Fund or ETF better?

masonic

JohnWinder said:

Thanks. Many all-equity funds hold some cash; were that to generate some interest the interest would be paid to investors lumped together with the stocks’ dividends, and both called ‘dividends’, I’ll assume.
And some/?all funds of mostly equities but with some bonds, will pay investors something which is only called ‘dividends’ even though some of the payments is interest from bonds, I’ll assume.
If that’s right, why couldn’t there be a component of the ‘dividend’ which is actually realised capital gains (assume the investor has neither sold nor bought during the year)?  Or are the components of the ‘dividends’ itemised for the information of the investor?

The threshold for funds is 40% equities. At or above this, all of the distribution is a dividend, below it interest. Investment trusts (company shares) always distribute dividends regardless of how they generate their profits. This can be useful if wishing to hold fixed interest outside of a tax wrapper where you have exhausted your personal allowance and personal savings allowance. You may pay for the privilege through higher ongoing charges however. Also, ITs normally trade at a premium/discount to NAV.

ColdIron

Without wishing to muddy the waters, not all pay dividends. Henderson Diversified Income plc (HDIV), which invests in global fixed income and floating rate asset classes, pays interest and classed as such on the annual consolidated tax certificate

masonic

ColdIron said:

Without wishing to muddy the waters, not all pay dividends. Henderson Diversified Income plc (HDIV), which invests in global fixed income and floating rate asset classes, pays interest and classed as such on the annual consolidated tax certificate

It looks like you've found quite a complex example. HDIV has a note on its website about distributions that makes interesting reading: https://documents.janushenderson.com/prod/documents/docId/LOECUE

It has been set up in a manner that it can make separate distributions both interest and dividends. The former are called "dividends" virtually everywhere you can look online, but are taxed as interest. The factsheet details under the dividend history chart (top right) instances where dividends vs interest was distributed in the year it changed its domicile to the UK. Thank goodness for the CTC!

It seems the IT may have a choice in how it structures its dividend, with domicile potentially being relevant.

ColdIron

Yes, up until 2017 it was domiciled in Jersey and all distributions were Overseas Dividends, after that they became Interest Payments. I have another (BIPS) which invests in similar asset classes but is still domiciled in Jersey and it pays Overseas Dividends

JohnWinder

You seemed to be talking about taxation of investors on the internal operations of a fund.

Yes.

Yes, fund payments derived from equity are called dividends

The threshold for funds is 40% equities. At or above this, all of the distribution is a dividend, below it interest. Investment trusts (company shares) always distribute dividends regardless of how they generate their profits.

So, a fund (not etf) liquidates some of its holdings to pay out fund holders who are leaving the fund. At least 4 possible CG consequences result:

1. That liquidation never results in a capital gain, because the fund always sells its component shares/bonds for the same price it bought them. NO WAY.

2. The liquidation may result in a capital gain within the fund.

   2a. The capital gain is never part of an annual 'dividend' to any fund holders, and is taxable by the fund or is tax exempt.

   2b. The capital gain is shared solely among the investors leaving the fund.

   2c. The capital gain is shared among all fund investors not leaving, and paid as part of the next regular 'dividend' distribution.

3. Insert others here....................

If Bloomberg is right, the answer is 2c in USA and elsewhere. https://www.bloomberg.com/graphics/2019-vanguard-mutual-fund-tax-dodge/

I think the taxation hazard (from distributed fund CG) for remaining fund holders arises because the fund is a pooled investment - investors' money is all thrown in together; individuals don't own a tiny bit of a share of APPLE purchased at £25.33. I'm speculating now.

An ETF is traded differently, so that you can sell your ETF units to another individual on the open market or to a market maker. The fund manager doesn't have to dispose of assets when investors want out.

What the situation with funds (not etf) in UK is I have no idea, but as I've read the discussion it's been implied that the answer is 2a, 2b or 3.

masonic

JohnWinder said:

You seemed to be talking about taxation of investors on the internal operations of a fund.

Yes.

Yes, fund payments derived from equity are called dividends

The threshold for funds is 40% equities. At or above this, all of the distribution is a dividend, below it interest. Investment trusts (company shares) always distribute dividends regardless of how they generate their profits.

So, a fund (not etf) liquidates some of its holdings to pay out fund holders who are leaving the fund. At least 4 possible CG consequences result:

1. That liquidation never results in a capital gain, because the fund always sells its component shares/bonds for the same price it bought them. NO WAY.

2. The liquidation may result in a capital gain within the fund.

   2a. The capital gain is never part of an annual 'dividend' to any fund holders, and is taxable by the fund or is tax exempt.

   2b. The capital gain is shared solely among the investors leaving the fund.

   2c. The capital gain is shared among all fund investors not leaving, and paid as part of the next regular 'dividend' distribution.

3. Insert others here....................

If Bloomberg is right, the answer is 2c in USA and elsewhere. https://www.bloomberg.com/graphics/2019-vanguard-mutual-fund-tax-dodge/

I think the taxation hazard (from distributed fund CG) for remaining fund holders arises because the fund is a pooled investment - investors' money is all thrown in together; individuals don't own a tiny bit of a share of APPLE purchased at £25.33. I'm speculating now.

An ETF is traded differently, so that you can sell your ETF units to another individual on the open market or to a market maker. The fund manager doesn't have to dispose of assets when investors want out.

What the situation with funds (not etf) in UK is I have no idea, but as I've read the discussion it's been implied that the answer is 2a, 2b or 3.

2b is what happens in the UK. Units in the fund are cancelled, so the surviving units are unaffected. There's also an element of 2a because dividends and capital gains are kept entirely separate in the UK tax system. Funds do not pay tax on their income (other than foreign WHT) or capital gains, investors do. This is true for ETFs, OEICs and UTs. For ETFs there is trading of shares (secondary market) as well as unit creation/destruction (primary market), but the latter is essential to enable the ETF to trade at NAV.

