IRS Targets ETF Seeding Transactions and Other Tax-Aware Fund Strategies in New Guidance

On September 28, 2026, the Treasury Department and the Internal Revenue Service concurrently released Revenue Ruling 2026-20 and Notice 2026-62, signaling heightened scrutiny of certain investment fund strategies that the government views as producing tax results inconsistent with the purpose of the federal tax laws. The guidance follows prior remarks by Treasury and the IRS expressing focus on these strategies.

Revenue Ruling 2026-20 concludes that the seeding of an exchange-traded fund (“ETF”) with appreciated assets that the ETF thereafter distributes to an authorized participant (“AP”) as part of the same plan, all in purportedly tax-free transactions, does not qualify for tax-free treatment.

Notice 2026-62 identifies the ETF seeding transaction described in Revenue Ruling 2026-20 along with four other strategies involving the use of Section 852(b)(6) of the Internal Revenue Code (the “Code”)¹ by regulated investment companies (“RICs”), as well as three categories of “tax-aware” fund strategies used primarily by partnerships and separately managed accounts (“SMAs”) and describes these transactions as inconsistent with the purpose and proper application of the relevant federal tax rules. Treasury and the IRS are requesting comments on all of the strategies identified in the Notice, with comments due by October 28, 2026.

Background

Section 852(b)(6) and ETF In-Kind Redemptions

Under Section 852(b)(6), a RIC generally recognizes no gain or loss on an in-kind distribution of property to a shareholder in redemption of the shareholder’s stock upon demand.² This provision turns off the gain recognition rule of Section 311(b) that would otherwise apply to distributions of appreciated property by a corporation. ETFs routinely use this mechanism to distribute appreciated portfolio securities in kind to APs in redemption of creation units, and the Notice states that, except as specifically discussed, it does not address and expresses no view on such ordinary in-kind distributions.

Section 351 and Transfers to Controlled Corporations

Section 351 provides that a person contributing appreciated assets to a corporation in exchange for stock in the corporation does not recognize gain on such contribution if certain requirements are met. Among other things, the assets contributed by each contributor must constitute a “diversified portfolio” and persons contributing assets to the corporation as part of the plan must collectively own at least 80% of the corporation following the contributions.

Revenue Ruling 2026-20: Section 351 ETF Seeding Transactions

Revenue Ruling 2026-20 addresses certain transactions that rely on the combination of Section 351 and Section 852(b)(6) to allow investors to materially change their investment exposure in a tax-deferred manner. Specifically, the Revenue Ruling contemplates the following fact pattern: An investor transfers appreciated securities constituting a diversified portfolio to a newly formed ETF in a transaction purporting to qualify under Section 351. As part of the same plan, the ETF then issues creation units to an AP in exchange for securities the ETF desires to hold or cash that the ETF will use to purchase such securities, and shortly thereafter, the ETF redeems the AP with the investor-contributed securities in a transaction intended to qualify under Section 852(b)(6), resulting in the ETF holding a materially different portfolio from the portfolio transferred by the investor.

The Revenue Ruling concludes that the investor’s transfer of assets to the ETF is “recharacterized to reflect the substance of the transactions carried out pursuant to the plan” and accordingly, the investor is treated as exchanging, in a taxable transaction, assets it contributed to the ETF that are then distributed to the AP in redemption of ETF shares.

The Revenue Ruling leaves a number of crucial terms undefined and many important questions unanswered. Notice 2026-62 explains that Treasury and the IRS continue to evaluate transactions like the transaction described in Revenue Ruling 2026-20 to determine whether further guidance is warranted. The Notice also expressly states that it does not address, and expresses no view on, Section 351 transactions in which a newly-formed ETF receives assets that are consistent with the ETF’s investment thesis and such assets are intended and expected to be retained absent a substantial change in circumstances (including unexpected changes in market or business conditions).

In a post on X, Treasury Secretary Scott Bessent further emphasized Treasury’s view that the ETF seeding transactions described in Revenue Ruling 2026-20 “don’t work under existing law” and, more generally, that Treasury is serious about cracking down on transactions designed to “dodge taxes” or “exploit” the Code.

