How ETFs are taxed in the UK

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Different types of ETF incur tax at different rates in the UK, and it’s very useful to have a working knowledge of the variations so that you can make your portfolio as tax efficient as possible. There are also quite a few little known tax events and exemptions that can be triggered, so here’s our detailed guide to help you navigate the ETF tax landscape as smoothly as possible. This table shows that the taxes you pay on an ETF or ETC are determined by its asset class.

ETF’s and ETC’s taxation determined by asset class

The UK’s progressive tax system typically means that higher earners pay more tax than lower earners and annual tax-free allowances are available for the above taxes too. However, most people pay their highest marginal rates on income tax and that’s why it’s commonly thought that bond ETFs should be sheltered in your ISAs and SIPPs first. Yet that rule-of-thumb is easily broken by your individual circumstances, the unpredictable future returns of your investments, and future changes to the tax system. For example, the ‘bonds-shelter-first’ guidance may not apply if you’re heavily invested in low-yielding short term bonds, and enjoy stellar equities growth that builds up large capital gains. A good tax planner may be able to help steer you, and they could also advise if you need help with the following list of tax wrinkles that affect many UK investors.

List of tax wrinkles that affect many UK investors

Accumulating/capitalising ETFs

You’re liable for tax on dividends and interest as normal regardless of whether the ETF physically pays you income, or reinvests it back into the fund as with accumulating/capitalising ETFs.

Non-reporting funds

If an offshore ETF does not have UK reporting status then your capital gains will be taxed at your income tax rates. Worse still, your profits won’t be protected by your tax-free capital gains allowance (the Annual Exempt Amount) and nor can you offset your gains with taxable losses. This is a problem worth avoiding given that income tax rates in the UK are considerably higher than Capital Gains Tax rates. Just check your ETF’s web page or factsheet to ensure that it counts as a UK reporting fund, then you can forget this problem. Some providers may indicate the ETF’s reporting fund status with an abbreviation such as UKFRS. An offshore fund means any fund – including ETFs – that isn’t domiciled in the UK. A non-reporting fund isn’t liable for capital gains if it’s held in your ISA or SIPP.

Excess reportable income 

Offshore funds with UK reporting status (including ETFs) may also declare excess reportable income (ERI). ERI is income that’s earned by the fund in excess of any distributions it made. You must declare ERI on your tax return, even if the sums were retained inside your fund. Use the calculation guidance provided by your fund’s provider. For the avoidance of doubt, distributions include dividends and interest, and ERI applies to accumulation/capitalising ETFs too. It’s the number of shares that you owned on the last day of the fund’s accounting year that matters, although you’re treated as receiving the income on the fund distribution date six months after the fund’s accounting period. Report ERI on your annual tax return that covers that date. Income tax applies to bond interest, and dividend tax applies to dividend income as usual. You can deduct your excess reportable income from any declarable capital gains you make when selling shares in an ETF. Your ETF provider should include excess reportable income data on its website. HMRC provide a list of UK Reporting Funds. There’s no need to worry about ERI on ETFs that you keep in your tax shelters.

Multi-asset ETFs

Multi-asset ETFs are rarer than unicorns in the UK but, if you should ever invest in one, its distributions count as interest, not dividends if it’s more than 60% invested in fixed interest assets (bonds and bills) and cash at any point during its accounting year. Its distributions/ERI would then be liable for tax at your income tax rate not your dividend tax rate.

Starting Rate for Savings

The Starting Rate for Savings is a relatively little known 0% income tax band that is most likely to apply  if your non-savings income (e.g. salary or pension) is relatively low. If you earn taxable bond or money market ETF interest that falls within this 0% tax band then it may not be liable for income tax. The Starting Rate for Savings protects interest earned in the income band that lies up to £5,000 above your Personal Allowance. Typically that means anywhere from £12,571 to £17,570 in the tax year 2023-24. If your non-savings and/or non-dividend income is higher than £17,570 then the Starting Rate for Savings does not apply. You lose £1 of your £5,000 Starting Rate for Savings for every £1 your non-savings, non-dividend income rises above your Personal Allowance. For example, if your non-savings, non-dividend income was £15,000 then the next £2,570 of your savings income would fall into the Starting Rate for Savings and you would not pay income tax upon it. Interest paid by a bond or money market ETF counts as savings income in this example. Your Personal Savings Allowance could then protect the next tranche of your interest.

Stamp Duty Reserve Tax (SDRT)

Stamp duty of 0.5% is charged on purchases of individual shares and investment trusts in the UK. Individual investors don’t pay this tax on their ETF purchases. However, a UK equity ETF created with shares bought on the London Stock Exchange will pay stamp duty on its underlying assets. These costs are likely to be passed on to investors through the tracking difference, except where the provider recoups them through cost-reduction techniques such as securities lending or using a swap.

Withholding tax

Withholding tax may be deducted from dividends and interest you earn on overseas investments. UK investors are exempt from withholding tax on the income they receive from ETFs domiciled in Ireland and Luxembourg. But you may well pay withholding tax on ETFs based in other territories (for example, France), even if you hold that investment in an ISA or a SIPP. If you are liable for withholding tax then you can usually mitigate the amount you pay thanks to country-level double taxation agreements. This normally entails completing tax forms for the overseas tax authority and declaring your overseas income on your UK tax return. Contact your platform or a tax specialist for guidance. ETFs and other fund types also pay withholding tax on the dividends and interest they receive from their underlying assets purchased in other countries. For example, S&P 500 ETFs pay withholding tax on their US shares even if the fund is domiciled in Ireland or Luxembourg. There are two wrinkles worth paying attention to when you own an ETF with significant US exposure:

• Physically replicating ETFs based in Luxembourg pay US withholding tax at a 30% rate. However, Irish domiciled ETFs only incur US withholding tax at 15%. It doesn’t make a huge difference, but it does make a difference when you own a US focussed tracker such as an MSCI World or S&P 500 ETF.
• Better still, synthetic or swap-based ETFs do not have to pay US withholding tax at all. This is due to a specific piece of US legislation that exempts swaps from incurring this tax when they’re used to track certain indices. Once again, you’re most likely to be able to use this knowledge when choosing an MSCI World or S&P 500 ETF. (Some swap-based ETFs can also avoid Stamp Duty on UK share purchases, too.)

Scottish and Welsh income tax 

Tax on interest and dividends is charged at UK tax rates, not at Scottish or Welsh Income Tax rates.

REIT ETFs

REIT ETFs are taxed in the same way as regular equity ETFs even though you’d be taxed differently if you held the underlying REITs directly.

Tax shelters

Dividends, interest, and capital gains earned in ISAs and SIPPs are not taxable (watch out for the withholding tax exception) so maximise your annual allowances where possible. Your annual tax allowances also shield your investments in taxable accounts too, at least for small amounts of income and capital gains.