A few weeks ago we started wondering if we were being taxed twice on total return ETFs. To recap, a total return ETF reinvests the dividends or interest payments on your behalf. This saves you the hassle (such as it may be) and fees of reinvesting dividends. It’s especially useful if you were going to buy more ETF units with your dividends.
Even though you never receive income from these ETFs, you still pay either tax on interest or dividend withholding tax as if you had received the cash. In the case of dividend withholding tax it all happens on your behalf, making this type of ETF delightfully free of admin – at first…
Since ETF issuers determine the price of ETF units based on the true value (or net asset value) of the ETF’s underlying investments, they don’t need to purchase more ETF units with the dividends. They simply raise the unit value of the ETF by the dividend or interest amount. As a result, the value of your ETF increases over time. When you sell your ETF, the price will have gone up by the amount of dividends or interest you received, although your number of ETF units haven’t increased.
Says Len Jordaan, head of ETF distribution at Absa, “The ETF makes what we call a ‘notional distribution’ to its investors. This means that the investor is deemed to have received the distribution and receives a tax statement to that effect, but never takes delivery of any cash. The distribution must be included in an investors’ tax return as income.
“If the investor then sold the unit, they would ordinarily realise a capital gain on the difference between the cost of acquisition and the sales price, which would be equal to the reinvested distribution amount.
“However, because the cash was deemed to have been paid to the investor (by way of the notional distribution), the investor is also deemed to have made a capital reinvestment into the fund when the fund manager reinvests the distribution.
“This increases their cost of purchase (their base-cost), which offsets the capital gain. There is therefore no capital gain, and no CGT liability.”
This is sadly where the admin catches up with you. When you sell your total return ETF, you would have to deduct the value of the reinvested dividends if you want to avoid paying capital gains. To do that you would have to keep track of when you paid tax on the income. It would be worth keeping all of the tax statements on the dividends paid to keep track of how much of your gain is from dividends. Once you sell your ETF and have to pay capital gains, you (or a very seasoned tax practitioner) can deduct the income from your capital gains liability.
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