A Marine Corps veteran with a finance Ph.D. has come up with a new way to avoid taxes.

Any American holding U.S. government securities has to pay income taxes on the interest they generate. For the richest investors, the Internal Revenue Service’s cut is 37%.

But a year-old investment fund offers returns that closely track short-term Treasuries, with starkly lower tax bills. The fund, Alpha Architect 1-3 Month Box ETF, uses a complex options strategy and a longstanding tax loophole that favors exchange-traded funds.

“We spent seven years figuring out how to do this,” said Wesley Gray, the ex-Marine and chief executive officer of Alpha Architect. “My job is just to deliver all the value I possibly can to my shareholders, within the law.”

The fund, known by its ticker BOXX, surpassed $1 billion in assets this month. It is one of a number of efforts to use the ETF loophole in creative new ways, said Jeffrey Colon, a tax professor at Fordham University’s School of Law in New York. He called BOXX “the poster child for tax arbitrage.”

Innovations like BOXX might bring fresh attention from Congress, where Ron Wyden, the Oregon Democrat and chairman of the Senate Finance Committee, floated the idea of ending ETFs’ special tax treatment in 2021. Any legislation would face stiff resistance from the $8.4 trillion ETF industry and its millions of individual investors.

In connection with Wyden’s proposal, nonpartisan congressional scorekeepers estimated that the tax code section that benefits ETFs was costing the government about $20 billion a year in foregone tax revenue. As fund managers figure out how to deploy it in new investing strategies, that figure could grow.

One aspect of BOXX that might be particularly interesting to policymakers: It uses options to generate huge taxable losses without losing any real money. It’s a twist on the tax-avoidance trades known as “heartbeats” that are often used by stock ETFs and that were highlighted in Wyden's proposal.

ETFs’ tax advantage stems from their ability to avoid capital gains. That’s the kind of taxable event that happens when you sell something for more than you paid. A 1969 law allows a certain type of investment fund to avoid those events if it hands appreciated securities, rather than cash, to an investor withdrawing from the fund—a transaction known as in-kind redemption. The tax break was rarely used until ETFs were invented two decades later.

Thanks to the tax treatment of in-kind redemptions, ETFs typically record no gains at all. That means the tax hit from winning stock bets is postponed until the investor sells the ETF, a perk holders of mutual funds, hedge funds and individual brokerage accounts don’t typically enjoy.

The ETF tax loophole works only on capital gains, though. Other kinds of taxable income, such as bond interest and dividend payments, are still passed along each year to investors, who must include them in that year’s taxable income.

That’s what makes BOXX notable: It has managed to generate a return similar to the interest payments from T-bills without distributing any taxable income.

Compare BOXX with the $31 billion SPDR Bloomberg 1-3 Month T-Bill ETF, known as BIL. Since BOXX’s inception in December 2022, it has returned 5.07% annualized after fees through Feb. 20, compared with 4.98% for BIL and 5.14% for an index of T-bills.

Each month, the T-bill ETF distributes taxable income to its shareholders, reflecting interest harvested from the short-term Treasuries it owns. Those earnings are taxable at the ordinary income tax rate that applies to salary, as much as 37%. And it must be paid each year, even if the investor continues to own the fund and reinvests payouts.

In contrast, at least so far, BOXX investors haven’t had to pay any tax unless they sell. And if they hold the ETF for at least a year, they get the preferential rate for long-term capital gains, which tops out at 20%, whenever they do sell.

An investor in the top tax bracket who bought the same amount of each ETF and sold after five years would end up paying about 46% less in federal taxes with BOXX than with BIL, and also would get the benefit of deferring payments for years.

Living in a state with a high-income tax rate, or selling BOXX in less than a year, could dilute or even reverse the tax benefit compared with T-bills. That’s because interest on Treasuries is exempt from state income tax, but gains from investments like BOXX are not. And the U.S. taxes short-term capital gains at the same higher rate as ordinary income.

So how does BOXX do it? Gray broke it down during a phone interview last month. A former Marine captain who served in Iraq before getting a doctorate from the University of Chicago, Gray, 43, spoke from his home in Puerto Rico, where he said he avails himself of the U.S. territory’s generous tax benefits for investors.

BOXX invests almost all of its money in box spreads, a form of debt frequently used by big trading firms, Gray said. A firm that has a little extra cash might buy a box spread to earn a modest return on idle money; a firm that needs to borrow might sell one. “It’s an alternative way to cut out the banks and directly borrow and lend,” he said.

