ETF Investment Special (1): What Taxes Are Involved for U.S. Residents and Overseas Residents Investing in U.S. Bitcoin ETFs?

Author: TaxDAO Exchange Traded Funds (ETFs) are similar to stocks, traded on stock exchanges, and can be bought and sold at market prices that fluctuate throughout the trading day based on supply and demand. These funds typically hold a variety of assets, such as stocks, commodities, or cryptocurrencies, and aim to track the performance of a specific index or asset. Compared to mutual funds, the net asset value of ETFs is calculated multiple times during the trading day, allowing investors to trade fund shares at prices close to the underlying asset market prices, providing greater liquidity and flexibility. With the U.S. SEC approving Bitcoin spot ETFs, their tax treatment has also become a focal point for investors. This article will start with the definition of Bitcoin ETFs and focus on the tax treatment that U.S., Hong Kong, and Singapore investors may encounter when investing in U.S. Bitcoin ETFs.

1. Definition of Bitcoin ETFs

1.1 Bitcoin ETF A Bitcoin ETF holds Bitcoin or contracts related to the price of Bitcoin, traded on traditional stock exchanges, allowing investors to gain exposure to Bitcoin price fluctuations without directly holding or managing Bitcoin, thus alleviating concerns about security and digital wallets. In the ever-evolving cryptocurrency investment landscape, Bitcoin ETFs have become an important financial tool. There are mainly two types of Bitcoin ETFs: Bitcoin spot ETFs and Bitcoin futures ETFs, each catering to different investment strategies and risk preferences. 1.2 Bitcoin Spot ETF A Bitcoin spot ETF is an exchange-traded fund that directly holds Bitcoin as its underlying asset, meaning the performance of the spot ETF is directly linked to the real-time value of the Bitcoin it holds. When investors purchase shares of a spot ETF, they are essentially buying Bitcoin, even though they do not personally hold the Bitcoin. 1.3 Bitcoin Futures ETF A Bitcoin futures ETF is an exchange-traded fund that does not directly hold Bitcoin but invests in Bitcoin futures contracts, allowing investors to speculate on future price fluctuations of Bitcoin without directly holding Bitcoin or futures contracts. Financial institutions issue shares to raise funds and establish Bitcoin futures ETFs to purchase Bitcoin futures contracts, tracking the future price of Bitcoin. When investors buy shares of a Bitcoin futures ETF, they are essentially buying a portion of the fund that holds these contracts, indirectly betting on the future price of Bitcoin. 1.4 Comparing Bitcoin Spot ETFs and Futures ETFs The main differences between Bitcoin spot ETFs and Bitcoin futures ETFs include underlying assets, performance influencing factors, liquidity requirements, potential price discrepancies, and exposure and risk. ① The difference in underlying assets is that Bitcoin spot ETFs directly hold Bitcoin, while the value of Bitcoin futures ETFs comes from futures contracts related to Bitcoin. ② The difference in performance influencing factors is that Bitcoin spot ETFs are linked to the real-time price of Bitcoin, while Bitcoin futures ETFs are influenced by the futures market. ③ Analyzing from the perspective of liquidity requirements, since Bitcoin spot ETFs need to hold and securely store Bitcoin, they do not trade frequently to ensure that ETF prices align with Bitcoin spot prices, whereas Bitcoin futures ETFs trade more frequently, and liquidity management processes are more complex, potentially rolling over contracts as they approach expiration. ④ The potential price discrepancies between the two types of Bitcoin ETFs arise because Bitcoin spot ETFs typically closely track the spot price of Bitcoin, while Bitcoin futures ETFs are affected by dynamics in the futures market and contract expiration dates. ⑤ From the perspective of exposure and risk, Bitcoin spot ETFs have direct exposure to Bitcoin price fluctuations, with risks primarily related to Bitcoin price volatility, while Bitcoin futures ETFs have indirect exposure to Bitcoin prices and risks, influenced by Bitcoin volatility and the complexities of the futures market (such as leverage and expiration dates).

