Exchange-Traded Fund (ETF) Transactions Come under IRS Scrutiny; Diversification Transactions Require Review

At a Glance

• Both the Notice and the Ruling focus on ETF uses of nontaxable transfers to ETFs followed by nontaxable in-kind redemptions.
• The Notice also calls out certain other ETF uses of in-kind redemptions that it labels as “atypical usage” of in-kind redemptions.
• The Notice and the Ruling call into question “diversification transactions,” which have been used to diversify one or more concentrated holdings in a tax efficient manner.

The Treasury Department and the Internal Revenue Service have issued Notice 2026-62, which identifies several investment fund strategies that they view as producing tax results that may be inconsistent with the purpose and proper application of the relevant federal tax rules and describes as "not the result of conventional, long-established tax planning that is consistent with the intent of Congress." Concurrently, they issued Revenue Ruling 2026-20, which addresses the federal tax characterization of one of the transactions described in the Notice. The Notice focuses on strategies employed by some exchange-traded funds (ETFs) that rely on what the government calls "atypical usage" of Internal Revenue Code (the Code) section 852(b)(6) to achieve a tax result not intended under the Code.

Although ordinarily, under section 311(b) of the Code, a corporation that distributes appreciated property generally must recognize gain, Code section 852(b)(6) allows a regulated investment company (RIC) to make an in-kind distribution without recognizing gain "if such distribution is in redemption of its stock upon the demand of the shareholder." A number of ETFs engage in frequent creation and redemption transactions and take the position that the distributions of securities in the redemption transactions are nonrecognition events. The Notice does not express a view regarding general use of in-kind redemptions by ETFs other than the specific situations it describes as potentially abusive.

Combining 351 and 852(b)(6)

The first strategy addressed by the Notice, which the IRS calls a "section 351 conversion transaction," involves in-kind contributions to a newly formed ETF in a nonrecognition transaction under section 351 of the Code.¹ These ETF-seeding transactions are addressed in both the Notice and the Revenue Ruling. In these transactions, investors contribute appreciated diversified portfolios to a newly formed ETF, even though some or all of the contributed securities do not fit the ETF's intended portfolio or investment thesis, or the contributed portfolio is overconcentrated in certain positions. As part of the same plan, the ETF issues creation units to an authorized participant for securities consistent with its investment thesis (or cash), then redeems those units under section 852(b)(6) with the securities the investors contributed that are unwanted. The investors avoid recognizing built-in gain while effectively exchanging their securities for an interest in an ETF with a materially different portfolio, using Code sections 351 and 852(b)(6) "as part of a plan to achieve a result that neither provision was designed to produce."

Rev. Rul. 2026-20 specifically addresses this transaction. The Ruling's facts involve a single investor, but the Notice says that the same reasoning applies for section 351 transactions involving multiple investors. Citing "step-transaction" and "substance-over-form" authorities, the Ruling concludes that the ETF "was merely a conduit through which securities transferred from Investor to AP pursuant to the plan." The Ruling recharacterizes the transactions as a taxable exchange under section 1001 of the contributed securities between the investor and the authorized participant.

The Ruling and the Notice purport to rely on existing "step transaction" and "economic substance" doctrines to address transactions that, pursuant to a single plan, combine two nonrecognition provisions of the Code to achieve a result that, if done directly, would require gain recognition. The Notice "does not address, and expresses no view regarding," transactions in which a section 351 transaction is used to seed a newly established ETF with assets that are consistent with the ETF's investment thesis and that are intended and expected to be retained by the ETF absent a substantial change in circumstances, such as an unexpected change in market or business conditions. ETFs that must unexpectedly adjust their portfolio holdings after an in-kind seeding should carefully document the changes in market or business conditions prompting that investment change.

Addition of Partnership Exchange Fund

The Notice next describes a variation of the first strategy aimed at investors whose appreciated holdings are not diversified enough to avoid gain recognition under section 351(e). Investors instead contribute concentrated appreciated positions to a partnership referred to as an "exchange fund." Under section 721 of the Code, contributions of property to a partnership are nonrecognition transactions, subject to the same investment company limitations that apply to corporations under section 351(e) of the Code. To avoid classification as an investment company, however, the partnership invests at least 20% of its assets in property other than cash, stocks, or securities. The partnership then contributes its assets into an ETF in a transaction that purportedly qualifies for nonrecognition under section 351. As with the first strategy, the ETF subsequently makes an in-kind redemption of an authorized participant that it treats as nontaxable under section 852(b)(6).

