ETF investors: don’t get caught out by the wrong domicile

Gains from exchange traded fund investments may be treated differently for tax purposes, depending on where the funds are domiciled.

The taxation of investments is a complex matter, but this shouldn’t stop investors from carrying out basic due diligence during the exchange traded fund (ETF) selection process to avoid unwelcome effects on returns.

UK investors have access to a wide array of ETFs listed on the London Stock Exchange. But being listed on the local UK 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, so these ETFs may have been initially designed to suit the needs of non-UK investors.

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Domicile matters

Typically, ETFs bought by UK-based investors are listed on the London Stock Exchange but domiciled in either Ireland or Luxembourg. The first thing investors 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, as the tax burden from capital gains is much lower. This vital piece of information is clearly spelt out in the ETF factsheet, but specific tax differences related to an ETF’s domicile must also be considered when selecting physically replicated ETFs.

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Some forms of tax dealt with by a fund management company, such as financial-transaction levies and stamp duties, affect the day-to-day management of Ireland- and of Luxembourg-domiciled physical equity ETFs in the same way. But others, such as dividend withholding taxes, affect funds differently in different jurisdictions.

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 Irish-domiciled ETFs, for example, benefit from the US/Ireland double taxation treaty, which reduces standard withholding tax rates on US stock dividends from 30 to 15 per cent, whereas Luxembourg-domiciled ETFs are subject to the full 30 per cent 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 assumption would be wrong, as the end result of this practice is that ETFs tracking the same equity index can end up offering very different return profiles.

To illustrate the point, we can compare two London-listed UBS ETFs that track the MSCI World index. They both levy an ongoing charge of 0.3 per cent, but one is domiciled in Luxembourg and the other in Ireland, which has more favourable double taxation treaties with more countries than Luxembourg is. Both funds are physically replicated but have minor differences in their approach to fund construction.

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

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Mind the gap

The table shows the returns of the two UBS MSCI World ETFs over one, three and five years on an annualised basis. Clearly, the Ireland-domiciled fund has routinely delivered superior returns relative to its Luxembourg-domiciled counterpart.

The difference in returns has fluctuated over time and will continue to on account of many other factors, including the funds’ relative size, fees, and management. However, dividend payments will continue to be a substantial driver of the funds’ performance, so choosing the wrong domicile could mean you lose out, especially as returns are compounded over the long term. 

Dimitar Boyadzhiev is a passive strategies research analyst at Morningstar.