells me the house for $150k.
There are cases where you could simply dissolve the entity and distribute the assets, which would avoid the sale and resulting taxes, in which case you’re just re-titling it and not selling it.
Tl;dr: this gets complicated really quickly.
What probably happens is that I sell you my share in the holding entity for $150k, and the entity sells me the house for $150k.
There are cases where you could simply dissolve the entity and distribute the assets, which would avoid the sale and resulting taxes, in which case you’re just re-titling it and not selling it.
Tl;dr: this gets complicated really quickly.
I'm not seeing why this is paying tax on the same thing twice? You'd have a new cost basis, so you'd only pay again if it went up even more. Even if it's on the same property, that's a separate gain and this is effectively dividing a single large gain into two smaller gains, one of which happens earlier.
It seems like the question here is how long you can delay taxes on a capital gain. It doesn't seem particularly unfair if you can't always delay capital gains tax as long as you like?
It seems like the question here is how long you can delay taxes on a capital gain. It doesn't seem particularly unfair if you can't always delay capital gains tax as long as you like?
My example conflates (or does not clearly distinguish between) partnerships (taxed as passthrough) and companies (taxed twice possibly). In the place I referenced taxed twice (only possible as a company), assume the federal rate on everything is 40% [to make the math forum-calculation-friendly].
Company starts with $200K, held 50:50 by two shareholders, losslessly buys two house for that, those go to $300K, company losslessly sells one of them for $150K, company pays $20K tax on $50K gain, and then owns a $150K house and $130K in cash. Shareholder B sells their 50% share in the company to shareholder A for $140K cash, realizing a $40K capital gain on their original shares investment [incurring $16K in taxes on the gain in their shares]. Shareholder A now owns all the shares with a basis of $240K for a company value of $280K.
I argue that Shareholder B’s economic interest in a single gain has been taxed twice.
Company starts with $200K, held 50:50 by two shareholders, losslessly buys two house for that, those go to $300K, company losslessly sells one of them for $150K, company pays $20K tax on $50K gain, and then owns a $150K house and $130K in cash. Shareholder B sells their 50% share in the company to shareholder A for $140K cash, realizing a $40K capital gain on their original shares investment [incurring $16K in taxes on the gain in their shares]. Shareholder A now owns all the shares with a basis of $240K for a company value of $280K.
I argue that Shareholder B’s economic interest in a single gain has been taxed twice.
The person who initially invested does. I don't see at all how this is a tax dodge.
Agreed I see this more as a transfer than a dodge.
The person who individually invested doesn’t have to pay the tax until they sell their shares in the ETF, perhaps decades later. That’s generally considered a tax dodge because deferral of taxes lets you keep that money and compound it.
$10 of taxes deferred for 30 years at a modest interest rate of 2% puts an extra $8 in the investor’s pocket that should have gone to the government.
$10 of taxes deferred for 30 years at a modest interest rate of 2% puts an extra $8 in the investor’s pocket that should have gone to the government.
I'm not sure that's a "generally considered" definition. By that definition, I'm dodging taxes every year I don't sell my shares that I hold in my brokerage account.
From your other comments, I see why you don’t want it to be this way, which is a valid philosophical point. However, this is how the tax code treats any transaction today. You’re right you don’t owe tax if you hold a single company’s stock, but you do if you hold a mutual fund that trades its underlying shares during the year, or if you trade one stock in your portfolio for another. You owe it even if you sell a stock for a net profit and buy it back for exactly the same price ten minutes later. ETF’s are treated differently ...
Please explain. Just holding a mutual fund won’t generate any taxable events... except for dividend/distributions... just like a stock. Buying and selling ETFs are also treated just like a stock.
Not true. Every year, a mutual fund is required to distribute an amount equal to the capital gains realized by the fund in that year. For a mutual fund that trades actively, that could be a sizeable fraction of the amount you have invested. This is cap gains, not a dividend. Stocks and ETF’s don’t do that. https://www.investopedia.com/terms/c/capitalgainsdistributio...
Good to know! My funds generate relatively small capital gains distributions (most of what I see on my 1099's is from dividends) so I never noticed it.
Edit: Though now that you mention it, I think I must've known this at some point in the past: that ETFs had preferential tax treatment. A while back, I moved my most recent investments to ETFs, even for the "same" fund (example: Vanguard Tech VITAX mutual fund vs VGT ETF) ...
Still, how are ETFs treated differently from a stock?
Edit: Though now that you mention it, I think I must've known this at some point in the past: that ETFs had preferential tax treatment. A while back, I moved my most recent investments to ETFs, even for the "same" fund (example: Vanguard Tech VITAX mutual fund vs VGT ETF) ...
Still, how are ETFs treated differently from a stock?
That's fine.
