Revenue Ruling 2026-20 (the Ruling) applies substance-over-form and step-transaction principles to conclude that a multi-step seeding transaction of an exchange-traded fund (ETF) with appreciated assets followed by an in-kind distribution of those assets to an authorized participant (AP) does not qualify as a tax-deferred exchange under Section 351 with respect to the distributed assets.[1]
In Notice 2026-62 (the Notice), the government requests comments on certain tax-aware strategies and transactions used by ETFs and other market participants that the government appears to view as “abusive.” The US Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) have requested comments on the transactions described in the Notice by October 28, 2026. They specifically requested comments on transactions that appear to be similar to the described transactions but that are distinguishable and on the appropriate scope of any future guidance.
Announcing the Ruling and Notice, Treasury Secretary Scott Bessent signaled a firm posture with respect to these strategies, stating, “Treasury is serious about cracking down on transactions designed to dodge taxes or exploit our federal tax code.”
REVENUE RULING 2026-20
Background and Facts
A newly formed ETF may initially be capitalized through an in-kind seeding transaction in which one or more investors contribute securities to the ETF in exchange for shares of the ETF. These in-kind contributions are often structured to qualify as tax-deferred transactions described in Section 351. Under Section 351(e), a taxpayer generally does not recognize gain on the contribution of appreciated assets to a corporation if, among other requirements, the assets contributed constitute a “diversified portfolio” and the taxpayer (and others that contribute assets to the corporation pursuant to the same plan) own at least 80% of the corporation’s stock following the contribution.
The Ruling addresses a scenario in which an investor transfers a diversified portfolio of appreciated securities to a newly formed ETF in exchange for ETF shares pursuant to a plan. The ETF intends to qualify as a regulated investment company (RIC) under the Code. Pursuant to the same plan, in a separate transaction from the investor’s contribution to the ETF, the ETF (1) issues shares to an AP in exchange for securities (or cash to acquire securities) consistent with the ETF’s investment thesis, and (2) shortly thereafter, the ETF redeems the AP’s shares in exchange for securities contributed to the ETF by the investor. Following these steps, the ETF holds a portfolio of securities that is materially different from the portfolio of securities contributed by the investor.
The redemption of the AP’s shares is intended to qualify for non-recognition treatment under Section 852(b)(6). As a general rule, a corporation is required to recognize gain on appreciated assets that the corporation distributes in kind to shareholders. Section 852(b)(6) provides that a RIC does not recognize gain with respect to appreciated assets that it distributes in kind to a shareholder if the distribution is in redemption of the RIC’s stock upon the demand of its shareholder.
The Analysis and Holding
The IRS applies the substance-over-form and step-transaction doctrines to recharacterize the transactions to reflect their substance, noting that the “ETF was merely a conduit through which securities transferred from [the investor] to AP pursuant to the plan.” The Ruling concludes that the investor and the AP are deemed to enter into a taxable exchange of the securities that the investor contributed to the ETF and that are subsequently distributed by the ETF to the AP in redemption of its shares. The Ruling states that the results would be the same if multiple investors participated in the transaction.
Observations
The Ruling states the IRS’s interpretation of existing law and therefore can be applied retroactively.
A revenue ruling is an official interpretation by the IRS that applies existing law to a stated set of facts. Accordingly, a revenue ruling generally applies retroactively, unless it invokes the IRS’s authority under Section 7805(b) to limit retroactive effect. That authority is not invoked in the Ruling. As such, the Ruling could be used to challenge transactions that occurred prior to September 28, 2026.
Taking a position contrary to the Ruling can carry penalty consequences that disclosure may mitigate.
Section 6662 imposes a 20% accuracy-related penalty on an underpayment of tax, including an underpayment attributable to a substantial understatement of income tax. However, that substantial-underpayment penalty does not apply to any portion of an underpayment that is attributable to the tax treatment of an item for which substantial authority exists.
Revenue rulings are among the authorities considered in determining whether substantial authority exists. Where a taxpayer does not have substantial authority for a position that is contrary to a revenue ruling, the penalty can still be avoided for that item if the position has reasonable basis and the relevant facts are adequately disclosed (for example, on a Form 8275).
