The returns you get from your funds are very important, but if you do not hold these in the most tax-efficient way then you negate some of your gains. The tax situation becomes more complex when it involves funds domiciled offshore, and as this applies to most exchange traded funds (ETFs) one of our readers has asked how to establish the after-tax yield and return he gets on his investments.
As most ETFs listed on the London Stock Exchange are domiciled in Luxembourg or Ireland tax is less of a concern, says Nathan Hall, partner, investment management tax, at KPMG. This is because Irish and Luxembourg taxes are not imposed on the capital gains from these funds or the dividends.
However, if you hold ETFs domiciled elsewhere you may have to pay tax in this jurisdiction.
The distributions from ETFs to UK residents are usually taxed as foreign dividends. "Foreign dividends are treated in a similar way to UK dividends," says Chris Springett, associate director of private client tax services at Smith & Williamson. "Therefore, income tax is applied at the individual's marginal dividend rate: 10 per cent for basic rate, 32.5 per cent for higher rate and 37.5 per cent for additional rate taxpayers."
Most non-UK dividends also qualify for a notional 10 per cent tax credit and foreign tax will often have been withheld on the dividends by the host country of the corporate.
"Often overseas dividends may have some foreign withholding tax deducted at source, but the investor can find this out from their income statements," says Adam Laird, passive investment manager at Hargreaves Lansdown. "These will be sent by the ETF provider or broker who holds the investments. Some ETF providers have tax guides on their website which can help with working it out."
And you may be able to claim foreign tax credit relief in order to avoid paying tax twice.
Double taxation agreements set out the rate of withholding tax that a country can charge on a UK resident receiving dividends from that country. For example, in the double taxation agreements between the US and the UK, the withholding rate of tax is 15 per cent for a US-domiciled ETF.
But you need to fill in form W-8BEN for the US tax authorities to achieve this reduced rate otherwise you pay 30 per cent.
And if you hold a bond fund ETF you may have to pay income tax rather than dividend tax on your distributions.
"In some circumstances, the distributions can be taxed as interest payments rather than dividends," adds Mr Springett. "This occurs when more than 60 per cent of the underlying investments of the ETF are comprised of interest-bearing assets. In these circumstances, the distributions will be taxed at the shareholder's full marginal income tax rate (20 per cent, 40 per cent or 45 per cent) with no notional credit available."
But if you hold these within a self-invested personal pension (Sipp) or individual savings account (Isa) it would negate any tax issues given the tax-free status of these wrappers.
Reporting status
It is important that the ETF you hold has UK reporting status so that when you dispose of your shares any capital gains are taxed within the UK capital gains tax regime. "If the ETF doesn't have UK reporting status, both capital gains and income are taxed within the holder's income tax regime, which can be more tricky to work out," says Mr Laird.
Income tax for higher and additional-rate payers is higher than capital gains tax as it is respectively 40 per cent and 45 per cent. Capital gains tax is less punitive as you have an annual allowance of £11,000 before you pay anything, after which basic-rate taxpayers incur 18 per cent on their gains, and higher and additional rate taxpayers incur 28 per cent.
"If your ETF has UK reporting status then the provider's website will tell you how much income an ETF generated in a tax year, how much was distributed and how much was retained in the fund," says Peter Sleep, senior portfolio manager at Seven Investment Management. Distributed and retained income amounts plus any realised capital gains should be entered on your tax return.
You can check if an ETF has reporting status on the provider's factsheet or website. Or HM Revenue & Customs has a list of investments that have reporting status:
https://www.gov.uk/government/publications/offshore-funds-list-of-reporting-funds
KPMG also has a database of funds with reporting status at KPMGreportingfunds.co.uk. Most mainstream ETFs listed in London tend to have reporting status but it is important you check this before you invest. If your ETF does not have reporting status one way to avoid this problem, according to Mr Laird, is to hold it within a Sipp or Isa. But you should confirm that the Sipp trustees or Isa provider are happy to hold these types of investment.