Yes, but the investor will pay more in taxes when they sell the actual ETF. It's more like deferring taxes than avoiding them.
Think of it this way, if the fund paid these taxes when they sell their various holdings, that less tax amount would be baked into the ETF valution, which would carry over to a smaller tax bill when an investor sells their ETF shares and pays taxes.
That's still advantageous in many ways, but I think people in this topic are thinking this is some kind of complete tax avoidance. It isn't.
Think of it this way, if the fund paid these taxes when they sell their various holdings, that less tax amount would be baked into the ETF valution, which would carry over to a smaller tax bill when an investor sells their ETF shares and pays taxes.
That's still advantageous in many ways, but I think people in this topic are thinking this is some kind of complete tax avoidance. It isn't.
Yes, I do agree the end result is likely beneficial to the average Joe trading ETFs...
> Except these institutions are not paying taxes on the gain??
Why should they? They are not people.
When you buy an item for $50 at a store, as a consumer you would pay sales tax on it. But every transaction made from the buying of raw materials up to the time the store sold you the item is done tax free by the businesses, only at the time of sale to the final consumer, a tax is due.
Here ETF is kind of similar, except that the consumer provides the raw materials: A consumer buys the ETF at a share price of $100, and sells it once the ETF reaches $150: $50 should be taxable to the consumer. Instead of it being categorized as "sales tax" it's "income tax" or "LTCG tax", but the principle is the same.
If the institution made money off that transaction, by charging someone a $5 fee for instance, then tax should be paid on those $5 by the institution, but I don't see why amount the fund grew should have an impact. It goes both way obviously, if the consumer buys an ETF a $100 but sells it at $75, the institution should not be able to claim a loss on those $25, but that doesn't seem to be something claimed by the article.
Why should they? They are not people.
When you buy an item for $50 at a store, as a consumer you would pay sales tax on it. But every transaction made from the buying of raw materials up to the time the store sold you the item is done tax free by the businesses, only at the time of sale to the final consumer, a tax is due.
Here ETF is kind of similar, except that the consumer provides the raw materials: A consumer buys the ETF at a share price of $100, and sells it once the ETF reaches $150: $50 should be taxable to the consumer. Instead of it being categorized as "sales tax" it's "income tax" or "LTCG tax", but the principle is the same.
If the institution made money off that transaction, by charging someone a $5 fee for instance, then tax should be paid on those $5 by the institution, but I don't see why amount the fund grew should have an impact. It goes both way obviously, if the consumer buys an ETF a $100 but sells it at $75, the institution should not be able to claim a loss on those $25, but that doesn't seem to be something claimed by the article.
Presumably the withdrawing investor also gets the fund's cost basis in the stock, so they'll be on the hook for the fund's capital gains themselves when they sell the stock. (The article didn't explicitly mention it, nor does the relevant statute https://www.law.cornell.edu/uscode/text/26/852#b_6, but that's the standard way that stock transfers work.)
I'd like to see details on that part. My guess is each side of the exchange keeps their cost basis and just divides it over the new to them shares -- like in an untaxed merger stock transaction. Otherwise, it would be a competition to send the other party stocks with the lowest cost basis.
I think the basis stays with the fund, and the capital gains are due when the ETF holders sell their shares.
The bank does not get hit with any capital gains due to the lower basis of the fund. The bank has their own basis in the shares that they brought into the fund which when traded for the other shares may trigger its own separate capital gain.
The shares the bank gets back at the end should have price equal to basis by that point I would think.
The bank does not get hit with any capital gains due to the lower basis of the fund. The bank has their own basis in the shares that they brought into the fund which when traded for the other shares may trigger its own separate capital gain.
The shares the bank gets back at the end should have price equal to basis by that point I would think.
The underlying investors do when they cash out.
You could make the same argument about buying into a mutual fund, yet mutual funds have to distribute capital gains every year.
Similarly, if I tried to re-create an index in my own account with individual stocks, I would end up incurring cap gains as I had to add and remove stocks when the index changes.
For whatever reason, we seem to feel like ETF’s deserve different treatment.
Similarly, if I tried to re-create an index in my own account with individual stocks, I would end up incurring cap gains as I had to add and remove stocks when the index changes.
For whatever reason, we seem to feel like ETF’s deserve different treatment.
> You could make the same argument about buying into a mutual fund, yet mutual funds have to distribute capital gains every year.
This is sort of true, but no longer completely true -- because of ETFs. For example, Vanguard uses ETFs that connect with their Mutual Funds in such a way that it has virtually eliminated capital gains distributions on the majority of its index mutual funds. They are now taxed more similarly to ETFs.
> Similarly, if I tried to re-create an index in my own account with individual stocks, I would end up incurring cap gains as I had to add and remove stocks when the index changes.