Box Spread Strategies

The third strategy involves "box spread" ETFs, which seek a stable, short-term-interest-rate-like return without current income recognition. A box spread combines four options² on the same underlying property that together produce a return similar to a short-term interest rate. Before the options with unrealized gain expire, the ETF issues a creation unit to an authorized participant and then distributes the appreciated options in redemption under section 852(b)(6). The ETF generally reports no dividends or capital gain dividends, so shareholders include nothing currently. Instead, they will ultimately recognize long-term capital gain when they sell ETF shares after holding them for more than twelve months. That gain generally corresponds to the ETF's box spread income. The Notice also describes a variation in which the ETF distributes the appreciated legs of a separate straddle and deducts the loss on the remaining straddle positions, even though the offsetting gain is never recognized.

Record Date or Rotational ETF Redemptions

The fourth strategy involves what the government calls "record date" transactions in fund-of-funds structures. A parent ETF that tracks an index through one or more acquired ETFs tracking the same index issues a creation unit shortly before an acquired ETF's dividend record date. It then distributes the acquired ETF shares to the authorized participant in redemption, replacing them with shares of a different ETF that tracks the same index but uses a different record date for distribution. The parent ETF takes the position that it avoids dividend income, and its shareholders defer any recognition until they dispose of their shares, even though the parent ETF's exposure to the index does not materially change. The government describes the purpose as eliminating "taxable dividend income without any material change to the economic characteristics of the assets of the parent ETF."

Using 852(b)(6) to Avoid Non-Qualifying Income

The fifth strategy involves the use of section 852(b)(6) to avoid the RIC qualifying income test. Under section 851(b)(2), at least 90% of a RIC's gross income must come from dividends, interest, securities loan payments, gains from stock, securities, or foreign currencies, other income derived from its business of investing in those assets, and net income from qualified publicly traded partnerships. The Notice describes ETFs that hold assets such as commodities or digital assets, either directly or through a grantor trust, the sale of which would produce nonqualifying gain. These ETFs distribute the appreciated assets in redemption of creation units and take the position that gain realized but not recognized because of section 852(b)(6) does not count for purposes of the income test. The government's concern is that this lets an ETF limit the gross income subject to section 851(b)(2) "without regard to the ETF's economic income."

Takeaways

1. The Ruling and Notice alert ETFs and investors to the Treasury Department and IRS's views that the foregoing transactions are abusive uses of in-kind redemptions. The Treasury Department and the IRS are considering further guidance, which may include regulations, notices, revenue rulings, and the potential identification of transactions as transactions of interest or listed transactions. Section 351 transactions involving investment companies are also included on the IRS's 2026-2027 priority guidance plan. Such guidance may apply retroactively. Further, the IRS may challenge these strategies on examination under existing law, including the Code, the regulations, and applicable judicial doctrines.
2. Any completed or planned in-kind contribution to a new ETF that was followed, or is expected to be followed, by a redemption distribution of the contributed securities should be reviewed in light of the Notice and Ruling. Investors participating in an in-kind seeding of an ETF that is expected to qualify as a nonrecognition transaction should exercise due diligence with respect to the ETF sponsor's intentions with respect to the contributed assets. Because the Ruling recharacterizes the investor's contribution as a taxable exchange on the basis of subsequent actions that are out of the investor's control, investors will want to seek appropriate assurances regarding the expected retention of contributed assets by the ETF.
3. Sponsors of ETFs using box spread strategies and in-kind redemptions, using in-kind redemptions to rotate out of underlying ETFs in order to avoid dividends, and commodity or digital asset ETFs that rely on in-kind redemptions to avoid nonqualifying income should also expect scrutiny.

Other Strategies Identified in the Notice

The Notice also addresses certain tax aware transactions that are not commonly used by ETFs and use identified straddles and other derivatives strategies to convert income character. We discuss the derivative strategies in "Treasury and IRS Flag Certain "Tax-Aware" Fund Strategies as Problematic."