Looking to save on withholding taxes? Here’s how you can do it with ETFs.

·       Physical ETFs directly own the assets they track, whereas synthetic ETFs use swap agreements, resulting in different implications on tracking error and risk levels.

·       Both replication methods involve counterparty risk, but synthetic ETFs are particularly dependent on swap providers for returns, which can be a concern for some investors.

·       After the Global Financial Crisis, physical ETFs became more prevalent due to concerns about counterparty risk with synthetic ETFs. However, advancements in synthetic ETF structures and associated tax benefits have made them more attractive for certain types of exposure.

·       With the London Stock Exchange coming online our platform in October 2023, Singapore investors can now be subjected to lesser or zero withholding taxes when investing in Irish-domiciled ETFs on the LSE relative to those in the US exchanges.

·       Investors can use a dollar-cost averaging strategy to avoid market timing and to help achieve financial goals. Consider our Regular Savings Plan (RSP), which allows you to build a diversified portfolio with as little as SGD 50 a month.

With more than 8,100 ETFs listed on our platform, choosing the right ETF for your portfolio can be challenging and time-consuming. In May this year, we shared the latest edition of our ETF Focus List which zeroes in on the best-in-class ETFs from a wide range of options.

With the London Stock exchange (LSE) coming online on our platform in October 2023, we previously highlighted the changes made to our recommended fixed income and equity ETFs. This is essential for investors as the withholding tax (WHT) on dividends from US-related ETFs is lower on the LSE than US exchanges, which would unlock greater cost-savings for investors residing in Singapore.

Related article: ETF Focus List 2024 – The best ETFs are here!

In this article, we discuss the differences between physical and synthetic ETFs, dividend WHT benefits of synthetic ETFs as well as the WHT benefits involving US-related equity and fixed income ETFs traded on the LSE.

Differences between physical and synthetic ETFs

ETFs can differ in terms of their replication method – physical or synthetic. Physical ETFs directly hold the assets they aim to replicate, while synthetic ETFs do not. Instead, synthetic ETFs use swap agreements with a counterparty who guarantees to provide the index’s return including all dividend payments to the ETF minus fees.

As a result, synthetic ETFs can often track their underlying index more precisely than physical ETFs, the latter which may experience deviations due to tracking error. However, the precision of synthetic ETFs comes with high counterparty risk.

Often, the parent bank of the ETF issuer serves as the sole swap provider which could give rise to potential conflict of interests. For instance, Deutsche Bank is the parent bank for ETF issuer DWS and Société Générale is the parent bank for ETF issuer Lyxor. In such cases, the ETF issuer may have little motivation to negotiate favourable terms with the swap counterparty. Moreover, if the sole counterparty defaults on its obligations, the ETF may not receive the expected returns. Hence, this may give rise to increased concerns regarding counterparty risk.

On the other hand, some physical ETFs may participate in securities lending, where the issuer lends out the underlying assets to another party. This may generate additional returns but may also introduce counterparty risk. Synthetic ETFs generally do not engage in securities lending since they do not directly hold the underlying securities.

Moreover, when an index comprises a large number of securities, the fund managers of physical ETFs might use a sampling approach to minimise trading costs which could further increase tracking error.

In terms of transparency, physical ETFs generally offer greater transparency as their underlying holdings are disclosed and publicly-traded while synthetic ETFs may offer lower transparency as they are reliant on swap contracts.

In the wake of the Global Financial Crisis (GFC), there were heightened concerns about counterparty risk involving synthetic ETFs. This is especially so after the International Monetary Fund (IMF) and the Financial Stability Board issued warnings regarding synthetic ETFs in 2011. This led to a shift towards physically-replicated ETFs.

That said, since then, ETF issuers have taken steps to enhance the synthetic ETF framework, such as engaging multiple swap counterparties and improving collateral transparency. For instance, Invesco’s synthetic ETFs can have up to six counterparties which may potentially reduce counterparty risks.

Withholding tax benefits of synthetic ETF

Currently, one of the most attractive features of synthetic ETFs is that Irish-domiciled synthetic ETFs have no dividend WHT as they hold a substitute basket comprised entirely of non-dividend paying stocks. In contrast, US-domiciled physical ETFs face a 30% WHT on US equity dividends, while Irish-domiciled physical ETFs face a 15% WHT.

