Exchange-traded funds (ETFs) have gained popularity with Australian investors because of a new breed of robo-advisers who make it easy to invest in ETFs. They’ve also gained a strong following of investors because they are tax-efficient and they offer a relatively low-risk strategy for long-term wealth growth. However, calculating the tax on ETFs can be somewhat complicated depending on several factors.

To explain some of the trickier areas of ETF taxation, first, let’s look at why ETFs are a tax-efficient investment.

How ETFs become tax efficient

Incurs lower capital gains tax
Compared to most active managed funds, ETFs incur lower capital gains tax. This is primarily due to ETFs having a low portfolio turnover as they track an index, like the ASX, rather than buy and sell stocks regularly.

It makes them more tax-efficient as there is rarely a capital gains tax (CGT) liability being passed to individual investors. Constant trading by actively managed funds means investors pay a lot more in capital gains tax while they’re invested in the fund.

Trades on stock exchanges
Unlike unlisted managed funds, ETFs are traded on stock exchanges, such as the Australian Securities Exchange. Moreover, ETF portfolio managers do not need to sell the shares they’ve invested in to raise cash to pay investors who redeem or sell the fund.

For unlisted managed funds, this redemption process can lead to a capital gains tax liability for all investors, regardless of how long they have owned the fund. One ETF investor’s decision to sell has no impact on other investors.

How to work out ETF tax

Despite ETFs being tax-efficient, calculating tax can be complicated given the different types of ETFs you can invest in, such as Australian and global ETFs, which are subject to different tax jurisdictions.

ETF tax differs depending on the location and domicile of the fund. There are also a number of different ways to own an ETF, which will impact how your tax information is shared with you.

Before you invest in ETFs, it’s important to find out what tax information your chosen provider will give you at tax time each year. It can differ from service to service, and some may not provide a comprehensive summary to help you prepare your tax. This could leave you or your accountant with a fair amount of tax work to complete each year, especially if you own a few ETFs, because the amount of tax on ETF dividends depends on several factors.

Top five things to consider on ETF tax

1. It is best to own ETFs in your own name

If your ETFs are not held in your name, tax can become even more complex and they may or may not be able to pass on all of the abovementioned tax benefits. The value of these can add up to over 1 per cent per year.

You may not own the ETFs in your own name if you invest in ETFs via investment platforms using:

• An overseas custodian
• A separately managed account
• A managed investment scheme structure that uses a custody or trustee structure

If you own ETFs through an online broker like Bell Direct or a robo-adviser such as Stockspot, the ETFs will be owned legally and beneficially in your own name on a Holder Identification Number (HIN) at the CHESS subregister.

From a tax perspective, owning ETFs in your own name is safest and simplest as it is clear what income and capital gains have been made by you through the year. Owning ETFs in your own name also means you get full access to franking credits.

It’s also crucial to ask your ETF provider what information they will provide you during tax seasons. However, not all ETF providers provide the same type of information, with some failing to provide comprehensive reports.

To help you prepare your taxes, make sure to ask if you’ll receive the following benefits:

• Franking credits on your Australian ETF income
• The 15 per cent withholding tax benefit on your overseas income
• The 50 per cent capital gains discount on investments held for 12 months.

2. Australian share ETFs can pass on franking credits

The dividend system in Australia can offer important advantage for investors in ETFs. If Australian company taxes are already paid by the companies within an ETF, investors don’t pay those taxes again at the personal level. The corporate taxes paid are passed down to the Australian investor through tax credits, often known as franking credits.

Franking credits can be used to reduce an investor’s total tax liability to account for the taxes on dividends already paid by companies. For individuals or complying superannuation entities, any excess franking credits can also be refunded at the end of the year if the investor’s tax liability is less than the amount of the franking credits.
3. Capital gains on ETFs

If you sold any ETFs during the year, you are required to calculate your CGT liability, if any, with respect to those ETFs. ETF issuers won’t send a capital gains tax statement by default, so it’s up to you to calculate capital gains and put it in the correct place on your tax return.

If you’ve owned an ETF for 12 months, the law allows the taxable capital gain to be reduced by 50 per cent for individuals. This means that tax is only paid on half of the capital gain.

4. Tax on ETF distributions

ETF distributions represent your share of the income earned by a fund. Each ETF may earn different types of income – for example, dividends, realised capital gains or interest. Also, the income may be Australian or foreign.

ETFs are structured as unit trusts, which mean the types of income earned by the trust may be split across different categories when they are distributed to you. If you manage your own ETF portfolio, the income components required to complete your tax return will be shown in the annual tax statement posted to you or available to download from the registry website associated with each particular ETF.

In 2016, the Australian Taxation Office created the Attribution Managed Investment Trust regime, which changed the rules surrounding trusts and made dealing with ETF tax more complex.

5. Tax on foreign ETF income and withholding tax

ETFs that invest in overseas companies may withhold some of the income distribution from investors. The level of withholding tax varies depending on where the company resides and the tax rules in place between Australia and the residing country.

For example, Australian investors who buy ETFs domiciled in the US will incur a 30 per cent withholding tax on any distributions. Australian investors are generally eligible to reclaim some of this back as a foreign tax credit. US-domiciled ETFs available on the ASX require that investors complete a W-8BEN form to reclaim a 15 per cent foreign tax credits.

Lodging your tax return

Things you need
If you own ETFs through an online broker, you need to calculate your tax liability each year using the annual tax statements from each ETF you own.

To do this, combine the totals provided by each ETF as well as calculate any capital gains or losses you’ve made during the financial year.

If you own ETFs via an investment platform, separately managed account or managed investment scheme, you need to ask them what tax information they’ll provide to you.

Some ETF investment services will make your tax life easier and calculate your tax liability for you, including ETFs that were sold or rebalanced during the year, and combine the statements from all ETFs you own. Income from the individual ETFs as well as any capital gains are summarised in your annual investor statement.

Seek professional advice

Each individual has his own personal and unique circumstance. What works for others may not work for you. That is why it is crucial to seek professional advice to learn more about the ETF tax treatment that applies to your individual circumstance.

ETFs bring a lot of tax advantages for investors, but they differ from person to person. Consult with your accountant or any other ETF expert you trust. That way, you will be able to discern how owning ETFs impact your personal taxes.