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.
“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.”
ETFs are typically eligible for investment within a stocks and shares individual savings account (Isa) or a self-invested personal pension (Sipp), according to Ben Thompson, director of business development, listed products and ETF UK for Lyxor.
“It is important for advisers to look for ETFs with UK fund reporting status as this means that gains made on the ETF are subject to capital gains tax rather than income tax.
“In addition, if the ETF distributes dividend income, investors will pay tax on the dividend payments.”
Investors don’t pay stamp duty reserve tax directly when buying ETFs, according to Nick Blake, head of retail at Vanguard.
Although, Mr Blake says stamp duty reserve tax costs borne by the manager are likely to be factored into the fund price or ongoing charges.
“Gains from the sale of ETFs may be taxed either as capital or income depending on the registration jurisdiction of the fund and its reporting status.
“Tax treatment is subject to change and depends on an investor’s individual circumstances. Investors should therefore seek tax advice that meets their specific requirements.”
ETFs listed in the UK are unusual from other equities listed on the London Stock Exchange in that stamp duty is not payable when they are traded, agrees Simon Luhr, managing partner of FinEx ETF, although stamp duty is payable by the ETF on the underlying holdings.
Mr Luhr says in 2007 the government opened up the UK ETF market to international players when it changed stamp duty rules to make it easier for overseas firms to issue ETFs on the LSE, which helped to attract global players to the market.
