ETF Investment Special (Part 1): What Taxes are Involved When U.S. Residents and Overseas Residents Invest in U.S. Bitcoin ETFs?

Exchange Traded Funds (ETFs), similar to stocks, are traded on stock exchanges and can be bought and sold throughout the trading day at market prices that fluctuate with supply and demand. These funds typically hold a variety of assets such as stocks, commodities, or cryptocurrencies and are designed to track the performance of specific indices or assets. Compared to mutual funds, ETFs have their net asset values calculated multiple times during the trading day, allowing investors to trade fund shares at prices closely aligned with the underlying asset market prices, providing greater liquidity and flexibility.

With the approval of a Bitcoin spot ETF by the U.S. SEC, tax considerations have become a focal point for investors interested in investing in U.S. Bitcoin ETFs. This article will focus on the tax treatment that U.S., Hong Kong, and Singaporean investors may encounter when investing in U.S. Bitcoin ETFs.

1. Definition of Bitcoin ETF

1.1 Bitcoin ETF

Bitcoin ETFs hold Bitcoin or contracts related to Bitcoin's price and are traded on traditional stock exchanges. They allow investors to gain exposure to Bitcoin price fluctuations without directly owning or managing Bitcoin, thus eliminating concerns related to security and digital wallets.

In the ever-evolving landscape of cryptocurrency investments, Bitcoin ETFs have become significant financial instruments. There are primarily two types of Bitcoin ETFs: Bitcoin spot ETFs and Bitcoin futures ETFs. These two types of Bitcoin ETFs cater to different investment strategies and risk preferences.

1.2 Bitcoin Spot ETF

A Bitcoin spot ETF directly holds Bitcoin as its underlying asset. This means that the performance of a 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 without the need to hold it themselves.

1.3 Bitcoin Futures ETF

A Bitcoin futures ETF does not directly hold Bitcoin but instead invests in Bitcoin futures contracts. Investors can speculate on future Bitcoin price movements without directly holding Bitcoin or futures contracts. Financial institutions issue shares and raise funds to purchase Bitcoin futures contracts, tracking the future prices of Bitcoin. When investors buy shares of a Bitcoin futures ETF, they are effectively purchasing a portion of the fund that holds these contracts, indirectly betting on Bitcoin's future prices.

1.4 Comparing Bitcoin Spot ETFs and Futures ETFs

The main differences between Bitcoin spot ETFs and futures ETFs include the underlying assets, factors affecting performance, liquidity requirements, potential price differences, and exposure to risk.

- Underlying Assets: Bitcoin spot ETFs directly hold Bitcoin, while Bitcoin futures ETFs derive their value from futures contracts related to Bitcoin.

- Performance Factors: Bitcoin spot ETFs are closely linked to the real-time price of Bitcoin, while Bitcoin futures ETFs are influenced by the futures contract market.

- Liquidity Requirements: Bitcoin spot ETFs do not trade as frequently because they need to hold and securely store Bitcoin to ensure that the ETF's price aligns with the Bitcoin spot price. Bitcoin futures ETFs involve more frequent trading and more complex liquidity management, potentially rolling over contracts as they approach expiration.

- Potential Price Differences: The two types of Bitcoin ETFs may have potential price differences due to Bitcoin spot ETFs closely tracking the spot price of Bitcoin, while Bitcoin futures ETFs are affected by the dynamics of the futures contract market and contract expiration dates.

- Exposure and Risk: Bitcoin spot ETFs provide direct exposure to Bitcoin price fluctuations, with risks primarily related to Bitcoin's price volatility. Bitcoin futures ETFs offer indirect exposure to Bitcoin prices and risks, influenced by Bitcoin's volatility and complexities in the futures market, such as leverage and contract expiration.

2. Taxation Involved in Investing in ETFs

The operation of ETFs primarily involves several key processes: creation and redemption of shares, investor withdrawal of returns (dividend income, income obtained through market trading spreads).

2.1 Creation and Redemption Process

The "creation and redemption" mechanism is how ETFs gain market exposure and is crucial to how ETFs operate. Unlike mutual fund shares, retail investors can only buy and sell ETF shares on the open market. Therefore, ETFs do not directly issue individual shares to retail investors nor redeem individual shares directly from retail investors; instead, they 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 market price is higher than its net asset value, and the ETF company wants to create new shares for its fund. They turn to APs for help. APs, in order to acquire ETF shares, assemble and deposit a specified basket of securities and cash into the fund, exchanging them for ETF shares in-kind. This process avoids selling and, therefore, capital gains taxes.

ETF redemption is the reverse process, where APs purchase large quantities of ETF shares on the open market and deliver these shares to the fund. In return, they receive a predefined basket of individual securities or cash equivalents. Redemption is also done through in-kind exchange, thus avoiding capital gains tax.

However, once APs receive ETF shares during the creation process, they can freely sell ETF shares to individual investors, institutions, or market makers on the secondary market at market prices, realizing the price spread. At this point, taxable events occur, and capital gains or income tax may apply.

