Investment Company Notebook

Practical insight and analysis on the accounting, audit and tax issues impacting investment companies.

Converting Separately Managed Accounts into Exchange Traded Funds: Tax Implications

As investors continue to search for new ways to drive alpha, lower costs and increase accessibility, there has been increased discussion across the investment management industry about converting separately managed accounts (“SMA”s) into exchange traded funds (“ETF”s).

The SMA to ETF conversion process requires thoughtful consideration concerning the tax implications of the transfer.

Generally, the Internal Revenue Code (the “Code”) allows for tax-free transfers to a corporation if certain hurdles are met. Generally, Code Section 351(a) provides that no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in the corporation and immediately after the exchange such person or persons are in control of the corporation. Control as provided in the Code under Section 368(c) contemplates the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation.


It seems simple enough. Unfortunately, Code Section 351(e) trumps the general nonrecognition rule of Code Section 351(a) when it concerns transfers of property to an “investment company.” Transfer to an investment company means either a transfer to a regulated investment company (“RIC”), a real estate investment trust (“REIT”) or a corporation more than 80% of the value of whose assets (excluding cash and nonconvertible debt) are held for investment and are readily marketable stocks or securities or interest in RICs or REITs. Thus, transfers to corporations qualifying as an “Investment Company” will require gain and loss recognition on the transfer of property when the transferor’s investment results, directly or indirectly, in diversification of their interest. See Regulation Section 1.351-1(c)(1).


Generally, the transfer of identical assets by two or more persons will not result in diversification, and thus no gain or loss will be recognized on the transfer. The situation is more complicated when there are transfers of non-identical property to an investment company. There is very little guidance provided by the taxing authorities. Generally, the regulations provide that a transfer ordinarily results in diversification of the transferor’s interest if two or more persons transfer nonidentical assets to a corporation. An exception to this general diversification rule exists in the regulations. Under Regulation Section 1.351-1(c)(6)(i), a transfer of stocks and securities will not be treated as resulting in a diversification of the transferor’s interest if each transferor transfers a diversified portfolio. A portfolio of stock and securities is considered diversified if it meets the 25% and 50% test provided in Code Section 368(a)(2)(F)(ii). Under this provision, a portfolio will be considered diversified if not more than 25% of the total assets is invested in in the securities of a single issuer and not more than 50% of the value of the portfolio is invested in five or fewer securities.  Therefore, if this standard is met, the transfers of diversified portfolios to a newly formed ETF will not result in gain or loss recognition on the transfer.


Beyond the diversification and ownership dynamics of the transfer, what other challenges may arise? From a mechanics perspective, shares of an ETF can only be issued/redeemed by an authorized participant (“AP”) (usually a broker). After the shares are issued to the AP, they then trade freely on an exchange. SMAs contributing in-kind to an ETF presumably would need to go through an authorized participant collectively, where the AP aggregates the underlying assets of the SMAs and contributes them in-kind to the ETF, delivering the ETF shares to the account holders afterward. Whether this conduit approach is acceptable is a question best left to legal counsel. Additionally, the contribution of securities in-kind from a separately managed account does not eliminate the potential capital gains tax on appreciated positions, but rather defers recognition into the future. The basis of the ETF shares received, in this situation, would be equal to the adjusted basis of the contributing account, and capital gains/losses would be realized upon the subsequent sale of these ETF shares.


In considering whether to embark on the process of converting separately managed accounts into a single pooled investment vehicle, such as an ETF, having discussions early with legal and tax advisors is the most prudent approach. For instance, certain managed accounts may desire to harvest built-in losses prior to this exchange, as Section 351 prevents the recognition of losses. Each fact pattern will be a little different from one group to the next. By considering all angles and circumstances throughout the process, the likelihood of missteps and unintended consequences is decreased.


As always, please reach out to us at BBD with any questions.