Nonresident alien with no US tax treaty & Irish ETFs

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This page shows why it may be better for a US nonresident alien (NRA) with no US tax treaty to invest in Ireland domiciled exchange-traded funds (ETFs) as opposed to the popular US domiciled mutual funds discussed often by US-based investors.

Please note that for Europeans it has become difficult to buy US domiciled funds due to 2018 European MiFID and PRIIPs regulations.

This page uses the rate of 30% for any dividend withholding calculations. This is the US dividend tax rate in the absence of a dividend tax treaty.

US tax treaties

Depending on your country of residence, you may be able to benefit from a US tax treaty for lower rates and higher exemptions. If you do, some parts of this article may not apply directly as you may be able to benefit from lowered treaty rates.

A list of treaties can be found at United States Income Tax Treaties - A to Z.

Why invest in Ireland domiciled ETFs as an NRA?

A few reasons for preferring Ireland domiciled ETFs over US domiciled ETFs:

  • Ireland domiciled ETFs can benefit from the US/Ireland tax treaty rate of 15% on dividends and 0% on interest paid to Irish corporations,[1] instead of 30% for US nonresident aliens in countries without a US tax treaty.
  • Ireland domiciled ETFs insulate investors from US estate taxes of up to 40% of the balance of US situated assets above $60,000.
  • US domiciled ETFs holding non-US securities can suffer double tax withholding. The US domiciled ETF pays withholding to international governments, then the US levies 30% of the remaining distributed dividends. Ireland domiciled ETFs avoid this.
  • Complex and constantly changing US tax laws affecting US nonresident aliens. Leave it to iShares and Vanguard Dublin to deal with those.
  • Non-residents of Ireland are not liable to Irish gift tax or inheritance tax.[2][3]
  • Availability of accumulating funds that reinvest dividends and which may help some investors reduce or avoid Level 3 tax.
  • For Europeans it has become difficult to buy US domiciled funds due to 2018 European MiFID and PRIIPs regulations.

More information about Irish funds: Why Ireland for funds?, by Irish Funds.

Caveats of investing in Ireland domiciled ETFs?

Some of the downsides:

  • US domiciled ETFs often have lower expense ratios.[4][5]
  • US domiciled ETFs usually have narrower bid/ask spreads.[6]
  • Most Ireland domiciled USD denominated ETFs have rather low daily trading volumes. See: Understanding ETF liquidity at ETF.com.
  • ETF options are limited but sufficient to build Bogleheads-style lazy portfolios.[7]
  • Depending on your broker, buying Ireland domiciled ETFs usually costs more in transaction fees. Beware that next to transaction costs, brokers can have annual custody fees.[8][9]
  • Some EU domiciled ETFs are synthetic. See EU investing for more information.
  • The taxation mentioned here is only applicable for non-Irish residents. For people residing in Ireland another set of rules applies.[10]

No Irish (capital gains or dividend) tax withholding for Ireland domiciled ETFs

Ireland does not withhold any taxes on capital gain or dividends paid by Ireland domiciled UCITS ETFs for non-residents of Ireland. [11] [12] [13]

Multiple levels of dividend tax withholding

Figure 1. Three levels of dividend taxation can apply to ETFs.

Investors that hold funds that hold securities can be taxed on dividends by multiple countries at multiple levels. [14]

There are 3 levels of dividend taxation to apply.

  • L1TW: Percentage of tax withholding by the home country of the security on the dividends distributed by the underlying international securities (Level 1).
  • L2TW: Percentage of tax withholding by the country where the fund is domiciled on the dividends distributed by the fund (Level 2).
  • L3T: Percentage of taxation that the individual investor needs to pay in their home country (Level 3).

Estimating Level 1 dividend tax withholding paid by US domiciled funds

According to the PWL Capital white paper,[14] the following are the percentages of tax withholding paid by different types of US domiciled ETFs

Fund Type Fund Used 2009 2010 2011 2012 2013 5-Year average
US-listed ETF of [ex-US] developed markets stocks iShares MSCI EAFE ETF (EFA) † 7.5% 8.1% 7.6% 7.2% 6.9% 7.5%
US-listed ETF of emerging markets stocks iShares MSCI Emerging Markets ETF (EEM) 10.3% 12.2% 10.4% 10.1% 11.1% 10.8%

† Note that iShares MSCI EAFE ETF (EFA) excludes the US. You can use that number to approximate Level 1 taxes for the ex-US developed markets portion of the fund in question. If the US domiciled fund you are analyzing has 60% US stocks vs 40% ex-US developed markets, the Level 1 tax withholding will be 0.40 * 7.5% = 3.0% approximately.

Estimating Level 1 dividend tax withholding paid by Ireland domiciled funds

Using annual reports of the most traded funds from iShares and Vanguard, the following is the resulting Level 1 percentages leaked by funds per percent dividend yield. Those figures were calculated for this wiki post. If you find other sources online confirming, please update and reference accordingly.

