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TAX CLINIC

One or more intermediaries, referred SEC under the Act and meet certain
Special Industries to as authorized participants, seed the diversification, income, and distribution
fund with cash and/or stocks in ex- requirements — are taxed as regulated
Mutual fund-to-ETF change for the fund shares and then list investment companies (RICs) under
conversion: Tax implications those shares on a secondary market to Subchapter M of the Internal Revenue
“Mutual fund” is the common term be bought and sold by the prospective Code. Under these rules, they are
for an investment vehicle that pools fund shareholders. not subject to entity-level tax if they
money from multiple investors and A traditional mutual fund can be distribute their net income and capital
invests in various assets such as stocks converted to an ETF. The present gains via dividends to their sharehold-
and bonds. Most traditional mutual discussion focuses on the tax implica- ers. Shareholders with nonqualified
funds, commonly referred to as “open tions of doing so. A conversion may taxable accounts ultimately bear the
ended” funds, issue shares directly to be appealing because of the greater tax tax burden.
shareholders and redeem them at the efficiency of ETFs (discussed below), ETFs are often more tax-efficient
demand of the shareholder at the fund’s lower expense ratios, and the fact that than traditional mutual funds, however.
net asset value (NAV). Mutual funds a conversion utilizes the scale and per- In the case of a mutual fund, besides
register with the SEC under the Invest- formance of an existing fund. Mutual the trading that occurs in the normal
ment Company Act of 1940 (the Act). funds’ appetite for converting was fur- course of business, other transactions at
While an exchange-traded fund ther enhanced by the SEC’s approving the fund level can result in an increased
(ETF) is similar to a traditional mutual Rule 6c-11 in 2019, which reduced the tax burden for the shareholders. For
fund in that it pools money into a time and cost of launching an ETF. instance, a portfolio rebalance and/or
fund to invest in various assets and can change in investment strategy can result
register with the SEC under the Act, it Tax efficiency of ETFs in the fund’s recognizing substantial
differs in that its shares are traded on a Both traditional mutual funds and gains. Large redemptions can also
secondary market as opposed to directly ETFs that are domestic corpora- cause a mutual fund to recognize gains
between the shareholders and the fund. tions — if they are registered with the because it may need to sell securities

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16 September 2022 The Tax Adviser