Taxation of US-ETFs

Introduction

Most European ETFs that physically replicate stock indices that also contain US stocks are based in Ireland. This is mostly due to the fact that US-Irish tax treaty reduces the US source tax on dividends from 30% to 15%, even for stocks held by funds. While many other tax treaties (double taxation agreements) do the same for private investors, Ireland is an exception where this reduction also counts for dividends paid to a fund (such as an ETF). Unfortunately, this 15% tax on dividends is internally paid by the fund and can therefore not be deducted from German taxes. This leads to a tax advantage of holding US-ETFs (i.e., ETFs domiciled in the US rather than in Europe) for German tax residents. While this tax advantage may not be enough for most German investors to go through the trouble of buying US-ETFs, it is a big relief for US persons who

Note that Germany changed tax laws in 2018, which improved the situation tremendously as described in this analysis. Previously, foreign funds were often treated as "intransparent" leading to a punitive taxation similar to the US PFIC treatment. Luckily, this was abolished in 2018 and since then US persons living in Germany can invest in a tax-efficient way in US-ETFs, as long as these rules do not change. Please check out our discussion of German investment taxes. In particular, we will answer the following questions:

1. How are ETFs taxed in Germany?

2. How can one buys US-ETFs in Germany?

3. What are the advantages of US-ETFs vs. European ETFs?

Taxation comparison: European ETFs vs. US-ETFs investing in US stocks

We compare two cases where a German tax resident invests into physically replicating ETFs that cover US stocks and pays dividends to the investors:

• European ETF. The ETF will receive dividends from US companies. Due to the fact that the ETF is based outside of the US, there will be a US source tax depending on the country where the ETF is based, which must be directly paid by the ETF. In most cases, Irish-domiciled ETFs are the best choice as the US source tax for Irish investment funds is only 15% (compared to 30% in many other European countries, even if private investors only pay 15% there). After the US tax is deducted, the ETF pays out the remaining amount (i.e., 85% of the original dividend in case of Irising ETFs) which is then taxed in Germany. As the ETF is a stock fund (Aktienfond), the tax rate will be only 17.5% (corresponding to 70% * 25% after Teilfreistellung) plus solidarity surcharge (of 5.5% applied to the German tax). In summary, 15% of the dividend go to the US, 17.5% (of the remaining amount) go to German taxes and 5.5% (of the German tax amount) goes to the solidarity surcharge. All charges are converted to EUR on the day of the payment.
  Example of 1000 EUR dividend: 150 EUR of US source taxes (paid by ETF), 148.75 EUR of German taxes, 8.18 EUR of solidarity surcharge, so 693.07 EUR remain after taxes.

• US-domiciled ETF. The ETF will receive dividends from US companies. As the ETF is domiciled in the US, there is no source taxation on the level of the ETF. Therefore, the ETF will pay out the full dividend, but the broker will withhold 15% US source tax if the investor filled in the IRS form W8-BEN to claim the tax treaty benefit. If the investor is a also US tax resident (and filled in the IRS form W9), there may be not such a tax withholding, but in this case the US tax resident will typically still be taxed at 15% after declaring US taxed. From the perspective of German taxes, the investor received a dividend, of which 15% were paid to the US, which can be credited against the German tax. As it is a stock fund (Aktienfond), the German tax on dividends will be 17.5% (computed as above) plus solidarity surcharge (of 5.5% applied to the German tax), but as the investor (and not the fund!) already paid 15% of US source taxes only the remaining 2.5% are applied.
  Example of 1000 EUR dividend: 150 EUR of US source (paid by investor), 25 EUR of German taxes, 1.38 EUR of solidarity surcharge, so 823.62 EUR remain after taxes.

Please check out this statement of the German ministry of finance from June 3, 2021. Under point 148a (Ausländischer Aktienfond), it is explained in detail that (a) the foreign source tax can be deducted from German taxes and (b) that the partial tax exemption (Teilfreistellung) of 30% applies to foreign funds investing in stocks. Please check the FAQs below for more details.