ETF / Year Inception Date 2011 2012 2013 2014 Average
Vanguard FTSE Developed World UCITS ETF (VEVE) 30-Sep-2014 - - - 12.3% 12.3%
Vanguard FTSE Developed Europe UCITS ETF (VEUR) 21-May-2013 - - - 5.5% 5.5%
Vanguard FTSE Emerging Markets UCITS ETF (VFEM) 22-May-2012 - - 9.8% 9.0% 9.4%
Vanguard FTSE All-World UCITS ETF (VWRL) 22-May-2012 - - 10.7% 9.8% 10.3%
iShares Core MSCI World UCITS (IWDA) 25-Sep-2009 12.6% 12.2% 11.9% 11.6% 12.1%
iShares MSCI Emerging Markets UCITS ETF (IDEM) 18-Nov-2005 11.4% 10.0% 10.1% 11.4% 10.7%
iShares US Aggregate Bond UCITS ETF (IUAG) 13-Sep-2011 - - 0.0% 0.0% 0.0%
iShares $ Corporate Bond UCITS ETF (LQDE) 16-May-2003 0.0% 0.0% 0.0% 0.1% 0.0%
iShares US Property Yield UCITS ETF (IUSP) 3-Nov-2006 12.6% 12.7% 13.6% 13.4% 13.1%

Keep in mind that each index provider (MSCI/FTSE) has a different definition of "Developed Markets" and "Emerging Markets". Different indices have different allocations of those markets, too.

Calculating dividend tax withholding as a ratio

To better compare different ETFs we can convert the tax withholding percentages into a total annual approximation, let's call it the Tax Withholding Ratio (TWR). This makes it easily comparable to the expense ratios found on funds' fact sheets.[15] See references[16][17] for more about this method.

To calculate the dividend Tax Withholding Ratio (TWR), we need four pieces of information:

  • L1TW: Percentage of tax withholding paid by the fund on the dividends distributed by the underlying international securities held (Level 1). This can be estimated using each fund's annual report, by dividing "Non-reclaimable withholding tax" by "Dividend Income".
  • L2TW: Percentage of tax withholding on dividends the individual pays (Level 2). If you are a non-treaty US nonresident alien investing in US domiciled ETFs, that number is 30%. If you are investing in Ireland domiciled ETFs and you do not reside in Ireland, you do not have to pay any Irish tax withholding.
  • YIELD: Annual yield of the fund. As you cannot know the amount of future dividends in advance, an approximation based on historical values (gross before withholding was paid) should be sufficient. Dividend yield is used in the formula as the Level 1 taxes are paid on dividends received by fund.
  • TER: The fund's Total Expense Ratio. Can be obtained from a fund's KIID document.[note 1]

The calculation after that is rather simple:

TWR = (YIELD × L1TW) + ((YIELD × (1 - L1TW) - TER) × L2TW)

The first term in parentheses calculates the Level 1 leakage. The second term uses the remaining dividend, deducts the fund's TER[note 2] and then applies the individual's Level 2 tax to the remaining sum.

You can now add the TWR to the fund's published expense ratio to get a comparable total ratio paid annually. Note that this does not include the dividend tax that the investor pays to their resident-country on the dividends actually received.

Example calculation for S&P 500 ETFs

Let us compare the US domiciled Vanguard S&P 500 ETF (VOO) vs Ireland domiciled Vanguard S&P 500 UCITS ETF (VUSA).

Vanguard S&P 500 ETF (VOO):

  • L1TW = 0%, as it is US domiciled, holding US securities
  • L2TW = 30%, US nonresident alien rate for countries without a US tax treaty
  • YIELD = 2.0%, estimated as we need it for comparison purposes, not exact dollar calculations
  • TER = 0.05%
TWR for VOO = 0 (no L1 withholding) + ((2.0% * (1 - 0) - 0.05%) * 0.30) = 0.59%

Vanguard S&P 500 UCITS ETF (VUSA):

  • L1TW = 15%, as it is Ireland domiciled, holding US securities[18]
  • L2TW = 0%, no Irish tax withholding on UCITS funds
  • YIELD = 2.0%, estimation
  • TER = 0.07%
TWR for VUSA = (2.0% * 0.15) + 0 (no L2 withholding) = 0.30%

L1TW for VUSA can be also calculated using its annual report[19]. For 2014, Foreign Withholding Tax (7,721,652) divided by Dividend Income (52,371,805) = 14.74%. TedSwippet explains that it's not 15.0% on the dot due to a 2.5% REIT allocation, which may distribute dividends or capital gains at different rates than the US treaty rate of 15% for dividends. A tax drag differing from the treaty rate may for instance be caused by foreign companies in an index, capital gains being taxed differently than dividends and REITs can recharacterize distributed dividends as return of capital, which is not to be taxed.

Including the funds' expense ratios: VOO's total cost is 0.64% for a nonresident alien with no US tax treaty, while VUSA's total cost is 0.37%. For this investor then, VUSA is the better holding.

Example calculation for FTSE World ETFs

Let us compare the US domiciled Vanguard Total World Stock ETF (VT) vs Ireland domiciled Vanguard FTSE All-World UCITS ETF (VWRL).

