4. Withholding, double taxation and domicile

Costs 5: Tax as a cost

That leaves the most invisible cost in the whole course. It is invisible because it appears on no invoice, nor in the TER we studied in level 1, nor in the fee schedule, nor on your tax return. It happens far away, before the money even reaches the fund you hold units in, and yet it is subtracted from your return every year with the punctuality of a clock.

As in the previous modules: this describes a mechanism, it is not tax advice, and the specific percentages depend on international treaties that get renegotiated.

Withholding at source

When an American company pays a dividend to a shareholder who is not resident in the United States, that country withholds a portion before the money leaves its borders. This is withholding at source: the state where the income arises takes its cut first. The general statutory American rate on dividends paid to non-residents stands, at the time of writing, at 30%.

The problem is obvious: when that dividend arrives in Spain, here it is income too and here it is taxed too. The same income taxed twice by two different countries. That is double taxation, and it is why treaties exist.

What a double taxation treaty does

A treaty for the avoidance of double taxation is a bilateral agreement between two countries that divides up the right to tax. It does two things:

• It lowers the rate of withholding at source to an agreed maximum. For portfolio dividends, that maximum is commonly set at 15% in many treaties, including the one binding Spain and the United States.
• It obliges the country of residence to make an adjustment for what has already been paid abroad, normally by allowing the foreign tax to be deducted from its own.

There is a subtlety here that is almost always overlooked and that is half the lesson: that deduction has a limit. Your country of residence lets you offset what you paid abroad, but typically only up to the amount that corresponds to the treaty rate, and never beyond what you owed at home. If you suffered a withholding above the agreed maximum because you had not properly evidenced your residence, that excess is not deductible: you have to reclaim it from the foreign administration, a procedure almost nobody sees through. The practical conclusion is an uncomfortable one: the excess wrongly withheld is not a deferral, it is a dead loss.

Why the fund's domicile changes everything

And now the part almost no investor weighs up when choosing a product. When you buy a fund or an ETF that invests in American shares, the one collecting the dividends on those shares is not you: it is the fund. And the fund suffers withholding at source too, according to the treaty in force between the United States and the country where the fund is domiciled, not yours.

Here the decisive asymmetry appears. A fund domiciled in Ireland has access, under the treaty between Ireland and the United States, to the reduced withholding on American dividends. Funds domiciled in other European jurisdictions have not been getting that same reduction and bear the general rate. The difference between the two cases is some fifteen percentage points on every dividend collected, year after year.

And now the sting in the tail: that withholding, the one the fund suffers, you cannot deduct anywhere. It does not show up on your tax return, because it is not your tax. There is no box for it. It was simply subtracted from the money that came into the fund, before the net asset value was calculated.

Why it is not in the TER, and what that implies

A fund's ongoing charge captures what the fund manager, the depositary and the auditor take. It is a cost of management. Withholding at source is not a cost of management: it is a tax borne by the portfolio, and it is deducted from the income before the charges figure even exists. Put another way, when you compare two ongoing charges you are comparing the part of the cost somebody chose to publish, and leaving out another part that may be larger than it. That is why two funds can publish the same TER, track the same index and spend years with a stable difference in return between them. The only way to detect it is what was already argued in level 4: look at the actual deviation from the index over several years instead of comparing prospectuses.

A worked example: the tenths of a point that matter more than the TER

An index of American shares paying out 1.8% a year in dividends. We compare two funds that track it:

• Fund A. Ongoing charge of 0.07%, internal withholding of 30%. Cost from withholding: 1.8% times 30%, which is 0.54 points a year. Approximate total cost: 0.61 points.
• Fund B. Ongoing charge of 0.20%, internal withholding of 15%. Cost from withholding: 0.27 points a year. Approximate total cost: 0.47 points.

Fund B is nearly three times more expensive on the fee that appears in the prospectus and still comes out 0.14% a year cheaper overall. Put in euros: 100,000 euros at 7% gross over twenty years give some 367,900 euros with a drag of 0.27 points and some 349,727 with a drag of 0.54. The difference caused by withholding comes to 18,173 euros, while the 0.13 points of difference in the ongoing charge account for only some 9,180. The cost that is not published weighs twice as heavily as the one that is.

That completes the map of the real cost: commissions, execution, product structure and tax. The next level adds them all up.