Funds: Are you paying too much tax?

On the iShares website the dividend yield of the popular S&P 500 exchange-traded fund (LSE: IUSA) is given as 1.35%. Yet the US iShares site gives the yield on the equivalent US-listed fund (NYSE Arca: IVV) as 1.91%. Why the difference? It's down to US withholding tax on dividends.

If, as a UK investor, you've ever held shares in US firms directly, you'll know that any dividends you receive have 30% taken off in tax. If you fill in a form to prove you're UK-resident and give it to your US broker, you can cut this to 15%.

Surprisingly, both IUSA and IVV are able to claim that they are tracking their underlying indices. IVV tracks the 'price and yield performance' i.e. total return of the S&P 500, while IUSA tracks the 'net total return' index. The key here is the word 'net' this tells you that income from the underlying shares is being received after tax. And in the case of the S&P 500, the index compiler assumes the maximum rate of deduction, 30%. This is true of almost any Europe-listed ETF investing in international equity markets. The most commonly tracked benchmarks MSCI World, MSCI Emerging markets, Euro Stoxx 50, for example are typically offered only in their net total return version, with the maximum tax deducted from dividends.

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This matters for two reasons. First, if you plan to hold your tracker for the long term say, in a pension plan then dividend income is crucial. Just as excess fund costs take a big toll over time, so does failing to receive all your dividends. Second, ETF providers can often get better tax treatment than the benchmark implies. For ETFs domiciled in Ireland, a double-tax treaty with the US means the withholding tax rate falls to 15%. For the S&P 500, that's an extra 0.29% a year from dividends. What's the fund manager doing with this income pocketing it, or sharing it with investors? Unfortunately, ETF providers' websites offer almost no information on dividend taxation. Typically, the implied tax rate used in the index calculation is nowhere to be found, and they don't tell you how much of any tax reclaimed goes to you, the investor.

This isn't just an ETF issue all offshore equity funds are affected. But next time you're looking at an international equity tracker, ring the provider and ask them what dividend tax rate their benchmark assumes, what their fund's effective tax rate is, and how much of any 'extra' income from dividends goes into the fund.

Paul Amery edits www.indexuniverse.eu