2. Tax Implications of Investing in ETFs

The operation of ETFs mainly involves several key stages: share creation, redemption, and investors receiving returns (through dividends or income from price differences in market trading). 2.1 Creation and Redemption Mechanism The "creation and redemption" mechanism is how ETFs gain market exposure and is key to ETF operations. Unlike mutual fund shares, retail investors can only buy and sell ETF shares in the market. Therefore, ETFs do not directly sell individual shares to retail investors or redeem individual shares from retail investors but rely on Authorized Participants (APs). APs can be market makers, specialists, or any other large financial institutions. ETF share creation occurs when the ETF's share price is above its net asset value, and the ETF company seeks to add new shares to its fund by turning to APs. To purchase shares from the ETF, APs aggregate and deposit a specified basket of securities and cash into the fund, exchanging them for ETF shares through physical transactions, thereby avoiding sales and capital gains tax. ETF redemption occurs when the ETF's share price is below its net asset value, and the redemption process is the opposite of the creation process. APs purchase large amounts of ETF shares in the open market and deliver these shares to the fund. In return, APs receive a predefined basket of individual securities or cash equivalents; redemption is also a physical exchange, thus avoiding capital gains tax. However, once APs receive ETF shares during creation, they can freely sell ETF shares to individual investors, institutions, or market makers in the secondary market, realizing the price difference per share, at which point a taxable event occurs, and capital gains tax or income tax must be paid. 2.2 Investor Returns Dividends and income from stocks obtained by investors from the fund must be taxed according to regulations at a certain tax rate. Additionally, investors can buy and sell ETF shares at market prices in market trading, and when investors earn income from price differences, they must pay capital gains tax based on the selling price minus the buying price. Foreign investors purchasing domestic ETFs and receiving interest dividends will involve withholding income tax, which is a type of income tax collected by a government at the source. This tax is mainly levied when non-residents receive stock dividends and bond interest, for example, U.S. residents purchasing U.S. ETFs do not face withholding tax, while Singapore residents investing in U.S. ETFs may face withholding tax.

