On September 28, 2026, the U.S. Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) released Notice 2026-62 (the “Notice”), and the IRS also issued Revenue Ruling 2026-20 (the “Revenue Ruling”), reflecting the government’s increased concern regarding certain investment fund strategies that it believes may produce federal income tax results inconsistent with the purpose and proper application of existing tax rules.
The Revenue Ruling – Section 351 Conversion Transactions involving ETFs
The Revenue Ruling addressed a transaction in which an investor (the “Investor”)contributed a diversified portfolio of appreciated securities to a newly formed ETF intending to qualify as a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”) in a purported tax-free exchange under Section 351 of the Code. The contributed securities were inconsistent with the ETF’s investment thesis. The ETF issued its own shares to an authorized participant in exchange for securities or cash that ETF intended to use to acquire securities consistent with the ETF’s investment thesis. Shortly thereafter, the ETF redeemed such shares in-kind using the securities contributed by the Investor. Following the completion of these transactions, the ETF held a portfolio of securities that was consistent with its investment thesis and that was materially different from the portfolio transferred to it by the Investor.
Applying the substance-over-form and step-transaction doctrines, the IRS viewed this series of transactions as part of the same plan and concluded that the ETF’s ownership of the securities contributed to it by the Investor in the purported tax-free exchange under Section 351 of the Code was transitory and should be disregarded, as the ETF served as a conduit pursuant to a plan between the Investor and the authorized participant. The entire transaction was thereby recharacterized as an over-the-top sale of securities between the Investor and the authorized participant. In particular, the Investor was treated as engaging in a taxable exchange under Section 1001 of the Code with the authorized participant. The IRS further stated that the same result would apply even if multiple investors participated in the transaction described in the Revenue Ruling.
The Revenue Ruling did not expressly consider whether the Investor may have been unaware of the existence of the authorized participant. However, the Notice suggests that the Revenue Ruling was intended to address a situation where the Investor anticipated acquiring an interest in an ETF with a materially different portfolio of securities without triggering the associated gain. As a consequence the Revenue Ruling is more expansive than the Notice and appears to have found the existence of a plan based on circumstantial evidence of close-in-time transactions involving multiple parties. The IRS highlighted the same by stating that the result would be same if multiple investors participated.
In addition, in the Revenue Ruling the IRS may be suggesting that a slightly different fact pattern is also under scrutiny. If the ETF in the Revenue Ruling simply owned appreciated assets that it wanted to sell, the ETF would have the option of selling them in the open market (which would trigger the gain in those assets) or having an authorized participant contribute cash to the ETF and shortly thereafter request a redemption which is satisfied with an in-kind distribution of those appreciated assets. It appears the IRS may be suggesting that such redemption of the authorized participant could lead to the same invocation of substance over form and step transaction principles to challenge the ability of the ETF to avoid recognizing the gain in appreciated assets pursuant to Section 852(b)(6) of the Code. Future guidance may clarify the scope of transactions the IRS views as abusive. However, the IRS made it clear that the IRS did not address such redemptions in the Notice.
The Notice
Additional ETF Strategies Under Review
In addition to the situation addressed by the Revenue Ruling, the Notice identified several other strategies that Treasury and the IRS are considering addressing through regulations, notices, revenue rulings or other guidance:
- Partnership variation of the conversion transaction addressed in the Revenue Ruling – The Treasury and the IRS identified transactions involving the use of partnerships to avoid the diversification requirement and achieve nonrecognition of gain under Section 351 of the Code. In such a transaction, investors contribute appreciated positions to a partnership structured to avoid characterization as an “investment company” for purposes of 721(b) of the Code. The investors take the position the contribution is tax-free under Section 721(a) of the Code. The partnership subsequently participates in a purported ETF conversion transaction under Section 351 of the Code. The Notice notes that the Treasury and the IRS are considering guidance that would deny nonrecognition treatment for the partnership contributions or otherwise recharacterize these overall transactions to reflect their substance.
- Box spread funds – The Treasury and the IRS also identified transactions where certain ETFs use purported in-kind redemptions under Section 852(b)(6) of the Code to distribute unexpired options within a box spread that have unrealized gain for federal income tax purposes. The transactions are designed to provide an economic return comparable to a short-term interest rate without current income recognition at the ETF or shareholder level (with such unrealized gain recognized by shareholder upon a later disposition of ETF shares). The Notice also identified a related strategy in which an ETF combines a box spread with a separate straddle transaction, where the ETF distributes the positions with unrealized gain and takes the position that losses on the remaining straddle positions may be deducted notwithstanding that the offsetting gain is never recognized.
