pwc Resolutions How regulations and taxes are shaping the future of ETFs PwC | Resolutions Contents Executive summary1 How regulations and taxes impact the growth and innovation of ETFs .4 Impact of regulations on ETFs .5 Regulatory impact on product structures . 7 Increased compliance and disclosure requirements . 8 Market infrastructure changes .9 Taxes and impact on ETFs.10 Where tax matters most . 13 Navigating the regulatory and tax course . 15 Contacts .16 PwC | Resolutions 1 Executive summary Skyrocketing popularity often comes at the price of sharp scrutiny, as the fast-growing exchange traded funds (ETF) industry is learning. With the number and variety of ETFs rapidly increasing, and total assets under management at an all-time high, ETFs have earned an extra level of scrutiny from regulators globally. Regulators appear to be committed to making sure that safeguards exist for accurately identifying and communicating risks and costs, as well as ensuring up-to-date compliance practices for ETFs. Whether such directives dampen growth and innovationor steer funds toward new opportunitiesmay depend on how well ETF sponsors manage risks and disclosures while also accommodating changing distribution technologies and new investment products. The continued growth in ETF assets will also be matched by increased complexity. In addition to traditional ETFs, which passively track market benchmarks, there are actively managed versions, and smart beta ETFs (which measure stock holdings based on factors other than market capitalization) as well as derivatives-based synthetic ETFsand an ever-expanding array of others, some of them less diversified and, therefore, riskier. PwC | Resolutions 2 An increasing number of ETF sponsors will explore geographic markets outside of their home territories, according to a recent PwC study. The survey, which drew global responses from more than 65 ETF managers, sponsors and service providers, asked respondents where they plan to expand, and which regulatory and tax obstacles they anticipate encountering. The survey-takers, whose firms collectively represent approximately 80% of global ETF assets under management, consist of ETF managers/sponsors (68%), service providers (20%), and market makers and other authorized participants (9%). Whether in search of institutional or retail investors, ETF firms are increasingly seeking to grow their global footprint well beyond their home markets. Based on our survey results, North American (86%), Europe (88%) and Asia (ii) do not impair compliance with the firms duty to act in the best interests of the client; and (iii) are clearly disclosed. Impact: It is thought MIFID II will level the playing field for products like ETFs that do not pay commissions and should boost their attractiveness to investors. PwC | Resolutions 7 Regulatory impact on product structuresUnited States Consideration of periodically disclosed active ETFs: There continues to be growing interest in periodically disclosed active ETFs (also known as “nontransparent active” ETFs). The SEC is evaluating different periodically disclosed active ETF models. Among U.S. survey respondents, 43% see the approval of periodically disclosed active ETFs as being most impactful to the U.S. ETF industry. Impact: The growth and innovation of ETFs could be significantly impacted with the approval of one or more of the proposed periodically disclosed active ETF models. Europe Europe ESMA share class paper: ESMA issued a share class paper on January 30, 2017 which contains 4 high-level principles: Common investment objective; Non-contagion; Pre-determination and Transparency. While the ESMA paper identified certain requirements and limitations around the purposes for usage of separate share classes, for instance share class level currency hedging, it did not comment on the concept of establishing exchange traded classes of mutual funds, which has drawn some debate within Europe in recent years. Impact: Focus will return to local regulators to review this matter. European ETF sponsors would save time, capital and resources if their local regulators approve them to issue separate ETF share classes. Solvency II & Accounting changes: Solvency II has imposed on insurers risk-based capital requirements around their investment portfolios. Solvency II applies a “look through approach” for investment funds, including ETFs that follow fixed income strategies. This would give fixed income ETFs an equal footing to a direct bond holding, rather than being classified as an equity holding, thus requiring lower capital charges. This is bolstered by some forthcoming changes to International Accounting Standards (specifically, IFRS 9), which is likely to lead to an increase in the level of financial instruments being held at fair value through profit or loss and will therefore put ETFs on an equal footing with other instruments for certain investors. Impact: Regulatory and accounting changes have the potential to enhance the attractiveness of ETFs for certain European investors, including insurance companies. Asia Hong Kong developments: In February 2016, the Securities and Futures Commission in Hong Kong (SFC) issued a “Circular on Leveraged and Inverse Products” setting out the requirements applicable to leveraged and inverse products structured as ETFs seeking authorization for public offering in Hong Kong. Impact: Given the appetite for more complex ETF products in Asian markets, the focus of the SFC on liquidity and localization of the underlying indices is a move to ensure risks are minimized. Singapore developments: Over the last two years, the Monetary Authority of Singapore introduced the concept of Excluded Investment Products (EIPs) in addition to the existing Specified Investment Products (SIPs). Previously all ETFs were classified as the latter which restricted the investments into ETFs as investors would have to be assessed for investment knowledge and experience before investing. Now, ETFs that make limited use of derivatives for efficient portfolio management fall under the EIP classification and can be invested in without prior assessment of investor knowledge and experience. This change effectively made 80% of the assets under management by ETFs listed on the Singapore Exchange Limited (SGX) accessible to non-institutional investors. Impact: These regulations have made most ETFs more attractive in Singapore to non-institutional investors.