However, if you did this with your own stocks, you could also take capital losses, which mutual funds cannot do (they cannot distribute capital losses to you), and you could also just decide to hold onto the individual stocks indefinitely. At a small percentage of your portfolio, it would probably not significantly effect performance (some evidence even suggests that stock portfolios that never sold stocks when dropped from the indexes even outperformed the indexes!).
Even worse, in a mutual fund, you can actually buy into already existing capital gains that you never even profited from. For instance, if a mutual fund had a lot of gains in 2017, you buy in at the end of 2017, and then the mutual fund realizes those gains, you would receive those distributions and pay taxes, which seems pretty unfair to pay capital gains taxes on.
There's a lot of nuance and oddities in how all of these taxes work, but it certainly seems far from clear that the way ETFs "dodge" (defer) capital gains taxes until you sell the asset is unfair. To me, mutual funds seem to be the weird tax structure, not ETFs, which at least have a clear and predictable capital gains cost (your sale price minus your purchase price).
This is sort of true, but no longer completely true -- because of ETFs. For example, Vanguard uses ETFs that connect with their Mutual Funds in such a way that it has virtually eliminated capital gains distributions on the majority of its index mutual funds. They are now taxed more similarly to ETFs.
> Similarly, if I tried to re-create an index in my own account with individual stocks, I would end up incurring cap gains as I had to add and remove stocks when the index changes.
However, if you did this with your own stocks, you could also take capital losses, which mutual funds cannot do (they cannot distribute capital losses to you), and you could also just decide to hold onto the individual stocks indefinitely. At a small percentage of your portfolio, it would probably not significantly effect performance (some evidence even suggests that stock portfolios that never sold stocks when dropped from the indexes even outperformed the indexes!).
Even worse, in a mutual fund, you can actually buy into already existing capital gains that you never even profited from. For instance, if a mutual fund had a lot of gains in 2017, you buy in at the end of 2017, and then the mutual fund realizes those gains, you would receive those distributions and pay taxes, which seems pretty unfair to pay capital gains taxes on.
There's a lot of nuance and oddities in how all of these taxes work, but it certainly seems far from clear that the way ETFs "dodge" (defer) capital gains taxes until you sell the asset is unfair. To me, mutual funds seem to be the weird tax structure, not ETFs, which at least have a clear and predictable capital gains cost (your sale price minus your purchase price).
The real question is why we don't treat other things the way we treat ETFs, which is more efficient.
If you own Stock A and it has appreciated significantly over the years, but now you think Stock B is a better choice, the fact that trading one for the other is a tax realization event may cause you to not do it. This doesn't get the government any revenue this year, and it costs the government revenue in the future if you were right that Stock B is now the better choice, because you'll have less taxable appreciation when you finally do cash out during your retirement. It also makes the economy less efficient in general by locking up capital in whatever people invested in years ago.
If you own Stock A and it has appreciated significantly over the years, but now you think Stock B is a better choice, the fact that trading one for the other is a tax realization event may cause you to not do it. This doesn't get the government any revenue this year, and it costs the government revenue in the future if you were right that Stock B is now the better choice, because you'll have less taxable appreciation when you finally do cash out during your retirement. It also makes the economy less efficient in general by locking up capital in whatever people invested in years ago.
For the same reason you pay income tax every year not just when you die. Taxes are designed to fund the government and also address inequality. You need to be taxed more frequently to address the inequality issue.
> For the same reason you pay income tax every year not just when you die.
You pay income tax every year because you consume about that amount of resources every year and the things you want to buy aren't tax deductible. If you didn't, and you have enough money to be worth doing it, there are already a zillion tax shelters that cause taxes to be deferred until you actually want to spend the money on something.
It would reduce inequality to make that available to ordinary people rather than only the super rich, as well as encourage people to have more savings so they have more stability and aren't as impacted by a large sudden expense.
> Taxes are designed to fund the government and also address inequality. You need to be taxed more frequently to address the inequality issue.
Except that you aren't, you just keep the holdings you have already instead, and then everything is worse for everybody. The government ends up with less in the long run, so does the taxpayer, so does the new business looking for investment capital to challenge the incumbents. About the only beneficiaries are the incumbents who retain capital that wouldn't continue to be allocated to them in a more efficient market.
You pay income tax every year because you consume about that amount of resources every year and the things you want to buy aren't tax deductible. If you didn't, and you have enough money to be worth doing it, there are already a zillion tax shelters that cause taxes to be deferred until you actually want to spend the money on something.
It would reduce inequality to make that available to ordinary people rather than only the super rich, as well as encourage people to have more savings so they have more stability and aren't as impacted by a large sudden expense.
> Taxes are designed to fund the government and also address inequality. You need to be taxed more frequently to address the inequality issue.