How much outperformance can one achieve through these tax savings

We determined that there is a tax advantage of ca. 13% on distributed US dividends when using a US-ETF. At a typical dividend yield of ca. 2% p.a. this leads to a better performance of ca. 0.26% p.a. for US stock indices. Note, however, that worldwide diversified ETFs do not only receive US dividends. For example, ETFs tracking worldwide stock indices, such as the MSCI World index, are only invested at ca. 60% in US stocks, so the resulting tax savings will likely be more around 0.16% p.a., so the resulting savings are not as impressive as they may seem at first sight.

However, let us emphasize that US-ETFs often have additional advantages, such as high liquidity (with large trading volume) and very low spreads. Moreover, established US-ETFs (such as Vanguard or iShares products) are very likely to exist for years to come, while many smaller European ETFs have been merged with other ETFs or discontinued (though, there appears to be more and more market consolidation in Europe). Even more important, US-ETFs often have extremely low fees with fees (and tracking differences) of often below 0.1%. While there also exist European ETFs with very low fees, the resulting tracking differences are often larger due to different treatments of the source tax in the reference index. For example, the excellent European BNP Paribas Easy S&P 500 UCITS ETF claims a tracking difference of -0.48% p.a., which would significantly beat the S&P500 index. However, this outperformance is achieved by comparing this SWAP ETF (which actually does not pay any US source tax, as explained later the FAQs) with a performance index that assumes an unrealistic source tax of 30%. At a dividend yield of ca. 2%, this assumption reduces the performance of the reference index by ca. 0.6% p.a., so that this ETF would actually have tracking difference of +0.12% with respect to the true performance index without source taxes. This tracking difference also appears much more realistic, as the total expense ratio (TER) is quoted to be 0.15%. If we compare this ETF with the American Vanguard 500 Index Fund ETF (VOO) on the same index (TER is quoted to be 0.03%), we find that the European ETF beats the American ETF by ca. 0.1% p.a. over the 5-year-period 2016-2020, so there exist exceptions. However, most European ETFs do not have a tracking difference of -0.48%, but are rather slightly behind. In this case, low fee US-ETFs with the described tax advantage are expected to lead to an outperformance of 0.2-0.5% p.a., where ca. 0.1-0.3% are due to the described tax advantage here and another 0.1-0.2% are due to the generally lower fees (TER) of US-ETFs.

US-ETFs can be worthwhile to extract a small outperformance of ca. 0.2-0.5% p.a., but there exist exceptions (such as the BNP Paribas Easy S&P 500 UCITS ETF) and one should be aware of the additional hassles:

• European investors can only invest in US-ETFs through professional brokerage accounts (see below), which do not automatically deduct German taxes, so a German tax declaration is required (see below).

• Even with professional brokerage accounts, it is not trivial to invest in US-ETFs, as the EU regulation makes it notoriously difficult for brokerage firms to sell foreign fund products to European retail investors (see below). Depending on EU regulation, this may become even more difficult in the future.

• German tax laws may change in the future. Before 2018, foreign funds, such as US-ETFs, were punitively taxed in Germany, so that it would have been rather unattractive for German investors to buy US-ETFs. German investors owning US-ETFs will be a minority, so it is unlikely that German lawmakers will be specifically careful (on the other hand, this could also be an advantageous, as there will be likely very little pressure to increase taxes for this small group).

In summary, investing directly into US-ETFs to take advantage of lower tracking differences and a reduced tax on US source taxes makes the most sense for the following two groups of people (and combinations thereof):

• People who like to optimize every little detail and get out the last 0.2-0.5% of ETF performance.

• People who are US tax residents or expect to become US tax residents in the future.

How to declare dividends of US-ETFs in Germany

German tax residents with a brokerage account that does not automatically deduct German investment taxes are REQUIRED BY LAW to declare their taxes. To our knowledge, there is no German broker that allows the purchase of US-ETFs directly, so this applies to almost anybody who owns US-ETFs. Before the EU MiFiD regulation came into effect, it was possible to buy US-ETFs in German brokerage accounts, but to our knowledge not all German brokers apply the US source tax correctly to foreign ETFs.

