I’ve heard ETFs are tax-efficient. Is this true?
While US investors can take advantage of some ETF tax benefits, the same is not true in Britain. ETFs are not given special treatment in the UK. In general, when it comes to taxes, ETFs and traditional funds are treated the same.
In that case, what should I keep in mind, in terms of taxes, when buying ETFs?
The most important thing to consider before buying an ETF is the country of issue. If an ETF was issued in the US or France, you may have to pay more tax on that investment than you otherwise would if you bought the ETF in the UK. Specifically France and the US have tax regimes that enforce withholding tax, which often tax ETF dividends at a very high rate. Dividends from ETFs domiciled in France can be subject to a 30% tax deduction at source, which is not always fully reclaimable. Dividends paid by American-based ETFs can be subject to a withholding tax of 30%. This withholding tax takes a big bite out of your investment gains.
What other tax factors should I consider before buying an ETF?
There is an important classification system that investors should be aware of that govern taxes for ETFs. It is very important to check an ETF’s classification before making a purchase. Many individuals, and even advisers, do not know to check this until it’s too late.
Roughly 75% of ETFs in the UK are given either ‘reporting’ or ‘distributor’ status. Investors want their ETFs to be classified in either of these categories because these classifications generally result in less tax. When an ETF has either of these classifications, it means that any ETF gains are subject to capital gains tax, which is generally a cheaper alternative to income tax. Capital gains tax rates are either 18% or 28%, instead of income tax rates which can be as high as 50%. (Keep in mind, this capital gains tax is not only applied to ETFs, but to other traditional investments such as funds and shares.)
It is critical to know that roughly 25% of ETFs in the UK and most ETFs listed on US or European exchanges do not have the ‘reporting’ or ‘distributor’ status. Without this status, investment gains can be charged as income tax, which can become very expensive.
HMRC has already shown that it has very little sympathy for investors who accidentally bought ETFs that weren’t classified under either ‘reporting’ or ‘distributor’ status. If they owe tax, they will have to pay it.
(Note: ‘Reporting’ status is very similar to ‘distributor’ status. ‘Reporting’ is just a newer, updated classification, compared to the older ‘distributor’ classification.)
What happens with dividends from ETFs?
Dividends generated from ETFs or any traditional investment are usually subject to income tax, because dividends are income for investor. The income tax rate depends on an individual’s income, but the rate can range from 20% to 50%.
Anything else investors should know?
When you first start investing, you probably won’t have to worry about being liable for capital gains taxes on ETFs or any of your investments. Individual investors are allowed to make £10,680 in capital gains on their investments without having to pay any tax at all. It’s only once you make more than £10,680 that you start getting taxed for capital gains.
Can I put ETFs in my ISA or SIPP to avoid tax?
ETF gains within any of these tax-efficient wrappers are generally tax-free. Wherever possible these are likely to be the most tax advantageous ways to hold ETFs. However, here again investors have to be aware that a withholding tax can be applied if the funds are domiciled in France or the US.
In summary, what are the main tax issues I should keep in mind when buying an ETF?
The single most important issue to keep in mind is whether an ETF has a ‘reporting’ or ‘distributor’ status. Thereafter, look at the domicile of the ETF and pay particular care to domiciles which apply withholding tax.
Alanna Petroff was speaking to Lee Robertson, CEO of Investment Quorum.
