How Tax Can Impact ETF Returns

There are specific tax differences related to the ETF domicile that must be considered when selecting physically replicated ETFs

Dimitar Boyadzhiev 16 October, 2018 | 8:50AM

tax calculations implications for returns etfs investing hmrc

Taxation of investments is a complex matter, but this shouldn't stop investors from carrying out basic due diligence when choosing an exchange traded fund (ETF) to avoid a negative impact on returns.

UK investors have access to a wide array of ETFs listed on the London Stock Exchange. But being listed in the local exchange is no guarantee of tax efficiency. Some of these ETFs are listed in London just because it is the trading venue of choice for many international investors, potentially meaning that these ETFs may have been initially designed to suit the needs of these investors rather than those of UK-based investors.

Typically, ETFs bought by UK-based investors are domiciled in either Ireland or Luxembourg. The first thing one should check when selecting an ETF is that the fund has UK tax-reporting and/or distributing status. This is to ensure that potential capital gains are taxed as such and not as income. This vital piece of information is clearly spelt out in the ETF factsheet. But there are also specific tax differences related to the ETF domicile that must be considered when selecting physically replicated ETFs.

Tax Implications of European Listed Funds

Some forms of tax, such as financial transaction levies and stamp duties, impact the day-to-day management of Ireland- and Luxembourg-domiciled physical equity ETFs in the same way. But others like dividend withholding taxes impact funds differently. Equity funds are required to pay taxes on the dividends distributed by their holdings. And dividend withholding tax rates vary across jurisdictions depending on the various tax treaties in place. So, for instance, Irish-domiciled ETFs benefit from the US/Ireland double taxation treaty which reduces standard withholding tax rates on US stock dividends from 30 to 15%, whereas Luxembourg-domiciled ETFs are subject to the full 30% tax rate.

Whether subject to reduced or full rates, all dividend tax payments are executed as part of the day-to-day management of an ETF. As a consequence, this is not a practice directly visible to the end investor, and some investors may wrongly assume that they should not concern themselves with the intricacies of portfolio-level taxation. However, this would be the wrong assumption to make, as the end-result of this practice is that ETFs tracking the same equity index can end up offering very different return profiles.

How Tax Can Impact Returns

To illustrate the point, we compare two London-listed UBS ETFs that track the MSCI World index. They both levy an ongoing charge of 0.3%, but one is domiciled in Ireland and the other in Luxembourg. They both are physically replicated, with minor differences in their approach to fund construction, e.g. the Irish-domiciled ETF uses optimised sampling, while the Luxembourg-domiciled ETF is fully replicated.

To estimate the impact of withholding taxes, we multiply the tax advantage of 0.15% by the average weight of the US stocks in the MSCI World Index of 50% and by the average dividend yield of US stocks over the past three- and five-year periods of 2.3%. According to our calculations, based solely on the difference in withholding taxes, investors in the Irish-domiciled ETF would have earned a higher return of 0.17% relative to the Luxembourg-domiciled counterpart.

comparing returns between ETFs which are taxed differently

The exhibit below shows the actual returns of the two UBS MSCI World ETFs over one, three, and five years on an annualised basis. And as one can see, the Irish-domiciled fund has routinely delivered superior returns relative to its Luxembourg-domiciled counterpart.

The difference in returns between the two funds has fluctuated over time and will continue to fluctuate on account of many other factors, including the funds’ size, fees, and management techniques. However, dividend payments will continue to be a substantial driver of the funds’ performance. Hence, choosing the wrong domicile in this particular case could result in sub-optimal performance, especially when left to compound over the long term.

A version of this article first appeared in Money Observer magazine

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Dimitar Boyadzhiev  is a Passive Strategies Research Analyst for Morningstar