German tax resident who own ETFs in a foreign brokerage account need to fill in the forms Anlage KAP and Anlage KAP-INV (based on German tax declaration for tax year 2020 - line numbers and terms may change):

• Anlage KAP 8 (Steuerabzugsbeträge zu Erträgen in den Zeilen 7 bis 25 und zu Investmenterträgen laut Anlage KAP-INV)
  Line 41 - Anrechenbare noch nicht angerechnete ausländische Steuern: This line should contain the total of foreign source taxes which were deducted from dividend payouts on the level of the brokerage account (source taxes paid inside of ETFs cannot be included here).

• Anlage KAP-INV 1 (Laufende Erträge aus Investmentanteilen, die nicht dem inländischen Steuerabzug unterlegen haben).
  Line 4 - Aktienfonds im Sinne des § 2 Absatz 6 InvStG (vor Teilfreistellung): This line should contain the total of all dividend payments paid out by ETFs to the investor without taking source taxes into account, which were deducted by the brokerage account.
  Line 9 - Aktienfonds im Sinne des § 2 Absatz 6 InvStG (vor Teilfreistellung): In most cases, this line should contain zero. This is because the Vorabpauschale is reduced by any dividends paid out by ETFs, which are much higher than the current interest rates (so that nothing is left after this reduction). This may be different by ETFs with stocks that do not pay dividends (growth stocks) or once the interest rates in Germany are higher than the typical dividend yield of US-ETFs.

For example, we consider a US-ETF that paid 1,000 EUR in dividends in the year 2020, of which 150 EUR in US source tax was deducted on the level of the broker. Moreover, we assume that in 2019 the dividend yield was significantly higher than the basic interest rate of 0.07%, so that the Vorabpauschale for 2019 (which is relevant for the tax year 2020, as it counts as received in the following tax year) is zero. We would therefore fill in the following information (based on the Elster tax form 2020). We assume that there were not sales of ETFs shares during the tax year (purchases do not lead to any taxes).

Finally, let us discuss how one would fill in the form Anlage KAP-INV 4 (Ermittlung der Vorabpauschalen zu Zeile 9 bis 13), where the Vorabpauschale is computed. As explained above, for most US-ETFs with reasonable dividend yield, we expect that this Vorabpauschale comes out to be zero. The Vorabpauschale relevant for the tax year 2020 is computed based on the value appreciation and interest rate for the tax year 2019 (as the Vorabpauschale counts as fictitiously received in the following tax year). We consider the following example:

• US-ETF: Vanguard Total World Stock ETF with ticker symbol VT

• Price on first trading day 2019 (January 2): 65.38 USD = 57.77 EUR (exchange rate 1 USD = 0.8835 EUR)

• Price on last trading day 2019 (December 31): 80.99 USD = 72.18 EUR (exchange rate 1 USD = 0.8913 EUR)

• Total dividend payments (per share) during the tax year 2019: 1.68 EUR
  Quarter 1 (paid on Mar 28): 0.281 USD = 0.25 EUR
  Quarter 2 (paid on Jun 20): 0.551 USD = 0.49 EUR
  Quarter 3 (paid on Sep 27): 0.435 USD = 0.40 EUR
  Quarter 4 (paid on Dec 27): 0.611 USD = 0.45 EUR

• Total number of shares: 100
  We assume that during the tax year, there were neither sales nor purchases of the respective ETFs. If there were sales, one would also need to pay tax on the profit (see here). If there were purchases, one would need to fill in a seperate form for each month, in which shares were purchased to determine a fractional Vorabpauschale proportional to the number of full months remaining (see line 43 below). In practice, the Vorabpauschale will be most likely zero if the respective ETF has a sufficiently high dividend yield.