A box spread typically takes the form of a package of options on the S&P 500 Index, but it’s structured so that the total value isn’t affected by the performance of the index. Instead, it’s designed to pay out a set amount on a certain date a month or two in the future. Lenders buy that future promise at a discount, allowing them to earn a return that closely tracks short-term Treasuries. The options BOXX buys are backed by Options Clearing Corp., which has an AA credit rating from Standard & Poor’s. That’s the third-highest rating, just a notch below U.S. government debt.

Earning bond-like returns but recording them as capital gains from options bets, rather than interest, gives BOXX a chance to deploy the tax magic of ETFs. It does that by turning a single stock into a perpetual tax-loss-generating machine.

The stock that BOXX uses for this task is usually Booking Holdings Inc., the owner of reservation websites like Priceline, OpenTable and Booking.com. In addition to placing box spreads on the S&P 500, from time to time BOXX will also buy one on Booking shares. Booking’s unusually high price, which hasn’t dipped below $3,000 this year, makes it an attractive stock for these trades, Gray said.

Although Booking spreads typically represent less than 1% of BOXX’s holdings, they play a key role in its tax planning. A box spread is akin to making two bets, one that a stock or index will go up, and one that it will go down. Since the bets are symmetrical, the overall value of the spread is unaffected by market movements. But the individual components are: If Booking rises, the long bet will gain in value, and the short one will lose.

Whenever BOXX wants to cancel out some capital gains, it uses an in-kind redemption to hand off the winning leg of the Booking trade to a market maker, Gray said. It keeps the losing leg on its own books, generating a tax loss.

Gray said BOXX usually turns to Chicago-based Wolverine Trading LLC for help with these trades, asking the market maker to redeem a certain amount of BOXX shares in exchange for a Booking spread. Wolverine executives did not respond to requests for comment.

A relatively small investment in Booking, combined with the ETF loophole, can easily generate large tax losses. Last May, BOXX bought a box spread on Booking for about $1 million. Three months later, the long side of the trade had gained more than $30 million and the short side had lost almost the same amount.

Then BOXX shed the winning part of the trade through an in-kind redemption and kept the losing part on its books. The fund’s daily holding reports show that the maneuver positioned BOXX to book a tax loss of about $32 million, even though its overall bets on Booking made a few thousand dollars. That loss is more than all the actual returns the fund earned last year.

When he started marketing BOXX, Gray was careful not to promise the fund would never generate taxable gains. After all, that depended on whether traders could execute its complex tax-management plan successfully. But after more than a year without tax distributions, investors are piling in. They have deposited $300 million since Jan. 1.

It hasn’t hurt that yields on short-term Treasuries, close to zero as recently as 2021, are now near two-decade highs. “It would not be surprising to me if BOXX was $5 billion by the end of next year,” Gray said.

When media and policymakers scrutinized the ETF loophole in the past, industry defenders argued that it serves to delay tax bills, not reduce them. That’s often the case for stock ETFs.

But it’s not true for BOXX. For investors holding the fund for at least a year, it mimics a highly taxed form of income but with a lower federal tax rate.

Colon, the Fordham professor, said lawyers, bankers and fund managers are all kicking around ideas for using ETFs’ in-kind redemption mechanism to solve new tax problems. One idea he’s heard: converting a hedge fund into an ETF to harvest winning bets and delay the tax bill. Another possibility is using ETFs in corporate takeovers to fend off selling shareholders’ taxes.

“Creative tax people are going to look for ways to apply it to different areas,” Colon said.

Asked about his 2021 ETF proposal, Wyden said in a statement that he continues to work to revamp parts of the tax code that help wealthy investors avoid paying their fair share. “I’m going to keep fighting to address the unfairness in our tax code that’s routinely flouted by the fortunate few while making sure to protect the interests of middle-class investors,” he said.

Eric Pan, president of the Investment Company Institute, an industry group, said more than 15 million U.S. households own ETFs. “ICI strongly opposes changing the tax treatment of the use of in-kind redemptions by ETFs and mutual funds, as this would harm those American investors,” he said.

Gray said billionaires have long had access to private, bespoke schemes to shelter wealth from the IRS. He sees ETFs as a way for regular investors to get some of the same benefits. “We’re one of a million products and ideas and innovations that, for lack of a better term, leverage the ETF tax technology to get a better outcome,” he said. “It’s more of a democratization of tax dodges.”

This article was provided by Bloomberg News.