Except that you aren't, you just keep the holdings you have already instead, and then everything is worse for everybody. The government ends up with less in the long run, so does the taxpayer, so does the new business looking for investment capital to challenge the incumbents. About the only beneficiaries are the incumbents who retain capital that wouldn't continue to be allocated to them in a more efficient market.
Unless you keep your capital as cash under the mattress it’s already participating in the economy and being allocated.
You are using the efficient market hypothesis in exactly the circumstance where it fails to be true.
In theory it shouldn't have mattered if you invested in Blockbuster or Netflix because if Blockbuster was doomed then their share price should reflect that already. But in the early 2000s Blockbuster still had a higher market cap, in part because someone who invested in Blockbuster in 1989 but now thinks Netflix has more promise would have to be extra sure before making the exchange since it would cause a lot of taxes to immediately come due. So then they don't, and it becomes harder for the challenger to raise capital and easier for the zombie incumbent to waste resources in its death throes, which is inefficient.
In theory it shouldn't have mattered if you invested in Blockbuster or Netflix because if Blockbuster was doomed then their share price should reflect that already. But in the early 2000s Blockbuster still had a higher market cap, in part because someone who invested in Blockbuster in 1989 but now thinks Netflix has more promise would have to be extra sure before making the exchange since it would cause a lot of taxes to immediately come due. So then they don't, and it becomes harder for the challenger to raise capital and easier for the zombie incumbent to waste resources in its death throes, which is inefficient.
This is intentional to prevent rampant speculation. If you could get in and out of shares with no tax consequence then it would cause extreme volatility in the market.
Having the zombie company isn’t inefficient. That company is still deploying its capital to its employees and vendors, paying rent, etc. They are still contributing to the economy.
Also remember companies aren’t making money from stock trades. They already got all the money at the IPO.
Having the zombie company isn’t inefficient. That company is still deploying its capital to its employees and vendors, paying rent, etc. They are still contributing to the economy.
Also remember companies aren’t making money from stock trades. They already got all the money at the IPO.
> This is intentional to prevent rampant speculation. If you could get in and out of shares with no tax consequence then it would cause extreme volatility in the market.
It isn't intentional and it doesn't do that. Speculation can already be done with no tax consequences or profitable tax consequences when the thing you're selling to buy something else has had zero or negative value appreciation, and can also be done by borrowing money to speculate with and using the shares you can't sell as collateral for the loan. But that too is less efficient because, although the speculation is happening, now there are a bunch of wasteful transaction costs.
Also, long-term investors shouldn't care about short-term value swings, and short-term investors get what they paid for.
> Having the zombie company isn’t inefficient. That company is still deploying its capital to its employees and vendors, paying rent, etc. They are still contributing to the economy.
When one company is paying people to build technology to reduce carbon emissions and the other is paying people to dig holes and fill them back in for no reason or rearrange the deck chairs on a sinking ship, diverting capital to the second company is most certainly inefficient.
> Also remember companies aren’t making money from stock trades. They already got all the money at the IPO.
The IPO for some companies hasn't happened yet. Moreover, existing companies can sell new shares, and the company's market value is used to assuage creditors and allow existing companies to borrow at lower rates because the creditors know the company could pay the debt by issuing new shares if necessary.
It isn't intentional and it doesn't do that. Speculation can already be done with no tax consequences or profitable tax consequences when the thing you're selling to buy something else has had zero or negative value appreciation, and can also be done by borrowing money to speculate with and using the shares you can't sell as collateral for the loan. But that too is less efficient because, although the speculation is happening, now there are a bunch of wasteful transaction costs.
Also, long-term investors shouldn't care about short-term value swings, and short-term investors get what they paid for.
> Having the zombie company isn’t inefficient. That company is still deploying its capital to its employees and vendors, paying rent, etc. They are still contributing to the economy.
When one company is paying people to build technology to reduce carbon emissions and the other is paying people to dig holes and fill them back in for no reason or rearrange the deck chairs on a sinking ship, diverting capital to the second company is most certainly inefficient.
> Also remember companies aren’t making money from stock trades. They already got all the money at the IPO.
The IPO for some companies hasn't happened yet. Moreover, existing companies can sell new shares, and the company's market value is used to assuage creditors and allow existing companies to borrow at lower rates because the creditors know the company could pay the debt by issuing new shares if necessary.
> Having the zombie company isn’t inefficient.
Yes, it is. If the price drops, it becomes that much more feasible for an outsider to rescue it with a takeover bid - either way, the company will surely be viable as a going concern. You don't seem to be making a consistent argument here.
Yes, it is. If the price drops, it becomes that much more feasible for an outsider to rescue it with a takeover bid - either way, the company will surely be viable as a going concern. You don't seem to be making a consistent argument here.
