IRS threatens crackdown on array of Wall Street tax dodges

The U.S. Treasury Department took a big step toward curbing a Wall Street boom in investment strategies that help cut tax bills, with a notice signaling potential action on an array of tactics and a ruling that will limit the benefits of a popular ETF maneuver. 

The notice detailed a list of tax trades similar to those deemed "potentially abusive" and "too good to be true" by Treasury officials at an industry seminar in July. These include hedge-fund strategies that use swaps and currency derivatives to generate ordinary losses that can offset income tax — transactions which are at the heart of products such as AQR Capital Management's Delphi Plus fund. 

Also on the list were so-called box spread ETFs, which use options to turn interest income into capital gains. They have been popularized by young ETF issuer Alpha Architect and its $15 billion 1-3 Month Box ETF, ticker BOXX.

The government said it's considering issuing additional guidance or taking further action to address the trades described. Possible measures include labeling such strategies as "transactions of interest" — a designation for deals with tax-avoidance potential that would require additional disclosure. For now, the Treasury is requesting additional details. 

Separately, the Internal Revenue Service issued a revenue ruling about the treatment of so-called 351 conversions, which seed an ETF with appreciated assets before offloading them via in-kind redemptions to avoid incurring capital-gains tax. Where the ETF uses that mechanism to transform its portfolio into one that is "materially different" from the one it was seeded with, it may be "recharacterized in accordance with its substance." the IRS said. 

The notice and ruling represent a step-up in Treasury policing of Wall Street's "tax alpha" complex, a collection of products, strategies and trades that have evolved to help wealthy investors pay less to the government. Having mostly begun as tools for only the richest Americans, their barriers to entry have gradually fallen, leading to a huge boom in their use — and big profits for the issuers and money managers creating them. 

A growing group of traditional asset managers, hedge funds and wealth-management startups has built businesses around these techniques. AQR has amassed tens of billions of dollars in tax-aware long-short strategies, while firms including BlackRock Inc. and Vanguard Group have expanded personalized portfolios and separately managed accounts that can be used for tax-loss harvesting. 

ETFs have become particularly useful building blocks for the industry because assets enter and exit via a non-taxable transaction, making them extremely tax efficient. While several tax avoiding strategies have emerged in the market, the surge in the use of 351 conversions has been among the most eye-catching.

"Treasury is saying, 'We see you and we're going to start taking a closer look at this stuff,'" Brent Sullivan, who runs the popular Tax Alpha Insider blog, said of Monday's notice and ruling. "They are still trying to understand exactly what's happening in the industry. So it seems like the 351 post-transaction stuff is the most concrete and the rest of it is just like, 'Okay, we're still gathering information.'"

The Treasury notice, which didn't name any particular product or issuer, covered two main categories of these tactics. The first are ETFs that make use of the in-kind redemption mechanism — which has long allowed ETFs to avoid incurring capital-gains tax — to achieve tax benefits that are "inconsistent" with that mechanism's purpose.

"I don't think there is anything new or different on their box spread comments," said Wes Gray, CEO and founder of Alpha Architect. "This seems to just be a formal version of their conversation" at the July event, he said.

The other category includes tactics used by tax-optimized funds. In one, a hedge fund takes advantage of the fact that swaps — called notional principal contracts in tax-speak — can generate both ordinary and capital gains and losses, depending on when these contracts are terminated.

A spokesperson for AQR didn't immediately respond to a request for comment. Affiliated Managers Group, which owns a stake in AQR, dropped about 1.5% as of 3:37 p.m. in New York after the IRS news.