ETFs or Exchange-Traded Funds are a bundle of diversified assets that can be bought and sold during trading hours on the stock exchange. They can comprise of stocks, commodities, bonds and other securities and can potentially lower risk and exposure while helping to diversity a portfolio.
An ETF and individual stock are similar, but are taxed differently. Both are taxable, provide and income streams, offer a multitude of options, can be bought, sold and traded however ETFs are highly tax efficient is used in the right way.
ETFs attract a more favourable tax treatment than stocks and mutual funds because of their structure. They tend to have a lower turnover and pay fewer capital gains (CGT). They also attract a lower taxable rate during their holding period than other types of funds which need to distribute capital gains from frequent rebalancing.
WHT ETFs Are Tax Efficient
ETFs are traded on stock exchanges, such as the Australian Securities Exchange (ASE) unlike listed managed funds. This means that fund manager doesn’t need to sell shares to raise cash to pay investors upon redemption or sale of the fund.
ETFs track an index in which the investments they contain are not bought and sold on a regular basis. They have a low portfolio turnover because they are traded like an index that buys and sells stocks regularly. Because of this, ETFs incur a lower CGT compared to other managed funds, which tend to be traded on a more regular basis.
Unlisted managed funds may lead to CGT for all investors regardless of how long the fund has been owned. In the ETF case, one investor’s decision to sell has no impact on other investors.
Pro Tax Tip: ETFs will incorporate many different components, such as franking credits, interest, foreign income, dividends and capital gains that will be have to be divided out and taxed at different rates when you lodge your tax return.
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Standards Distribution Statement (SDS)
The ETF should supply a Standard Distribution Statement (SDS) that breaks down the different components in the ETF at the end of the financial year. Upon disposal of an ETF, the SDS will show the capital gains or losses made from the sale of units.
Dividend/Distribution Reinvestment
Often, ETFs are reinvested resulting in a distribution of shares instead of cash. Distributions will need to be declared in a tax return despite not withdrawing cash. Tax is applied to dividends and distributions even if they are automatically reinvested. Dividend or distribution reinvestment is considered income and treated the same was as receiving cash.
Pro Tax Tip: If company taxes have been paid within an ETF, investors will not need to pay personal taxes. Corporate taxes are passed to investors through franking credits.
Paper Losses
Capital gains or losses will need to be declared when you lodge your tax return. Capital losses only happen on the sale of a share; however claims can’t be made for losses if the share price drops but the share continues to be owned. Losses can only be offset against capital gains and not on other types of income. Gains can be forwarded into future year’s losses to offset CGT.
Some income from an ETF may come from overseas. The level of withholding tax depends on which country it comes from the tax rules in place between Australia and the country where the company resides. Some foreign income can be claimed back as a foreign tax credit.
Pro Tax Tip: Many investors close out losses before the year is over but keep the gains for more than one year. Tax is reduced to 50% for individual if the capital gain is held for more than 12 months. Gains receive long-term capital gains treatment whilst lowering your taxable income.
Record Keeping
When dealing with ETFs at tax time, it’s best to make sure your records are current and detailed. Records should be dated, show prices, commissions and the details of taxable events such as share splits, share consolidations, mergers and demergers.
Records to keep include:
- The date of purchase/reinvestment.
- The purchase amount/value.
- Details of any non-assessable payments.
- The date and amount of any calls (if shares were partly paid).
- The date of sale and sale price (if you sell them).
- Any brokerage costs or commissions paid when ETFs are sold.
- Details of events such as share splits, share consolidations, returns of capital, takeovers, mergers, demergers and bonus share issues.
- Details of capital losses made in previous years – you may be able to offset these losses against future capital gains.
- Dividend or managed investment distribution statements (Standard Distribution Statements).
ETFs can be complex because they are structured in a similar way to unit trusts and not ordinary shares. Income earned will need to be split across different categories when it comes time to lodge your tax return. ETFs can provide profit to some investors, but they may differ from person to person. It’s advised to seek professional help to understand how trading in ETFs will impact your personal income tax