> If you could get in and out of shares with no tax consequence then it would cause extreme volatility in the market
Obvious counterexamples to your logic: ETFs using heartbeats and foreign buyers can buy and sell without tax consequences in the US.
Obvious counterexamples to your logic: ETFs using heartbeats and foreign buyers can buy and sell without tax consequences in the US.
If I sell my car and buy another for the same price, should I avoid sales tax?
Making it possible to trade stocks without tax consequences may make it easier to better deploy capital, but it would also have a destabilizing effect, because it could make the markets more exposed to emotional reactions and poor information.
Making it possible to trade stocks without tax consequences may make it easier to better deploy capital, but it would also have a destabilizing effect, because it could make the markets more exposed to emotional reactions and poor information.
> If I sell my car and buy another for the same price, should I avoid sales tax?
In most states, when you sell your car and buy another in a single transaction, you do avoid sales tax on that amount. (This is common in a dealer "trade-in" scenario.)
In most states, when you sell your car and buy another in a single transaction, you do avoid sales tax on that amount. (This is common in a dealer "trade-in" scenario.)
Interesting, I learned something. I did not realize this was the case in the US. Arguably a tax subsidy for dealers, since I presumably don't receive that treatment if I instead sell the car myself a week later.
> If I sell my car and buy another for the same price, should I avoid sales tax?
Did the person you sold your old car to have to pay an equal amount of sales tax? Because in that case yes.
> Making it possible to trade stocks without tax consequences may make it easier to better deploy capital, but it would also have a destabilizing effect, because it could make the markets more exposed to emotional reactions and poor information.
This sounds like the argument a monopolist makes for why competition is bad.
Did the person you sold your old car to have to pay an equal amount of sales tax? Because in that case yes.
> Making it possible to trade stocks without tax consequences may make it easier to better deploy capital, but it would also have a destabilizing effect, because it could make the markets more exposed to emotional reactions and poor information.
This sounds like the argument a monopolist makes for why competition is bad.
> Did the person you sold your old car to have to pay an equal amount of sales tax? Because in that case yes
If you like, but that is not how sales tax works. My point is that taxing economic activity that is not in cash form (such as trading shares) is not generally considered unreasonable. Arguably, by selling my car, I am better deploying economic resources, as the other guy evidently had more use for it than I do.
If we taxed only translation into cash, the largest fortunes would grow the most rapidly of all, as wealthy people have less use for cash, proportionally. That's arguably against the public interest.
Anyway - I am not taking a position - I am observing that it is not illogical to prefer the current system.
If you like, but that is not how sales tax works. My point is that taxing economic activity that is not in cash form (such as trading shares) is not generally considered unreasonable. Arguably, by selling my car, I am better deploying economic resources, as the other guy evidently had more use for it than I do.
If we taxed only translation into cash, the largest fortunes would grow the most rapidly of all, as wealthy people have less use for cash, proportionally. That's arguably against the public interest.
Anyway - I am not taking a position - I am observing that it is not illogical to prefer the current system.
> If you like, but that is not how sales tax works.
It frequently is. In many cases it goes the other way, e.g. if you buy a PC for $1000 and pay sales tax on it, and then you sell it some years later for $200, the buyer often doesn't owe sales tax because you already paid it when the PC was new. And when a business buys a product as inventory they don't pay sales tax on it, because the customer will.
It's generally not a good policy to charge the same tax twice on the same product. But that's not even what we're talking about here:
> My point is that taxing economic activity that is not in cash form (such as trading shares) is not generally considered unreasonable.
My point is that it isn't doing that.
You can't avoid income tax by having your employer buy you a car. The value of the car just becomes taxable income.
Deferring taxes when securities are exchanged isn't doing that, because your tax basis in the new securities would be the same as it was in the original ones. You still owe the tax whenever you want to sell the securities and spend the money.
Doing it this way would also allow you to get rid of a lot of the rules that really do reset the tax basis, like the one that happens to inherited property. The concern there is that property inherited through generations would have a tax basis of nearly zero, so the entire value would be taxable income and that amount of tax would make it uneconomical to ever sell the property, even if continuing to own it was highly inefficient. But if you could exchange it for another investment vehicle of equal value and just transfer the tax basis then that wouldn't be necessary and the government could continue to defer the tax obligation rather than waiving it entirely as they do now.
It frequently is. In many cases it goes the other way, e.g. if you buy a PC for $1000 and pay sales tax on it, and then you sell it some years later for $200, the buyer often doesn't owe sales tax because you already paid it when the PC was new. And when a business buys a product as inventory they don't pay sales tax on it, because the customer will.
It's generally not a good policy to charge the same tax twice on the same product. But that's not even what we're talking about here:
> My point is that taxing economic activity that is not in cash form (such as trading shares) is not generally considered unreasonable.
