A more recent White Paper is available: The Definitive Guide To 2015 ETF Taxation
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.