Understanding tax efficient ETFs – avoiding US withholding taxes

As the ETF market continues to grow, an increasing number of investors would be seeking to build globally diversified portfolios at low cost.

I’ve blogged previously about using ETFs to build your own personal investment portfolios, which brings numerous advantages from diversification, risk reduction to cost savings.

As a quick recap, ETFs are traded on an exchange which invest in an underlying basket of securities, be it stocks, bonds or other instruments like gold, silver and in the future, perhaps even Bitcoin.

What this means is that by investing in an ETF, you can invest in a basket of securities through a single instrument in a single trade. These ETFs will track an index decided by the fund manager, which then provides you with exposure to the asset class it is designed to track.

However, not all ETFs that track the same index or invest in the same basket of securities are the same. One difference is the tax efficiency of the ETF, which can affect the long term returns of your investment.

Without being too technical about the details, this article will explore the finer nuances about investing in Ireland-domiciled ETFs and how Singaporean investors can take advantage of this knowledge to maximise their returns from an ETF.

Remember, taxes are a very complicated topic so take this article as a simple introduction to a much deeper world.

Introduction

Suppose you want to get investment exposure to the largest consumer market in the world – the United States.

One way to do that is to invest into US companies listed on the US stock exchange. The S&P 500 index fund is one way to do that – which invests into 500 largest companies that comprise the S&P 500 index, in their market capitalisation proportions.

There are many US-listed ETFs from different fund managers that passively track this index.

  • SPDR S&P 500 ETF (SPY)
  • iShares Core S&P 500 ETF (IVV)
  • Vanguard S&P 500 ETF (VOO)

If you’re a European or UK investor, then there are also alternative options available nearer to home. For example, the iShares Core S&P 500 UCITS ETF (CSPX), which tracks the same index but is domiciled in Ireland, is listed on the London Stock Exchange.

If you’re Singaporean, then there is yet another option to invest using US-dollars through the SPDR S&P 500 ETF (S27) which is listed on the Singapore Exchange.

So what’s the difference anyway, and why should you care?

Investing in US securities (stocks, bonds, ETFs) will expose you to US tax regulations. These regulations are far-reaching and affect both US residents and non-US residents worldwide.

Let’s explore a little bit about these tax laws.

The US non-resident alien (NRA) test

One of the key tests is to determine a person’s US tax residency for US taxation purposes.

If you are not a US citizen or green card holder and have not been in the US for 183 days (calculated over a 3 year period), then you are a nonresident alien (NRA) for US tax purposes.

Now, even if you are a NRA living outside the US but holding US investments or assets, you are vulnerable to various taxes levied by the US.

Taxes which apply to NRA

If you are a US NRA, then the following taxes apply to you –

  • US dividend withholding taxes
  • US estate taxes

The following taxes do not apply to you in general –

  • Capital gains taxes from US domiciled ETFs (as they do not count as effectively connected income with a trade or business in the United States)
  • Most interest taxes (except those interest effectively connected with operating a US trade or business)

Dividend withholding taxes for a NRA

If you are a NRA, the US will withhold taxes through your broker on dividends received by you.

Your broker has on file when you decide to trade in US markets, your W-8BEN form, which is a requirement of the US Internal Revenue Service (IRS) to document that an account holder is the beneficial owner of the income and is not a U.S. person.

The standard withholding tax rate is 30% which may be reduced or exempted depending on whether your country of residence has a tax treaty with the US. To see which countries have an income tax treaty with the US, click here. For countries with an income tax treaty with the US, the withholding tax rate may be lowered to an average of 15%.

Unfortunately, Singapore does not have an income tax treaty with the US hence Singaporean investors who invest in a US stock or US-domiciled ETF will have their dividends payments withheld at 30%.

US estate taxes

In addition to dividend witholding taxes above, a NRA whose home country does not have an estate treaty with the US will be subjected to US estate taxes.

An estate is the net value of all the investments, assets, and interests of an individual.

The US levies a 40% estate tax on US assets (stocks, bonds, ETFs, funds, cash in a US-based brokerage) above US$60K when the account holder who is a NRA passes away.

The importance of fund domicile

ETFs, or any funds in general, have a country of domicile which the fund’s holding company is legally incorporated.

Despite holding the same assets in the funds as described above, investors with varying tax treatments (e.g. whether you’re a NRA or US-resident) will see different returns depending on the domicile of the ETF they hold that is tracking the same index.

Taking a NRA residing in Singapore as an example, the NRA holding the iShares Core S&P 500 ETF (IVV) domiciled in the US will receive 70% of his dividends, after having them withheld by 30% through his broker, plus being at risk of US estate taxes.

However, the same NRA holding the iShares Core S&P 500 UCITS ETF (CSPX) domiciled in Ireland receives 85% of the dividend distributions after the the fund pays 15% in withheld taxes internally to the US.

If the ETF holds international (non-US) stocks instead of US stocks, then the tax advantage when investing through an Irish-domiciled ETF is much greater, because the dividends paid by non-US stocks is also withheld at 30% if investing through a US-domiciled ETF, but 0% if investing through a Ireland-domiciled ETF.

Gaining tax efficiency through Ireland-domiciled ETFs

Ireland is one of the most popular countries for funds and ETFs to be domiciled and distributed, thanks to its favourable tax treaty networks with countries worldwide and reduced withholding tax rates under the US/Ireland Double Tax Treaty.

At the portfolio level (i.e. underlying assets), withholding taxes on US-sourced distributions are reduced:

  • Reduction in withholding taxes for US-sourced interest: 30% to 0%
  • Reduction in withholding taxes for US-sourced dividends: 30% to 15%

Ireland is also home to almost 50% of all European ETF assets and the number one European domicile for ETF issuers.

