Introduction

ETFs may be claiming fund market share globally but in the US this has been amplified by advantageous tax treatment versus mutual funds, whereas no such advantage exists for ETF investors in Europe. 

While both ETFs and mutual funds are subject to taxation on capital gains and dividend income in the US, the way ETFs are structured means that the final tax bill paid by investors is less than what would be paid in an equivalent mutual fund. 

This owes to the fact the ETF structure creates fewer taxable events than mutual funds. The reason for this is mutual fund managers must continuously rebalance a fund to accommodate shareholder redemptions, or to reallocate their assets in the case of active mutual fund managers. 

Each of these small transactions within the fund portfolio in turn generates capital gains for investors. 

Managers of many ETFs, meanwhile, can benefit from in-kind creation, enabling them to navigate inflows and outflows from their strategies by creating new ETF shares or redeeming shares for baskets of equivalent securities, rather than disposing of securities for cash. 

There are caveats to consider. For instance, ETFs with higher turnover – such as active ETFs – may have higher turnover and may therefore be exposed to more taxable events. 

Similarly, the underlying assets of some ETFs – such as bonds or cryptocurrencies – may suit cash rather than in-kind create-redeems. 

However, while mutual fund managers attempt to minimise the impact of taxation by performing tax migration strategies, the most common ETF iteration – passive equity trackers – have an insurmountable tax advantage that can generate percentage points of impact each year for investors. 

No ETF tax edge for Europeans

Unfortunately for European investors, no such advantage exists and in fact, some may face comparatively harsh tax treatment when opting to use ETFs versus mutual funds or even underlying securities.  

This is true for Spanish ETF investors, for example, who have been unable to benefit from the ‘Traspasos’ tax break since January 2022. Mutual fund investors, meanwhile, are able to defer capital gains when switching between funds under the Traspasos regime. 

Interestingly, ETFs not listed in Spain were eligible for the regime between 2016 and 2022, with investors able to shift between non-Spain-listed ETFs and other collective investment schemes and not being taxed on capital gains until they exited their positions. Even during this period, ETFs listed in Spain faced the same shares. 

Even more punitive is Ireland’s approach to taxing the ETF investments of its own citizens. While Irish domiciled UCITS ETFs are favoured by investors globally for their favourable withholding tax treatment on US equities, Irish investors face more severe capital gains taxation on ETF investments than on share dealing. 

In fact, investors based in the country pay 33% capital gains on profits made when selling stocks versus a 41% exit tax on profits when they sell ETFs within eight years. 

Perhaps even more significant is the tax disadvantage faced by buy-and-hold ETF investors. Ireland’s ‘deemed disposal’ system means investors are automatically taxed 41% on unrealised gains after eight years of holding an ETF, even without exiting their position. 

The disposal scheme was introduced by the Irish Revenue Commissioners in 2006 because it did not want to wait decades to collect tax revenue from long-term ETF investments, even though tax revenues would likely be greater on gains left to compound over the course of decades.