The exchange traded fund (ETF) tax nightmare
NOTE: A version of this article first appeared at Cuffelinks.
ETFs have been a boon for self-directed investors, offering access to a basket of underlying investments, conveniently rolled-up into one security that trades like a stock. They’re listed on public exchanges and require small minimum investments. Launched in 1993, their popularity has soared with total assets scraping the USD $3.5T mark at the end of 2017. In fact, in 2018 21% of investors tracking their SMSFs on Sharesight bought or sold an ETF.* This is a significant increase on just 3% in 2008.
Nowadays there’s an ETF for everything: emerging markets, water scarcity, even cryptocurrencies. A colleague of mine owns a cybersecurity ETF (ticker: ASX: HACK) that’s returned 39% in one year. I’ve personally owned ETFs that track commodity futures and one that shorted the real estate market.
But with this expanded investment menu of ready-access ETFs, Australian self-directed investors face complex realities. That’s because despite all the positive aspects of ETFs, in actuality they are a tax nightmare for Australian investors who’ve chosen to go off-platform or not rely on a managed service.
The ETF tax nightmare in Australia
For Australian investors, ETFs create tax complications because instead of classifying them as ordinary company shares, the ATO classifies ETFs as trusts. To make things more convoluted, in 2016 the ATO changed the rules around investment trusts by creating the Attribution Managed Investment Trust (AMIT) regime.
Since the vast majority of ETFs issue distributions (even those that are growth focused), investors face highly complex annual taxation statements. If you own an ETF, you’ll know exactly what I’m talking about, and chances are your accountant does too!
An example of the ETF tax nightmare: Vanguard Australian Shares (VAS)
In our research, one purchase of VAS shares, which paid just four dividends throughout the year morphed into 17 distribution and two capital gains components on the annual taxation statement. In turn these correspond to 10 items on an individual tax return. Staggering complexity for just one buy!
VAS annual tax statement 2018
Why does this happen? VAS invests mostly in ASX shares, whose companies in turn pay dividends, are subject to franking credits and which undergo corporate actions. This creates all sorts of tax implications. VAS also invests in unlisted securities, derivatives and overseas companies each with their own tax nuances.
When you a run a portfolio that big, you need to leave room at the margins for inflows, outflows, rebalancing and hedging. It’s impossible for a portfolio manager to be 100% exposed to their core mandate at all times. And the VAS portfolio changes daily, which means the underlying components of each distribution will be different quarter to quarter as corporate actions occur, or the portfolio turns over so when you buy in or sell out impacts your annual tax situation.
As time goes by, you receive VAS distributions in cash (usually quarterly or half yearly), along with a simple statement from the registry showing the net payment. At the end of the year, the registry will send you a final statement.
These final statements contain all of the component and subcomponent information and are far more detailed than what you received during the year. This information can retroactively modify your cost base and taxable dividend income, making your tax lodgement very difficult and risking investors paying more tax than they need to.
How fintech is easing the ETF tax nightmare
Fintechs like Sharesight have created the expectation for real-time investment information. Once-per-year investment statements are no longer good enough for investors seeking accurate performance data about their hard-earned investment portfolios.
Case in point: in order to provide accurate performance and tax reporting for our clients, we sought to improve the depth and accuracy of exchange traded funds (ETFs) distribution data for our self-directed clients and partners.
We knew this would be a big undertaking, but it proved more difficult than anticipated. After beginning our journey we realised there was a lack of information and even clear rules available to investors. No one at the ASX, the ETF providers, professional firms, or even the share registries held the answer — but all recognised the problem.
Ideally, we thought we’d license the detailed distribution data from the registries or ETF managers on an ongoing basis. This proved impossible because they don’t calculate the data as the tax year progresses. It’s just one opaque process at year end.
Fortunately, Computershare came to the table and agreed to provide us with the detailed information for some of the most popular ETFs as soon as the financial year ended. We use this data as a basis for calculating the distribution components for the 2017 and 2018 Australian financial years.
Unfortunately, not all the registries were able to provide data for their ETFs. We have no idea how it can be that a registry can send personalised taxation statements out to millions of Australians but not be able to provide even notional data to software companies like Sharesight. In some cases we did receive sample data, but not always in a useable format.
After months of hard work, including working with our robo-advice partner Six Park, tracking down the right people at Computershare, and even buying ETFs ourselves in a Sharesight company account just to get the statements, we have managed to build a solution that simplifies ETF tax administration for self-directed investors. After months of research we could not find clear answers from the industry, so we believe our feature hits the mark in terms of both accuracy and usability. Hopefully our efforts to serve DIY investors push the industry towards better reporting standards.
ETFs remain terrific investment options
ETFs have helped democratise investing. I use them myself for long and short term investing and support Sharesight partners who use them as building blocks for their clients’ portfolios. However, it seems that the zest to market new ‘easy’ ETF investment products wasn’t matched by an ease in tax administration.
The reality is that all investments have a tax implication of some kind. For example, ASX-listed stocks are vulnerable to future franking credit decisions. And now ETFs bring their own tax complexities. This is just a new piece of the puzzle investors must keep in mind when building and administering their portfolios.