Tax Hot Topics
On Sept. 28, 2026, the Treasury Department and IRS issued Notice 2026-62 (PDF - 252.33KB) to identify certain investment fund strategies that they believe may produce tax results that are inconsistent with the purpose and proper application of the Internal Revenue Code. The notice was issued concurrently with Rev. Rul. 2026-20 (PDF - 124.92KB), which addresses one of the identified strategies.
The notice states that Treasury and the IRS are considering additional action, which could include regulations, revenue rulings, notices, or potentially identifying certain transactions as transactions of interest or listed transactions. The IRS requested comments by Oct. 28, 2026, to help inform their forthcoming guidance.
The notice focuses on two categories of strategies undertaken by exchange-traded funds (ETFs) or the funds): (i) strategies involving application of Section 852(b)(6) to produce results that are inconsistent with the purpose and proper application; and (ii) strategies used by tax-aware funds.
Grant Thornton insight:
The IRS said labelling a strategy as “tax-aware” or “tax-advantaged” alone does not cause them concern. Instead they are focused on the strategies that seek to create a pattern of generating capital gain and ordinary loss in similar amounts from offsetting transactions or that seek to elect character in a way inconsistent with their purpose.
Background
A regulated investment company (RIC) is defined in Section 851. To qualify as a RIC, a corporation must meet a gross income test under Section 851(b)(2) which provides at least 90% of its income must come from specified sources. Generally, a RIC must recognize gain upon a distribution of appreciated property under Section 311(b). However, Section 852(b)(6) provides that Section 311(b) does not apply to a distribution by a RIC if such distribution is in redemption of its stock upon the demand of the shareholder.
Notice 2026-62
The notice describes the following strategies that involve Section 852(b)(6):
- 351 Conversion Transactions: Investors contribute appreciated securities to a newly formed ETF in a purported Section 351 transaction and, through a coordinated redemption involving an authorized participant, effectively exchange those securities for an interest in a materially different portfolio without recognizing gain (Rev. Rul. 2026-20 illustrates this type of transaction. See below for further discussion).
- Transfer to Partnership Involving 351 Conversion Transaction: Investors contribute appreciated securities to a partnership designed to avoid section 721(b), and the partnership subsequently engages in a 351 conversion transaction with an ETF.
- Box Spread: The fund uses a “box spread,” a combination of four options on the same property, to generate returns economically similar to interest income and then uses section 852(b)(6) to avoid current income recognition and defer taxation until investors dispose of ETF shares.
- Record Date: The fund distributes shares of dividend-paying ETFs shortly before the dividend record date and then replaces those investments with economically similar investments with the objective to avoid dividend income while maintaining substantially the same market exposure.
- RIC Income Test Avoidance: The fund holds assets such as commodities or digital assets distributes their appreciated positions through Section 852(b)(6) redemptions before recognizing gain to take the position that the unrecognized gain is excluded from the RIC income test.
The notice also describes the following strategies used by “tax-aware” funds involving the following:
- Identified straddles with mixed character: A strategy involving identified straddles that include both a position that gives rise to capital gain or loss and an offsetting position that gives rise to ordinary income or loss, to generate gross capital gain and ordinary loss from offsetting positions.
- Same-day acquisitions and dispositions of foreign currency forward contracts: A strategy that enters into short-term foreign currency forward contracts and electing capital treatment under section 988(a)(1)(B) only for contracts that generate gains, while allowing loss positions to remain ordinary under the default section 988 rules.
- Selective terminations of notional principal contracts to obtain inconsistent character: A strategy involving notional principal contracts (NPCs) that may be long or short positions and are typically short-term. If an NPC is a gain position, the investment fund terminates or disposes of the NPC before a scheduled payment date and takes the position that it has capital gain under Section 1234A. If an NPCs is a loss position, the investment fund holds the NPC until the scheduled payment or expiration date and takes the position that it has an ordinary expense.
Notice 2026-62 should serve as a warning to taxpayers that Treasury and the IRS are closely scrutinizing a variety of investment fund strategies that may obtain favorable tax results. Notice 2026-62 indicates that the Treasury Department and the IRS will apply all applicable tax rules, including anti-abuse rules and judicial doctrines, and that future guidance could apply retroactively. The Notice requests public comments and indicates that additional administrative guidance, enforcement actions, or transaction-reporting requirements may follow.
