Mutual funds sometimes merge or choose to reorganize. There is a long history of those reorganizations being treated as a tax-free exchange, if structured properly and the appropriate actions are taken during the transaction.

Frank "Kip" Meadows
Nottingham Fund Administrators
Founder, CEO

Over the last decade especially, exchange traded funds ("ETFs") have continued to increase in popularity, but actively managed ETFs still have not yet taken off. That is expected to change now that several non-transparent and semi-transparent ETF structures have been approved by the SEC.

Actively managed strategies can be tax inefficient as realized capital gains have to be distributed and are taxable to shareholders, where ETFs have a structural tax efficiency that can help avoid that issue. ETFs also are quite popular, especially among younger generations, as ETFs can be traded throughout the business day, where traditional mutual funds can only be bought or sold at the market close.

These attractive attributes for ETFs have many actively managed open-end mutual fund advisors thinking about the possibility of converting their mutual fund to an ETF.

There has been a great deal of discussion among fund industry professionals on the possibility of existing open-end mutual funds merging or reorganizing into ETFs as a tax-free exchange. The issue is whether the existing fund must treat its conversion into the new structure as a liquidation of its portfolio, realizing all capital gains in the portfolio. If the structures are deemed substantially the same, and the portfolio composition in the new fund entity is the same as prior to the conversion, the tax issues are met for a tax-free exchange.

Most investment company tax experts believe the similarity of structure test can be met. Both open-end mutual funds and ETFs are governed by the Investment Company Act of 1940 and are subject to the same tax treatment. A proper reorganization would require that the portfolios be substantially similar both before and after the reorganization.

The tricky issue is one of logistics. While mutual funds and ETFs are very similar in structure, there is a fundamental difference in how they are held by shareholders that can present an issue.

Mutual funds can be purchased and held through an investment account with a broker-dealer. Mutual fund shares can also be held either directly with the mutual fund transfer agent, or held on a platform for retirement plan administration, for instance. ETFs are traded on a stock exchange, and therefore must be purchased through and held by a broker-dealer.

Because mutual funds can be acquired and held without using a broker-dealer, there are likely shareholders in a mutual fund who do not have an investment account with a broker-dealer. So how can those shareholders receive their ETF shares in a reorganization?

There will need to be some creativity to solve this issue. One potential option is to partner with a broker-dealer interested in adding new clients, and to hold the new ETF shares in an omnibus account at that broker dealer, establishing new accounts for those shareholders that do not have a broker-dealer investment account. A registered transfer agent likely can be a valuable participant in such an arrangement, as the transfer agent can allocate shares among the shareholders.

Kip Meadows is the founder and CEO of Nottingham, a fund administration firm and white-label ETF issuer based in Rocky Mount, North Carolina.

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