The University of Chicago Business Law Review
The much-touted tax efficiency of equity exchange traded funds (ETFs) has historically been built upon portfolios that track indices with low turnover and the tax exemption for in-kind distributions of appreciated property.
This rule permits ETFs to distribute appreciated shares tax-free to redeeming authorized participants (APs) and reduce a fund’s future capital gains. ETFs and APs, working together, exploit this rule in so-called heartbeat trades in which an ETF distributes shares of a specific company or companies to a redeeming AP, instead of a pro rata basket of the ETF’s portfolio. The distributed securities are appreciated shares of companies that are on the verge of being acquired in a taxable transaction or that are slated to be removed from the index tracked by the ETF. In the absence of heartbeat trades, the ETF would recognize gain from the sale of the shares.
Through everyday redemptions and heartbeat trades, equity ETFs are able to make tax-free portfolio adjustments and avoid generating capital gains until their shareholders sell their shares. The quasi-consumption tax treatment of ETFs is unwarranted and gives ETFs an unfair tax advantage over mutual funds, publicly traded partnerships, and direct investments by investors. Although these redemptions could be treated as taxable exchanges between the ETF and an AP under substance-over-form principles, given the vagaries of the tax common law, Congress should simply eliminate the exemption for in-kind redemptions. Congress could alternatively limit the exemption to redemptions consisting of a pro rata portion of an ETF’s portfolio. Either alternative would limit tax-free portfolio adjustments and better align the taxable and economic gains of ETF shareholders.
Colon, Jeffrey M.
"Unplugging Heartbeat Trades and Reforming the Taxation of ETFs,"
The University of Chicago Business Law Review: Vol. 2:
1, Article 2.
Available at: https://chicagounbound.uchicago.edu/ucblr/vol2/iss1/2