Revenue rulings do not have the force and effect of Treasury Regulations. Rather, a revenue ruling reflects the IRS’s interpretation and serves as precedent for the disposition of other cases.[2] Courts are not bound by revenue rulings, and revenue rulings are entitled to respect only to the extent they are persuasive to a court.[3] RICs, investors, investment advisers, and APs evaluating their exposure with respect to similar transactions should consult their tax advisors to weigh the risks of these transactions, including tax and non-tax risks.
Key Concepts
The Ruling uses the words “shortly thereafter” in describing when the in-kind redemption occurs. It is ambiguous, however, as to the reference point—that is, whether the redemption occurs shortly after the AP’s creation of shares or shortly after the in-kind contribution by the investor. The Notice indicates that the Ruling refers to an in-kind redemption shortly after the in-kind contribution of assets by the investor. This interpretation is consistent with Revenue Ruling 71-336, 1971-2 C.B. 299, which the Ruling amplifies. In a different factual context, Revenue Ruling 71-336 also uses the words “shortly thereafter” as describing the time between an in-kind contribution and an in-kind redemption.
The Ruling twice states that the portfolio of securities held by the ETF following the transactions described is “materially different” from the assets contributed by the investor. The Ruling also indicates that the deemed exchange is of “property differing materially in kind or extent from” the securities contributed by the investor. The meaning of these phrases in the context of an ETF’s assets is not clear, although the language echoes Cottage Savings Association v. Commissioner[4] and Treasury regulations under Section 1001.[5]
It is unclear whether the use of “materially different” in the Ruling was intended to merely reinforce the holding of the Ruling (i.e., that the transactions are treated as a taxable exchange under Section 1001) or whether the language was intended to operate as a factual condition that is necessary for the Ruling to apply to a given transaction. If the language was intended to operate as a condition for the application of the Ruling, it is unclear whether the IRS will apply a hair-trigger standard in determining whether assets contributed in kind by an investor to an ETF may be materially different from the ETF’s future portfolio.
Regardless, it is unlikely that the Ruling’s “materially different” in-kind language blesses seeding transactions in which the contributed securities are replaced with the same securities through a planned create/redeem transaction, thereby resetting the basis of such securities.
The Ruling concludes that the in-kind exchange of appreciated securities and the subsequent redemption of the AP’s shares were carried out pursuant to the same “plan.” Stakeholders should carefully assess whether a plan exists (or existed) with respect to any similar transaction.
The Ruling does not address what factors should be considered to determine whether a plan exists. We expect that stakeholders will consider, among other facts, the time that elapses between contributions and distributions, evidence of intent by the parties to enter into steps similar to those described in the Ruling, and the connection between the transactions and the ETF’s ordinary, ongoing creation, and redemption activity.
Notably, Treasury regulations under Section 351 include an anti-abuse rule based on whether a plan existed. Under those Treasury regulations[6], if a transfer “is part of a plan to achieve diversification without recognition of gain, such as a plan which contemplates a subsequent transfer, however delayed,” the original transfer is treated as resulting in diversification and does not qualify as a Section 351 exchange. The Ruling, however, does not rely on or cite those regulations.
The Deemed Transactions
The Ruling recharacterizes the treatment of the contributed securities “that are used by ETF to redeem AP.” Under the Ruling, the investor is deemed to enter into a taxable exchange of those securities with the AP. However, the Ruling is silent on the details of the deemed transactions that would need to occur to cause the investor and the ETF to maintain their actual economic and legal relationships.
As noted above, the Ruling indicates that the investor receives in the deemed exchange “property differing materially in kind or extent from” the securities contributed by the investor. Presumably the “property” deemed received by the investor could include cash or securities that were actually contributed by the AP in exchange for creation units. The Ruling is silent on whether and how any such property should be deemed transferred to the ETF, although presumably the property must be deemed contributed to the ETF by the investor.
The Ruling’s approach to the deemed transactions raises a number of other interesting questions, including how to identify which securities were distributed to the AP in kind (and deemed exchanged with the investor); how to determine the basis, holding-period, and gain-computation consequences of a bifurcated transaction; how the Section 351 diversification tests may be affected by the partial recharacterization; and how and whether the deemed transactions affect the RIC’s computation of its gains and losses in the assets distributed to the AP.
