The Investment Company Institute, the trade association representing more than $45 trillion in assets across mutual funds, ETFs, and other fund structures, has filed a comment letter with the United States Treasury Department requesting formal guidance on so-called Section 351 ETF conversions, a fast-growing tax planning strategy that allows investors to contribute appreciated securities to an exchange-traded fund without immediately recognizing capital gains. The request for guidance comes at a moment of regulatory uncertainty, as Treasury has been actively assessing the practice and has internally discussed a range of potential responses, including the possibility of curtailing the strategy or designating certain conversions as transactions of interest subject to heightened IRS scrutiny.
A Section 351 conversion allows an investor holding a concentrated stock position or a broader portfolio of appreciated securities to contribute those assets to an ETF in exchange for shares of the fund, without triggering the capital gains tax that would ordinarily apply to a sale of those securities. Once inside the ETF structure, the fund can use the exchange-traded fund industry’s well-established in-kind redemption mechanism, which allows ETFs to distribute appreciated securities to authorized participants in exchange for ETF shares without generating a taxable gain at the fund level, to gradually swap out the contributed securities for different holdings. The practical result is that an investor can rebalance a portfolio of highly appreciated assets and effectively reset its composition over time without ever paying tax on the built-in gains at the time of the initial conversion.
Treasury’s internal deliberations reflect the tension between the strategy’s legitimate uses and its potential for abuse. The ICI has met with Treasury officials on at least two occasions to discuss the practice, and those discussions have included consideration of whether certain conversions should be designated as transactions of interest. Transaction of interest is a formal designation that signals the IRS and Treasury view a transaction as having tax-avoidance potential and that triggers enhanced disclosure and reporting requirements for participants. While that designation remains a possibility, the ICI has advocated against a broad-based curtailment of the practice, emphasizing that Section 351 conversions serve genuine non-tax purposes, including portfolio diversification, access to the operational and cost efficiencies of the ETF structure, and competitive fee arrangements that benefit investors.
The regulatory risk associated with seeking formal guidance is one that the industry is navigating carefully. Submitting a comment letter and requesting clarity creates a formal record and invites a response that could take a less favorable form than the current ambiguity. However, the absence of clear rules has created operational uncertainty for fund managers who are offering or considering offering Section 351 conversion vehicles. Treasury has not indicated a timeline for action, and it remains possible that no formal guidance will be issued in the near term. For more information about this update, contact Liskow attorneys Leon Rittenberg III, Caroline Lafourcade, and Kevin Naccari, and visit Liskow’s Tax Practice page.