IRS rules contribution to ETF is taxable
Simultaneous with Notice 2026-62, in Rev. Rul. 2026-20, the IRS ruled that an investor had a taxable exchange under Section 1001 when the investor transferred securities to an exchange-traded fund (ETF) with the intent to qualify as a tax-free exchange under Section 351.
In addition to the determination itself, this reveals how the IRS applies rules to a Section 351 conversion transaction.
In a case that led to the ruling, the investor transferred a portfolio of securities to an ETF, which was a newly formed corporation intended to qualify as regulated investment company (RIC) under Section 851. At the time, the transferred securities were appreciated with built-in gain and they were diversified within the meaning of Treas. Reg. Section 1.351-1(c).
Pursuant to the same plan, an authorized participant (AP) transferred securities to the ETF which were consistent with the ETF’s investment thesis, or cash that would be used by the ETF to acquire such securities, for shares of the ETF, or “AP Shares”. Then the ETF redeemed the AP Shares for the portfolio of securities that were transferred by the investor in a transaction intended to qualify under section 852(b)(6), which would allow the ETF to avoid recognizing built-in gain under Section 311(b).
As a result of the transactions, the ETF ended up holding a portfolio of securities that was consistent with its investment thesis and materially different from the securities contributed by the investor.
The IRS explains the transactions were undertaken as part of a plan designed to enable the investor to exchange investor’s appreciated portfolio of securities for a materially different portfolio without recognizing any built-in gains in those securities. The IRS recharacterized the transaction to reflect the substance rather than the form, which is a taxable exchange under Section 1001.
While Section 351 serves to protect taxpayers from recognizing gain when there is merely a change in the form of ownership, the IRS makes it clear that this provision cannot be exploited. Section 351 provides that no gain or loss is recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and, immediately after the exchange, such person or persons are in control (as defined in section 368(c)) of the corporation. The IRS focuses on the intent behind Section 351, citing Portland Oil Co. v. Commissioner, 109 F.2d 479, 488 (1st Cir. 1940):
[T]he purpose of [Section 351] [is] to save the taxpayer from an immediate recognition of a gain, or to intermit the claim of a loss, in certain transactions where gain or loss may have accrued in a constitutional sense, but where in a popular and economic sense there has been a mere change in the form of ownership and the taxpayer has not really ‘cashed in’ on the theoretical gain, or closed out a losing venture.
The IRS concluded that the transaction must be recharacterized in accordance with its substance and treated as a taxable exchange under Section 1001. The IRS relied on the substance-over-form and step-transaction doctrines, which permit transactions undertaken pursuant to a single integrated plan to be recharacterized in accordance with their economic substance rather than their formal structure. E.g., Commissioner v. Court Holding Co., Kuper v. Commissioner, and Rev. Rul. 71-336.
Specifically, the IRS based the ruling on its view that the ETF served merely as a conduit for the transfer of investor’s securities to AP and, in substance, the investor exchanged appreciated securities for a materially different portfolio of securities. The IRS stated that the same result would apply if multiple investors participated in the transaction.
Contacts:
Content disclaimer
This content provides information and comments on current issues and developments from Grant Thornton Advisors LLC and Grant Thornton LLP. It is not a comprehensive analysis of the subject matter covered. It is not, and should not be construed as, accounting, legal, tax, or professional advice provided by Grant Thornton Advisors LLC and Grant Thornton LLP. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this content.
For additional information on topics covered in this content, contact a Grant Thornton professional.
Grant Thornton LLP and Grant Thornton Advisors LLC (and their respective subsidiary entities) practice as an alternative practice structure in accordance with the AICPA Code of Professional Conduct and applicable law, regulations and professional standards. Grant Thornton LLP is a licensed independent CPA firm that provides attest services to its clients, and Grant Thornton Advisors LLC and its subsidiary entities provide tax and business consulting services to their clients. Grant Thornton Advisors LLC and its subsidiary entities are not licensed CPA firms.
Tax professional standards statement
This content supports Grant Thornton Advisors LLC’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. It is not, and should not be construed as, accounting, legal, tax, or professional advice provided by Grant Thornton Advisors LLC. If you are interested in the topics presented herein, we encourage you to contact a Grant Thornton Advisors LLC tax professional. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein.
The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal, tax, or professional advice provided by Grant Thornton Advisors LLC. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact a Grant Thornton Advisors LLC tax professional prior to taking any action based upon this information.
Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton Advisors LLC assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.
Grant Thornton Advisors LLC and its subsidiary entities are not licensed CPA firms.
Trending topics
Share with your network
Share