Definitive Guide To MLP ETFs And ETNs

April 04, 2013


When a return-of-capital distribution is issued to an MLP ETF, the entire amount can theoretically be passed on to shareholders of the ETF. The individual investor’s cost basis in the ETF drops by the amount of that distribution. With a long enough time horizon, the cost basis will eventually drop to zero. When that happens, any future distributions from the ETF will have to be treated as current-year capital gains distributions. While better than being treated as ordinary income—as is the case with the ETN—it still represents an increase in current-year taxes from tax-deferred return-of-capital distributions.

How early the cost basis in the ETF is exhausted is dependent on the amount of the distribution yield; the percent of distributions labeled return of capital; and the yearly MLP return performance.

To show how quickly this can occur, we built the following table assuming distributions to be 85% return of capital:

It is not far-fetched to assume that cost basis will be exhausted within 20 years. A bigger risk to short-term holders could be the possibility of the ETF/corporation’s cost basis in the MLPs running to zero. The onus is on the fund manager to prevent low-cost-basis MLPs from reaching that point and incurring internal capital gains taxes.

The good news is the portfolio manager does have some control over this. The fund, like most ETFs, reserves the right to execute creations and redemptions either in cash or in-kind. The standard procedure is in-kind, but the fund manager reserves the right to execute redemption in cash to the extent that it will help her effectively manage his tax liability. Otherwise, both the fund and investors will be paying capital gains taxes on distributions that are normally distributed as return of capital.





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