- Record-date strategies – Another transaction identified in the Notice is a strategy where a parent ETF, desiring to seek a return that tracks an index, invests in another ETF that tracks the same index. The parent ETF then disposes of its shares in such other ETF through an in-kind redemption, under Section 852(b)(6) of the Code, of an authorized participant. In the situation identified, the authorized participant made a cash or a share contribution to the parent ETF (of shares of a different ETF tracking the same index) shortly before such other ETF’s dividend record date. If the authorized participant contributed cash to the parent ETF, the parent ETF would then use the cash contributed by the authorized participant to reinvest into a different ETF that tracks the same index. In effect the parent ETF replaces the position it held with an economically similar position. But the parent ETF would take the position that it avoids recognizing the anticipated dividend income, without materially changing its investment exposure.
- RIC qualifying-income strategies – The Treasury and the IRS also identified a strategy where certain ETFs intending to qualify as RICs invest directly in commodities, digital assets or interests in grantor trusts holding similar positions that would otherwise produce gains that are not qualifying income for RICs. However, these ETFs avoid recognizing such gains by distributing such investments in redemptions, intended to qualify under Section 852(b)(6) of the Code, of an authorized participant that made a cash or an in-kind contribution to such ETFs. These ETFs take the position that the resulting unrecognized gain from the distributions is excluded from the 90% qualifying-income test under Section 851(b)(2).
The concerns expressed in the Notice associated with the above strategies appear to be consistent with the previous statements made by Treasury and IRS officials during the Wall Street Tax Association seminar hosted on July 21, 2026 (the “Wall Street Tax Seminar”).
“Tax-Aware” Fund Strategies
The Notice also identified several multi-position strategies used by certain investment partnerships and separately managed accounts to “create a pattern of generating capital gain and ordinary loss in similar amounts from economically offsetting transactions or that seek to achieve effective character electivity by using certain elections in ways that are inconsistent with their purpose”. The Notice emphasized that describing a strategy as “tax-aware” or “tax-advantaged” is not itself a cause for concern, distinguishing these identified strategies from long-standing established tax-loss harvesting and similar techniques that are consistent with Congressional intent.
The “tax aware” investment strategies the Treasury and the IRS identified are as follows:
- Identified straddles: Transactions where offsetting positions are taken by a fund that maximize favorable capital gains and ordinary losses while effectively minimizing ordinary income and capital losses. For example, a fund may enter into a transaction where the fund pairs a foreign currency forward (that produces ordinary income or loss under Section 988 of the Code) with an offsetting regulated futures contract (that produces 60% long-term and 40% short-term capital gain or loss under Section 1256 of the Code) that together are identified as a straddle under Section 1092 of the Code. However, the Notice does not address the use of identified straddle transactions that give rise to consistent character and holding period results.
- Same-day foreign currency forward transactions: Transactions where a fund enters into foreign currency forward contracts that terminate on the same day they are entered into and, after the fund learns whether each contract generated gain or loss, makes selective elections under Section 988 of the Code to treat gains as capital while simultaneously preserving ordinary treatment for losses.
- Selective termination of appreciated notional principal contracts (“NPCs”): Transactions where a fund terminates appreciated NPCs shortly before a scheduled payment and treats the resulting termination payment as capital gain, while holding other NPCs in loss positions through a scheduled payment or maturity and treating the resulting payments as ordinary expense. Treasury and the IRS view the selective treatment as producing different tax character for economically similar payments on the same types of instruments.
The concerns expressed in the Notice associated with “tax-aware” or “tax-advantaged” strategies appear to be consistent with the previous statements made by Treasury and IRS officials during the Wall Street Tax Seminar.
Key Takeaways
The Notice explains that future guidance may apply prospectively or retroactively to prevent abuse. Such action could include identifying a transaction as a “transaction of interest” or “listed transaction” (as such terms are defined under the Code). Lastly, it also cautions that the IRS may challenge the identified strategies on examination under existing statutory, regulatory and judicial authorities, even before additional guidance is issued.
Therefore, investment advisers, ETF sponsors, fund boards and tax professionals should consider:
- Reviewing existing and proposed transactions intended to qualify as tax-free under Section 351 of the Code to determine whether contributed securities are expected to be retained or instead distributed pursuant to a prearranged or integrated plan.
- Evaluating the technical support, economic substance, and non-tax business purposes underlying in-kind redemption practices involving box spreads, acquired-fund positions, commodities, digital assets and other practices resembling the strategies described in the Notice beyond the anticipated tax benefits.
- Reviewing derivatives and tax-aware strategies that systematically produce capital gains and ordinary losses.
- Assessing disclosure and risk-management procedures, particularly where offering materials describe tax efficiency, tax-loss generation or the anticipated tax treatment of in-kind creations and redemptions.
- Preserving documentation of independent investment purposes, portfolio construction decisions and the absence of any prearranged plan regarding contributed or distributed securities.
- Distinguishing contemplated strategies from the current holding of the Revenue Ruling and from strategies that the Notice identifies may be subject to possible future guidance, recognizing that the IRS may seek to challenge such contemplated strategies under existing law.
Vedder is available to assist ETF sponsors, investment advisers, fund boards and other market participants in evaluating the implications of the Notice and the Revenue Ruling and reviewing affected investment and operational practices.