Notice 2026-62

Section 852(b)(6) Strategies

In addition to discussing the ETF seeding transaction described in Revenue Ruling 2026-20, Notice 2026-62 identifies four other strategies involving Section 852(b)(6) that Treasury and the IRS are considering addressing with future guidance:

1. Partnership Variation on ETF Seeding Transactions

In a twist on the ETF seeding transaction at issue in Revenue Ruling 2026-20, this strategy involves investors with non-diversified portfolios contributing appreciated assets to a partnership (structured as an exchange fund) that holds at least 20% non-stock/securities assets to avoid recognition under Section 721(b).³ The partnership, which now holds a diversified portfolio of securities, then engages in a Section 351 conversion transaction as described above. Treasury and the IRS are considering guidance that would deny nonrecognition or recharacterize such transactions. The Notice does not address other exchange fund transactions.

2. Box Spread Funds

ETFs use “box spreads” (combinations of four option positions) to produce a short-term, interest-rate-like return. In the transaction at issue, the ETF distributes option legs with built-in gain via in-kind redemption before expiry and takes the position that Section 852(b)(6) applies, with the result that shareholders recognize no current income and only capital gain upon sale of their ETF shares, although they economically benefit from a return consistent with a short-term interest rate. A variant involves straddle positions in which gain legs are distributed and loss legs are realized, with the resulting losses used to offset other gains within the ETF even though the gain in the other straddle leg is never recognized. The Notice does not address other box spread transactions.

3. “No Dividend” Strategies

An ETF seeking to track an equity index does so by holding shares of another ETF tracking the same index. Shortly before a dividend record date of the lower-tier ETF, the upper-tier ETF distributes the lower-tier ETF shares to an AP in an in-kind redemption purportedly described in Section 852(b)(6) and replaces the exposure with shares of a different ETF tracking the same index, thereby avoiding dividend income. Similar strategies are used with bond ETFs. The Notice notes that the purpose of the disposition of one lower-tier ETF and the acquisition of a different ETF is to eliminate taxable dividend income without any material change to the economic characteristics of the upper-tier RIC. The Notice does not address ETFs investing in ETFs that track different indices.

4. Non-Qualifying Income Avoidance

An ETF holds assets (such as commodities or digital assets) that do not produce qualifying income, either directly or through a grantor trust. The ETF distributes such assets in kind in a transaction purporting to qualify under Section 852(b)(6) to avoid recognizing gain and takes the position that such realized but unrecognized gain does not need to be factored into the determination whether the ETF meets the 90% qualifying income requirement applicable to RICs. The Notice does not address other structures, such as investments through controlled foreign corporations.

Tax-Aware Fund Strategies

Notice 2026-62 separately identifies certain strategies used by “tax-aware” funds—typically structured as partnerships or SMAs—that create a pattern of generating capital gain and ordinary loss based on technical differences among economically similar financial products or payments or timing and identification rules. The Notice acknowledges that the label “tax-aware” is not itself cause for concern and that year-end loss harvesting is a well-established practice.

The targeted strategies include: (a) identified straddle transactions under Section 1092(a)(2) involving positions with mixed character (e.g., a Section 988 foreign currency forward paired with a Section 1256 futures contract on the same currency), in which the futures leg is terminated first; (b) same-day Section 988(a)(1)(B) elections made with hindsight only for gain-producing forwards; and (c) selective termination of notional principal contracts (“NPCs”) by trader funds, which terminate appreciated NPCs shortly before a scheduled payment claiming capital gain treatment under Treas. Reg. Section 1.446-3(h) and Section 1234A while holding loss-producing NPCs to maturity and claiming an ordinary loss.

Effective Dates

Revenue Ruling 2026-20 does not contain an effective date, indicating that the IRS appears to view it as an application of existing law, and therefore applicable to transactions that have already taken place.

Notice 2026-62 states that future guidance could apply prospectively or retroactively and that Treasury and the IRS intend that any guidance issued will target specific abusive transactions, will minimize compliance burdens, and will respect market expectations for conventional, long-established tax planning that is consistent with the intent of Congress. The Notice also emphasizes that the IRS may challenge these strategies on examination under existing law and judicial doctrines.

If you have any questions about Rev. Rul. 2026-20, Notice 2026-62, or their implications for your fund structures, please contact Jim Brown, Pamela Glazier, Franziska Hertel or your regular Ropes & Gray contact.