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 in 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, while investing in an ETF might look similar to an investment in 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 (with a provider like H&R Block (NYSE:HRB)) can be almost impossible.
When an investor disposes of units, the year-end statement will show the capital gains or losses made from the sale of the units which also need to be included in tax returns.
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.
Dealing with the tax implications of shares and ETFs can be very complex. Many investors use a tax agent, like H&R Block, 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; or
- The 50% capital gains discount on investments held for 12 months.
It can make sense to take tax advice throughout all stages of your investment journey, from the initial investment right through to the sale of your portfolio.
Mark Chapman is the director of tax communications at H&R Block. As well as operating his own private practice, Mark spent seven years as a Senior Director with the Australian Taxation Office. Mark is a Chartered Accountant, CPA and Chartered Tax Adviser and holds a Masters of Tax Law from the University of New South Wales.