Dividend leakage in ETFs and stocks
As a novice investor, you may encounter a phenomenon known as dividend leakage. The term dividend leakage is encountered when investing in stocks and ETFs. It is also called dividend leakage and can have an impact on returns. Fortunately, as an investor, you can do something about it! This blog provides insight into dividend leakage, dividend leakage in the popular VWRL ETF and how you can prevent leakage.
What is dividend leakage?
Dividend leakage, also known as dividend leakage, is a situation where part of the dividend paid to investors is lost. This can happen when you receive dividends from companies in other countries. In many cases, a withholding tax is withheld from the dividend by the country of origin of the company. This tax is deducted from the total dividend amount before it is paid out to the investor. The withheld dividend tax that you cannot reclaim from the tax authorities during your tax return is the dividend leakage.
Not sure what dividends are? Read our article: What exactly is dividend in ETFs?
Dividend tax explained
Before we delve further into dividend leakage, it is helpful to first understand the concept of dividend tax. Dividend tax is a levy that is withheld from the profit distributions that companies make to their shareholders , or dividends. Dividend tax is usually levied at the time the dividend is paid.
In the Netherlands, dividend tax currently amounts to 15%. This means that when a Dutch company pays a dividend to its shareholders, 15% of the dividend amount is withheld and paid to the tax authorities. Shareholders can then offset this withheld dividend tax against their income tax or corporate tax. In this case, as an investor, you do not pay any dividend tax on balance.
It is important to know that dividend tax differs per country. Each country has its own rules and rates for dividend tax. In some cases, the dividend tax levied abroad can be higher than the Dutch dividend tax, which can lead to dividend leakage. You cannot reclaim the full amount of tax.
The influence of the country of residence on dividend tax
The amount of dividend tax depends on the country of establishment of the institution that pays out the dividend. See below for an illustration, the dividend tax for common countries of origin for investments:
- Netherlands: 15%
- United States: 30%
- Ireland: 0%
The dividend tax ultimately due also depends on the country in which the recipient of the dividend is established. This is because many countries have concluded tax treaties with each other. These treaties prevent investors from having to pay more dividend tax than they would pay in their own country on domestic dividends.
For example, the Netherlands has a tax treaty with the United States. This treaty ensures that Dutch investors do not pay the American rate of 30%, but the Dutch rate of 15% on dividends received from American companies.
These tax treaties help to reduce the effects of dividend leakage. However, in some cases dividend leakage may still occur when the dividend tax withheld abroad is higher than the rate in the country of the recipient, or when the offsetting of withheld dividend tax is not fully possible. It is important to know which tax treaties the Netherlands has with other countries and how they affect your investments.
Now that we have a better understanding of dividend taxation, we can better understand how dividend leakage occurs and what steps investors can take to mitigate its effects.
The Origin of Dividend Leakage
Now that we have explained the basics of dividend tax and tax treaties, it is time to look at how dividend leakage occurs. Dividend leakage occurs when there is a difference between the dividend tax withheld abroad and the rate that the dividend recipient would pay in their home country. This can arise due to differences in dividend tax rates between countries and the way tax treaties are drafted.
In some cases, dividend leakage can occur because the dividend tax rate withheld in the country of the distributing company is higher than the rate in the country of the recipient. When this happens, the dividend recipient cannot offset the full amount of the dividend tax withheld against their own tax return, resulting in a loss of income.
Example: Dividend leak
Let’s look at an example to further clarify the concept of dividend leakage.
Suppose you are a Dutch investor interested in investing in an ETF that invests in stocks worldwide. This ETF is based in Ireland and pays dividends to its investors. One of the companies in which the ETF invests is an American company that pays a dividend.
- The US company pays out a dividend of €100 and withholds 30% (€30) dividend tax at the US rate.
- The Irish ETF receives €70 (€100 – €30) and then pays out this amount to you as a Dutch investor.
- According to the tax treaty between the Netherlands and the United States, you should only pay 15% dividend tax on the American dividend. However, you have already paid 30% withholding tax via the Irish ETF.
- In this case, you can offset the overpaid dividend tax (15% or in this case €15) in the Dutch tax return. But the remaining 15% (€15) remains unsettled and leads to dividend leakage.
In this example, you lose €15 in dividend income due to dividend leakage, which negatively impacts your total return. This illustrates the importance of taking dividend leakage into account.
The impact of dividend leakage
Dividend leakage can have a significant impact on your investment returns, especially over the long term. If some of the dividend paid to you is lost to taxation, this could result in a lower return than you originally expected.
To assess the impact of dividend leakage on your returns, it is important to look at the total costs of the investment products you choose, including any taxes and withholding taxes. Bear in mind that the impact of dividend leakage on returns can vary depending on:
- The country in which the company or ETF is domiciled
- The tax treaties that apply.
The impact of a dividend leak lies in the principle of compound interest . You not only have to deal with the loss in that year, but you can also no longer achieve any return on this lost return in the years after.
Preventing dividend leakage
While it’s not always possible to completely avoid dividend leakage, there are some strategies you can employ to minimize the risk:
- Invest in Dutch ETFs
- Invest in ETFs domiciled in countries with favorable tax treaties
- Invest in stocks or ETFs that pay little or no dividends, such as growth stocks or ETFs that focus on capital preservation.
- Consider investing in synthetic ETFs. These ETFs replicate the performance of an index without actually owning the underlying stocks, reducing the chance of dividend leakage.
- Check the tax treaties between the Netherlands and the country where the company or ETF is established to determine whether there are possibilities to reclaim the withheld withholding tax.
Preventing Dividend Leakage in America: W8-BEN Form
You don’t have to look only at Dutch ETFs. You can also request the W8-BEN form in America, which is often offered by brokers. You must complete this form to make use of the tax treaty that both countries have with each other. This prevents you from paying double tax on the dividend that you receive annually. The form must be completed again once every three years to continue using it. According to the European MiFID guidelines, an ETF may only be issued in a European country if the documentation for this is available in the language of the country. As a result, not all American ETFs may be available from your broker.
Dividend leakage in Ireland
Ireland is a popular location for many ETFs due to its favorable tax climate and tax treaties. Many ETF managers are based in Ireland due to the 0% dividend tax. In some cases, investing in Irish ETFs can help reduce dividend leakage. This is because Ireland has tax treaties with several countries, which means that the withholding tax on dividends can be lower than in other countries.
Conclusion: Dividend leakage in equities and ETFs
Dividend leakage is an important aspect to consider when investing, especially when investing in foreign stocks, ETFs or mutual funds. While it is not always possible to completely avoid dividend leakage, as an investor you can implement strategies to minimize the risk and limit the impact on your investment returns. These include choosing tax-efficient ETFs, investing in countries with favorable tax treaties, and reclaiming withheld withholding taxes where possible.
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