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:
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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.

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And their response:
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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.


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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.

[Jeff W]

They didn't answer the question.

[Sniper]

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They didn't answer the question.

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Yes they did, they basically said it would not create a taxable event to the fund...

[spider]

Yeah, I don't know if they answered it or not, but it's not as clear as I hoped it would be. I knew it was going to be sort of general and legalistic like this (I mean, I'm giving them a hypothetical) but I was hoping to be able to decipher it and I really can't though they do seem to sort of suggest there might not be serious tax consequences.

I'm still waiting to hear back on my followup. I guess I'll just give a call on Monday if they haven't replied by then. Or maybe see if Vanguard can give any better answer.

[Jeff W]

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They didn't answer the question.

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Yes they did, they basically said it would not create a taxable event to the fund...

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I do not think that is clear from the e-mail.

[spider]

Finally they got back to me.

My followup question:
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Is this basically suggesting that if MSCI dropped Taiwan and/or South
Korea, then the market makers would effectively make an in-kind exchange
of a basket of stocks including Taiwan/SK for a basket of stocks NOT
including Taiwan/SK, and this would NOT trigger a tax event for the
market maker equivalent to selling Taiwan/SK and buying something else?

I don't know if this is a helpful analogy, but is this the same idea as
a 1031 exchange for U.S. real estate? (Where the investor doesn't have
to pay a tax on the gains if he/she reinvests the gains in a comparable
property.)

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Their response:
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Basically when there is an “in-kind” transfer it does not affect the shareholders of the iShares funds. Therefore, if MSCI dropped Taiwan and/or South Korea any “in-kind” transfer associate with Taiwan and/or South Korea would not affect the shareholders of the iShares funds. The fund would have replaced the holdings of Taiwan and/or South Korea with other emerging markets funds with no effect to the shareholders of the iShares funds.

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[spider]

Also, in terms of a precedent, it appears that from 1993 to 2000, SPY did not report capital gains expept in one instance which was allegedly a mistake of some sort. And there would have been multiple changes in the S&P 500 over those years. I'm having trouble locating the link. Will post it later if I find it.

[Jeff W]

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Also, in terms of a precedent, it appears that from 1993 to 2000, SPY did not report capital gains expept in one instance which was allegedly a mistake of some sort. And there would have been multiple changes in the S&P 500 over those years. I'm having trouble locating the link.

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This is normal. ETFs can minimize or eliminate capital gains by efficient tax management. The turnover in the S&P 500 is a different beast from liquidating 27% of an ETF's holdings.

I still am not convinced by those e-mails that splitting Korea/Taiwan won't create a taxable event. They never directly answered the question. Also, Vanguard Emerging Markets has less flexibility because the ETF is a share class of the mutual fund. I wouldn't want to own EEM because of the egregious 0.75% ER.

[spider]

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I still am not convinced by those e-mails that splitting Korea/Taiwan won't create a taxable event. They never directly answered the question.

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Seemed pretty direct to me. I'm not going to tell you to believe the answer, but they answered it as clearly or better than I expected.

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Also, Vanguard Emerging Markets has less flexibility because the ETF is a share class of the mutual fund. I wouldn't want to own EEM because of the egregious 0.75% ER.

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Yeah, I wish I understood the implications of VWO being part of a mutual fund better than I do. I agree EEM's expense ratio sucks, but I think this will eventually fall. EEM is just too dominant/popular right now.

OTOH, if EEM's structure actually gives it a significant tax advantage over VWO in the event of a Taiwan/Korea index change, EEM could still come out ahead. I'm not suggesting this is necessarily true, just sayin...

[Jeff W]

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I still am not convinced by those e-mails that splitting Korea/Taiwan won't create a taxable event. They never directly answered the question.

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Seemed pretty direct to me. I'm not going to tell you to believe the answer, but they answered it as clearly or better than I expected.

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Direct to me would be "We will not distribute capital gains from the sale of S. Korea and Taiwan shares if they are removed from the index."