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Tax treatment of ETFs

This article is part of
Guide to Exchange-Traded Funds

Morningstar’s European passive fund analyst team states exchange-traded funds are not given special treatment in the UK.

In general, when it comes to taxes, ETFs and traditional funds are treated the same as mutual funds.

Morningstar’s European passive fund analyst team adds there is an important classification system that investors should be aware of that governs taxes for ETFs.

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“It is very important to check an ETF’s classification before making a purchase. Roughly 75 per cent of ETFs in the UK are given either ‘reporting’ or ‘distributor’ status. 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 per cent or 28 per cent, instead of income tax rates which can be as high as 50 per cent. Keep in mind, this capital gains tax is not only applied to ETFs, but to other traditional investments such as funds and shares.

“Regarding dividends, those generated from ETFs or any traditional investments are usually subject to income tax, because dividends are income for investors.”

As with other investments, Mark Johnson, head of UK sales at iShares, says tax on ETFs has to be considered at three levels:

1) Investment level

Portfolio level withholding tax is an important consideration when investing in some asset classes, such as US or Eurozone equities, for example. The rate of withholding tax depends in part on the double tax treaty status of the holder.

Where the holder is an Irish mutual fund, withholding tax is in some cases beneficially reduced by the double tax treaty that Ireland has with the investee country, but not in others.

2) Fund level

Offshore mutual funds typically pay no tax at fund level, either on their portfolio income or by way of withholding. Some onshore fund types do pay taxes at this level.

3) Investor level

Each investor also has their own tax position to consider, and of course this can be affected by the choice of investment vehicle.

A full study of the tax efficiency of an investment strategy should consider whether any withholding tax suffered at portfolio or fund level can be offset against the investor’s domestic tax, according to Mr Johnson.

For UK resident individual investors, Mr Johnson says distributions from equity index funds are taxed as dividends.

However, Mr Johnson says distributions from fixed income index funds, with less than 60 per cent fixed income portfolio content, 60 per cent of assets in bonds, cash, or cash equivalents, are taxed in the UK as interest.

Any gains on disposal from equity and fixed income ETFs will be subject to capital gains tax provided the fund has UK reporting fund status, Mr Johnson adds.

“UK resident corporate investors are taxed on distributions from fixed income ETFs under the loan relationships regime. Distributions from equity ETFs are taxed under the foreign profits regime.”