NOTICE 2026-62
The Notice provides a description of several transactions the Treasury and IRS are studying, signaling the government’s current views on those transactions, and importantly, represents a formal request for comments by October 28, 2026. The Notice states that future guidance on the transactions described may take the form of regulations, notices, revenue rulings, or other published guidance, including the possible identification of a transaction as a “transaction of interest” or a “listed transaction.” The Notice reinforces this retroactive effect, cautioning that future guidance “could apply prospectively only or retroactively to transactions that already have taken place,” and that the IRS may separately challenge these strategies on examination as inconsistent with existing law.
The Notice closely tracks concerns previewed by Treasury officials on July 22, 2026, when Acting Assistant Secretary for Tax Policy of the Department of the Treasury and Acting Chief Counsel of the IRS Kevin Salinger and Senior Counsel in the Office of Tax Policy of the Department of Treasury Erika Nijenhuis described and discussed the same categories of transactions described in the Notice at a Wall Street Tax Association panel. The Notice carefully states that it does not address, and expresses no view on, ordinary-course ETF creation and redemption activity and conventional, long-established tax planning that is consistent with the intent of Congress.
ETF Transactions
The Notice describes a set of ETF strategies and transactions that in the government’s view make improper use of various provisions of the Code, including certain in-kind redemptions described in Section 852(b)(6) and certain in-kind contributions described in Section 351:
- Section 351 conversion transactions: The Notice describes the transactions at issue in the Ruling (see above). The IRS’s view is that these transactions purport to use Sections 351 and 852(b)(6) to achieve a result that neither provision was designed to produce. The Notice specifically states that it does not address, and expresses no view regarding, in-kind seeding contributions to an ETF of assets that are consistent with the ETF’s investment thesis and intended and expected to be retained by the ETF “absent a substantial change in circumstances (including an unexpected change in market or business conditions).”
- Partnership (exchange fund) variation: The Notice describes a variation of the transactions in the Ruling involving a partnership.In that variation, investors transfer a non-diversified portfolio of appreciated assets to a partnership (sometimes called an “exchange fund”) at least 20% of whose assets are not stocks or securities, then the partnership contributes an aggregate, diversified pool of stocks and securities to an ETF, and finally, the ETF redeems an AP with an in-kind distribution of the contributed assets. The IRS views this variation as combining Sections 351, 721, and 852(b)(6) to reach an unintended result. Presumably, the steps of this transaction following the contribution to the partnership could fall within the scope of the Ruling.
- Box-spread funds: The Notice describes ETFs that generate a stable, time-value-of-money return using a “box spread” of four options[7] on the same underlying property.The ETFs dispose of the appreciated options comprising the box spread through in-kind redemption before the options expire. This disposition purportedly avoids recognition of income or gains on the box spread at the ETF level (and therefore avoids taxable distributions to the ETFs’ shareholders). As a result, shareholders economically benefit from a return consistent with a short-term interest rate, but they include no taxable income currently. Shareholders would instead be expected to recognize capital gain on disposition of their shares rather than receiving current dividend distributions. A variant pairs the box spread with an offsetting “straddle” described in Section 1092(c)(1). In this variant, the ETF claims a loss on the retained legs while the offsetting gain is never recognized.
- Record-date (dividend-avoidance) strategies: The Notice describes certain equity ETFs that hold shares of other underlying equity ETFs that track an index. Shortly before an underlying ETF’s dividend record date, the upper-tier ETF distributes the underlying ETF’s shares in an in-kind redemption to an AP and replaces those shares with shares of a different underlying ETF (with a different dividend record date) tracking the same index. The Notice indicates that the purpose of the in-kind distribution of shares of one underlying ETF and replacement with shares of another underlying ETF is to avoid current dividend income without any material change in economic exposure. The Notice indicates that similar transactions may take place with ETFs investing in bonds.
- RIC-income-test avoidance: RICs (including most ETFs) must derive at least 90% of their gross income from specific qualifying sources. The Notice describes an ETF that holds assets that would generate income that is generally not qualifying income for a RIC (for example, commodities or digital assets or grantor trusts that hold these assets). Rather than selling those assets and recognizing nonqualifying income or gain, the ETF distributes those assets in kind to an AP, taking the position that the gain is not recognized under Section 852(b)(6) and is therefore not included in the 90% income calculation under Section 851(b)(2).
