Creating a Tax Efficient Portfolio with ETFs

• Among their many advantages — intraday liquidity, transparency and ease of use — exchange traded funds (ETFs) are touted for their tax efficiency and low cost.
• Australian ETF investors could receive franking credits along with any distributions for Australian funds with Australian underlying constituents.
• ETF investors may be eligible to receive up to half of the realised gains distributed by an ETF tax-free.
  

ETFs Minimise Capital Gains Distributions

Investors can seek to minimise the impact of capital gains taxes by choosing a tax-efficient investment product with low turnover, and a widely diversified underlying portfolio. 

Among their many more obvious advantages — low cost, intraday liquidity, transparency and ease of use —ETFs are touted for their tax efficiency. (Note that tax efficiency refers to how well an investment minimises an investor’s taxes while they own it). ETFs typically generate fewer capital gains distributions than unlisted funds for two reasons:        

• Low Portfolio Turnover. Because they track indices, ETFs tend to have lower turnover than actively managed unlisted funds, which has two important benefits.

        1. Low turnover means a longer holding period for each of the underlying             investments which creates the potential for lower capital gains             distributions.  By simple design, ETFs generally hold underlying             securities longer than 12 months (at least), which qualifies for the             long-term capital gains tax discount.                   

       2. The second reason holding periods are important is the ’45-day rule’ –             this is the length of time a security must be held around its ex-date for             the investor to qualify for the franking credits.        

• Secondary Market Transactions. Unlike unlisted funds, when ETF investors sell their units, portfolio managers do not need to sell stocks to raise cash for the redemptions. So, unlike traditional unlisted funds, one ETF investor’s sell decision has no impact on other investors and capital gains distributions are kept low. An unlisted fund’s distributions, taxable to all investors, regardless of how long they have owned the fund, can result in a capital gains tax bill, even in years when the unlisted fund registers a loss.

The unique structure of ETFs can reduce capital gains distributions for tax-aware investors and allow for more assets to remain invested without the drag of ‘premature’ gain realisation — typically increasing the growth potential of the investment. 

The Advantage of Dividend Imputation

The dividend imputation system in Australia can represent an important advantage for investors over the dividend taxation schemes found in other countries because it largely eliminates the double taxation of corporate profits in Australia. If Australian corporate taxes have already been paid on profits used to fund dividends, those taxes need not be paid again at the personal level by investors. 

The corporate taxes paid are attributed, or imputed, to the Australian investor through tax credits called franking credits. These franking credits can be used to reduce an investor’s total tax liability. For investors who are individuals or complying superannuation entities, any excess franking credits can also be refunded at the end of the year if the investor’s franking credits are greater than their tax liability.

Let’s look at an example. ABC Corporation makes $1.00 per share in pre-tax profit during a given period and would like to pay it all out in the form of dividends. After paying the 30% corporate tax, ABC Corporation distributes $0.70 per share in fully franked dividends. To the Australian investor, this is equivalent to being paid an unfranked, “grossed up” dividend of $1.00 per share. The 30% corporate taxes already paid will accompany the dividend in the form of a $0.30 per share franking credit and act similar to an “IOU” from the tax office. 

From this we can see that:

Dividend + Franking Credit = Grossed Up Dividend

The taxpayer must now pay the appropriate level of tax on the grossed up dividend less any franking credit. In other words, the franking credit can be used to offset taxes due on the dividend (for 45% and 32.5% marginal tax rate investor) or entitle the investor to a tax refund (19% and 0% marginal tax rate investor). An investor with 0% taxes due will be entitled to receive the entire franking credit back as a tax refund. (Figure 1 below shows the example involving 100 shares of ABC Corporation).  

Dividends and Franking Credits for the Australian Investor

A company that pays all its income tax domestically in Australia will usually pay a fully franked dividend, i.e. a dividend with a franking proportion of 100%. However, some companies’ franking proportions can be less than 100%, especially for companies paying taxes outside of Australia. 

Other companies that do not pay any Australian tax, and have no franking credits from prior years available to roll forward, may pay an unfranked dividend. The franked vs unfranked proportion of a stock will therefore have a material effect on after tax returns making it an important issue for all investors to consider.

ETF Investors Can Receive Franking Credits and Tax-Free Distributions

Equity-based ETFs hold a basket of stocks that pay varying levels of dividends, at varying levels of franking proportions. Investors holding Australian ETFs on and around the distribution dates (which can be quarterly or semi-annually, for example, month end June and December) could receive valuable franking credits along with any distributions they receive. 

As well as distributing income like dividends or interest, ETFs also distribute any realised gains from the investments they hold. Under the capital gains tax (CGT) rules, some of these realised gains may be classified as “discounted.” ETF investors may be eligible to receive up to half of the realised gains distributed by an ETF tax-free.