2.2 Investor Withdrawal of Returns

Any stock dividends or income received by investors from the fund, including dividend income or income gained through market trading spreads, may be subject to individual income tax according to regulations.

Furthermore, investors can buy and sell ETF shares on the market at market prices. When investors earn income through price spreads, they may be subject to capital gains tax, which is calculated by deducting the purchase price from the selling price. Foreign investors purchasing their home country's ETF and receiving interest dividends may be subject to withholding tax, which is a type of income tax levied by a government at the source. This tax is mainly imposed on non-residents receiving stock dividends and bond interest, meaning that U.S. residents purchasing U.S. ETFs may not face withholding tax, while Singaporean residents purchasing U.S. ETFs might be subject to withholding tax.

3. Taxation for U.S. Residents Investing in Bitcoin ETFs

The taxation of Bitcoin ETFs at the lower level is generally similar to other ETFs and involves capital gains tax, income tax, and withholding tax. In the sale and redemption of ETFs, the sale triggers a capital gains tax event, while the redemption is not a taxable event and does not require taxation

3.1 Taxation for U.S. Tax-Resident Investors in Futures Bitcoin ETFs

The taxation treatment of futures Bitcoin ETFs depends on the specific type of futures contracts the ETF invests in. There are two main types of futures contracts:

(1) ETFs Exposed to Regulated Futures Contracts:

These are ETFs that hold a certain quantity or proportion of regulated futures contracts in their portfolios and are therefore sensitive to the market performance, price fluctuations, or related risks of these contracts. According to Section 1256 of the U.S. Internal Revenue Code (IRC), "regulated futures contracts" are contracts that meet the following criteria: (a) the amount required to be deposited and the amount allowed to be withdrawn depend on a marking to market mechanism, and (b) the contract is traded on a compliant exchange or is subject to its rules.

For Bitcoin ETFs, if their portfolio includes Bitcoin contracts traded on the Chicago Mercantile Exchange (CME), which is a compliant exchange, then the ETF falls under the category of ETFs exposed to regulated futures contracts. If investors sell these ETFs at a profit, regardless of how long they held them (even if it's just for a day), 60% of the profit will be considered long-term capital gains, and 40% will be considered short-term capital gains.

(2) ETFs Exposed to Unregulated Futures Contracts:

These are ETFs whose portfolios include contracts traded in informal, unregulated markets, such as over-the-counter (OTC) contracts. These contracts may not be subject to regulation or may have limited regulation, and their terms and conditions can be freely negotiated between counterparties. These ETFs generally carry higher risks due to the lack of standardization and trading transparency.

3.2 Taxation for U.S. Tax-Resident Investors in Spot Bitcoin ETFs

The tax rules for spot Bitcoin ETFs are consistent with general capital gains tax rules. If spot Bitcoin ETF assets are sold within one year of holding, any resulting short-term capital gains are subject to ordinary income tax rates. If the shares are held for more than 12 months before selling, any resulting long-term capital gains are taxed at the 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 for U.S. Tax-Resident Individuals and Corporations

3.3.1 Tax Rates for U.S. Tax-Resident Individuals

Long-term capital gains: Long-term capital gains are subject to three tax rates based on the investor's total taxable income and tax filing status: 0%, 15%, and 20%. For single taxpayers or heads of households, long-term capital gains up to $44,625 are tax-exempt; gains between $44,625 and $492,300 are taxed at a rate of 15%; and gains exceeding $492,300 are taxed at a rate of 20%.

Short-term capital gains/dividend income: These gains are taxed at regular income tax rates, ranging from 10% to 37%, depending on total taxable income and tax filing status. For example, for single taxpayers or heads of households, income up to $11,000 is taxed at a rate of 10%, while income over $578,125 is taxed at a rate of 37%.

Other taxes: If an investor's net investment income or modified adjusted gross income (MAGI) exceeds specific thresholds, there may be an additional 3.8% Net Investment Income Tax (NIIT) on the excess income. The thresholds for NIIT are as follows: $200,000 for single taxpayers or heads of households, $250,000 for married taxpayers filing jointly, and $125,000 for married taxpayers filing separately.

3.3.2 Tax Rates for U.S. Tax-Resident Corporations

Corporations are subject to the same tax rates for ETFs as individuals, including the classification of gains as long-term or short-term capital gains. The tax rate for net capital gains is 21%. For corporations, gains or losses from the sale or exchange of capital assets held for over 12 months are considered long-term capital gains or losses. Gains or losses from assets held for 12 months or less are considered short-term capital gains or losses. The net long-term capital gains are taxed based on this calculation. If there are long-term capital gains losses but short-term gains, the short-term gains are taxed first and cannot offset long-term losses.

