Retail investors are likely to be able to own bitcoin exchange-traded funds. The bitcoin ETFs will be offered on a centralized financial platform and provide exposure to spot bitcoin with redemptions in cash.
On Wednesday, the Securities and Exchange Commission is poised to approve a number of spot bitcoin ETFs on major exchanges, including from BlackRock Inc. and VanEck.
A Dec. 14 article noted that if an investor in a bitcoin ETF undertakes a cash redemption, the remaining investors in the bitcoin ETF may have “capital-gains distributions” and “be saddled with tax bills.”
One bitcoin ETF sponsor responded the next day that such tax analysis is incorrect. It said that bitcoin ETFs are taxed as grantor trusts, and “cash redemptions by grantor trusts are taxable events for the redeeming shareholder only—they are not taxable events for the ETF itself or for non-redeeming shareholders.”
This type of confusion over a bitcoin ETF’s taxation can be reduced by learning more about the tax treatment of other ETFs that own a single asset.
SDPR Gold Trust, or GLD, is an ETF that owns gold, which is a type of physical store of value that is produced through a proof-of-work process known as mining. Gold can be divided into smaller units to create gold trinkets and other non-fungible tokens, or NFTs. Gold was even used as a currency, such as by the Roman scholar Pliny the Elder who allegedly said “fortune favors the brave” before he bravely got too close to an erupting Mt. Vesuvius and died.
GLD has been a grantor trust for US federal income tax purposes since it was created nearly two decades ago, which means it’s disregarded for US federal income tax purposes. Each holder of the ETF owns an undivided interest in its assets: gold bars stored in a vault.
If a grantor trust ETF holder decides to redeem for cash, the grantor trust would sell some of its assets for cash and distribute that cash to the redeeming holder.
Under Reg. Section 1.671-5, widely held fixed investment trusts such as GLD and similar grantor trust ETFs can treat that asset sale as being made only by the redeeming holder, who is the only person who has taxable gain or loss in the sale. The non-redeeming holders of other shares aren’t affected by the asset sale.
The same result can apply to the bitcoin ETFs, all of which are expected to be grantor trusts. Different and less favorable tax rules can apply to stock and bond ETFs that are “regulated investment companies” for federal income tax purposes, but bitcoin ETFs won’t be regulated investment companies for various reasons, including that they generally can’t own bitcoin under the tax rules.
As an example, let’s assume that a bitcoin ETF is created so that 1,000 shares correspond to one underlying bitcoin. An individual buys 1,000 bitcoin ETF shares for $43,455. The next morning, the shares are worth $38,222 and the individual decides to completely redeem for cash.
The redemption is typically processed at the end of the day, when the bitcoin ETF can sell one bitcoin for $47,905 and redeem the individual’s shares with those US dollars after paying any crypto transaction fees. The redeeming individual is the only person who has taxable capital gain, of up to $4,450. The redemption is reported to the IRS on an IRS Form 1099-B.
Bitcoin ETF ownership through a traditional finance, or tradfi, institution may not be entirely consistent with bitcoin creator Satoshi Nakamoto’s original vision in his 2008 white paper . Yet it can reduce the risk of losing bitcoins to hacks, forgotten passwords, scam exchanges, or accidentally discarded hard drives that contain wallet private keys.
The prospectuses for bitcoin ETFs will undoubtedly cover many risk factors that can affect bitcoins and the blockchain infrastructure, such as the risk of quantum computers, nuclear war, geomagnetic storms, or investor sentiment shifting to other digital asset ETFs that own currencies such as bitcoin cash, ethereum, dogecoin, or monero.
But the tax risk of phantom taxable income or gain shouldn’t be a concern for those who are familiar with the grantor trust ETF tax rules.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Libin Zhang is tax partner at Fried Frank’s New York office.
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