Update : Although this is one of my older posts on Dividend Withholding Tax, the content remains relevant and helpful, especially for people searching for how it matters to the selection of exchange traded funds (ETFs) for index investors around the world.
Dividend Withholding Tax was one area that I had a little difficulty understanding. If you have a good and easy to understand resource, please please please share it with me here.
Doing Google searches tend to dig up a whole lot of complicated and complex information that tend to confuse rather than educate. This is especially important when we have ETFs that are domiciled all over the world. Having a basic appreciation would likely help result in lower leakage and better returns.
Well, what I can say is that I have a rough idea of how it works in the context of a Singaporean retail investor. Through trial & error, reading scraps of information and in-between forum posts, at least things seem to make some sense now. How about a blog post that makes Dividend Withholding Tax somewhat easier to understand?
Challenge accepted! Read on to see how we can better understand it using some sample scenarios.
Disclaimer : Forgive me if I make mistakes here. There is a Chinese idiom which translates to bringing jade by laying bricks – 抛砖引玉. It means that what one is offering is somehow lacking, and one is in hopes that others will, seeing it, offer something that is better.
Introduction to dividend withholding tax
I didn’t know there was such a thing. Dividend Withholding Tax was an alien term to me. I was puzzled when the U.S. Government took a 30% bite out of my dividends, as shown on my Standard Chartered statement.
US tax law requires the withholding of tax for non-US persons (non-resident aliens) at a rate of 30% on payments of US source stock dividends, short-term capital gain distributions and substitute payments in lieu. You may be eligible for a reduced rate of withholding if there is a treaty in effect between your country of tax residence and the US.
What the heck was that?!
Two tiers of taxation
As you know, dividends always flows from companies to individuals. I have a simple representation below.
Company >> Investor
In the case of ETFs, which holds a basket of stocks, the declared dividends (probably hundreds of them) from all the companies first flow to the ETF e.g. which consolidates it and pay them out to investors on a regular basis. Thus, it looks like this.
Companies >> Fund >> Investor
Depending on which country each of the two or three components are based in, the funky thing called tax kicks in. Pretty easy to understand for “company” and “investor”. For “fund”, we’re interested in which country the ETF is domiciled in. Make a mental note – this last point is important.
DOMICILE – One’s primary residence for tax purposes.
Edit : Reader Andy commented the following which I thought is helpful – “Domicile” doesn’t necessarily mean your primary residence for tax purposes. Indeed it is very common to be domiciled in one country but tax resident in another. For example, the majority of British expats living in Singapore, even those who are Singapore Permanent Residents are probably only Singapore tax residents but still legally domiciled in the UK. I’d probably use the term “country of tax residency”. Financial Times Lexicon has this to say about residence and domicile.
To have an easier understanding of Dividend Withholding Tax and how it comes into play eventually, I would like you to imagine there being two tiers of taxation being applied to declared dividends. Let’s learn from examples!
Scenario 1 : Singaporean Buys Apple Stock
Company (US) – 0% – Fund (n/a) – 30% – Investor (SG)
Simplest example of only 1 stock. For non-US persons like Singaporeans, 30% of the declared dividends get withheld by the US government. When you get slapped with withholding tax directly, you will see it in your brokerage statement, something like the one I have below. Yeah, from my Apple adventure days, haha!
Oh my gawd, imagine if I had held my Apple stock all the way till now?!
Tier 1 tax = Not applicable.
Tier 2 tax = 30%.
Scenario 2 : Singaporean buys Vanguard S&P 500 (VOO) ETF
Companies (US) – 0% – Fund (United States) – 30% – Investor (SG)
Let’s see another relatively simple scenario this time. We’re still concerned only with US stocks. If you happen to buy a US-domiciled ETF such as S&P 500 which have only US companies, no Tier 1 taxation takes place (I could be wrong) since US companies are paying dividends to a US-domiciled fund. However, you are subjected to the same 30% withholding tax just like Scenario 1.
Therefore, Tier 1 tax = 0%.
Tier 2 tax = 30%.
Scenario 3 : Singaporean buys Vanguard S&P 500 (VUSD) ETF
Companies (US) – 15% – Fund (Ireland) – 0% – Investor (SG)
Let’s twist things around and buy S&P 500 ETF on London Stock exchange instead. Wow, the rules of the game has totally changed. With VUSD domiciled in Ireland, the 500 (or so) US companies now pay their dividends to a foreign corporation outside of the United States.
Luckily, there is an US-Ireland tax treaty rate of 15% on dividends paid to Irish corporations. This is what I meant when I sometimes say dividends are taxed at source. Haven’t reach Ireland, already kenna makan. Secondly, Ireland does not withhold any taxes on dividends paid by Ireland-domiciled ETFs to us. Yesss!
Now, Tier 1 tax = 15%.
Tier 2 tax = 0%.
This is one reason why many investors prefer to buy Vanguard ETFs on London Stock Exchange instead – myself included.
Scenario 4 : Singaporean buys Vanguard S&P 500 (3140) ETF
Company (US) – 30% – Fund (Hong Kong) – 0% – Investor (SG)
Just for the fun of it, since Vanguard launched another S&P 500 ETF (2015) at our side of planet Earth, we take a quick look at it. First thing : it is a Hongkong-domiciled ETF.
With no tax treaty in place between the US and HK, Vanguard HK gets whacked with a 30% rate on dividends paid to non-US corporations. Luckily, it “redeems” itself in Tier 2 since it does not withhold any taxes on dividends, which is the same as Ireland. Yeah, you can believe me on that because Vanguard HK said so to me in their email.
Yes, the newly launched S&P 500 index ETF is a Hong Kong domiciled ETF. Also, US tax is withheld on dividend distributed by HK listed S&P 500. The dividend withholding tax is at 30% for S&P 500 ETF. It will be paid by the fund, thus the impact for an investor will be a 30% less dividend when our ETF distribute dividend.
The idea of dividend withholding tax being “paid for by the fund” is similar to Scenario 3 (Vanguard UK), as these are so-called Tier 1 tax to me. Most importantly to you, it simply means if they declare dividend is $1, you get $1. Don’t need to think so much, lah.
Tier 1 tax = 30%.
Tier 2 tax = 0%.
Hmm. It would appear the net effect (30%) is rather similar to buying VOO. Do the Maths on the exchange rates and fund expense ratio and you can probably decide on which is better.
Bonus Scenario : Singaporean buys Vanguard All World ETF (VWRD) ETF
Companies (US & Ex-US) – ?% – Fund (Ireland) – 0% – Investor (SG)
Ah, the one we all have been waiting for.
I confess. I have no idea on how to compute this in exact terms. Remember that I’m not a numbers guy? I tend to state 15% because it is difficult to explain this, but I shall try. Well, we can always turn to annual reports. Don’t you worry, I did the hard work for you. From Vanguard 2014 annual report, for VWRD on page 55, dividend income came in to $7,496,554 while foreign withholding tax is $734,078 – which is roughly 9.8%. But, why?
If you have read through Scenario 1-4, you probably have already guessed why we ended up with a percentage that is not 15%. VWRD does not only hold US companies, isn’t it? Each of these countries applies a different tax rate when dividends flow into Vanguard UK. With US holdings roughly half of VWRD, it goes without saying that the other countries are more generous since Ex-US rate would have to be less than 10%.
Phew. That’s It.
Yet another topic that I’ve always wanted to touch on for Index Investors who are keen to go global. Let’s hope my understanding isn’t too far off from what’s right.
Jade, where are you? Come out, come out, wherever you are.
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