At the individual level, unlike the US, Ireland does not impose a dividend withholding tax for UCITS funds.

Wait, what? Portfolio level? Individual level?

Withholding taxes are applied on multiple levels

Remember how an ETF works? It is a fund, domiciled in a certain country, which invests in a basket of securities – which can be country-specific or worldwide.

If we take the above example of two ETFs investing in S&P 500 stocks (i.e. only US stocks) and these stocks distribute dividends:

  • iShares Core S&P 500 ETF (IVV)
    • US-domiciled
    • TER 0.04%
  • iShares Core S&P 500 UCITS ETF (CSPX)
    • Ireland-domiciled
    • TER 0.07%

The first level (L1) of withholding taxes are applied when the underlying securities distribute the dividends to the ETF.

For a US person, or US-domiciled ETF, dividends from US stocks are not withheld. But if you’re a NRA, as above, then you’re subjected to withholding taxes at the standard rate or reduced rate if you have a treaty.

Because Ireland has a tax treaty with the US, CSPX will have a reduced withholding tax rate of 15%.

  • iShares Core S&P 500 ETF (IVV)
    • 0% withholding at the first level (distributions to fund)
  • iShares Core S&P 500 UCITS ETF (CSPX)
    • 15% withholding at the first level (distributions to fund)

The second level (L2) of withholding taxes are applied when the fund or ETF distributes these dividends back to you as the investor.

We apply our earlier knowledge on NRA in this scenario, assuming you’re a Singaporean investor:

  • iShares Core S&P 500 ETF (IVV)
    • 30% withholding at the second level (distributions to individual)
  • iShares Core S&P 500 UCITS ETF (CSPX)
    • 0% withholding at the second level (distributions to individual)
Withholding taxes on US equities based on ETF domicile. Source: Blackrock

There is also a third level (L3) of withholding tax, at the individual or investor level, that is paid to the local tax authorities in their home country. In the case of Singapore, Foreign Sourced Income for resident individuals is exempt from tax.

Calculating the tax withholding ratio (TWR)

Putting it all together, we assume a dividend yield of 2% of the S&P500 index fund.

To calculate the tax withholding ratio, i.e. the total annual approximation of tax withholding percentages, we use a rather simple calculation.

  • iShares Core S&P 500 ETF (IVV)
    • Dividend yield: 2%
    • L1 tax: 2% x 0% = 0%
    • L2 tax: (2% x (1-0) – 0.04%) x 30% = 0.588%
    • L3 tax: 0%
    • TWR: 0% + 0.588% + 0% = 0.588%
  • iShares Core S&P 500 UCITS ETF (CSPX)
    • Dividend yield: 2%
    • L1 tax: 2% x 15% = 0.3%
    • L2 tax: (2% x (1-0.3) – 0.07%) x 0% = 0%
    • L3 tax: 0%
    • TWR: 0.3% + 0% + 0% = 0.3%

*L2 dividend withholding tax is applied to the net dividend yield after L1 DWT subtracting the fund’s TER

CSPX has a slightly lower overall TWR! Hence, investing in CSPX over IVV can give you 0.28% in additional returns annually for free (assuming no other costs involved).

In reality, of course, other considerations such as transaction costs, liquidity of the ETF, tracking error and bid-ask spread matter.

The above discussion also only covered dividends from US stocks and not international stocks. I would expect that when investing internationally, dividends from international stocks will be withheld at 30% for US-domiciled funds when distributed to the individual, while 0% for Ireland-domiciled funds – this will further increase the difference in TWR.

Concluding thoughts

For NRA like Singaporeans, investing in Ireland-domiciled ETFs over US-domiciled ones is one way to mitigate costly US tax traps which may impact your long-term investment performance.

While there is no way to avoid US dividend withholding taxes completely, reducing them is entirely possible through thoughtful portfolio construction.

Taxation is by no means a static theme due to its constantly changing nature, and its complexity goes far beyond what is mentioned and discussed in this article.

Please consult a financial or tax advisor if you need personalised guidance.

I hope it gives you a better understanding on taxation implications for your ETFs and helps you stay on track to be a better spider.

Further Reading

Derrick is a digital native, finance geek and avid photographer. He loves spontaneity but is a control freak at the same time.

3 comments On Understanding tax efficient ETFs – avoiding US withholding taxes

  • On this topic, what say you about your beloved StashAway then? Hehehe

    • I think it’s not an ideal long-term solution but definitely still great for people who don’t diversify at all!

      • I have concerns regarding how they try to get around the US estate tax and the ETFs legal ownership. These are their statements regarding US estate tax and who are the legal owners of the ETFs.

        “If you invest as an individual, the estate tax regulation applies. However, since you are registered on our ledger as a beneficiary of Asia Wealth Platform (StashAway’s legal entity), which is a corporate, you are not subject to this estate and gift tax (unless you’re an American citizen). This is also one of the advantages of investing with StashAway.”

        “Technically, the ETFs are owned by Saxo, our broker. Asia Wealth Platform Pte Ltd (our legal entity) is a beneficiary of Saxo. Similarly, you are a beneficiary on our ledger. So in short, you are the owner of the ETFs in your portfolio(s).”

        Is what Stashaway doing to get around US estate tax 100% legal in the eyes of US laws? It also seem like Stashaway investors do not actually have full legal ownership of the ETFs as they are only listed as a beneficiary. What is going to happen to the legal ownership of the ETFs and the issue of US estate tax if one day Stashaway ceased to exist? These issues should be a serious concern for Stashaway investors or any other potential investors.

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