Tax Benefits Go Through in ETF-of-ETFs Structure

The ’40 Act ETFs – structured as regulated investment companies – are taxed differently than ’33 Act funds, which themselves come in different flavors with different tax implications – grantor trust vs. commodity pool. (You can read the article in its entirety here.)

What may seem obvious, but it’s worth remembering, is that the tax treatment of these different ETF structures carries across to ETFs investing in other ETFs – a fund-of-funds structure. That’s especially significant if the ETF-of-ETFs you choose includes ’33 Act funds to access commodities/futures, currencies, and bitcoin.

There are quite a few ETF-of-ETFs in the market today that fit that bill. Funds like DWAT, RPAR, QAI, FIG, TRTY – all are fund of funds that allocate some of the portfolio to ’33 Act ETFs. Consider a fund like the Arrow DWA Tactical Macro ETF (DWAT) – a ’40 Act multi asset fund of funds that invests in other funds, including ’40 Act and ’33 Act ETFs. (Some of DWAT’s current underlying holdings funds such as DBE, XLE and DBO.)

Like all other ETFs, DWAT offers an extensive explanation of taxation in its prospectus, beginning on page 30. Here’s a short excerpt:

Taxes on Distributions: As stated above, dividends from net investment income, if any, ordinarily are declared and paid annually by the Arrow DWA Tactical: Macro ETF and Arrow Reverse Cap 500 ETF and declared and paid quarterly by the Arrow DWA Tactical: International ETF…
In general, your distributions are subject to federal income tax when they are paid, whether you take them in cash or reinvest them in a Fund. Dividends paid out of a Fund’s income and net short-term capital gains, if any, are taxable as ordinary income. Distributions of net long term capital gains, if any, in excess of net short-term capital losses are taxable as long-term capital gains, regardless of how long you have held the Shares …

You will find in the explanation direct mentions of capital gains, long-term vs short term rates, ordinary income – there’s plenty to digest, which is probably why it’s common to see ETF prospectuses suggest you seek advice from a professional tax expert.

But for the purposes of do-it-yourself homework, perhaps the most important point to remember when looking at a fund-of-funds ETF structure is that ’40 Act ETFs are pass through vehicles when it comes to taxes, to quote Elisabeth Kashner, director of ETF Research at Factset. They must pass through distributions/income and capital gains taxes to the end investor to avoid double taxation, and they must do that in the form it was created. (Here’s the formal Internal Revenue Service language this structure from a tax perspective).

“Pass through income must retain its original character,” Kashner says. “Any ordinary income that the fund earns must be distributed as ordinary income; any qualified dividends must be distributed as qualified dividends; and capital gains must be distributed as capital gains (ST or LT).”

• If the ETF of ETFs owns ’40 Act funds, those holdings will face the tax treatment ’40 Act ETFs receive: long-term capital gains taxed at 20% if you hold for more than 12 months (any shorter holding period than 12 months would be taxed as ordinary income), and any distributions made get taxed as ordinary income with the highest marginal rate sitting at 37%.
• If the ETF of ETFs owns ’33 Act funds structured as grantor trusts, those holdings would be taxed as collectibles, facing short term gains that are taxed as ordinary income, and long-term gains that are taxed at 28%. But the ETF of ETFs (itself a ’40 Act RIC) would not issue a grantor statement.
• If the ETF of ETFs owns ’33 Act funds structured as commodity pools (futures-based portfolios), those holdings would be required to mark-to-market income and face a blended 60/40 long-term/short-term tax rate: 28% for collectibles and 37% for ordinary income, respectively. But the ETF of ETFs (itself a ’40 Act RIC) would not issue a K-1.

“A fund of funds RIC uses tax information from the underlying ETFs in the portfolio to determine the character of the distributions that the RIC makes,” tax expert Jay Laurila, partner at Cohen & Company, says.

According to Laurila, the ETF of ETFs – structured as a RIC – must do the heavy lifting, calculate all of its distributions, determining their original character to see that they are appropriately taxed as dividend income, long-term/short-term capital gains, or return of capital, passing that through to investors.

If you consider that we’ve welcomed more than 420 new ETFs to the market in the past year, raising the number of total U.S.-listed ETFs to above 3,000, all the while assets continue to find their way into ETFs from veteran and first-timer investors alike, education around the ETF wrapper never stops.

When it comes to taxation in an ETF of ETFs structure, just remember that if you prefer to access a type of asset through a ’40 Act or through a ’33 Act wrapper for tax treatment reasons – metals, commodities, bitcoin all come to mind as prime examples – the implications of those choices would still hold true in a fund-of-funds. That’s what a pass-through vehicle is all about.

Disclosure

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Tidal is the Adviser to the RPAR Risk Parity ETF (RPAR) which is distributed by Foreside Fund Services, LLC.

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