On September 28, 2026, the Department of the Treasury and the Internal Revenue Service issued Notice 2026-62 and Rev. Rul. 2026-20, taking aim at a group of fast-growing investment fund strategies. The revenue ruling reaches an immediate conclusion on one type of Section 351 ETF conversion transaction, while the notice identifies a broader set of ETF and "tax-aware" fund strategies for possible future guidance and examination challenges.
The guidance arrives after Section 351 conversions moved quickly from a niche ETF-seeding technique into a significant part of the market. Industry data published by BNY in June 2026 reported that 77 U.S. ETFs had launched with approximately $16.6 billion of seed assets from individual investors. The new guidance focuses on transactions in which formal nonrecognition, timing, or character rules are combined with prearranged steps or selective trading decisions to produce a tax result that Treasury views as disconnected from the transaction's economic substance.
Background: Section 852(b)(6) and ETF In-Kind Redemptions
A corporation generally recognizes gain under Section 311(b) when it distributes appreciated property. Section 852(b)(6), however, turns off Section 311(b) for certain distributions made by a RIC in redemption of its shares. The nonrecognition rule now reflected in Section 852(b)(6) traces back to 1969, when Congress added a predecessor exception to Section 311 to allow mutual funds to make in-kind redemptions without recognizing gain. Congress moved this rule to Section 852(b)(6) in 1986, seven years before the modern U.S. ETF launched in 1993. ETFs later paired this preexisting tax rule with the authorized participant (AP) creation-and-redemption mechanism, which permits large financial institutions to exchange baskets of portfolio securities for large blocks of ETF shares and facilitates arbitrage that keeps an ETF's market price close to its net asset value. ETFs routinely rely on Section 852(b)(6) when an AP redeems a creation unit and receives a basket of portfolio securities, often including appreciated securities. The ETF recognizes no gain on the in-kind redemption; the AP generally takes a cost basis in the distributed assets; and the appreciated securities, together with their built-in gain, can leave the ETF without triggering a capital-gain distribution to the ETF's continuing shareholders.
Notice 2026-62 expressly acknowledges this conventional creation-and-redemption mechanism and generally leaves it alone. The Notice instead addresses transactions in which the redemption mechanism is used as one step in a larger plan to avoid income or gain that otherwise would be recognized under Subchapter M or other Code provisions.
Rev. Rul. 2026-20: Section 351 ETF Conversion Transactions
Section 351 generally permits property to be transferred to a corporation solely for stock without current gain or loss if the transferors control the corporation immediately after the exchange. Section 351(e) denies that treatment for certain transfers to investment companies that diversify the transferors' interests. However, under Treasury Regulation 1.351-1(c)(6), if a transferor contributes a portfolio that is already diversified under the applicable tests the transferor generally does not obtain prohibited diversification merely by making the contribution. That rule has supported transactions in which appreciated portfolios are contributed to newly formed ETFs without immediate recognition of built-in gain.
Rev. Rul. 2026-20 addresses a more specific fact pattern. An investor contributes an appreciated, diversified portfolio to a newly formed ETF. As part of the same plan, the ETF then issues a creation unit to an AP for cash or securities that fit the ETF's intended investment thesis and, shortly thereafter, redeems the AP with the securities that the investor contributed. When the planned steps are complete, the investor owns ETF shares, but the ETF holds a materially different portfolio that reflects its intended strategy rather than the investor's contributed securities.
The IRS does not attack the transaction by concluding that the technical control or diversification requirements of Section 351 were never satisfied. Instead, it applies substance-over-form and step-transaction principles. The ETF's transitory ownership of the contributed securities is disregarded because, in the IRS's view, the ETF is merely a conduit for transferring those securities from the investor to the AP. The investor is therefore treated as engaging in a taxable exchange with the AP under Section 1001. The ruling states that the same analysis applies when multiple investors participate in the transaction. Thus, for example, if an ETF is seeded in-kind with appreciated securities, and the ETF subsequently redeems the securities in-kind to move to the ETF's desired portfolio, the IRS may disregard the ETF and treat the transaction as the investors selling the appreciated securities to the AP.
Notice 2026-62 expressly says it does not address a Section 351 transaction used to seed a newly established ETF with assets that are consistent with the ETF's investment thesis and are intended and expected to be retained absent a substantial change in circumstances. Thus, the guidance does not establish a holding period or mechanical percentage test. It instead makes the planned use of the contributed assets a central factual question.
Notice 2026-62: A Broader List of Scrutinized Strategies
cNotice identifies several additional strategies but does not yet prescribe their tax treatment. Treasury and the IRS request comments and state that future action could include regulations, notices, revenue rulings, or designation of a transaction as a transaction of interest or a listed transaction. The identified strategies include:
- Partnership exchange-fund variations. Investors with concentrated appreciated positions contribute them to a partnership that holds enough non-stock or non-security assets to avoid investment-company treatment under Section 721(b). The partnership is then made sufficiently diversified to participate in the Section 351 ETF conversion strategy described above. The Notice does not address traditional exchange funds that do not engage in this additional conversion step.
- Box-spread funds. An ETF uses non-Section 1256 option contracts to create a synthetic short-term interest-rate return and distributes appreciated option positions through Section 852(b)(6) redemptions before those positions would otherwise produce taxable income or gain. A related variation couples the box spread with a separate straddle and attempts to retain deductible losses while permanently removing the offsetting gain positions.
- Record-date strategies. A parent ETF that owns another ETF tracking the same index uses an in-kind redemption to dispose of the acquired ETF immediately before its dividend record date and substitutes a different ETF with materially similar market exposure, with the asserted result that the parent avoids dividend income without meaningfully changing its investment exposure.
- RIC income-test avoidance. An ETF holding commodities, digital assets, or similar positions distributes appreciated assets through in-kind redemptions and takes the position that the realized but unrecognized gain does not enter the 90% qualifying-income test under Section 851(b)(2).
- Tax-aware derivative strategies. The Notice targets investment partnerships and separately managed accounts that pair economically offsetting positions with different tax character or timing rules. Examples include mixed-character identified straddles involving Section 988 currency forwards and Section 1256 futures, same-day Section 988 elections made after the fund knows whether a currency forward produced gain or loss, and selective terminations of appreciated notional principal contracts while loss contracts are held to payment or maturity.
The Common Thread: Tax Rules and Economic Returns
Although the Notice addresses a diverse group of strategies, a recurring theme is the use of transaction-specific tax rules that the IRS views as a change in the timing or character of an investment return without a corresponding change in the fund's economic position. The concern is not tax-efficient investing itself. Instead, the Notice focuses on strategies that the IRS believes separate the tax consequences of an investment from its underlying economics.
The box-spread strategy seeks to produce the economics of a short-term interest return without current income recognition. The record-date strategy maintains substantially the same index exposure while seeking to eliminate dividend income. The RIC income-test strategy uses in-kind redemptions to prevent gains from nonqualifying assets from entering the Section 851 income test. And the tax-aware derivative strategies use differences in character, elections, identification rules, or the timing of terminations to seek capital gain and ordinary loss from economically offsetting or similar positions.
Viewed together, these examples suggest that the Notice is less about any specific product, such as ETFs, exchange funds, box spreads, currency contracts, or swaps, than about the interaction between investment economics and rules designed for particular tax purposes. The Notice repeatedly contrasts the identified transactions with conventional market practices and asks commenters to identify similar transactions with different facts or economics that warrant different treatment. That distinction will be important as Treasury determines whether and how to translate the Notice's concerns into more specific guidance.
Treasury and the IRS have requested written comments on Notice 2026-62 by October 28, 2026.