Tax implications for ETFs when underlying index changes

[spider]

In a different thread , Jeff W suggested that if MSCI were to drop Taiwan or South Korea from the MSCI emerging markets, this could trigger undesirable capital gains taxes for ETFs based on the index. He suggested emailing Vanguard which runs the VWO fund. I couldn't find the email easily so I emailed Barclays which has the iShares ETF EEM (and they have gotten back to me quickly in the past).

My email to them:
[ QUOTE ]
Hello, I am a holder of the iShares Emerging Markets ETF (EEM) and recently became concerned about possible tax issues down the road. Specifically, I have heard that if MSCI drops Taiwan and/or South Korea from their emerging markets index, then iShares would sell shares of Taiwan and South Korean companies, triggering capital gains taxes for investors holding EEM in taxable accounts.

I realize, of course, that you can't say anything definitive about this, but I am wondering if you can give me any basic guidance as to how iShares would react (as far as EEM is concerned) in the event that MSCI were to drop Taiwan and/or South Korea from the emerging markets index.

[/ QUOTE ]

And their response:
[ QUOTE ]
If the iShares Emerging Market funds would drop Taiwan and/or South Korea from the fund, Barlcays Global Investors would drop the underlying securities associated with those two countries in a process called creation/redemption.

The most important thing to understand about buying and selling iShares Funds is that, you, as an individual investor, would purchase and sell iShares Funds just as you would a stock. Therefore, you would pay cash to purchase the security and you would receive cash when you sell the security. As far as the creation and redemption process is concerned, much of the potential confusion regarding the process often involves a misunderstanding of what these two words mean and their function in the context of iShares Funds.

Simply put, the creation process is the method by which the iShares Funds are created and thus made available to the public. Market makers and financial institutions, who must be a member of the Continuous Net Settlement System of the National Securities Clearing Corporation or a DTC Participant, act as "creators". When they want to create iShares Funds, these "creators" deposit a portfolio of stocks that closely resemble the holdings of the Fund and cash. In exchange for the stocks and cash, these "creators" receive large blocks of 50,000 iShares Funds (or multiples thereof), also known as a Creation Unit. Once created, these iShares Funds would be sold and traded on the secondary exchange to you the investor through a broker. With iShares Funds, the secondary exchanges are the American Stock Exchange, New York Stock Exchange, ArcaEx, or the Chicago Board Options Exchange.

The redemption process is the reverse of the creation process and is only applicable to those "creators" mentioned previously. Just as iShares Funds can only be created in Creation Units, they also can only be redeemed in Creation Units. These "creators" would provide the Fund with 50,000 iShares Funds (or multiples thereof, the Creation Unit) and the Fund would give them a portfolio of stocks and cash. In other words, they are receiving back what they originally deposited to the Fund. This is different than when you sell as an individual investor, as you are selling your iShares Funds through a broker and you receive cash.

In Addition, The "in-kind" nature of creation and redemption — ETF shares created and redeemed by APs in securities rather than cash — greatly reduces the market impact of transactions in the underlying ETF portfolio securities. Additionally, this "in-kind" transfer of securities minimizes the potential for taxable transactions.


[/ QUOTE ]

So, I am still not sure what the deal is, maybe this makes more sense to you guys. I knew about the basic creation/redemption thing but I apparently don't really understand the exact tax implications. Maybe I'm dense, but I sent a followup question and will post that when they answer.