While there has already been significant commentary regarding the use of box-spread strategies by RICs, IRS scrutiny of the record-date strategies and RIC-income-test avoidance was first signaled in the July 22, 2026 Wall Street Tax Association panel and is now formalized in the Notice. ETFs entering into these transactions or strategies should pay close attention to developments around this issue and consider submitting comments in response to the Notice.
Strategies Used by Tax-Aware Funds
In addition to the ETF transactions, the Notice identifies a separate set of transactions entered into by so-called tax-aware funds and separately managed accounts. The Notice observes that labeling a strategy as “tax aware” or “tax advantaged” does not represent cause for concern. However, the Notice expresses the government’s view that certain transactions are exploiting technical differences among economically similar products or payments, or timing and identification rules, to selectively generate capital gains and ordinary losses.
- Section 1092(a)(2) identified straddles used to convert character: The Notice describes transactions involving “identified straddles” consisting of a position giving rise to capital gain or loss and an offsetting position that gives rise to ordinary income or loss. As an example, the Notice describes an “identified straddle” involving a forward on a foreign currency governed by Section 988 paired with a futures contract governed by Section 1256 on the same currency. In this example, regardless of performance, the futures leg is terminated first. The fund takes the view that either (1) it recognizes capital gain on the futures contract and an ordinary loss on the forward or (2) if the futures contract is in a loss position, the loss on the future is capitalized into the basis of the forward, reducing the ordinary income (or increasing the ordinary loss) on the forward. The Notice alludes to a variation of this transaction involving equity index swaps and futures contracts on the same equity index.
- Same-day acquisitions and dispositions of foreign currency forward contracts: The Notice describes a strategy involving a fund that enters into and disposes of foreign currency forward contracts on the same day. Although these contracts typically generate ordinary income or loss, a fund can elect under Section 988(a)(1)(B) to treat foreign-currency forward contracts as generating capital gain, as long as that election is made before the close of the day on which the transaction is entered into. Because the fund’s contracts are acquired and disposed of on the same day, the fund determines whether to make the election in respect of contracts at a time when it knows whether the election will be beneficial, and the fund can obtain inconsistent character between forwards in a gain position and forwards in a loss position.
- Selective terminations of swaps: The Notice describes funds that enter into short-term swaps that are treated as “notional principal contracts” for tax purposes and that call for one or more contingent payments. The funds do not take into account the contingent payments under the swaps until payment, disposition, or maturity, although the contingent payments are expected to result in ordinary income or expense when received or paid. If a particular swap has appreciated in value, the funds terminate or dispose of it shortly before a scheduled payment, taking the position that the payment is made in termination of the contract and therefore generates capital gain under Section 1234A. If a particular swap has declined in value, the funds continue to hold the contract through the scheduled payment date, make the payment and take the position that the payment is an ordinary expense. This strategy is intended to generate gross capital gains and gross ordinary losses.
Request for Comments
The Notice requests information on the transactions it describes and on similar transactions and requests comments on their appropriate tax treatment. Specifically, the Notice requests comments on the following:
- Whether the descriptions of the transactions are accurate, and whether there are additional facts or considerations the Treasury and IRS should be aware of in determining the appropriate tax treatment
- Whether there are transactions that appear to be similar to the transactions described in the Notice but that have different facts or different economics that warrant different federal income tax treatment, and whether there are crucial differences between the transactions described and transactions that might appear to be similar
- What future guidance commenters would suggest and what is the appropriate scope of that guidance “so that it does not adversely affect well-established market practice that is consistent with the intent of Congress”
NEXT STEPS
Funds, sponsors, investors, and advisers should identify past or future transactions that are described in the Ruling or Notice as well as transactions that are similar. They should assess possible exposure under existing law (including disclosure and penalty considerations) and they should preserve documentation of the non-tax business purposes for the transactions.
The Notice requests that comments be submitted by October 28, 2026. This is a relatively short window for comments, but the Notice appears to represent a genuine request for assistance in tailoring future guidance to avoid affecting transactions that are sufficiently distinguishable from the transactions described.
The Notice specifically states that additional information about the described transactions and about transactions that may appear similar but have different facts, different economics or different tax policy implications will be taken into account. Market participants involved in transactions that are similar to the transactions described in the Notice should strongly consider whether to provide comments to help shape future guidance.
HOW WE CAN HELP
Morgan Lewis’s tax team stands ready to help evaluate specific structures, quantify exposure, and prepare comments for market participants.