3.4 Special Provisions for U.S. ETF Taxation

Bitcoin ETFs are also subject to wash-sale rules. A wash sale refers to the selling or trading of securities at a loss and repurchasing "substantially identical" securities or contracts within 30 days before or after the sale. If a loss is disallowed due to a wash sale, the disallowed loss is not deductible and is added to the cost basis of the new Bitcoin ETF, effectively deferring the tax deduction until the disposal of the new Bitcoin ETF. Additionally, the holding period calculation for the new Bitcoin ETF must include the previously sold Bitcoin ETF's holding period.

If an ETF's underlying assets include not only Bitcoin but also other assets such as currencies, futures, and metals, these specialized assets in the ETF may be subject to specific tax rules.

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  Currency ETFs: Most currency ETFs are structured as grantor trusts, meaning profits from the trust result in tax obligations for ETF holders and are taxed as ordinary income. This type of ETF does not benefit from special tax treatment such as long-term capital gains even if the ETF has been held for several years. Because currency ETFs involve currency pair trading, tax authorities assume that these transactions are short-term in nature.
  
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  Futures ETFs: These funds trade futures contracts of commodities, stocks, U.S. treasuries, and currencies. Regardless of the holding period, gains and losses generated by these ETFs due to holding futures contracts are taxed at a 60% long-term and 40% short-term ratio. Furthermore, ETFs trading futures are subject to mark-to-market valuation at year-end. This means that unrealized gains (profits) at the end of the year are treated as if they were sold and are taxable.
  
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  Metal ETFs: Trading or investing in gold, silver, or platinum is considered dealing with "collectibles" in the eyes of tax authorities, and this policy also applies to ETFs trading or holding these precious metals. If gains from collectibles are short-term, they are taxed as ordinary income. If gains exceed one year, they are subject to the higher 28% capital gains tax rate, which means they do not enjoy the benefits of the regular capital gains tax rates.
  

4. Taxation for Hong Kong Residents Investing in Bitcoin ETFs

Hong Kong investors face withholding taxes when investing in ETFs from other countries or regions. For example, when Hong Kong residents invest in U.S. Bitcoin ETFs, they are subject to a 30% withholding tax on dividends paid by U.S. ETFs due to the absence of a Double Taxation Agreement (DTA) between Hong Kong and the United States. However, since Bitcoin ETFs do not generate dividends, there is no withholding tax issue. Additionally, Hong Kong residents investing in U.S. ETFs do not need to pay capital gains tax and are only subject to taxation according to Hong Kong regulations.

At the fund level, Bitcoin ETFs are generally not subject to additional taxes in Hong Kong on income generated outside of Hong Kong, as Hong Kong's tax laws follow a territorial source principle. Therefore, Hong Kong investors typically do not need to pay additional taxes on these income unless there are specific Hong Kong elements related to the trading or income of Bitcoin ETFs.

5. Taxation for Singapore Residents Investing in Bitcoin ETFs

Singapore investors also face withholding taxes when investing in ETFs from other countries or regions. For example, when Singapore residents invest in U.S. Bitcoin ETFs, they are subject to a 30% withholding tax on dividends paid by U.S. ETFs, similar to Hong Kong investors, due to the absence of a Double Taxation Agreement (DTA) between Singapore and the United States. However, as Bitcoin ETFs do not generate dividends, there is no withholding tax issue. Additionally, Singapore residents investing in U.S. ETFs do not need to pay capital gains tax and are only subject to taxation according to Singapore regulations.

At the investor level, Singapore also follows the territorial source principle, meaning that only income generated in or derived from Singapore is taxable. However, Singapore's income tax law specifies that if income derived from outside Singapore is remitted, transmitted, or brought into Singapore, it may be treated as income "derived from Singapore."

Individual investors who remit their income from Bitcoin ETF investments into Singapore generally need to pay personal income tax. Singapore's personal income tax rates for 2024 range from 0% to 24%, depending on an individual's taxable income.

Singapore-resident businesses enjoy tax exemptions for foreign-sourced dividend income if certain conditions are met: (1) the foreign country where the income is derived has a headline corporate tax rate of at least 15%, (2) the income has been taxed in the foreign jurisdiction, and (3) the authorities consider the exemption favorable to the resident company.

With changes in Singapore's tax laws, as of January 1, 2024, there may be taxation for foreign asset sale proceeds remitted into Singapore under specific conditions, reflecting Singapore's gradual alignment with international tax standards. However, for income from Bitcoin ETF investments, investors typically only have to fulfill their withholding tax obligations in the United States if they do not remit the income into Singapore.

6. Conclusion and Recommendations

By examining the tax treatment of Bitcoin ETF investments for residents in the United States, Hong Kong, and Singapore, it is evident that the taxation of Bitcoin ETFs depends on factors such as their jurisdiction of registration, type, the investor's place of residence, and the jurisdiction of the investment target. Investors can make informed investment decisions by understanding the tax policies at various stages, such as creation, redemption, and returns for Bitcoin ETFs in their place of residence and the ETF's place of registration.

As cryptocurrency ETFs become a global phenomenon, TaxDAO will continue to analyze the regulatory and tax policies for cryptocurrency ETFs in major countries through dedicated ETF investment topics. We welcome readers to follow our updates on this subject.