This information leads to the following tax form entries:

How to buy US-ETFs as European resident

The main problem of this strategy is that the EU MiFiD regulation prohibits brokerage firms to sell funds to European retail investors, which do not provide certain regulatory documents, such as a Key Information Document (KID). Notably, differences in US and EU regulation make it impossible for US-ETFs to provide such documents. Among other reasons, this is because EU regulation requires forward looking statements, while US regulation does not allow ETF provider to make such statements. Moreover, European ETFs have generally slightly higher fees (though there is a trend of further decreasing fees), so American ETF provider (such as iShares and Vanguard) actually have little incentive to offer US-ETFs to European investors if they can create European-based ETFs with slightly higher fees.

Let us emphasize that EU regulations DOES NOT MAKE IT ILLEGAL for European retail investors to own, to hold or to buy foreign ETFs. The regulation only affects brokerage firms that are not allowed to sell such products to typical retail investors. Still, there are ways for European retail investors to acquire shares of US-ETFs:

• Open a brokerage account with a non-European address. The easiest solution is to get a brokerage account that does not enforce the EU regulation. This is possible by opening an account with a non-European address. In our experience, the easiest solution is to open an Interactive Brokers account with a non-EU address and in particular an Interactive Brokers Lite account if one has a US address.

• Open a brokerage account with a non-European company. If you do not have a non-European address, you might be able to open an account with a brokerage firm that does actively operate within Europe, while still offering service to European clients. While Interactive Brokers has non-European subsidiaries, they will only accept clients with European addresses within their European subsidiaries (which then falls under EU regulation preventing clients from buying US-ETFs). However, there are US firms, such as Tradestation and Tastyworks, which are based in the US and which do accept European clients without adhering to the EU regulation. Therefore, this allows EU customers to buy directly US-ETFs, as of writing (August 2021), but of course this may change in the future in case the EU is able to enforce its regulation for these firms.

• Get an exemption. European investors can circumvent the EU regulation by applying for an exemption with their brokerage firm. Many professional brokers offer this option, but the investor needs to prove that they are professional investors, as explained here. You need to satisfy two out of the following three conditions:
  (1) You have carried out trades in significant size (EUR 200,000 or greater) on the relevant market at an average frequency of 10 per quarter over the previous 4 quarters.
  (2) Your entire portfolio including cash (and positions held with other institutions) exceeds EUR 500,000.
  (3) You have worked in the financial sector for at least 1 year in a professional position.

• Buy US-ETFs indirectly through options. The EU restrictions on US-ETFs does not affect to sale of options on the respective ETFs. Therefore, a European broker can allow European retail investors to buy and sell options (put and call options) on US-ETFs. Typical options expire weekly, monthly or quarterly and there exist options for most major US-ETFs. Therefore, European investors could sell cash-covered in-the-money put options shortly before their expiration, which are almost certain to be exercised. This leads to an indirect purchase of the underlying US-ETF in multiples of 100 shares (as each option contract requires the purchase and sale of 100 shares). This approach is a bit cumbersome, but perfectly legal and in full compliance with current EU regulation. In practice, this only makes sense to for large account values, as buying US-ETFs in multiples of 100 shares often requires individual investments of large amounts. We still list this method, as it might be useful to know for some investors (and quite feasible for ETFs trading around 10 USD).
  Example: A European investor would like to invest in VTI (Vanguard Total Stock Market) covering the US market. The shares are currently trading at 230 USD each. Today expires a put option with strike price 240 USD, which gives the owner of the option the right (but not the obligation) to sell 100 shares of VTI for the strike price of 240 USD (so 10 USD more than the current trading price) to the entity that sold the option (that has the obligation to buy at this price). As the option is close to expiration, it will trade close to 10 USD per share, i.e., as one option represents 100 shares, the put option will cost close to 1000 USD. A European retail investor could now sell one such option and would immediately receive 1,000 USD. If VTI trades by the end of the day still below 240 USD, the owner of the option will very likely exercise the option and so the retail investor is forced to pay 24,000 USD to receive 100 shares of VTI. This transaction is counted as typical sell transaction through the broker, but rather settlement of the option contract and therefore not affected by EU restrictions. In effect, the European investor will have paid 24,000 USD for the shares, but previously received 1,000 USD for selling the option. Therefore, the effective price will be 23,000 USD, but with the small catch that the 1,000 USD of income (from selling the option) will be taxed immediately and the cost basis of the ETF will be at 240 USD per share. It is therefore advantageous to sell options just slightly above the strike price.