My point is that it isn't doing that.
You can't avoid income tax by having your employer buy you a car. The value of the car just becomes taxable income.
Deferring taxes when securities are exchanged isn't doing that, because your tax basis in the new securities would be the same as it was in the original ones. You still owe the tax whenever you want to sell the securities and spend the money.
Doing it this way would also allow you to get rid of a lot of the rules that really do reset the tax basis, like the one that happens to inherited property. The concern there is that property inherited through generations would have a tax basis of nearly zero, so the entire value would be taxable income and that amount of tax would make it uneconomical to ever sell the property, even if continuing to own it was highly inefficient. But if you could exchange it for another investment vehicle of equal value and just transfer the tax basis then that wouldn't be necessary and the government could continue to defer the tax obligation rather than waiving it entirely as they do now.
The ability to delay a capital gain until death, at which point it disappears, seems like a remarkable tax dodge? I agree that it shouldn't disappear, but it seems like the fix would be to have some limits on how long a capital gains can be delayed so that they will mostly be paid in installments during a person's lifetime, rather than in a big chunk at the end.
Perhaps the money should be held in escrow until a sale or death happens, much like tax withholding for wages.
Perhaps the money should be held in escrow until a sale or death happens, much like tax withholding for wages.
> I agree that it shouldn't disappear, but it seems like the fix would be to have some limits on how long a capital gains can be delayed so that they will mostly be paid in installments during a person's lifetime, rather than in a big chunk at the end.
The problem with this is that the "capital" in many of these cases is a family business. You have some auto shop and the company owns the shop with its land and equipment, but it's all needed to continue operating the business, so you can't sell it without shutting down. Meanwhile the business only makes enough to pay the salaries of the owner-employees, who would likewise shut down the business if they weren't getting paid. So the business is worth more than the taxes it owes, but the only way to pay them would be to liquidate the assets and cease operations. The government sensibly prefers to allow the business to continue operating and collect the taxes later.
But then that creates another perverse incentive. You've just graduated medical school when you inherit an auto shop. If you sell the shop and use the money to found a medical practice (or just invest it in a major ETF and go work for a hospital), you immediately lose $250K to taxes. If you continue operating the auto shop, you don't, which gives it an advantage it shouldn't have and you end up with a doctor running an auto shop. It creates too much of a preference for not selling the shop. So to solve that we reset the basis. But how is that better than leaving its basis where it is but allowing it to be sold and the low tax basis transferred to the medical practice or the stock purchase?
(edit: basis isn't set to zero, taxable gain is zeroed out by setting basis to FMV)
The problem with this is that the "capital" in many of these cases is a family business. You have some auto shop and the company owns the shop with its land and equipment, but it's all needed to continue operating the business, so you can't sell it without shutting down. Meanwhile the business only makes enough to pay the salaries of the owner-employees, who would likewise shut down the business if they weren't getting paid. So the business is worth more than the taxes it owes, but the only way to pay them would be to liquidate the assets and cease operations. The government sensibly prefers to allow the business to continue operating and collect the taxes later.
But then that creates another perverse incentive. You've just graduated medical school when you inherit an auto shop. If you sell the shop and use the money to found a medical practice (or just invest it in a major ETF and go work for a hospital), you immediately lose $250K to taxes. If you continue operating the auto shop, you don't, which gives it an advantage it shouldn't have and you end up with a doctor running an auto shop. It creates too much of a preference for not selling the shop. So to solve that we reset the basis. But how is that better than leaving its basis where it is but allowing it to be sold and the low tax basis transferred to the medical practice or the stock purchase?
(edit: basis isn't set to zero, taxable gain is zeroed out by setting basis to FMV)
The basis is reset to the FMV on the date of death currently. It's probably possible to 1031 exchange the real estate portion into the real estate portion of the medical practice. (I am not a tax expert.) More likely though, you just take the inherited step-up in basis and sell the thing outright.
> how is that better than leaving its basis where it is but allowing it to be sold and the low tax basis transferred [to another investment]?
IMO, that is better from a record-keeping and audit perspective. It is often not possible to determine when or at what basis an asset was acquired, particularly when the original purchaser can no longer be interviewed. It is not a particularly exploitable loophole as you have to die to "take advantage" of it.
> how is that better than leaving its basis where it is but allowing it to be sold and the low tax basis transferred [to another investment]?
IMO, that is better from a record-keeping and audit perspective. It is often not possible to determine when or at what basis an asset was acquired, particularly when the original purchaser can no longer be interviewed. It is not a particularly exploitable loophole as you have to die to "take advantage" of it.
[deleted]
>Imagine that a grocer got a tax deduction every time someone returned a box of cornflakes to his store. Heartbeats are when the grocer asks a friend to buy all the boxes and return them, just to pocket more deductions.
