An exchange-traded fund (ETF) is a type of investment fund and exchange-traded product with tradeable shares on a stock exchange. ETFs typically track an index, commodities, bonds or a basket of assets.
ETFs provide investors with exposure to a diversified portfolio of assets. They are traded on stock exchanges like individual stocks. Investors can buy and sell ETF shares throughout the trading day at market prices. Investors in Spot Bitcoin ETFs own shares representing a portion of the actual Bitcoin (BTC) the ETF holds.
The value of these ETFs is directly tied to the price movements of BTC. Bitcoin Futures ETFs invest in financial derivatives known as futures contracts, which derive their value from the future price of Bitcoin.
Crypto taxes across the world
According to PricewaterhouseCoopers’ annual global crypto tax report 2024, noncompliance and misreporting on crypto-asset holdings currently range from 55% to 95%.
The report also provides guidance on reporting regimes that address tax implications for different types of digital assets, namely, cryptocurrencies, stablecoins, nonfungible tokens (NFTs), central bank digital currencies (CBDCs) and other tokenized forms of real-world assets (RWAs).
Crypto Asset Reporting Framework
The Crypto Asset Reporting Framework (CARF) is a tax regime set up by 168 Organisation for Economic Co-operation and Development (OECD) member countries to bring transparent and standardized tax policies for digital assets. The OECD has established Common Reporting Standards (CRS), which will serve as the tax framework for tokenized real-world assets.
In the United States, the Internal Revenue Service (IRS) treats cryptocurrencies as property for tax purposes. Cryptocurrency transactions, including buying, selling and trading, may trigger capital gains or losses. The taxation of crypto ETFs follows the rules for capital gains tax.
In the European Union, the taxation of cryptocurrencies varies across countries. Some countries treat crypto gains as capital gains, while others may tax them as income. The EU is working toward creating a unified approach to crypto taxation. Cryptocurrency taxation varies widely worldwide, with some countries providing specific guidelines and others still developing their approach.
In regions like the United Kingdom, Australia and Japan, crypto gains incur capital gains tax.
But how are Bitcoin ETFs taxed, and how are they different from holding and trading BTC? How would tax treatment for these assets and investment vehicles differ between an institution and a retail individual?
Tax treatment of Bitcoin ETFs
Bitcoin ETFs, like other investments, are subject to capital gains tax, which is triggered when investors sell or exchange their ETF shares for a profit. The holding period determines whether the gain is considered short-term (held for one year or less) or long-term (held for more than one year). Long-term gains are generally taxed at a lower rate.
The creation and redemption of Bitcoin ETF shares may not trigger a taxable event for the ETF itself. However, investors buying or selling ETF shares on the secondary market could incur capital gains or losses. If the Bitcoin ETF pays dividends, these are typically taxed as ordinary income unless the fund qualifies for special tax treatment.
However, there could be subtle differences in the tax treatment between spot Bitcoin ETFs and Bitcoin Futures ETFs. This is because spot ETFs issue shares backed by actual Bitcoin. Therefore, tax implications to holders of the ETFs would be based on transactions they perform and the price of Bitcoin at that time.
In the case of Bitcoin Futures ETFs, holders are invested in derivative contracts rather than actual Bitcoin. The gains or losses the Futures ETF investors make depend on the performance of the contracts rather than spot Bitcoin prices.
The creation and redemption process for Bitcoin ETFs
Creation and redemption of ETF shares involve the process by which new shares are introduced to the market (creation) or removed from the market (redemption). These processes typically occur between institutional investors and the ETF issuer, known as an authorized participant (AP).
An AP, often a prominent institutional investor, assembles a portfolio of assets that mirrors the ETF’s holdings. The AP exchanges this portfolio with the ETF issuer in return for newly created ETF shares. This process allows the ETF to increase its share capital and provide liquidity to the market.
An authorized participant returns ETF shares to the issuer during the redemption process. In exchange, the AP receives the underlying assets of the ETF’s portfolio. This helps the ETF manage its share capital and maintain its target investment exposure.
Typically, the creation and redemption of ETF shares are considered in-kind transactions. In an in-kind transaction, the transfer of assets doesn’t involve the sale of assets for cash. Because there is no sale of assets, it is not considered a taxable event for the ETF itself. The ETF does not recognize capital gains or losses when shares are created or redeemed in this way.
However, Bitcoin ETFs cannot use in-kind transactions and must sell the underlying assets to meet redemption requests, which could lead to taxable events for the fund. The sale of cryptocurrencies, like Bitcoin, may trigger capital gains or losses, which could then impact the tax situation of the ETF.
Tax treatment: Bitcoin ETF holders vs. Bitcoin holders
Bitcoin holders are responsible for tracking their transactions, including purchases, sales and transfers, to calculate gains or losses accurately. ETF investors may benefit from simplified tax reporting, as the ETF fund manager handles the underlying assets and provides periodic reports.
Bitcoin ETFs may offer certain tax efficiencies compared to holding actual BTC. With Bitcoin, every buy and sell transaction constitutes a taxable event, triggering capital gains or losses. Depending on their structure, spot Bitcoin ETFs may only generate taxable events when shares are bought or sold, potentially reducing the number of taxable events throughout a year.
In general, ETFs often handle the calculation and reporting of capital gains and losses on behalf of the investors, simplifying tax filing. Some ETFs may be eligible for holding in tax-advantaged accounts like Individual Retirement Accounts or 401(k)s, allowing for tax-deferred or tax-free growth. This is currently not possible with directly holding Bitcoin in most cases.
Also, ETFs allow investors exposure to Bitcoin without directly dealing with wallets, private keys and the associated complexities.
Tax planning disparities between institutional and retail crypto holders
Institutional investors often have more sophisticated tax planning strategies and resources than retail investors. Retail investors may face additional challenges in terms of record-keeping and tax reporting, especially if they engage in frequent trading.
Institutional investors may be subject to the same capital gains tax rates as retail investors, but their overall tax situation could be more complex due to other investment activities. Retail investors and institutional investors alike should consider their individual tax situations, including factors like income level and filing status.
Institutional investors may have additional compliance requirements and reporting obligations compared to retail investors, given their larger scale and potential impact on the market.
Written by Arunkumar Krishnakumar