Exchange traded funds face income tax alert

Take care if you invest in exchange traded funds outside the tax ‘wrapper’ of an ISA (individual savings account) or Sipp (self-invested personal pension) as you may be liable for a higher tax rate on your investment gains than you thought.

Lack of 'distributor' status

A new report has revealed that a quarter of all UK-listed ETFs do not have ‘reporting’ or ‘distributor’ status with the tax authorities. As a result any gains are liable to be taxed at the income tax rate of up to 50%, rather than the lower capital gains rates of either 18% or 28%.

ETF providers such as iShares, db x-trackers and Lyxor are rushing to apply for the status for their funds that do not have it.

Nevertheless, the revelation has opened a can of worms for some investors who bought ETFs outside the tax shelters of ISAs and Sipps.

Investors could face HMRC penalty

Deborah Fuhr, global head of ETF research at investment group BlackRock (above), says such investors have two choices.

• they can do nothing, which would mean once they have disposed of the ETF they would be liable to income tax on the whole lot.
• or, they can elect on their tax return for a ‘deemed disposal and reacquisition of the holding at the time the UK reporting status starts’, meaning they will only be charged income tax for the period before the ETF acquired reporting status.

Unfortunately, the oversight means investors may have unknowingly – and wrongly – paid CGT tax on their gains when it should have been subject to income tax.

Under HMRC regulation, investors who paid CGT on gains from non-distributor funds would have to repay the difference, which could amount to as much as 28% extra.

However, if they are shown to have not taken reasonable care with their tax returns, they could be thumped with an additional 30% penalty.

Setback to ETF appeal

Edward Allen, a partner at Thurleigh Investment Managers in London (above), said the issue was a headache for investors. ‘It’s really not advertised well enough. It’s interesting that people are picking up on it this and hopefully a bit of publicity will make investors more aware of the issue.’

The potential tax hike is a blow for investors who have been drawn to ETFs by their low costs and flexibility. The BlackRock study showed ETFS charge 0.42% a year, up to 1% cheaper than actively managed unit trusts. ETFs offer access to all the main stock markets in the world as well as a host of commodities and specialist sectors.