Fund domicile and avoidable US taxes — Passive Investing Australia

There are 2 types of US tax to be wary of

US estate tax (death tax)

[Edit: This page previously stated that the W8-BEN form was also for the estate tax treaty, however that is only used for the income tax treaty]

If a fund is domiciled in Australia, it means the company that holds the underlying shares is an Australian company and is under taxation laws of Australia.

If a fund is domiciled in the US, it means the company that holds the underlying shares is a US company and is under taxation laws of US.

Unfortunately, the US has draconian estate tax (death tax) laws for non-Americans.

For US domiciled funds, if you have under the estate tax threshold for your given country’s tax-treaty agreement (at the time of writing I believe it is $11.4 million for Australian residents), you may be fine regarding estate tax (death tax) to the US government, but this is predicated on the US government not changing this. If it is changed in the future and you have a lot of capital gains, it would be costly to get out of it.

For countries without a tax-treaty agreement, the threshold is $60,000.

Above the limit of your country, the US will take 40% of your US domiciled shares for estate tax that your heirs otherwise would have gotten, and that is 40% of your total assets, not 40% of the capital gain.

You can check the laws for your country of tax residency in the 2 links just below.

Australian vs US domiciled funds for global exposure

There are a few US domiciled funds on the ASX (check the last column of the link just below), but the most commonly used US domiciled funds by DIY’ers on the ASX are VTS (total US market) and VEU (total ex-US markets).

To get a global cap-weighted exposure to the entire investable world, there are 2 groups of global funds to choose from – Australian domiciled and US domiciled.

Australian domiciled
	VGS	Developed LC + MC
	VISM	Developed SC
	VGE	EM (Emerging Markets)

US domiciled
	VTS	US total market LC + MC + SC
	VEU	Ex-US total market LC + MC (both developed ex-US and emerging markets)

Dividend tax

There are three layers at which dividends are taxed:

The country of the asset
The country of the fund
The country of the investor

Australian listed ETFs that are either not Australian domiciled or that hold funds domiciled outside Australia, and where those funds hold assets from outside their own country, have tax drag (a reduction in returns due to tax treatment). Tax drag occurs when withholding tax that could normally be offset via a double taxation treaty agreement cannot be offset because another country is in between Australia and the country of the asset itself.

Examples of this include

Vanguard’s VEU and VGE
BlackRocks IVE and IEM
BetaShares DHHF

Looking above at the 3 layers of dividends, all of those funds besides VGE and IEM contain assets that are Australian shares (being the asset – layer 1), within a fund that is not Australian domiciled (level 2) and as a result franking credits are not passed on. This money that is lost due to inability to claim it back on your tax return is called tax drag.

It won’t be a lot since Australian companies make up so little of the world, but far more important than missing out on franking credits is missing out on the ability to claim back withholding taxes from double taxation agreements (DTA) between Australia and non-US companies. Looking above at the 3 layers of dividends, all of those funds contain assets that are from countries with a DTA between Australia and that country (being the asset – layer 1), within a fund that is not Australian domiciled (level 2) and as a result the ability to claim the withholding tax is not passed on. Just as with franking credits above, this money that is lost that otherwise would not be, is known as tax drag, but unlike franking credits which make up a tiny amount of global funds, Australia has a DTA with a lot of countries, so there will be a lot of tax that you’re unable to claim back from your tax return each year.

Just to make it as clear as possible, the problem is not that less withholding tax is paid by Australian domiciled funds, but that you cannot claim the tax already paid by the fund in your tax return. As a result, the tax drag is going to be close to the entire withholding tax paid by the fund.

This tax drag isn’t known by most of the public because who would know of such a thing to even search for unless they randomly came across it.

Let’s go into a bit more detail.

For funds (or persons) holding US assets –

The US takes 30% tax on dividends of US shares unless you or the fund holding them has a tax treaty with the US in which case it takes 15%.

This doesn’t affect Australian residents, but if you’re a tax resident of a country with no tax treaty with the US (e.g. Singapore), then buying a US domiciled fund with US shares (e.g. VTS) will require 30% tax on dividends.
If you purchased an Ireland or Australian domiciled version, you would pay only 15% tax on dividends of US shares since the fund is domiciled outside the US and in a country with a dividend income taxation treaty with the US.

For funds holding NON-US assets –

If a fund is US domiciled (e.g. VEU) then the US takes 30% tax on dividends on top of the tax for the underlying shares non-US companies pay to their own country unless you or the fund holding them has a tax treaty with the US, in which case it still takes 15% tax on dividends on top of the tax for the underlying shares of non-US countries pay to their own country.
If you purchased an Ireland or Australian domiciled version that held the assets directly and not by simply holding the US fund within it, you would pay no tax to the US government on non-US stocks as you’re bypassing them entirely.

Another issue regarding US domiciled funds that hold non-US assets (e.g. VEU) is that any non-US income tax paid before it gets to you cannot be claimed by non-Americans. For instance, there are Australian shares in VEU and Australians cannot claim the franking credits on those. While the amount of franking credits lost will likely not be significant, for countries where Australia has a DTA, they will also not be claimable with US domiciled funds that hold assets from those non-US countries. Also note that this will also be the case with Australian domiciled funds that hold US domiciled funds within them such as VGE, IEM, and DHHF which are Australian domiciled funds but hold US domiciled funds within them, and some of those funds hold non-US assets of which any tax that you would ordinarily get credit for is lost.

Note that if your country of tax residency has a double taxation treaty with the US, such as Australia, you can claim the US income tax against your income tax, so for example, if you were required to pay 15% tax to the US before it gets to you, you get a credit for that amount, therefore, as long as your marginal tax rate is above that, it won’t cost you any more to hold a US domiciled fund (that holds US assets) compared to a fund domiciled in Australia or Ireland that holds the assets directly. If your marginal rate is below that or if you’re not from a country where you can claim that against income beyond this amount, it is costing you more than you realise.

Please note that some European countries allow the fund to re-invest the dividends and treat them as capital gains to get the long term capital gains discount, and for tax residents of those countries, there are Ireland domiciled “accumulation” funds specifically for this which would suit you.