3. Tax Treatment for U.S. Residents Investing in U.S. Bitcoin ETFs

The taxation of Bitcoin ETFs is generally similar to other ETFs, involving capital gains tax, income tax, and withholding tax. In the sale and redemption of ETFs, selling is a capital gains tax event, while redemption is not a taxable event and does not require tax payment. 3.1 Tax Treatment for U.S. Tax Residents Investing in Bitcoin Futures ETFs The tax treatment of Bitcoin futures ETFs depends on the specific type of futures contracts the ETF invests in. The specific futures contracts are divided into two types: (1) ETFs exposed to regulated futures contracts: This refers to ETFs that hold a certain number or proportion of regulated futures contracts in their portfolios, thus being sensitive to the market performance, price fluctuations, or related risks of these contracts. According to Section 1256 of the Internal Revenue Code (IRC), "regulated futures contracts" refer to contracts that meet the following conditions: (a) the amounts required to be deposited and withdrawn depend on the marking to market mechanism; (b) the contract is traded on a compliant exchange or is subject to its rules. For Bitcoin futures ETFs, if their portfolios include Bitcoin contracts traded on the Chicago Mercantile Exchange (Bitcoin contracts are generally traded on the Chicago Mercantile Exchange), since that exchange is a compliant exchange, the ETF falls under the category of ETFs exposed to regulated futures contracts. If a Bitcoin ETF's portfolio includes regulated futures contracts as defined in IRC Section 1256, regardless of how long investors hold these ETFs (even if only for one day), when they sell the ETF and make a profit, 60% of the profit will be treated as long-term capital gains, and 40% will be treated as short-term capital gains. (2) ETFs exposed to non-regulated futures contracts: This refers to ETFs whose portfolios only include contracts traded in informal, unregulated markets, such as over-the-counter (OTC) contracts. These contracts may not be subject to or only subject to limited regulation, and their terms and conditions can be freely negotiated among trading counterparts. Such ETFs generally carry higher risks due to a lack of standardization and trading transparency. The taxation of such ETFs is consistent with the taxation of general capital gains and is also consistent with the taxation of spot Bitcoin ETFs; the following discussion will address this uniformly. 3.2 Tax Treatment for U.S. Tax Residents Investing in Bitcoin Spot ETFs The tax rules for Bitcoin spot ETFs are consistent with the general capital gains tax rules. If the Bitcoin ETF asset is sold within one year of holding, the resulting short-term capital gains are taxed at ordinary income tax rates. If shares are sold after holding for more than 12 months, the resulting long-term capital gains are taxed at capital gains tax rates. The specific tax rates applicable depend on the investor's tax filing status and income level. 3.3 Capital Gains Tax Rates Applicable to U.S. Residents Individuals and Corporations Investing in ETFs 3.3.1 Tax Rates for U.S. Resident Individuals Long-term capital gains: Based on the investor's total taxable income and tax filing status, there are three tax brackets: 0%, 15%, and 20%. For single filers or heads of household, long-term capital gains are tax-exempt for amounts below $44,625; the tax rate for long-term capital gains between $44,625 and $492,300 is 15%; and for amounts exceeding $492,300, the rate is 20%. Short-term capital gains/dividend income: Taxed at income tax rates, ranging from 10% to 37%, depending on total taxable income and tax filing status. For example, for single filers or heads of household, the tax rate is 10% for taxable income below $11,000; for taxable income above $578,125, the tax rate is 37%. Other taxes: If the investor's net investment income or modified adjusted gross income (MAGI) exceeds specific thresholds, income above those thresholds may be subject to a 3.8% net investment income tax (NIIT). The NIIT thresholds are as follows: $200,000 for single filers or heads of household, $250,000 for married couples filing jointly, and $125,000 for married couples filing separately. 3.3.2 Tax Rates for U.S. Resident Corporations The taxation of ETFs for corporations is the same as for individuals, including recognition of long-term capital gains and short-term capital gains. The tax rate on net capital gains is 21%. For corporations, gains and losses from the sale or exchange of capital assets held for more than 12 months are treated as long-term capital gains and losses. Gains and losses from the sale or exchange of capital assets held for 12 months or less are treated as short-term capital gains and losses. Net long-term capital gains exceeding net short-term capital losses are treated as net capital gains, and taxes are paid based on this. If there are long-term capital losses and short-term gains, short-term gains must be taxed first, and long-term losses cannot be offset. 3.4 Special Provisions for ETF Taxation in the U.S. Bitcoin ETFs are also subject to wash sale rules. A wash sale refers to the sale or trading of securities at a loss, followed by the purchase of "substantially identical" securities or contracts or options to acquire "substantially identical" securities within 30 days before or after the sale. If the loss is deemed invalid, the wash sale loss cannot be deducted for tax purposes and will be added to the cost of the new Bitcoin ETF, thereby increasing the cost basis. This cost adjustment effectively defers the tax deduction for the loss until the new Bitcoin ETF is disposed of. Additionally, the holding period for the new Bitcoin ETF must include the holding period of the previously sold Bitcoin ETF. If an ETF's underlying asset package includes not only Bitcoin but also other assets, such as currencies, futures, and metals, individuals investing in these special asset ETFs are subject to specific tax rules.

