A:

The exchange-traded fund (ETF) is a relatively new investment vehicle, hitting the market in 1993. A fund company can create ETFs when it is awarded specific exemptions from the Investment Company Act of 1940, a law enforced by the Securities and Exchange Commission (SEC) that governs companies offering investment funds to the public. Typically, a fund company must be awared three exemptions from the Investment Company Act of 1940 before the prospective ETFs are allowed to be sold on the market. These exemptions relieve ETFs of the following:

  • the requirement for funds to be individually redeemable
  • the requirement that funds cannot be traded at a negotiated price
  • the disallowance of funds to be traded as in-kind transactions

Some ETF issuers have requested exemption from other rules that usually apply to mutual funds. Up to this date (2005), no ETF issuers have been awarded the request for exemption from the requirement to pay out dividends collected from securities held in their funds. Some ETFs, however, have been granted permission by the SEC to reinvest the proceeds from dividends in ETF holders' accounts. (Costs of running an ETF are subtracted from dividends to be paid to ETF holders at least annually.) Dividends received or reinvested are taxed as personal income to the ETF unit holders. In the case of ETFs that realize a capital gain, the gain is passed onto the holders of the ETF funds, and also taxed as personal income.

So, as of 2005, the SEC has not granted any exemptions to laws that require distribution of income on a fund's holdings. However, an investment company can deduct its expenses for running the ETF from distributions it receives on its holdings. That is, the investment company can deduct its business costs of running the ETF from the money it generates on the ETF's funds.

Though there aren't any ETFs that are exempt from the requirement to make distribution payments to the fund's shareholders at least annually, ETFs are still developing. As securities laws are constantly changing, it is possible that future ETFs may be exempt from distribution requirements.

For more information on ETFs check out our An Inside Look At ETF Construction.

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