Tax guide for ETF investors

At its simplest, an Exchange Traded Fund (ETF) is a 'basket' of shares, rolled-up into one security. For those looking to diversify into many different shares but without the time or inclination to manage each share purchase individually, investing into an ETF can be a convenient way to spread risk and to get access to stocks that the fund manager thinks will be high-performing. However, whilst investing in an ETF might look similar to an investment into an individual share, the tax implications are very different. 

Basically, an ETF takes the form of a trust and the return paid by an ETF is treated like a distribution from the trust. However, that return will incorporate many different components, such as dividends, franking credits, interest, foreign income and capital gains. Each of those individual elements then needs to be split out by you and entered into the correct boxes on your tax return. The potential for mistakes is considerable. 

Fortunately, most ETF providers give investors a year-end tax statement, which breaks down the total distribution by the various elements and often contains instructions on which specific boxes to complete on your tax return. Make sure you look out for (and keep) your annual tax statement because without it, completing your tax return accurately can be almost impossible. 

Franking credits on distributions 

Dividends paid by companies are typically paid with franking credits, representing the tax already paid on the underlying profits of the company. These franking credits then flow through to the individual investor who reports the gross dividend (including the franking credit) on their tax return, and can then claim a tax offset for the amount of the franking credit. Therefore, investors only pay tax on the difference between the company tax rate and the investor's own marginal tax rate. If the investor is on a low income (and has a tax rate less than the company rate), some or all of the franking credits will be refunded to the investor. 

When an ETF receives dividends that include franking credits, those dividends and the attached franking credits flow through to investors directly through the fund distributions. 

What about capital gains? 

As the fund buys and sells shares, capital gains arise based on the difference between what the fund originally paid for the shares (the base cost) and what the fund sold them for (the sales proceeds). If the fund held the shares for at least 12 months, it might be entitled to the 50% capital gains tax (CGT) discount which can potentially halve the rate of CGT payable. 

There are two types of ETFs: broad based index portfolios or actively managed ETFs. The former have a low portfolio turnover and therefore generate lower capital gains; the latter regularly trade and therefore lead to higher capital gains.  

These capital gains (and the associated discount) will flow through to the individual investor. Therefore, when a fund makes capital gains, the year-end statement will show the capital gains or losses made from the sale of the shares, which also need to be included in tax returns. 

In addition, the investor may choose to sell units in the fund itself. This could also give rise to capital gains which will need to be reported in your return (and the 50% discount will apply if you held the units for more than 12 months). 

What if returns are reinvested, rather than paid? 

ETFs often provide unitholders with an option to reinvest their distribution. Generally speaking, taxpayers will need to declare distributions despite not withdrawing any money from their account. Anything received through a dividend or distribution reinvestment plan is considered income and is treated for tax purposes in the same way as receiving cash. 

And finally... 

Dealing with the tax implications of shares and ETFs can be very complex. Many investors use a tax agent to ensure that their return is completed accurately. In particular, they will check that you are receiving all of your entitlements and that these flow through into your tax return, such as: 

• franking credits on your Australian ETF income 

• the 50% capital gains discount on investments held for 12 months 

If you have an InvestSMART professionally managed account, check out our tax hub for answers to common questions about InvestSMART PMAs and tax.