US Treasury Flags Concern Over Wall Street Tax Strategies

The US Treasury Department has expressed concern over a number of high-profile tax strategies promoted by Wall Street, warning that some may be "too good to be true."

Speaking at an industry gathering in New York on Tuesday (Jul 21) morning, officials stated that the department considers certain products potentially abusive and is actively evaluating the tools available to address them. However, they stopped short of announcing new guidelines, instead stating they "expect a serious dialogue with the market before positions harden" and investors are placed at greater risk.

Strategies Under Scrutiny

The strategies being examined include:

• 351 conversions – converting a portfolio of assets into an ETF to rebalance without realizing a capital gain
• Box-spread exchange-traded funds
• Products that offset ordinary income
• Funds that avoid dividend income by flipping between other ETFs

Treasury Officials' Remarks

Speaking at a Wall Street Tax Association seminar, Kevin Salinger, deputy assistant secretary for tax policy at the Treasury, and Erika Nijenhuis, senior counsel, said the department has no wish to over-engineer rules but cannot ignore a market developing around transactions with results Congress did not appear to intend.

"We're not here to be over-broad or disruptive, but we are also not prepared to turn the blind eye to aggressive planning," Salinger said. "We do not want to act in a way that rewards taxpayers or promoters who have crossed lines that should not be crossed and disadvantages taxpayers who have stayed within the lines."

Context and Market Impact

The comments come amid a boom in transactions and products that help wealthy American investors reduce or delay the taxes they owe. Known as tax alpha strategies, these largely deploy financial engineering to take advantage of various rules in the US tax code, primarily focused on capital gains, though some specialized products have managed to offset regular income.

Funds Generating Ordinary Losses

Funds that generate ordinary losses are among the more controversial in the tax-aware industry, as they aim to wipe out income subject to the highest tax rates, including wages. A notable example is the AQR TA Delphi Plus Fund, which had US$6.6 billion as at Jun 30 and last year recorded ordinary losses equal to 28% of capital invested, according to documents seen by Bloomberg News.

"We have seen pitch decks where they advertise that if you invest a million dollars, you may get a US$300,000 ordinary loss," Salinger said, without naming any products or money managers. "I would advise investors to be cautious when something looks too good to be true, because it probably is."

Affiliated Managers Group, which owns a stake in AQR Capital Management, dropped as much as 6% in early afternoon trading.

Specific Concerns Raised

Notional Principal Contracts (NPCs)

Delphi Plus generates losses by taking advantage of tax rules for notional principal contracts (NPCs), the legal term for swaps. In a swap, payments are ordinary in nature, meaning ordinary losses arise when an investor must pay their counterparty for a losing bet. However, when a position is terminated early, it can be booked as either a capital gain or loss.

The two Treasury officials raised concerns over how NPCs can be used to selectively create ordinary losses and capital gains for similar economic transactions. They also discussed other methods giving rise to ordinary deductions, including:

• Identified straddles
• A rule allowing a trader to elect whether a foreign-currency derivative position receives ordinary or capital treatment

ETF Rebalancing Mechanisms

Salinger and Nijenhuis covered various ways the rebalancing mechanism of ETFs—which enables them to offload appreciated assets without incurring capital gains—can be used to avoid taxes. While such in-kind transactions alone are not a problem, they can be combined with other steps to produce results "inconsistent with what Congress intended," Salinger said.

He specifically mentioned:

• 351 conversions where the redemption mechanism is used to dispose of appreciated securities, which are then replaced with positions fitting the product's intended strategy
• Deals where stocks are first contributed to an exchange fund, which then conducts the ETF conversion

Potential Designation as "Transactions of Interest"

When asked about possibly labeling 351 exchanges as "transactions of interest"—a designation for deals with tax-avoidance potential requiring additional disclosure—Salinger said "all the tools are under consideration for all of the transactions that we're going to talk about today."

Other ETF Strategies

The officials also discussed:

• ETFs that trade in and out of other ETFs to avoid dividend distributions
• Box-spread ETFs – the largest being the US$13 billion Alpha Architect 1-3 Month Box ETF, which uses option trades to generate returns similar to Treasury bills, taxed as capital gains on the ETF rather than interest income

Personnel Note

Salinger will be acting assistant secretary for tax policy at the Treasury as well as acting Internal Revenue Service chief counsel after the departure of Kenneth Kies, Bloomberg Tax reported on Tuesday, citing a Treasury e-mail.

Source: Bloomberg