With the increasing popularity of international share ETFs, investing in foreign companies has become far more accessible and affordable for the average Australian. Although these ETFs offer extensive exposure to international shares at a competitive cost, many investors might overlook some factors that might impact their returns. One such factor is the fund's domicile, which can have significant tax implications.

NOTE: This information is general in nature, and doesn't account for your individual circumstances. Tax implications can change in different jurisdictions, so do your research or speak to a licensed tax professional before making a decision.

What is a fund domicile?

The fund domicile refers to the legal jurisdiction where an investment fund (such as an ETF) is registered. If a fund is domiciled in Australia, it is legally registered in Australia and abides by Australia's tax rules.

On the other hand, if the fund's domicile is in the U.S., it is registered there and falls under U.S. tax jurisdiction. It's worth noting that many investment funds listed on the ASX have their domicile in other countries, particularly in the U.S.

This choice of domicile can impact your returns in two important ways:

1. Dividend tax:

2. Franking credits

1. Dividend tax

When Australian investors invest in an ETF domiciled outside Australia, and that fund holds assets outside its domicile, a 'tax drag' can occur. Let's consider an example.

The Vanguard All-World ex-US Shares Index (VEU) is a popular international ETF domiciled in the U.S. that invests exclusively in non-U.S. assets. Suppose VEU earns a $10 dividend from a German company. Germany will withhold a 15% tax ($1.5) due to VEU's U.S. domicile, leaving $8.5 for VEU. When VEU subsequently distributes dividends from this amount to its non-U.S. shareholders (like Australians), a 15% tax on the original $10 is withheld. This means Australians effectively pay $3, or 30%, in foreign taxes and receive only $7.

While the Australian government does provide a foreign tax credit for such withholdings, investors can't claim the full $3 in this scenario. They can only obtain credit for the U.S. tax portion ($1.5). As a result, there's a tax drag of $1.5 or 15%. This drag is especially noticeable for funds like VEU, which invests solely outside the U.S.

An Australian-domiciled ETF would potentially be more tax-efficient in this context due to the Double Taxation Avoidance (DTA) treaty between Australia and Germany. When such an ETF receives a dividend from a German company, Germany would withhold only 15%. Australian investors could then claim this 15% as a foreign tax credit.

The impact diminishes for domiciled ETFs in the U.S. like the Vanguard US Total Market Shares Index ETF (VTS) that invest solely in U.S. companies. There's no intermediary country involved. Given the DTA between Australia and the U.S., this withholding can generally be claimed as a foreign tax credit. However, being U.S.-domiciled means Australian investors must periodically complete U.S. tax documentation (W8-BEN) and may not have the convenience of automatic dividend reinvestment.

2. Franking Credits

Another aspect to consider is franking credits. If an ETF is not domiciled in Australia, investors can't claim franking credits on taxes paid by the fund. For instance, investors would miss out on the associated franking credits if VEU holds shares in Australian companies like BHP or the Commonwealth Bank. Nonetheless, this impact is relatively minor since most global funds maintain only a small allocation to Australian companies. For more information, read our comprehensive guide on franking credits.