Another point that is specific to the UK is the 30 day rule. If an investor sells a fund and then reinvests in it within 30 days, then it is not treated as a disposal and there are no CGT consequences. For qualifying disposals, investors would pay either 0%, 10% or 20% tax on their capital gains depending on their income and available tax free allowance. This is incompatible with 2c as the fund house could never know the investor had reacquired the units and that the sale was exempt, or which rate of CGT would have applied to the disposal. There is a fairly easygoing guide to how the UK system works here: https://www.gov.uk/capital-gains-tax

Just out of interest, in the USA under the 2c regime, how does an investor know what to declare on their tax return if they are making daily unknown capital gains and losses through others trading the funds? If they are buying and selling units themselves over the course of a tax year, and their share of the capital gain is subject to the number of units they held on each day of trading, then it seems a horribly complex calculation.

Edit: I've found the following article, which sort of explains it: https://taxdiversification.com/active-versus-passive-investing-the-pros-cons-and-tax-implications-of-each-approach/

So this is the origin of the US tax system favouring passive funds, which is not applicable to the UK - something that @dunstonh has been warning us about for years.

JohnWinder

There's also an element of 2a because dividends and capital gains are kept entirely separate in the UK tax system

I wrote:

2a. The capital gain is never part of an annual 'dividend' to any fund holders, and is taxable by the fund or is tax exempt.

I may have confused the discussion with 'dividend' as I wrote it. I meant annual or other interval scheduled distribution from the fund to the investor, because I thought we had established that this payment in UK is referred to as 'dividend' even though it may be partly interest from cash or bonds. Reading your comment makes me think you are separating true stock dividends from CG.

Secondly,

Funds do not pay tax on their income (other than foreign WHT) or capital gains,

As this is so, 2a cannot apply to UK as my 2a option has the fund paying tax on capital gains were they to eventuate; furthermore, in the way you've added to my understanding, it seems funds (not etf) may not generate any capital gains other than those attributed to each investor when they bail out. So we're left with 2b and C.

Another point that is specific to the UK is the 30 day rule. If an investor sells a fund and then reinvests in it within 30 days, then it is not treated as a disposal and there are no CGT consequences

But my scenario is talking about what happens to the remaining investors when an investor sells, a different situation. However, the 30 day consideration would be irrelevant to remaining investors as you've indicated that it's only the leaving investors who may have CGT liabilities.

This is incompatible with 2c as the fund house could never know the investor had reacquired the units and that the sale was exempt, or which rate of CGT would have applied to the disposal.

I'm certainly losing faith in 2c, but I disagree. The fund house knows the identity of each investor, and thus will know when they sold/reaquired, surely? I do see how the fund house would not know which rate of CGT would apply, but I don't think the fund house needs to know that, if the investor is responsible for completing their own personal annual tax report for Inland Revenue.

Thanks for the links. I didn't read all of the uk.gov information, so if there's a specific bit relevant to my initial concern, don't hesitate....

JohnWinder

Just out of interest, in the USA under the 2c regime, how does an investor know what to declare on their tax return if they are making daily unknown capital gains and losses through others trading the funds?

Don't know. But computers can do a lot of stuff very quickly if you tell them what you want to know, and it is within the capacity of a fund house to keep track of individual investor's trades, trading prices, gains/losses etc and attribute to them interest from cash, coupons from bonds (if the Inland Revenue wants to know this), dividends and capital gains. If the investors needs it for their tax return, the fund house would be out of business if they couldn't provide it.

wmb194

ColdIron said:

Yes, up until 2017 it was domiciled in Jersey and all distributions were Overseas Dividends, after that they became Interest Payments. I have another (BIPS) which invests in similar asset classes but is still domiciled in Jersey and it pays Overseas Dividends

You need to be a careful with these as they might need to be reported as foreign interest, not foreign dividends:

"interest from overseas unit trusts and other investment funds, including from reporting offshore funds (use the details on your unit trust or fund voucher) – where the offshore fund is more than 60% invested in interest bearing assets, any distribution that you receive, or that is reported to you, is treated as interest received"

https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/973733/sa106-notes_2021.pdf

EdSwippet

masonic said:

Just out of interest, in the USA under the 2c regime, how does an investor know what to declare on their tax return if they are making daily unknown capital gains and losses through others trading the funds? If they are buying and selling units themselves over the course of a tax year, and their share of the capital gain is subject to the number of units they held on each day of trading, then it seems a horribly complex calculation.

The simple answer is that the fund issues capital gains distributions, alongside dividend distributions. Literally, you receive a check for your share of the capital gains realised by the fund. And at the end of the year, the broker or platform reports dividends and capital gains distributions to both shareholders and the IRS, on forms 1099-DIV and 1099-B respectively.

For index tracking funds in particular, annual capital gains distributions can be relatively rare. Not always, though. Vanguard US recently cost some investors thousands of dollars in unwanted and arguably unnecessary (or at the very least, early) capital gains tax by reorganising assets across some of their funds, resulting in a lawsuit:

Vanguard created big tax bills for target-date fund investors, lawsuit claims

Imagine buying $100k of a fund on Monday, receiving $10k back as a capital gain distribution on Tuesday, leaving you with $90k in the fund, and then finding that you have to pay income tax on that $10k distribution. Equivalent to paying tax on a refund of principal. This is the type of reality that capital gains distributions in particular can create for unwary (or even wary) US investors.

Not a concern for UK investors, though. It's US fund regulation that forces US domiciled funds to pay capital gains distributions to shareholders. Non-US domiciled funds don't have this same problem; already covered by several other posters upthread.