How will tax hit your ETF holdings?

At this time of year, many investors ask questions about the tax implications of using exchange traded funds (ETFs).

There is a hierarchy of three levels of tax to consider when investing in funds and ETFs.

First is within the ETF itself. The investment the fund is making in equities or fixed income and where those securities are domiciled relative to the domicile of the fund will impact on the taxes on income or capital gains within the fund.

Then there is tax relating to where the fund is domiciled. This will have an impact on the type and level of tax the fund might incur in the country in which it is domiciled.

At the investor level, tax on income and capital will be determined by the domicile of the investor and the type of investor, based on where the fund is domiciled, registered for sale, and the type of tax reporting undertaken by the fund.

Withholding tax inside a fund may be on income or capital gains. How these taxes are determined is based on the framework of tax treaties between the country where the fund is domiciled and the country where the fund’s investments, equities or fixed income securities are domiciled.

For illustrative purposes only, we will look at how this difference might work for a non-US based investor in a fully replicating physical S&P 500 fund in three different domiciles. 

An S&P 500 fund domiciled in Luxembourg will typically incur 30% withholding on any dividends paid by the stocks in the fund, while an S&P 500 ETF domiciled in Ireland will typically incur 15% withholding. An S&P 500 fund domiciled in the US, meanwhile, will not suffer withholding on dividends paid by the stocks in the fund.

In synthetic ETFs, the index performance paid to the fund will be determined by the terms of the swap contract, the domicile of the counterparty and the domicile of the investment. 

Depending on the underlying investments in the fund, the ETF may also suffer stamp or transaction based taxes. 

Fund level withholding can occur when the country where the fund is domiciled withholds taxes on distributions being paid to investors.

Typically there is no withholding on distributions from Irish or Luxembourg funds to investors in Europe, while US domiciled funds will typically withhold 30% on income paid to non-US based investors. Depending on tax treaties and the investor filing a W8BEN form, the withholding from a US-domiciled fund might be reduced to 15% or zero. 

Investor level tax implications are determined based on a number of factors such as the type of investor, their tax status, their domicile/residence and the fund’s domicile. The investor should also look at whether the fund is making any necessary tax filings in their domicile.

The Foreign Account Tax Compliance Act (Fatca) is a new law, which is in the process of being implemented by the US to require financial institutions to report details of US investors holding assets outside the US to the US tax authorities.

The current plan is for Fatca to be phased into effect from July 2013 through January 2015. Financial institutions that fail to comply with the reporting requirements will suffer 30% withholding on the gross sales proceeds on any US securities, as well as the 30% withholding on income.

But tax is just one of the factors investors should look at when making an investment decision.