Bloomberg recently reported on an exchange-traded fund (ETF) with the ticker symbol BOXX. The ETF exploits various tax rules to transform what’s effectively interest income, subject to a top federal tax rate of 37%, into long-term capital gains, which are taxed at no more than 20% to BOXX’s shareholders. The strategy’s promoter calls it “a democratization of tax dodges,” per Bloomberg. But will the scheme hold up if challenged by regulators? I doubt it—nor should it.

BOXX already has more than $1 billion in assets and, according to its promoter, BOXX may reach $5 billion by the end of next year. BOXX gets its name from its principal investment: box spreads. They’re collections of paired and opposite bets on the direction of asset prices or market indexes like the S&P 500 that are designed to cancel each other out and thus avoid investment risk.

The ETF effectively earns a return on each box spread that roughly matches the return on Treasury bills. As box spreads mature, new ones are entered—and the BOXX shares continue to appreciate. When investors sell their shares, they claim the appreciation as capital gain (and, while the investors hold shares in the fund, they are shielded from annual income by the ETF’s use of a variety of tax tricks). As Bloomberg summarized, “for investors holding the fund for at least a year, it mimics a highly taxed form of income with a lower federal tax rate.”

I have some experience with policymaking that limits this kind of tax-dodging transformation of income. In 1993, as a staffer at the Joint Committee on Taxation, I helped Congress draft Code section 1258, the Tax Code’s anti-conversion statute. (Conversion refers to the converting of higher-taxed ordinary income into lower-taxed capital gains.)

At the time, Senate Finance Committee Chairman Lloyd Bentsen was concerned that a widening differential between tax rates on ordinary income and capital gains would increase demand for so-called conversion transactions. Today, the value of converting interest income into capital gains is even greater.

Section 1258 imposes a two-part test to determine whether a given transaction is a “conversion transaction.” First, “substantially all” of the taxpayer’s expected return from the investment must be attributable to the time value of the taxpayer’s net investment in the transaction. If the gain is attributable to how long the investment has been held, and not to investment risk, then the return more closely resembles interest than a capital gain.

Second, to be considered a conversion the transaction must be one of four specified types—with Nos. 3 and 4 especially relevant here: (1) a “cash and carry” trade, (2) a straddle (3) a transaction that has been marketed or sold as producing capital gain from a time value return, or (4) any other transaction specified by Treasury regulations.

Earning interest-equivalent income while paying capital-gains taxes is especially alluring today, with short-term interest rates near a 20-year high. But, despite its popularity, BOXX violates both the letter and the spirit of the anti-conversion statute.

Referring to the first of the controlling statute’s two-part test, substantially all of the shareholders’ expected return is attributable to the time value of their net investment. There is no question the shareholders expect an interest-like return on their purchase of BOXX shares.

Regulators hoping to strip the tax benefits from BOXX also can point to its marketing as a transaction that produces capital gains from a time value return. The regulators will find plenty of help in the company’s own promotional materials. On its website, the company describes an investment in BOXX as seeking a similar risk and return as Treasury bills. And the prospectus for BOXX describes investments in the ETF as an opportunity to earn interest-like returns with capital-gains taxation. Moreover, if there were any uncertainty in the regulators’ minds about whether BOXX was marketed or sold as producing capital gains, Bloomberg’s interview with the promoter presumably resolved it.

But, even if the marketing of BOXX did not establish investment in the fund as a conversion transaction, regulators could still proceed under the catch-all fourth provision. It’s straightforward to specify an investment in BOXX as a transaction with substantially all of its expected returns attributable to time value. Whatever criterion Treasury uses to clarify the scope of the anti-conversion rules, the BOXX tax advantages should be closed, as they contravene Congress’ clear intent to stop conversion of ordinary income into capital gains.

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