• Hire a financial management firm. There are financial advisors who will be able to setup an account for you, through which they can buy US-ETFs. In practice, they will manage your account, so you will be typically less flexible and this service comes at an additional cost of often 0.5-1.0% p.a., but if none of the other options work for you, this may still be an option.

FAQs

• Would it not be better to buy SWAP ETFs instead that do not pay any source tax in the US and reinvest dividends?
  For German investors without US tax residence, this could be generally an attractive option. SWAP ETFs do not replicate a stock index by investing directly into the respective stocks (as a physically replicating ETF would do), but rather have a contract with a partner (typically a large bank). The ETF holds some basket of securities (often not related to the underlying index), while the SWAP partner will guarantee to pay any difference to the index for some fee. In practice, the SWAP partner will hold some or all of the respective US stocks, but according to Section 871(m) of the US tax authority IRS, there is no source tax for dividends in the case of typical major stock indices. Therefore, it is possible to avoid the source tax altogether. Unfortunately, as of writing many European SWAP ETF still have higher fees when compared to US-ETFs, even after taking this tax advantage into account, but there are exceptions (for example, we found in an analysis here that for the period 2016-2020 the European SWAP ETF BNP Paribas Easy S&P 500 UCITS performed as good as the US Vanguard S&P 500 ETF before source taxes and ca. 0.1% better after taxes). As of writing, US-ETFs together with the above taxation rules will still beat most European SWAP ETFs by ca. 0.1-0.3%, but this may change in the future. Note that SWAP ETFs that directly reinvest dividends internally will lead to a non-zero German Vorabpauschale, which typically gives again a slight tax advantage (due to compounding interest in a tax-sheltered way), but also requires careful documentation of all German tax payments, so that one can prove in the future by how much the cost basis was increased (see here). Finally, if a US tax residence comes into play (either because the German investor is US person or expects to move to the US in the future), investing in US-ETFs is still the best choice.

• Does the 30% tax reduction Teilfreistellung actually apply to non-European ETFs (i.e., non-UCITS)?
  Yes, this is explicitly discussed in the notice of the German ministry for finance issued on June 3, 2021. The application of the 30% tax reduction is discussed under point 148a (Ausländischer Aktienfond). Moreover, this was also confirmed explicitly by the German tax authorities according to this source.

• Is one even allowed to reduce the German taxes by the US source tax if it was paid by myself for a US-ETF (in particular, if the source tax was paid in a foreign brokerage account, such as Interactive Brokers?
  Yes, this is explicitly discussed in the notice of the German ministry for finance issued on June 3, 2021. The reduction of the German taxes is discussed under point 148a (Ausländischer Aktienfond), just like 30% tax reduction discussed in the previous question.

• In order to get the 30% tax reduction, one needs to prove to the tax authorities that the respective ETF holds a sufficiently high percentage of stocks (namely 50%). How difficult is this proof?
  For many typical and well-known ETFs (such as Vanguard ETFs on major FTSE stock indices), the German tax authorities will accept the 30% tax reduction without further questions, as it is obvious that a physically replicating ETF on these indices must hold a sufficiently large percentage of stocks (namely, close to 100%).

