ETFs & Funds · Pro · 4 min

Fund domicile and withholding tax as a principle

You can explain what a fund's domicile is, why withholding tax can reduce a fund's return before it reaches you, and how tax treaties change the rate.

Where the fund lives

Two ETFs track the same index and charge the same fee. Year after year, one of them trails the other by a few tenths of a percent. Neither fund company is doing anything wrong.

Part of the explanation can be where each fund is legally based. That decides how much tax is taken from its dividend income before the money ever reaches the fund. This lesson explains the principle. It is not tax advice, and the rules that apply to you depend on your own situation.

Tax before the fund

Every fund has a fund domicile: the country under whose laws it is set up and supervised. Many ETFs sold in Europe, for example, are domiciled in Ireland or Luxembourg, even when they are sold elsewhere.

Taxes can be charged at three levels:

  1. At source: when a company pays a dividend to a foreign shareholder, its home country often withholds tax. A fund is such a foreign shareholder.
  2. In the fund's country: some domiciles tax funds themselves, many do not.
  3. At the investor: your own country taxes your income from the fund, as described in the rubric on accounts.

The first level depends on tax treaties. The IRS withholds 30% on US dividends paid to foreign persons unless a treaty or exemption lowers it. The US–Ireland treaty, for example, limits the rate on ordinary portfolio dividends to 15% for residents who qualify for its benefits. Whether a particular fund can use a treaty rate depends on its legal form and domicile.

Tax withheld inside the fund usually cannot be reclaimed by you. It simply reduces the fund's income, and shows up as a slightly worse tracking difference against an index that assumes a different tax rate.

85 vs. 70

Two fictional ETFs hold the same US shares. The shares pay dividends of 2% a year.

Comparison A US dividend of 100 paid to a fund: at a 15% treaty rate the fund keeps 85, at the 30% default rate it keeps 70. Treaty rate US dividend 100 US tax 15% Fund keeps 85 Default rate US dividend 100 US tax 30% Fund keeps 70

On a 2% dividend yield, Fund A loses 0.3% of its assets to withholding tax each year, Fund B 0.6%. The 0.3 percentage point gap is about as large as many ETFs' entire yearly fee, and it compounds like any other cost.

Common mistakes

The takeaway

Where a fund is based decides which tax treaties it can use. Withholding tax on dividends can be lost inside the fund, before you see it.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

  1. 1Tap the case in which more of the dividend stays inside the fund.

    Tap the chart.

    Comparison Chart for the question: Tap the case in which more of the dividend stays inside the fund. Treaty rate US dividend 100 US tax 15% Fund keeps 85 Default rate US dividend 100 US tax 30% Fund keeps 70

    A fund that can use a treaty rate of 15% loses less to US withholding than one paying the 30% default.

  2. 2What is the standard US withholding rate on dividends paid to foreign persons without a treaty?

    The IRS applies 30% to US-source dividends paid to foreign persons, unless a treaty or exemption lowers it.

  3. 3What does the US–Ireland tax treaty allow for ordinary portfolio dividends?

    The treaty limits US tax on such dividends to 15% for residents of Ireland who qualify for treaty benefits.

  4. 4Why can withholding tax paid inside a fund matter to you?

    Tax withheld from the fund's income lowers its returns before anything reaches investors.

of 4 correct.

Sources