How Your Single Stock ETF Can Qualify for RIC Taxation

Single stock ETFs, which have been available in Europe since 2018, have finally made their way across the pond to the U.S. The first single stock ETFs were approved and launched in the United States in July 2022 to allow for leverage or inverse trading of a single stock. These funds typically will not hold a portfolio of stocks, or even the single stock they intend to track, but instead use derivatives, such as swaps or options, to generate the desired exposure. 

The SEC has approved leveraged and inverse leveraged ETFs on several stocks, but in some cases limited the leverage allowed for funds based upon the volatility of the underlying stock being tracked. Various prospectus filings for the funds specifically caveat that the funds are intended for short-term trading vehicles and not for long-term investments. 

As part of the innovation in the ETF industry, many are trying to understand how single stock ETFs meet the qualifications under Subchapter M of the tax code so they can be taxed as Regulated Investment Companies (RICs).  

The same rules apply to any RIC, including single stock ETFs. Accordingly, any single stock ETF wishing to be taxed as an RIC will need to:

• Be a domestic corporation that, at all times during the taxable year, is registered under the Investment Company Act of 1940 or treated as a management company, unit investment trust or a business development company. 
• Elect to be taxed as an RIC.
• Derive at least 90% of annual income from investing in stock, securities or currencies. Revenue Ruling 2006-1 generally allows a RIC to look through a derivative to the underlying asset to determine whether the investment generates this type of income.
• At the close of each quarter of the tax year, the fund must have:
  • At least 50% of the value of assets of the corporation represented by cash, government securities, investments in other RICs, and investment in issuers representing less than 5% of the value of the fund and less than 10% of the outstanding voting securities of the issuer.
  • No more than 25% of the value of assets of the corporation invested in securities (other than cash, government securities and securities of other RICs) of any one issuer, two or more issuers controlled by the corporation, or securities of qualified publicly traded partnerships.
• Distribute at least 90% of the investment company taxable income and tax-exempt income of the fund.

We expect to see significant innovation and new entrants in this area as sponsors look to launch single stock ETFs to offer exposure, ease of trading, and transparency to traders and investors in these products. Given the investments held by these single stock ETFs, meeting these requirements can be complicated and may create unique issues for these funds.

Contact Rob Velotta at rvelotta@cohencpa.com or a member of your service team to discuss this topic further.

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.