The U.S. Treasury Department has initiated concrete measures to address tax avoidance strategies employed by wealthy individuals involving exchange traded funds (ETFs). In a recent notice, the Treasury announced it is examining tactics that it considers “potentially abusive,” including the aggressive use of ETFs designed to minimise taxable gains.

Central to the Treasury’s focus is a strategy known as the 351 conversion, which allows investors to rebalance portfolios holding appreciated assets without triggering immediate tax liabilities. The Internal Revenue Service (IRS) issued a ruling targeting this specific method, signaling intensified scrutiny on practices that exploit favorable tax treatments associated with ETFs.

The 351 conversion involves the rapid reshuffling of securities in a way that does not align with an ETF’s stated prospectus, followed by swift in-kind redemptions. While this approach has gained traction among hedge funds and high-net-worth investors keen on maximising “tax alpha” — returns generated through reducing tax obligations — the Treasury’s action marks a significant shift in regulatory oversight.

Brent Sullivan, an independent tax analyst and editor of the Tax Alpha Insider newsletter, described the ruling as a “seismic moment” for the ETF market. He noted that although the guidance could lead to heightened enforcement, routine tax planning involving the 351 conversion might still be permissible depending on the specific facts and circumstances.

The Treasury’s notice also outlined its intent to gather more information on a range of strategies employed by tax-savvy funds. It highlighted several ETF-related manoeuvres under review and suggested that further regulatory guidance or actions, potentially with retroactive effect, could be forthcoming.

This development follows earlier indications in July when Treasury officials publicly acknowledged an ongoing probe into similar tax strategies at an industry event. The heightened scrutiny comes amid a growing market for tax-aware investing; hedge funds pursuing tax alpha strategies accrued more than $90 billion in assets from early 2023 through April this year. Since 2021, ETFs utilizing 351 conversion techniques have raised an estimated $21 billion, according to data from Tax Alpha Insider.

The market reacted swiftly to the Treasury’s announcement. Shares of Affiliated Managers Group, which holds a stake in AQR Capital Management—a leading hedge fund credited with pioneering tax-aware investment techniques—declined by as much as 2 percent. AQR, alongside firms like Quantinno, has popularized strategies involving leverage, algorithmic trading, and systematic loss harvesting to optimize tax outcomes at scale.

The Treasury’s actions underscore a regulatory push to close loopholes perceived to undermine the intent of federal tax laws. While the full implications remain to be seen, investors and fund managers engaging in sophisticated tax planning will likely face increased examination in the near term.