While the coveted physically backed bitcoin exchange traded fund remains, well, coveted, meaning there's little in the way of positive insight regarding when the Securities and Exchange Commission (SEC) will approve such a fund.
Still, ETF issuers are making due. The current bitcoin ETF landscape in the U.S. is comprised of futures-based funds and at least one that takes the novel approach of mixing equities and bitcoin futures. At least clients can access bitcoin via the ETF wrapper, but with that choice comes some responsibility for advisors.
In fact, the growth of the domestic bitcoin ETF population presents advisors with considerable value-add opportunity with clients because there are some structural issues with futures-based bitcoin ETFs to consider and these are points most clients aren't well-versed in.
Here's what's happening with bitcoin futures ETFs. While these are new products, they're becoming quintessential examples of ETFs with similar names that actually aren't structured the same way and that's where advisors come in.
C-Corp vs. RIC
Many clients think all funds, be it an ETF, index fund or actively manged mutual fund, are structured the same, but advisors know there are important differences between funds that are registered investment corporations (RICs) and those that are built as C-Corporations (C-Corps). Most funds are RICs, but that's not the case in the still nascent bitcoin futures space.
The “established” bitcoin futures ETFs are structured as RICs, but the newly minted VanEck Bitcoin Strategy ETF (XBTF) is a C-Corp fund. Among bitcoin futures ETFs, XBTF's C-Corp structure is potentially material regarding returns and tax consequences. Typically, a RIC doesn't pay fund-level taxes. Rather, it distributes all income and capital gains to investors.
“If a fund elects to be treated as a C-Corp for tax purposes, it does not have the same requirements for diversification and qualifying income. It will be required to pay taxes at the fund level and any distributions to investors are also taxable to the investor,” according to VanEck. “This potential for 'double taxation' is generally something to avoid and why most funds elect to meet RIC requirements. However, the tax treatment of bitcoin futures, and specifically how a fund structures its investments in order to meet the RIC requirements, may result in a C-Corp being more tax efficient, particularly for individuals in higher tax brackets and for corporations.”
RICs that hold bitcoin futures through a Cayman Islands unit can treat income as qualifying income, but using the offshore subsidiary can lead to unwanted tax consequences regarding treatment of distributions and losses.
This is important when it comes to bitcoin ETFs because the RIC distribution won't be treated as qualified dividend income (QDI) or capital gains, meaning those distributions can't be taxed at lower, more favorable rates. Conversely, the C-Corp structure offers benefits to bitcoin ETF investors.
“Distributions from a C-Corp are QDI and DRD eligible regardless of the source of the income or gains earned by the C-Corp,” adds VanEck. “Additionally, with respect to the 40/60 capital gains treatment on futures contracts, the C-Corp is not required to distribute long-term capital gains and thus will only distribute 40% of the capital gains earned by the fund (less applicable federal taxes paid by the fund). This allows investors to defer tax at the individual level and retain assets in the fund, thus maintaining greater exposure to the investment class.”
More XBTF Benefts
There are other reasons advisors might want to discuss XBTF with clients and again, this is wonky stuff that clients usually aren't experts in. Considered how losses are treated. In bitcoin futures RIC fund, losses can't be carried forward or back. That means the only way a client can get any tax benefit from those losses is to sell shares of the fund.
“However, a C-Corp can carry capital losses back for three years and forward for five years. This allows the C-Corp to take the tax benefit of losses by using those losses to either receive a refund of taxes previously paid by the fund or to offset gains earned in future years. This will decrease the fund’s tax accruals and also result in lower dividend distributions to investors,” according to VanEck.
Overall, a bitcoin fund using the C-Corp structure, such as XBTF could lead to higher after-tax returns for clients.
“Tax exempt investors or individuals investing through tax deferred accounts may not be well-suited to invest in a fund structured as a C-Corp,” concludes VanEck.
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