Don't Be Taxed More Than Necessary With ETFs

[This article comes from the Learn section of our website.]

Tax is a complex subject and one that ETP issuers, perhaps understandably, shy away from giving formal advice on. But it's an important area to understand, since choosing the wrong product can mean you receive a suboptimal stream of income, or that you may get hit by an income tax rate that's higher than a capital gains tax rate you could otherwise be assessed.

Despite their reluctance to offer advice, some issuers' websites offer excellent guidance on tax—iShares' site stands out in this regard—and so you should consult these sources freely, contacting ETP firms' client service desks for additional help if needed. Your broker/platform/custodian should be able to provide statements of tax withheld; in some cases, your domestic tax authority may then give you a credit for this.

To understand ETP taxation, it helps to look at three types of levy.

Investment-Level Tax

The rate at which ETPs receive income from their underlying investments depends on: the domicile (place of issue) of the ETP; the country of origin of the investment income; the type of income (e.g., equity dividends or interest); and any double-taxation treaties between the two countries.

For example, most European ETFs are domiciled in Ireland and Luxembourg, and many have substantial holdings of US equities. A double-taxation treaty between the US and Ireland allows most Irish-domiciled funds to receive dividends from US companies after a 15% deduction for withholding tax. However, many Luxembourg-based funds suffer a higher deduction—30%—from US dividend income because of a less favourable tax treaty between the two countries.

With US dividend yields currently around 2% a year, that's a difference between receiving 1.7% or 1.4% a year into your ETF from US shares, depending on the fund's domicile. This could easily offset any headline difference in fund fees.

Tax can also be payable on transactions within the fund. Stamp duty is payable on purchases of UK shares within an ETF, for example. A rising number of European countries are introducing or considering similar transaction-based taxes. If your ETF has low underlying turnover levels, such taxes may not cause concern; in a high-turnover fund, they could cause a significant drag on returns. This is not an ETF-specific issue—turnover taxes affect financial transactions of all kinds—but one worth paying attention to.

Fund-Level Tax

Funds in some jurisdictions (for example, the UK) suffer domestic income (corporation) tax. Funds may also tax distributions of income to investors.

Most European ETPs (for example, those domiciled in Ireland and Luxembourg) have neither tax.

But if you buy a US-domiciled ETF, as a non-US investor, you will suffer a 30% deduction from the fund's dividend distributions (unless you live in a country that has a tax treaty with the US, enabling you to cut this rate to 15%). Part or all of such deductions may be offset against your personal UK tax liability, though (see the "Investor-Level Tax" section below).

French-domiciled ETFs also deduct a tax from dividend distributions to non-residents.

Whereas UK stamp duty used to be payable on purchases of London-listed, foreign-domiciled ETFs (i.e., all of them), in 2006, this tax was removed. So while London is not a centre for ETF incorporation because of the income tax levied on UK-domiciled funds, there's no longer a tax inhibiting trading of ETFs in the UK.

Investor-Level Tax

Finally, your personal tax status and the tax status of the fund are critical in determining whether an ETP is tax-efficient or not.

For UK-based investors, the reporting tax status of the ETP determines whether you get taxed at income tax or capital gains tax rates on any gains (see "UK Reporting Tax Status" for further information).

You should also check whether any withholding tax suffered at investment or fund level can be offset against your domestic tax bill. There's a well-established mechanism for doing this for tax withheld from US equities (or US mutual funds), but that may not be the case for other combinations of source income and fund domicile. Here, you may need specialist advice.

Finally, using a tax-efficient savings vehicle (an ISA or a SIPP) can help (see "ETPs And ISA, SIPP Eligibility" for further information).