Vanguard Total World Stock ETF (VT):

  • L1TW † = 0% * 52% (US) + 9% * 10.8% (Emerging Markets) + 39% * 7.5% (ex-US developed) = 3.9%
  • L2TW = 30%, US nonresident alien rate for countries without a US tax treaty
  • YIELD = 2.0%, estimation as we need it for comparison purposes, not exact dollar calculations
  • TER = 0.17%

† Ratios of US/EM/DM obtained from VT's Vanguard.com portfolio page.

TWR for VT = (2.0% * 0.039) + ((2.0% * (1 - 0.039) - 0.17%) * 0.30) = 0.07794 + 0.52562 = 0.60%

Vanguard FTSE All-World UCITS ETF (VWRL):

  • L1TW = 10.3%
  • L2TW = 0%, no Irish tax withholding on UCITS funds
  • YIELD = 2.0%, estimation
  • TER = 0.25%
TWR for VWRL = (2.0% * 0.103) + 0 (no L2 withholding) = 0.21%

Including the funds´ expense ratios: VT's total cost is 0.77% for a nonresident alien with no US tax treaty, while VWRL's total cost is 0.46%. For this investor, VWRL is the better holding. Note that as allocation to countries changes over time, the tax drag will change over time as well. Also note that as yield changes over time, the tax drag will change over time as well.

Notes

  1. Background info for KIID: UCITS IV: Key Investor Information Document-KIID, from PwC Luxembourg
  2. Some countries allow funds to subtract the fund's TER before paying the dividends, some don't. Please review the taxation of the country where the fund is domiciled

See also

References

  1. PwC Ireland Tax Facts 2015 / Appendix 2 "Withholding tax on payments to Ireland"
  2. KPMG Ireland Taxation of non-resident unitholder/investor in a resident fund
  3. A&L Goodbody: An Overview of the Taxation of Irish Regulated Funds
  4. iShares Core U.S. Aggregate Bond ETF (AGG)
  5. iShares US Aggregate Bond UCITS ETF (IUAG)
  6. London Stock Exchange Historic ETFs and ETPs Statistics
  7. justETF.com ETF Screener
  8. Saxo Bank Trading Rates
  9. TD Direct Investing International - Fees and Commissions
  10. Bogleheads® forum topic: Help needed. US ETFs vs UCIT ETF for an Irish resident
  11. According to Dillon Eustace law firm:Ireland: Taxation Of Collective Investment Funds And Availability Of Treaty Benefits "Taxation of investors from the perspective of the investment funds (Non-Residents): As outlined above, Irish investment funds are not subject to any taxes on their income (profits) or gains arising on their underlying investments. In addition, there are no Irish withholding taxes in respect of a distribution of payments by investment funds to investors or in relation to any encashment, redemption, cancellation or transfer of units in respect of investors who are neither Irish resident nor ordinarily resident in Ireland, provided the fund has satisfied and availed of certain equivalent measures or the investors have provided the fund with the appropriate relevant declaration of non-Irish residence."
  12. According to iShares UK:TAX IMPLICATIONS OF iSHARES FAQ "Distributions from Exchange Traded Funds (ETFs) such as Dublin-domiciled iShares are exempt from Irish withholding tax by virtue of the shares issued by Dublin-domiciled iShares being settled via a recognised clearing system (Crest)."
  13. A reply received from Saxo Bank customer support dated March 2015: "Our corporate actions team replied that on VWRL there has previously been 0% tax. On Irish ETFs in general they can’t give an answer – it may be different on different ETFs."
  14. 14.0 14.1 From a Canadian perspective, according to PWL Capital:PWL Capital - Foreign Withholding Taxes: How to estimate the hidden tax drag on US and International equity index funds and ETFs "Investors are potentially subject to withholding taxes levied by the countries where the stocks are domiciled, whether that is the US, developed markets outside North America (western Europe, Japan, Australia), or emerging markets (China, Brazil, Taiwan). We refer to this as Level 1 withholding tax. When international stocks are held indirectly via a Canadian-listed ETF that holds a US-listed ETF, investors may also be subject to what we've called Level 2 withholding tax. This is an additional 15% [30% if no tax treaty] withheld by the US government before the US-listed ETF pays the dividends to Canadian investors. You can think of Level 1 foreign withholding tax like a departure tax you pay when taking a direct flight to Canada from a foreign country (including the US). Level 2 tax is like a second departure tax you pay when an overseas flight to Canada has a layover in the US."
  15. Forum discussion Re: ETF portfolio for non-resident alien with no tax treaty, by Micks (and Galeno), direct link to post.
  16. Tax withholding calculation indirectly mentioned by Canadian Couch Potato post "Foreign Withholding Tax Explained"
  17. PWL Capital - Foreign Withholding Taxes: How to estimate the hidden tax drag on US and International equity index funds and ETFs, June 30, 2106.
  18. PwC Ireland Tax Facts 2015 / Appendix 2 "Withholding tax on payments to Ireland"
  19. Vanguard UK Annual Report 2014 - S&P 500 on page 109

External links