Beware the ETF tax trap

Many investors now enjoy the cost benefit and simplicity of exchange-traded funds (ETFs). But if you are one of them, watch out: there is a chance you may be liable for far more tax than you thought.

A report by fund manager BlackRock has revealed that a quarter of all the ETFs listed in Britain do not have 'reporting' or 'distributor' status. That may sound arcane, but it is very important in tax terms. Without it, gains from an ETF can be liable for income tax rather than capital gains tax (CGT). And that could make a big difference to your tax bill. For example, if you are a higher-rate taxpayer, liable for CGT at 28%, and you own a non-distributor ETF, you should be paying 40% tax on gains treated as income.

HM Revenue & Customs is not sympathetic to anyone claiming ignorance. It has said that investors who have inadvertently paid CGT rather than income tax will need to pay the difference. On top of that, where ETF investors have not taken "reasonable care" with their tax returns, they could face an "inaccuracy penalty" of up to 30% of the tax owed, plus interest.

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Now for some good news you may not be affected. If you own ETFs within an Isa or Sipp, the tax status of the ETF is irrelevant as your gains are tax-free. Likewise, if you hold the ETF within an offshore bond you won't be liable for tax on gains.On any other ETFs you hold, it's up to you to find out whether they have distributor or non-distributor status remember, you've only got a problem if it's the latter. Check with the fund provider.

Fortunately, this looks like it will be a short-term problem. Most ETF providers are currently in the process of registering the majority of their ETFs so they will have distributor status. All gains will then be subject to CGT. iShares, for example, has 20 non-distributor funds, but is moving towards changing the status of all but one of its UK-listed products the exception will be the Private Equity ETF.

You will be liable for income tax up until the point when the ETFs have their status switched. So the best bet from now on is to check the tax-status of an ETF before you buy it. Even though the majority of UK-listed ETFs are likely to make the same switch, most internationally-listed ETFs still won't have distributor status. So do check after all, no one wants to be landed with an unexpected tax bill.