>Fund managers and bankers say the trades are perfectly legal...
How is this legal, this seems to me to be fraud?? If this was small town grocer and John Doe, how would this not be rolled up into a defrauding the government?
https://www.justice.gov/jm/criminal-resource-manual-923-18-u...
How is this legal, this seems to me to be fraud?? If this was small town grocer and John Doe, how would this not be rolled up into a defrauding the government?
https://www.justice.gov/jm/criminal-resource-manual-923-18-u...
It's a poor metaphor.
Taxes have an outsize impact on markets.
People shouldn’t really care about the difference between 15 versus 25 percentage point taxes if they feel they’re timing the market right. But if you look at a chart of redemptions and CG taxes (check Wikipedia), it turns out a 5-9 percentage point decrease occurs around 9-40x increases in redemptions during the low tax period. This is basically why you observe Republican (i.e. low tax) administrations experience traditionally low stock market prices—everyone is selling and turning their imaginary paper into cash!
Capital gains taxes are essentially the free shipping of equities. They totally distort people’s behavior disproportionate to their impact on returns, most of all by discouraging normal (retail) investors from selling when their gut tells them to, and then they bear most of the losses. Obviously a more equitable scheme would make capital gains taxes progressive instead of time based.
Just to make it clear about the article, if you made ETFs pay the taxes we’d get even more correlation and asset inflation. The best example of that is the cryptocurrency market.
People shouldn’t really care about the difference between 15 versus 25 percentage point taxes if they feel they’re timing the market right. But if you look at a chart of redemptions and CG taxes (check Wikipedia), it turns out a 5-9 percentage point decrease occurs around 9-40x increases in redemptions during the low tax period. This is basically why you observe Republican (i.e. low tax) administrations experience traditionally low stock market prices—everyone is selling and turning their imaginary paper into cash!
Capital gains taxes are essentially the free shipping of equities. They totally distort people’s behavior disproportionate to their impact on returns, most of all by discouraging normal (retail) investors from selling when their gut tells them to, and then they bear most of the losses. Obviously a more equitable scheme would make capital gains taxes progressive instead of time based.
Just to make it clear about the article, if you made ETFs pay the taxes we’d get even more correlation and asset inflation. The best example of that is the cryptocurrency market.
To address the timing problem, one could make capital-gains taxes time-independent, or smoothly-varying with time.
Making capital-gains taxes progressive would address an entirely different set of concerns, and applies a different set of forces onto the market.
Making capital-gains taxes progressive would address an entirely different set of concerns, and applies a different set of forces onto the market.
Cap gains are taxed in progressive brackets on an annual basis.
When all is said and done, this ends up seeming like pretty much the exact same treatment that "like-kind exchange" gives to Real Estate. In both cases you're allowed to swap an asset without capital gains at the swap time (but your basis stays at the low old price, so you eventually will).
I'm not sure how much I like these rules, but either they're both "dodges" or neither is.
I'm not sure how much I like these rules, but either they're both "dodges" or neither is.
But don't investors eventually pay the tax when they sell the ETF?
Yes, but meanwhile the deferred taxes compound. The question is wether rebalancing an ETF should trigger taxes or not.
How would ETFs (and passive investment systems in general) work without this trick? If there were no tax free way to do rebalancing, how could you really track the exchange?
Mutual funds do this by distributing capital gains to investors annually. Yes, that would be one reason they might lag the index.
If ETFs are able to dodge taxes that mutual funds cannot, why do people still invest in mutual funds? Different risks?
One disadvantage of an ETF is that you have to pay a brokerage commission each time you trade it. Many mutual funds have no fees for buying/selling shares. If you have a savings strategy like automatically investing a percentage of every paycheck, the commissions on ETF trades could add up quickly.
Brokerage commissions are $0 for Vanguard ETFs in a Vanguard brokerage or Fidelity ETFs in a Fidelity brokerage, etc. This isn't a real downside unless you want to trade ETFs in a brokerage account unaffiliated with the ETF.
ETFs only trade interday; mutual funds only trade end of day. It can be more convenient to automatically invest some portion of your pay in a mutual fund than an ETF. (Also, Vanguard mutual funds are shares classes of their ETFs, so they have the same tax benefit ETFs do here.)
You can buy fractional shares of mutual funds.
Vanguard only lets you auto-invest on a schedule into mutual funds.
Mutual funds trade once a day, at the end of the day, for the intra-day-valume-based average cost so you are not timing the hour.
I'm willing to join in the outrage at Wall Street (a|im)morality but this one doesn't particular bother me. Let me explain why.
So imagine an S&P 500 ETF went from a $10B valuation to $15B in 5 years. Lots of transactions took place as the index gets rebalanced. Companies leave the index. Others take their place. No tax is paid by the fund. You're tempted to be outraged. Let's say that the offset tax amounts to $1B for simplicity.
