Last updated: July 9, 2010 7:05 pm

Income tax hit for ETF investors

Investors buying exchange traded funds (ETFs) are being urged to confirm their tax efficiency, as capital gains from some ETFs can be subject to income tax at rates of up to 50 per cent.

Wealth managers and analysts warn that most ETFs listed on US or European exchanges, and up to a quarter of the few hundred listed on the London Stock Exchange (LSE), do not have “distributor” or “reporting” status, so creating a significant tax disadvantage for UK investors.

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Without this designation, gains from ETFs are taxed as income in the hands of investors, rather than the less-penal capital gains tax (CGT) rates of 18 or 28 per cent which normally apply to investment funds and shares.

Mick Gilligan, funds analyst at Killik & Co, an advisory stock broker, said: “The tax status of ETFs makes a huge difference and is a huge headache for investors.”

Having gains taxed as income would generally outweigh other benefits of investing in ETFs such as their low costs. However, for investors in individual savings accounts (Isas) and self-invested personal pensions (Sipps), an ETF’s tax status does not matter as all gains are tax-free in these shelters.

Christopher Aldous, chief executive of Evercore Pan-Asset, which manages ETF portfolios for private clients, said: “ETFs are wonderful things, but the tax position is definitely a problem that investors may not take into account when choosing funds.”

Wealth managers say that most private investors will not even be aware that ETFs can have this disadvantage, which stems from ETFs being “offshore” investment funds without a UK tax domicile.

Investors using no-advice online stockbrokers could be particularly at risk from picking tax-inefficient funds. Leading brokers including Barclays Stockbrokers, TD Waterhouse and Selftrade all allow trading in hundreds of ETFs without indicating which funds lack distributor status.

While the most commonly bought ETFs do have distributor status, Killik’s Gilligan said that investors were also likely to be mistakenly buying non-distributor funds.

Online brokers said they had not received complaints. But James Daly of TD Waterhouse conceded that investors buying a tax-inefficient ETF through a no-advice dealing service “could be making an expensive decision”, and that highlighting those without distributor status was “something we will have to consider”.

However, brokers said they were reliant on information from ETF managers and that investors should check the tax status of an ETF with the fund provider before buying.

Deborah Fuhr, global head of ETF research and implementation strategy at BlackRock, the sector analyst, said: “Private investors can buy many things that aren’t suitable for them. This is why they need to check the fund prospectus and take advice.”

iShares, the biggest ETF provider, which has 20 non-distributor funds out of 90 listed in the UK, claimed it did a “strong job” of communicating the status difference through its website and fund factsheets.

But investment advisers criticised providers for failing to explain the implications of not having distributor status. “They typically caveat information with statements that they can’t give tax advice,” said James Norton, director of Evolve Financial Planning.

iShares said some of its ETFs could not obtain distributor status because of cross-holdings in other funds while other “accumulation” ETFs would be subject to CGT under a new “reporting fund” system that is replacing the existing distributor regime.

Deutsche Bank’s db x-trackers said it was applying to HMRC to have all its non-distributor funds taxed to CGT. Overall, a quarter of the 239 ETFs listed in the UK lack distributor status, according to recent research by BlackRock.

 ETF investors could face tax penalties
 

Investors who incorrectly declare gains from exchange traded funds (ETFs) that should be liable to income tax (see left) could face penalties, says HM Revenue & Customs.

Christopher Aldous, chief executive of Evercore Pan-Asset, a portfolio manager, suggested that many individual ETF investors could have mistakenly underpaid tax because they were not aware that gains on some funds were subject to income tax. “Thousands of submissions to HMRC would have wrongly put down gains from non-distributor funds as being subject to capital gains tax (CGT),” he said.

HMRC said that where ETF investors had not taken “reasonable care” with their tax returns, they could face an “inaccuracy penalty” of up to 30 per cent of the tax owed, in addition to the outstanding tax and interest. As well as having gains taxed as income, investors in ETFs can encounter other tax differences compared with buying mainstream funds and shares.

The income from some ETFs can be subject to foreign withholding tax that can’t always be fully reclaimed, advisers have warned. This can be a problem with ETFs domiciled in France and the US for tax purposes, even where those funds have a stock market listing in the UK.

Dividend payments from ETFs domiciled in France are subject to a 25 per cent deduction at source, according to Justin Modray of CandidMoney.com, a financial guidance website. However, investors can only credit 15 percentage points against their UK income tax liability, which for higher-rate taxpayers is 32.5 per cent of the gross dividend. US-domiciled ETFs are subject to withholding tax of 30 per cent on dividends, reduced to 15 per cent for investors filing a W-8BEN form.

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