• Currency ETFs: Most currency ETFs adopt a trust format, meaning profits from the trust create a tax obligation for ETF holders and are taxed as ordinary income. This type of ETF does not have special tax treatments such as long-term capital gains, even if the ETF has been held for several years. Since currency ETFs involve currency pair trading, tax authorities assume these transactions occur on a short-term basis.
• Futures ETFs: These funds trade futures contracts for commodities, stocks, U.S. Treasury bonds, and currencies. Regardless of holding time, gains and losses from these ETFs are taxed at a ratio of 60% long-term and 40% short-term. Additionally, futures trading ETFs must adhere to mark-to-market rules at year-end. This means that unrealized gains (paper profits) at year-end are treated as if sold, and taxes must be paid.
• Metal ETFs: If trading or investing in gold, silver, or platinum, these precious metals are viewed as "collectibles" by tax authorities, and this policy also applies to ETFs trading or holding gold, silver, or platinum. For individuals, if the gains from collectibles are short-term, they are taxed as ordinary income. If held for more than one year, they are taxed at a higher capital gains tax rate of 28%, meaning they cannot benefit from the normal long-term capital gains tax rate.

4. Tax Treatment for Hong Kong Residents Investing in Bitcoin ETFs

When Hong Kong investors invest in Bitcoin ETFs from other countries or regions, they will incur withholding tax. For example, when Hong Kong residents invest in U.S. Bitcoin ETFs: Since there is no Double Taxation Agreement (DTA) between Hong Kong and the U.S., as non-U.S. tax residents, Hong Kong investors must pay a 30% withholding tax on dividends from U.S. ETFs. However, Bitcoin ETFs do not generate dividends, so there is no withholding tax issue. Additionally, Hong Kong residents investing in U.S. ETFs do not need to pay capital gains tax, only needing to comply with Hong Kong tax regulations. Under Hong Kong income tax law, due to the territorial principle, income generated outside of Hong Kong is generally not taxed. Therefore, unless the trading or income from Bitcoin ETFs has specific Hong Kong elements, Hong Kong investors typically do not need to pay additional taxes on these earnings.

5. Tax Treatment for Singapore Residents Investing in Bitcoin ETFs

When Singapore investors invest in Bitcoin ETFs from other countries or regions, they will incur withholding tax. For example, when Singapore residents invest in U.S. Bitcoin ETFs: There is also no DTA between Singapore and the U.S., so Singapore investors face similar tax obligations as Hong Kong investors, needing to pay a 30% withholding tax on dividends from the ETF. However, similarly, since Bitcoin ETFs do not generate dividends, there is no withholding tax issue for investing in Bitcoin ETFs; and Singapore residents investing in U.S. ETFs do not need to pay capital gains tax, only needing to comply with Singapore tax regulations. Singapore tax law also follows the territorial principle, taxing only income generated or sourced from Singapore. However, Singapore income tax law stipulates that if income generated outside of Singapore is remitted, transmitted, or brought into Singapore, it is also considered "sourced from Singapore." Individual investors who remit income from investing in Bitcoin ETFs into Singapore generally must pay personal income tax on that income. Singapore's personal income tax rates for 2024 range from 0% to 24%, depending on the individual's taxable income. Singapore resident corporations enjoy tax exemptions on overseas sourced dividend income if they meet the following conditions: (1) the highest corporate tax rate in the foreign country generating the income is at least 15% when the income is received in Singapore; (2) the income has already been taxed overseas; (3) the authorities believe that the exemption will benefit the resident company. With adjustments to Singapore's tax laws, starting January 1, 2024, income from the sale of foreign assets brought into Singapore under specific conditions may be subject to tax, reflecting Singapore's gradual alignment with international tax standards. However, for income from Bitcoin ETF investments, if the income is not remitted to Singapore, investors typically only bear the withholding tax obligations in the U.S.

6. Conclusion and Recommendations

By examining the tax treatment of Bitcoin ETFs for residents of the U.S., Hong Kong, and Singapore, it can be observed that the taxation of Bitcoin ETFs is related to factors such as their registration location and type, the investor's residence, and the jurisdiction of the investment objectives. Investors can reasonably plan their ETF tax burdens and profits by understanding the tax policies in their residence and the ETF's registration location regarding creation and redemption, as well as the returns for Bitcoin investors. As cryptocurrency ETFs become a global hotspot, TaxDAO will analyze the regulatory and tax policies of major countries regarding cryptocurrency ETFs through a series of ETF investment topics, and we welcome all readers to follow along.