But consider: someone invested $10k in that fund and held for 5 years. They sell and owe taxes on $5k.
If the ETF had been paying taxes that $15B would be $14B and the seller would owe taxes on $4k instead of $5k.
In Australia, when you hold a company and it, say, pays dividends. It typically pays corporate taxes on that. As a stockholder you not only receive that dividend but you receive a credit for taxes paid (called "franking credits"). If the dividend is fully franked (meaning the full corporate tax rate was paid) then you might receive a $700 dividend and $300 (30% of the gross $1000 dividend) in franking credits. When you do your taxes, if your tax rate is higher than 30% you pay the difference. If it's less you'll get a refund.
This is to avoid double taxation, basically. In the US, you don't have this. Earn income through a company, it pays taxes, it pays a dividend and you pay taxes again. This was the whole reason for the (misguided) passthrough entity tax break with the Trump tax cuts. It would be a lot easier if US dividends were just taxed at source and they came with a tax credit that could be applied to, say, US tax liabilities.
So, you can view heartbeat trades as simply a way of avoiding double taxation. It's at least debatable. After all, if you invest in a company you only pay taxes when you sell on the gain (dividends notwithstanding) so this is really just treating ETFs the same way.
So imagine an S&P 500 ETF went from a $10B valuation to $15B in 5 years. Lots of transactions took place as the index gets rebalanced. Companies leave the index. Others take their place. No tax is paid by the fund. You're tempted to be outraged. Let's say that the offset tax amounts to $1B for simplicity.
But consider: someone invested $10k in that fund and held for 5 years. They sell and owe taxes on $5k.
If the ETF had been paying taxes that $15B would be $14B and the seller would owe taxes on $4k instead of $5k.
In Australia, when you hold a company and it, say, pays dividends. It typically pays corporate taxes on that. As a stockholder you not only receive that dividend but you receive a credit for taxes paid (called "franking credits"). If the dividend is fully franked (meaning the full corporate tax rate was paid) then you might receive a $700 dividend and $300 (30% of the gross $1000 dividend) in franking credits. When you do your taxes, if your tax rate is higher than 30% you pay the difference. If it's less you'll get a refund.
This is to avoid double taxation, basically. In the US, you don't have this. Earn income through a company, it pays taxes, it pays a dividend and you pay taxes again. This was the whole reason for the (misguided) passthrough entity tax break with the Trump tax cuts. It would be a lot easier if US dividends were just taxed at source and they came with a tax credit that could be applied to, say, US tax liabilities.
So, you can view heartbeat trades as simply a way of avoiding double taxation. It's at least debatable. After all, if you invest in a company you only pay taxes when you sell on the gain (dividends notwithstanding) so this is really just treating ETFs the same way.
It's only double taxation if you arbitrarily consider the transfer of the dividend from the company to yourself to be a non taxable event. Until that point the money isn't "yours" in the full normal sense. If I buy 1% of Exxon I don't have the legal right to extract 1% of its income.
Another argument for "double" taxation : corporations are artificial entities created by law with significant privileges, such as shielding owners from direct liability in most cases. That's a privilege society extends and it is arguable reasonable that it is subject to a different tax regime than capital which is owned directly by the individual.
Another argument for "double" taxation : corporations are artificial entities created by law with significant privileges, such as shielding owners from direct liability in most cases. That's a privilege society extends and it is arguable reasonable that it is subject to a different tax regime than capital which is owned directly by the individual.
Heatbeats don't avoid double taxation.
They just defer capital gains incurred by fund turnover in an ETF.
They just defer capital gains incurred by fund turnover in an ETF.
That's brilliant. Love the visualization as well.
should be... "One of Wall Street's Dirty Little Secrets"
note: title was changed from its original posting of "ETF Tax Dodge is Wall Street's Dirty Little Secret"
note: title was changed from its original posting of "ETF Tax Dodge is Wall Street's Dirty Little Secret"
mruts(2)
> On the other hand I am not convinced that one should look at the transaction in isolation here. My view of the situation is not only that “an ETF is a mutual fund that doesn’t pay taxes,” but also that everyone accepts that. There just seems to be broad agreement among investors and regulators and policymakers that an ETF is supposed to be tax-efficient, that ETF investors get to defer capital gains until they sell their shares. (Again: This is a very widely advertised benefit of ETFs. 7 ) Some ETFs ran into a bit of a technical problem that might have required them to pay taxes, and so they developed a very technical solution that fixed it. The fact that the solution is a little shammy-looking would be a problem if everyone expected them to pay the taxes, but since people don’t expect that, any old solution will do.
[1] https://www.bloomberg.com/opinion/articles/2019-03-29/deals-...