Updated Sep, 2019

Fund domicile and avoidable US taxes

There are 2 types of US tax to be wary of

US estate tax (death tax)

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 your country of tax residency has a treaty with the US (Australia does), then provided you don’t forget to send in the W8BEN form every 3 years and you have under the estate-tax-threshold amount for your given country’s tax-treaty agreement (at the time of writing I believe it is $11.4 million for Australian residents), you should be fine regarding estate tax (death tax) to the US government (provided they don’t change this without you realising).

However, for US domiciled funds, when you die, if your country of tax residency does not have a treaty with the US or if you forgot to send the form in after it has expired, the US will take a large chunk of your assets that your heirs would otherwise receive.

Check the laws for your country of tax residency (see the 2 links just below), or just avoid US domiciled funds entirely to avoid the risks.

Even if your country does have a tax treaty, as you age, your cognitive abilities decline and it’s hard enough remembering what you did the other day let alone a W8BEN form every few years. Imagine the scenario where your children move you into a nursing home, the form goes to your old address, and since you did not fill out the form, when you die, the US government takes 40% of your US domiciled shares for estate tax that your heirs otherwise would have gotten. Was the lower MER worth it?

More information:
Nonresident alien taxation – Bogleheads
Outline of Non-US domiciles – Bogleheads

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 + SC (both developed ex-US and emerging markets)

Essentially the choice comes down to

  • If your country has an estate tax treaty (Australia does) and if you can be sure you will not forget to fill out the W8-BEN form and submit it to your broker every 3 years, then the US domiciled funds are cheaper, simpler, and more diverse. The proportion for market cap weighting is around 50/50 VTS/VEU.
  • If you have potential heirs who will suffer from you forgetting to send in the W8-BEN form and consequently may lose a large portion of their inheritance due to the harsh US estate tax (death tax), then the Australian domiciled funds make more sense. The Australian domiciled funds are overwhelmingly recommended due to this, so for the examples in the equity funds page, I used the Australian domiciled funds, but feel free to use the US domiciled funds if you consider the risks low enough or worth it.

More information:
List of Australian exchange-traded funds – Wikipedia

Dividend tax

There are three layers at which dividends are taxed:

  1. The country of the asset
  2. The country of the fund
  3. 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

  1. Vanguard’s VEU and VGE
  2. BlackRocks IVE and IEM
  3. 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.

More info
Multiple levels of dividend tax withholding – Bogleheads
Taxation of your investments – Bogleheads

Still unsure?
Ask on the Bogleheads non-US subforum, they have people asking about this regularly.