• Are there problems with bequeathing stocks to the next generation for non-US tax residents (for example, German citizens living in Germany who hold US-ETFs)? It is often said that US holdings could be problematic as an inheritance.
  The key message: Based on the US-German tax treaty, this should only be a problem if the total inheritance exceeds 11,700,000 USD with even higher limits for your spouse. The situation may be different for people who are not German tax residents. In the following, let us review the most important rules.
  The following rules apply for US taxation of inheritances and gifting of US assets for German tax residents according to the current treaty (we do not discuss the German inheritance tax, which would come on top and is independent from the US taxation):
  (1) For investments up to 60,000 USD of US assets, there is no US tax on inheritances of people who are NOT US tax residents. Taxation for US tax residents (including citizens and greencard holders are different, as they are generally only taxed when the inheritance exceeds 11,700,000 USD).
  (2) Note that US stocks, US funds and other assets (such as properties etc.) count as US assets. Indirectly held US assets, such as through an ETF based in Europe, do NOT count as US assets.
  (3) The US-German tax treaty on inheritances gives German tax residents a fraction of the US tax-free amount of 11,700,000 USD where the fraction corresponds to the part of US assets in the total inheritance. Therefore, as long as the total inheritance value is below 11,700,000 USD, there will not be any US tax (as in this case, the tax-free amount is necessarily equal or larger than the respective US assets). For example, if the total inheritance is valued 10,000,000 USD with 3,000,000 USD in US assets. In this case, the tax free amount corresponds to 30% of 11,700,000 USD, which equals 3,510,000 USD and is thus more than the 3,000,000 USD in US assets.
  (4) The tax-free limits are even higher for spouses. First, only 50% of the US assets are included in the calculation and on top of this the remaining value of US assets is reduced by 11,700,000 USD. Only what remains is then included in the calculation of (2), so for spouses only US assets valued much higher than 23,400,000 USD will lead to a taxation in the US.
  In summary, US inheritance taxes for German tax residents only become relevant at amounts, where one has enough money to think about more elaborate structures to organize inheritances.

• Does the same approach also work with ETFs from other countries? In principle, yes, but it highly depends on the respective tax laws. For example, a German-based ETF that physically replicates the German stock index DAX will need to pay 15% in taxes (Körperschaftssteuer) on dividends, which must be directly paid inside the fund. Consequently, an investor would only receive 85% of the dividends which are then taxed regularly with a tax discount of 30% on the 25% (to which 5.5% solidarity surcharge is added). In total, the investor will thus pay 30.69% on the dividends without any way to credit source tax. The situation may different for other countries, but for practical purposes the US most likely the main country where this approach makes sense. This is due to the fact that US stock markets cover are by far the single most important public markets by market capitalization.

• Does it make sense to use US-ETFs to cover markets outside of the US? The tax advantage of using US-ETFs to invest into non-US markets is almost negligible. If a US-ETF invests into foreign markets, dividends from foreign companies will be reduced by local source taxes in the respective countries. Not all countries have such a tax, so the average source tax is often around 10% for developed markets. This source tax is internally paid by the ETF and thus cannot be used to offset German taxes. When the reduced dividend is paid out to investors, there is an additional source tax of 15% on the remaining amount and non-US tax payers cannot use the foreign taxes to offset this US source tax. However, as this 15% tax is applied when the ETF pays out its dividend to the investor, this US tax can be deducted from German taxes on the dividends. Therefore, German tax payers will only pay 2.5% (rather than 17.5%) on the dividends, which then reduces the solidarity surcharge which is exclusively applied to the German tax, so that the total German tax is 2.64% on the total dividend of the US-ETF. Therefore, this case is very similar to the situation of US-ETFs covering US markets with the difference that the ETF dividend is already reduced by foreign source tax withholding. In consequence, the additional US source tax (which as first sight makes this rather unattractive, as it comes on top) actually reduces the total tax slightly as crediting the 15% US source tax against the German tax reduces the solidarity surcharge to only 0.14% of the total dividend.
  Overall, this minimal advantage is certainly not worth it to go through this trouble, but if the respective US-ETF also has lower fees than a comparable European ETF or if the investor is also US tax resident (or expects to become US tax resident in the future), it might be reasonable to continue to invest in US-ETFs even to cover foreign markets.

Further ressources

• Reddit discussion on this topic (in German). In the context of writing this article, we initiated this reddit discussion among German tax payers.