To be clear, synthetic ETFs use swaps in which the swap counterparty agrees to pay the ETF's index return, including all dividend payments and in return, the counterparty receives a fee and the return on a portfolio of securities held as collateral.

As a result, the assets of a synthetic ETF are not invested directly in the replicated index but rather in a collateral portfolio that secures the swap agreement. This collateral portfolio often does not closely match the replicated index.

For instance, a synthetic ETF tracking European equities might also include Japanese equities in its collateral portfolio. The choice of securities for this collateral basket is generally influenced by the financing needs of the counterparty.

Hence, while synthetic ETFs offer tax benefits for investors, they still come with greater counterparty risk relative to physical ETFs.

Withholding tax difference between LSE vs US exchanges

An investment in an ETF generally constitutes three levels of taxation:

1.       At investment level: Tax withheld on the income from the underlying stocks distributed to the fund

2.       At the fund level: Tax withheld on distributions by the fund to the investor

3.       At investor level: An investor might be subject to taxation on income and capital gains

For equity ETFs, Singapore investors face a dividend WHT of 30% on US-domiciled ETFs on the ETF fund level but a lower dividend WHT of 15% on physical Irish-domiciled ETFs at the investment level. For synthetic Irish-domiciled ETFs, there is no dividend WHT. Hence, an investor can enjoy greater tax benefits when investing in a dividend-paying US-related Irish-domiciled ETF listed on the LSE relative to the ones traded on US exchanges.

Note: As a general rule for US-domiciled ETFs, investors in Singapore are subjected to a 30% WHT for its distributions. However, investors may be subjected to reduced WHT, or even exempted when there is a tax treaty between the foreign investor’s country of residence and the US.

Source: iShares.

As for fixed income ETFs, Singapore investors face WHT of 30% on US-domiciled ETFs. On the other hand, there are no WHT on fixed income US-related ETF listed on the LSE. Hence, for fixed-income ETFs, we recommend investors to consider the LSE-listed options (if available) over the US-listed ones for greater tax efficiency.

Source: iShares.

Table 1: Overview of the different WHT treatments

Type	Equity ETFs with US exposure			Fixed-income ETFs with US exposure
Exchange	NYSE, NASDAQ, BATS	Irish ETFs on LSE		NYSE, NASDAQ, BATS	Irish ETFs on LSE
Replication Method	Physical / Synthetic	Physical	Synthetic	Physical / Synthetic
Withholding tax	30%	15%	0%	30%	0%

Conclusion

Physical ETFs are often preferred by investors seeking direct ownership of the underlying assets and generally have lower counterparty risk. On the other hand, synthetic ETFs may be favoured for their smaller tracking error and tax advantages, particularly for international investors. Hence, investors should weigh the trade-offs between the two replication methods and invest accordingly.

For dividend-paying US-related Equity ETFs, synthetic ETFs listed on the LSE are not subjected to any dividend WHT. On the other hand, physical ETFs listed on the LSE are subjected to a WHT of 15% which is still lower compared to ETFs listed on US exchanges.

For fixed-income US-related ETFs, ETFs listed on the LSE are not subjected to any WHT on interest income while those listed on US exchanges are subjected to 30% WHT. Hence, given the differences in the WHT across LSE and US exchanges, investors should consider the LSE-listed options over the US-listed ones especially if the ETF has exposure to US assets with dividends or interest income.

To start investing in an ETF, we recommend investors to consider adopting a Regular Savings Plan (RSP) with us. A RSP is a monthly subscription that allows you to invest a fixed amount of money regularly into a specific investment product. As of 28 August 2024, there are a total of 51 LSE-listed ETFs spanning different sectors and markets available for RSP on our platform.

With a RSP, you can start building a globally diversified portfolio with as little as SGD 50 a month. You can choose to invest using cash (via automatic GIRO deductions), CPFIS-OA, CPFIS-SA, or SRS accounts, with monthly deductions automatically handled.

The RSP utilises dollar-cost averaging which eliminates the stress of market timing. By investing consistently, you purchase more units when prices are low and fewer units when prices are high. This approach can result in a lower average cost per unit over time, even in rising or fluctuating markets. Whether you are saving for retirement, your child's education, a wedding, or a new home, an RSP offers a disciplined investment strategy to help you achieve your financial goals.