Dividend “tax leakage” is a concern for any investor in collective investment vehicles (CIVs) that own shares in overseas equity markets. Tax leakage occurs when investors in a fund are forced to suffer withholding taxes on dividends from the underlying shares at a higher rate than would have applied if they had purchased those shares directly.
For a pension fund investor, for example, double tax treaties often allow for the rate of withholding tax on overseas equities to be reduced to zero. Accessing foreign equities via a pooled fund may make great practical sense for an investor, as this enables portfolio diversification via a single purchase. However, to the extent that a fund suffers withholding taxes that cannot be reclaimed on its overseas equity income, there is an automatic drag on the returns received by the end-investor.
Collective investment vehicles may be able to gain access to some tax relief under double taxation treaties (in other words, dividend withholding tax rates may be reduced, if not eliminated completely). However, according to Paul Radcliffe, senior vice president in Citi’s Tax Products and Transactions group, “claiming double taxation treaty (‘treaty’) benefits by collective investment vehicles can be a vexed subject. Treaty interpretation can differ from source country (the country in which the income arises) to source country; the treaty claim process can be laborious, unclear and paper-intensive, with treaty forms being required to validate a claim; and the layout and information required by such forms may differ, based on each source country’s requirements.” 1
For passive, benchmark-tracking vehicles such as exchange-traded funds (ETFs) and index funds, dividend tax leakage is a particular problem. Tracker funds aim to do what their name suggests—track their underlying indices. However, any lost dividend income leads directly to an unrecoverable tracking error between the fund and its index benchmark (assuming that the benchmark is based on the receipt of dividends before any deduction for withholding taxes). This tracking error is incurred over and above the more familiar underperformance that results from portfolio management expenses.
According to David Blitz, Joop Huij, and Laurens Swinkels2, “European index funds and exchange-traded funds underperform their benchmarks by 50 to 150 basis points per annum. The explanatory power of dividend withholding taxes as a determinant of this underperformance is at least on par with [that of] fund expenses.”
In practice, index providers do factor in the effect of dividend withholding taxes into their return calculations, by publishing both “gross total return” (i.e., pre-withholding tax) and “net total return” (post-withholding tax) versions of international equity indices.
In turn, index fund and ETF managers usually track the post-tax, net total return, rather than the zero tax (gross total return) versions of their benchmarks.
In this article we seek to quantify the dividend tax leakage that has occurred over the last ten years in seven popular index benchmarks. Dividend tax leakage is defined as the proportion of the gross dividend income forgone by an investor receiving only the net, post-withholding tax index return. We look at the trends in tax leakage and the absolute levels of leakage from the indices surveyed. To get a feel for the importance of dividend tax leakage as a cost faced by the end-investor, we compare average tax leakage with funds’ expense ratios. Finally, we examine the withholding tax rate assumptions used by index providers and question their appropriateness.