ETF 101

Use Of Profit

What does the fund do with assets’ profits (dividends for stocks)? There are two strategies here: Accumulating and Distributing.

A Distributing fund distributes profits among the shareholders every time the underlying assets distribute profits (dividends, in case of stocks).

An Accumulating fund reinvests profits according to its current strategy.

Which one is better? It usually doesn’t matter much. Unless there’s a big difference in how financial profits are taxed in all the countries involved (your country of residence, the country where the fund is domiciled, the country where the underlying assets are traded) it’s just a matter of personal taste.

Distributing funds focus on income, accumulating funds favor wealth appreciation. Tax and fees excluded it’s essentially the same. You can take dividends of a distributing fund tracking an index XYZ and use those dividends to buy new shares of the same fund and achieve the same performance of an accumulating fund over the same index XYZ.

Case of study: Switzerland

In Switzerland profits are taxed as income, while capital gain is not taxed. It means assets appreciations are not taxed, while the profits they generate are.

If you buy a stone for 100 CHF and sell it for 1000 CHF you take the difference – unless you’re a professional stone trader, in that case it’s profit and taxed as such – if you rent the stone for 10 CHF per month, the rent is taxed as income.

I got it! I got it!! On accumulating ETFs you don’t pay taxes! It’s all capital gain and no profits!

I’m sorry my friend, as you may expect the tax authority is not dumb. In general, tax authorities are smart enough you can’t play against them. You risk something horrible trying to outsmart them, like having the entire capital gain taxed as profit!

The ICTax (Income and Capital Tax) department of the FTA (Federal Tax Administration) produces every year a list of all the financial products recognized by them. If your accumulating fund is on that list, then they either know when the assets owned by the fund distribute their profits or they just make up a fictional “profits distribution date” and a precise enough “profits amount“. If you own the fund on that date, you earned profits and they will be taxed as such on next year tax declaration.

What if my fund is not on that list?

In that case all the capital gain is considered profit and you pay taxes on it. Avoid it. Always check that your fund is on that list!

For example, here’s my STOXX600 Accumulating ETF:

You can see the ISIN (International Securities Identification Number) and some of the fund details, like the fact it’s an Accumulating fund.

They have no data shown for 2017 dividends (we’re still in May at the time writing this article), they have no data for 2016 (that scares me, original taxes deadline was end of March) but they have data for 2015:

Here you can see:

  • The fund share value on December 31st 2015 – 76.70 CHF (lol, it dropped to ~61 EUR when I started investing in February 2016) – that you should use for your wealth tax (oops forgot to mention we have a Wealth Tax in Switzerland that range from 0% to 0.6% of your net worth each year)
  • The fictional profit distribution date – November 30th.
  • The value of the profits – 1.827 CHF per share (dividend yield 2.38%)
  • A simulation for 1000 shares – assets value 76.7k, profits 1.8k. Assuming marginal tax bracket of 30% the expected tax bill is 550 CHF. [Personal note: Ouch, on ~250k CHF I had invested on December 31st 2016 I may expect 5k profits (2% yield) and ~1.5k taxes for 2016 (and north of 2k on 2017) maybe I should account for that in my NW spreadsheet :(]

I got it! I got it!! I should sell the fund the day before the fictional profits distribution date and buy the fund back the day after! Since the fund is accumulating I don’t expect any loss, except 2 days of regular market fluctuations

Good luck with that! There’s a caveat: the FTA could classify you as professional trader and – listen to me carefully  – you don’t want that! If you’re a professional trader everything (including capital gain) is taxed as income.

So if your accumulating fund appreciates 10% this year while the underlying assets distribute 2% dividends (expected S&P500 dividend yield for 2017), you pay income taxes on the whole 10% if you’re a professional trader while just on 2% if you are not.

The actual guideline to avoid being considered a professional trader is: any asset you buy, hold it for at least 6 months. That’s a guideline, not a strict rule. If you play fancy you may be classified as professional trader nevertheless and if you sell assets before 6 months holding period once in a while you may still be classified “a regular person who’s managing their wealth“.

Ok… and what if I play as a professional trader or buy an accumulating fund not in the list (that issue dividends anyway) but at the end of the year the fund or my whole portfolio loses money?

That’s a tricky situation and I’ve never experienced that. In theory you don’t pay income taxes you would have paid otherwise. Not that it’s a situation that I hope, having my fund depreciating for a fiscal year… Anyway, I wouldn’t play it hard. I suspect being a professional trader is kind of viral, so you’ll pay the consequences on bull market years.

For the sake of completeness, I must mention that some Swiss companies issue special dividends named KEP (Capital reimbursement) that is not considered income. So you may find some Swiss ETF where dividends (or big portions of them) are not taxed.

Domicile

Assets have a domicile, they’re fiscally registered somewhere. If you buy a share of Coca Cola, it’s an American company, domiciled in US and traded on NYSE – New York Stock Exchange (Wall Street).

Funds have a domicile too and it’s totally uncorrelated with the assets owned. You may launch a fund domiciled in Italy that holds German stocks and that is traded in London Stock Exchange (LSE)

Why is that important? Taxes, obviously!

Case of study: Switzerland

Disclaimer: I’m not suggesting anything illegal! It’s perfectly legal to hold assets domiciled abroad and to benefit of some advantages (not many though).

