US ETFs are not the only ETF wrapper with a tax advantage, Irish-domiciled ETFs have one too!

Mar 15th, 2023 | By | Category: ETF and Index News

By Manooj Mistry, Chief Operating Officer, HANetf.

HANetf is an independent ETF specialist working with asset management leaders to bring differentiated, modern and innovative UCITS ETF exposures to investors via an independent white-label platform. Its ICAV platform allows partners to launch UCITS ETFs in Europe quickly, efficiently, and with minimised barriers to entry. HANetf is also able to launch ETCs.

Manooj Mistry, Chief Operating Officer, HANetf

Manooj Mistry, Chief Operating Officer, HANetf

In the roughly 30 years since their invention, exchange-traded funds (ETFs) have gained popularity around the world. The US market is the leader in ETF adoption, with total ETF AUM at around $7 trillion, up from $151 billion in 2003. [1]

There are many reasons for this extraordinary growth including the cost-effectiveness, ease of access and transparency of ETFs. However, a notable driver of ETF growth in the US has been the tax benefits they offer when compared to mutual funds.

In the US, mutual funds have to pay capital gains tax when selling any assets that have appreciated in value. For instance, if an investor in a mutual fund wishes to withdraw their money, the mutual fund needs to sell holdings to generate cash which triggers the need to pay capital gains. In contrast, when ETFs have outflows, this is done via an “in-kind” or “in-specie” transaction, whereby assets such as stocks or bonds are exchanged for ETF shares with authorised participants rather than cash The cashless nature of this process allows capital gains tax to be minimised and give ETFs in the US an advantage over mutual funds.

This unique feature is credited with kickstarting the ETF revolution. It is also now said to be one of the reasons for the growth of active managers using the ETF wrapper. Indeed, in 2021 60% of the nearly 500 ETFs that launched in the US in 2021 were actively managed.

The European ETF market has seen strong growth over the past 20 years, reaching around $1.3 trillion in AUM. According to a PWC survey, that figure is expected to reach $2.5 trillion by 2025. But despite this strong adoption and growth, the ETF market in Europe is behind the US, with US ETF AUM around six times higher. At the same time, ETFs represent 12.6% of equity assets in the US compared to 7.5% in Europe. [2]

Is there a similar tax advantage for ETFs in Europe?

In Europe, UCITS mutual funds and ETFs are not subject to any capital gains tax when securities are sold. Therefore, European ETFs and mutual funds are on a level playing field when it comes to taxation within the ETF or fund and ETFs do not enjoy the same tax advantage over mutual funds as their US counterparts. However, we believe this is a misconception.

As we will explain below, there is a tax advantage over mutual funds when it comes to ETFs in Europe. If anything, what is holding back ETF growth in Europe is not the lack of a tax advantage but instead a lack of widespread appreciation of such an advantage for European investors. It is probably the European ETF market’s best-kept secret.

In Europe, mutual funds are typically subject to a 30% withholding tax (WHT) on US equity dividends. However, Irish-domiciled ETFs are only subject to a 15% WHT. ETFs domiciled elsewhere are subject to the full 30%. Therefore, Irish-domiciled ETFs do have a tax advantage when it comes to holding US equities.

This tax advantage can help add performance or “alpha” to investors’ portfolios, regardless of whether the ETF tracks an index or is actively managed. The 15% WHT means that for every 1% of yield on a US equity portfolio, 15 basis points is saved compared to mutual funds paying 30%. Put differently, 15bps of alpha is generated through using the Irish ETF wrapper.

Therefore, if we take a US equity portfolio yielding 5%, using an Irish-domiciled ETF would add 75bps of alpha each year. This means adding over half a percentage point to performance, simply due to choosing the right fund wrapper. A global equity fund with a 50% allocation to US equity, the alpha would be 7.5bps for every 1% of yield which if the portfolio yielded 5% would generate 37.5bps of alpha each year.

UCITS v 40 Act (US ETF Wrapper) Tax Advantage

UCITS ETFs and funds are also increasingly favoured by investors in Middle East, Asia and Latin America. This is due to their advantages compared to US 40 Act funds when it comes to WHT on distributions and recognition of the UCITS regulations.

Distributions from US 40 Act ETFs are typically subject to WHT of 30% at source (similar to that on US equities). Some investors may be able to reclaim some or all of this WHT deduction but it requires forms to be completed and submitted to US tax authorities and investors have to wait for any reclaimed amount to be paid to them. Investors would then have to include the total income received as part of any tax returns filings in their home jurisdiction.

Distributions from UCITS ETFs domiciled in Ireland are not subject to any WHT at source. Investors effectively receive the distribution “gross” and there is no need to complete any forms to reclaim taxes. Instead, all investors have to do is include the income received as part of any tax return filings in their home jurisdiction.

So, for many investors, owning a UCITS ETF has many advantages compared to owning a US 40 Act ETF.

Investors, in Latin America in particular, increasingly favour UCITS ETFs due to the recognition of a robust regulatory framework and the tax advantages of UCITS ETFs over US 40 Act ETFs.

Another benefit of ETFs for Active Managers in Europe: Enhanced Distribution Potential

The fragmented nature of European fund market means that many active managers have a strong presence in their home market but do not have brand recognition or the distribution capabilities across other European markets. Cross-listing an ETF, supported by the right marketing and distribution set-up, can help active managers access an audience across Europe.

The ETF revolution that started 30 years ago is far from over. This growth has primarily been driven by ETFs tracking indices but we believe the next phase of growth will be driven by active managers using ETFs. For active strategies providing full or majority exposure to US equities then Irish domiciled ETFs are the optimal wrapper for any asset manager looking to access investors across multiple markets. With the tax benefits on US equities and enhanced distribution potential, Irish-domiciled ETFs can be an attractive alternative to traditional mutual funds for both passive and active asset managers in Europe.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)




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