Alerian MLP ETF (AMLP), the first ETF structured as a C-corporation, issued a prospectus supplement dated April 19, 2012 (pdf). Total Annual Fund Operating Expenses increased from 0.85% to 1.40%, resulting from “Other Expenses” climbing by 0.55% due to past tax liabilities. AMLP’s press release of April 20 (pdf) makes no mention of this fact while continuing to tout the after-tax yield.

For the period January 1, 2011 to November 30, 2011, the Fund had a current tax liability of 0.55%. “Other Expenses” does not reflect deferred income tax liability to be incurred by the Fund.

Along with the recent tax payment (believed to be about $5 million), AMLP has withheld an additional $113 million of shareholder’s money (Total Market Value minus Total Net Assets) for future tax payments. This represents 3.6% in additional expenses (based on current assets) not fully reflected in the expense ratio. Unless AMLP loses significant value, it appears the expense ratio is destined to climb further. However, AMLP continues to assume a future tax expense of 0.00% while making daily adjustments to share value to pay for those future taxes.

Since inception, AMLP has provided shareholders with only 60% of the underlying index’s return. The fund has posted a 13.0% annual return versus 21.5% for the underlying index. This represents an effective 8.5% per year in costs to shareholders, yet AMLP prefers to call it a tracking error. This is about 6x the amount of the newly revised 1.40% expense ratio.

AMLP shareholders need to be aware of the possibility that all assets in the Fund may eventually incur the 35% corporate tax rate if held long enough:

  1. All capital gains of AMLP are liable for the 35% federal corporate tax.
  2. Distributions AMLP receives from the MLPs it holds are not traditional dividends but consist primarily of “return of capital” which will be taxed at the 35% federal corporate tax rate when sold.
  3. Once the cost basis of an MLP holding reaches $0, which is typically about 12-13 years for an MLP yielding 8%, all future distributions AMLP receives from that MLP will be current-year taxable at the 35% federal rate.
  4. Once the cost basis of an MLP holding reaches $0, all of its value (100%) then represents a capital gain that will face the 35% federal corporate tax when realized.

All of the above is before shareholders incur their own tax liabilities for buying, holding, and selling shares of AMLP. Remember, distributions that shareholders receive from AMLP are not tax-free dividends. Approximately 85% of those distributions are tax-deferred return of capital.

Disclosure covering writer, editor, and publisher: I am not a tax advisor, but I can usually recognize double taxation when I see it. No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.