We’ve already discussed profit vs wealth vs capital gain taxes. There are other tax implications you want to consider: withholding taxes. Funds domiciled in Europe and US generally withhold part of the profits the fund makes as anticipation of the actual taxes you should pay. It’s not the fund that withhold the tax, it’s the national tax authority of the country where the fund is domiciled.

In Switzerland you may deduct from your tax bill the amount foreigner tax authorities withhold from your funds. So it may seem a tax neutral process: instead of paying 100 in Switzerland you pay X in the nation where your fund is domiciled, and the remaining 100 – X in Switzerland. It’s cool.

Except it isn’t a pain-free process. You should get fiscal documents for tax withholding from the foreigner tax authorities and file them at tax declaration time.

At beginning of 2016, when I performed my deepest research in this field, Ireland and Luxembourg were popular countries for funds domicile since they don’t withhold anything for investors resident in Switzerland. I don’t know if anything changed in the meantime, I’m not keeping myself up to date on this. According to shared knowledge among invest-savvy friends and colleagues it’s still true.

So, investing in funds domiciled in Ireland and Luxembourg makes your tax declaration easier – again, that’s perfectly legal, there are no tax actually saved just a pain-free tax declaration process.

Cool, so let’s filter our ETFs by domicile now 🙂

…But there’s one exception!

US always withholds 15% (or 30% for investors resident in US) of profits at assets level.

Ok, what’s the problem? I don’t invest in US!

You sure? Don’t you want to invest in S&P500? Or a World ETF?

Yeah, but I’m going to pick a fund domiciled in Ireland, I’m smart!

The withholding is at assets level! It means as soon as companies issue dividends, US government takes 15% of it and uses it to produce more bombs. If your fund is accumulating, your share value reflects that immediately. If it’s distributing, the fund receives a dividend which is 85% of the original dividend. The problem is that it’s not you that are being taxed. Your fund is. No way you can redeem that. You end up paying double taxation on the dividends!

Oh no 🙁 we’re all doomed now, there’s nothing we can do…

Not true. You can redeem the 15% withholding tax if and only if the fund is domiciled in US via the DA-1 Form (more info here).

Hooray we saved the world!

Well, there are other implications like US Estate Tax, i.e. if you die while holding a US domiciled fund your heirs will be taxed (potentially a lot)…

Nooo, the world is doomed again… So? What to do?

Personal taste, as always. Quantity matters.

Let’s do a case study (myself) within this country level case study (Switzerland)

Nested Case Study: myself

As December 31st 2016 I owned US based ETFs for ~140k USD (94k S&P500, 48k Tech US). They are all domiciled in Ireland. Let’s see how much I am leaving on the table by not switching to US domiciled funds (assuming funds with same costs and performances).

Assuming 2% Yield on S&P500 and 1% Yield on Tech (a lot of big tech companies don’t distribute dividends), profits are expected to be ~2360 USD (1880 from S&P500 and 480 from Tech).

My unredeemable withhold tax is ~350 USD.

I’m leaving 350 USD on the table.

What do I get for 350 USD each year:

  • Simpler tax process
  • No estate tax (though it may be close to zero for such “small” amounts)

Is it worth changing strategy?

I don’t know. I’m lazy. Buying/selling at 0.08% trade fee each trade costs ~240 USD one-off. I’ll think about it.

Anyway, back on justETF. Let’s filter ETFs domiciled in Ireland or Luxembourg!

All 8 funds are still available – all of them are domiciled in Ireland or in Luxembourg – cool!

(continue on next page)

8 comments

  1. I’m very happy that investing series are back 🙂 As always, I’ve learned few new things and I thank you for sharing it with us. Really looking forward to IB 101 😉

  2. Hi Mr. RIP,

    Here one guy also trying to reach the FI, baby steps at the moment :). It’s really a pleasure to read your blog :). I also live in Switzerland and there are not so many blogs out there speaking about financial swiss topics (or at least not in English :D), like taxes.

    What’s your point of view on DGI investing from Switzerland?

    As I am building my portfolio based on that philosophy. Since I moved to Switzerland, I think it has less advantages compared to ETFs, due to the fact that in Switzerland there is no taxation on capital gains, while for dividends you pay taxes.

    When I lived in an UE country with tax on capital gains, I didn’t see the taxes on dividends as a huge disadvantage for the strategy, as anyway I would be taxed when I wanted some cash back, for supporting my living when I would be no longer working, not the case in Switzerland.

    I tend to think that, for a fiscal resident in Switzerland, dividend growth stocks are good for recession times, when at least you can, more or less, rely on your continuous stream of money. But, while in a country with taxation on capital gains by selling your stocks I would allocate most of my portfolio on DGI strategy, maybe in Switzerland I would keep an small amount, seen as a “recession proof” part of the portfolio.

    Thanks!, and really happy about your investment series!

    1. :o, I hadn’t read pages 3 and 4 when posting the comment ?

      This clarifies a lot and destroys my ideal view of non-tax on ETFs in Switzerland ?

  3. Great article! I’m looking forward to the next one about IB. I wanna know if IB is good for people with little income for investing?

    1. If you go directly with IB they charge (10$ minus paid fees) per month. And their fees are very low. If you hold more then 100k in the account, there are no minimum fees. I opened account with IB trough “proxy”, which means I have lower minimum fees, but each trade is associated with higher costs. Works well for buy and hold 🙂 but not suitable for daily traiders.

      Mr. Rip: everthing ok? I’ve notice it is almost the middle of the month and no mothly update so far. Hopefully, you’re just superbusy with the wedding ceremony 🙂

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