With respect to foreign dividend funds/ETFs (such as those in registration at Vanguard, or offered by Wisdom Tree, others, etc.)...
The SEC requires that funds that hold >25% of their holdings in MLPs to be taxed as corporations, and accrue a deferred tax liability, which is included in the reported expense ratio of the the funds.
See for example, disclosure from AMLP, available here:
http://www.alpsfunds.com/documents/pdfs/amlp-edu-20120509.pdf and expense ratio, as listed at left here:
http://www.alpsfunds.com/resources/AMLP.
Why then, doesn't the SEC require that mutual funds that own foreign dividend-paying stocks report two expense ratios:
1. One expense ratio for taxable investors; and
2. One expense ratio for non-taxable investors (such as those investing through IRA accounts, for example).
While foreign taxes paid are - to some extent - recoverable via foreign tax credit or deduction, any credit can not be obtained when the funds are held in a retirement account.
Shouldn't the additional "locational burden" be disclosed, on either a mandatory (SEC) or voluntary basis? Is anyone aware of any fund that highlights the extra cost in their prospectus or annual report?
Other resources below. Thanks.
Tax Rate Schedule, circa 2011 [for example, see second table]
http://topforeignstocks.com/2011/01/23/withholding-tax-rates-by-country-for-foreign-stock-dividends/Investopedia on Foreign Tax Credithttp://www.investopedia.com/articles/personal-finance/012214/understanding-taxation-foreign-investments.aspSchwab on Claiming Foreign Tax Credit Deductionhttp://www.schwab.com/public/schwab/nn/articles/Claiming-Foreign-Taxes-Credit-or-Deduction
Comments
First let me note that many funds do not pass through foreign taxes at all. Global funds are not allowed to pass through the taxes if less than half their assets are foreign. Other funds simply choose not to pass through the expenses.
Say a fund has $1.10 in income, and pays $0.10 in foreign taxes. It pays a $1 dividend to you in cold, hard cash. As far as the taxes go, it has two choices.
It can say that you netted $1 of income, end of story. That is, treat the foreign taxes the same as any other expense (notably like commissions that don't show up in the ER either).
Or it can say that you received $1.10 of income, but that it held back $0.10 to pay your share of foreign taxes. That way, you show more income, but also have a pass through expense to use on your tax return.
If you choose to treat it as a deduction, you wind up with taxable net income of $1 - the same as you've got in the IRA (where you got that $1 of cash). That's also the same result as if the fund hadn't passed through the tax expense to you (you got $1 income, end of story).
Up to here, there's no difference, after taxes, between what happens with the IRA and what happens in the taxable account. Either way, you're netting $1 of taxable income. The IRA defers the taxes, but it's still $1 of income when you withdraw the dividend. That's what Schwab is talking about with its "timing issue".
There is another way to treat foreign tax pass throughs, but only in taxable accounts. So if there's a difference, it's not between taxable accounts and IRAs, but between taxpayers who take a deduction and taxpayers who take a credit. The fund doesn't know which choice you made on your 1040.
I believe the theory behind taking a credit is the same idea as paying income taxes in two states (or two countries). If one moves between states, it is possible that both states will tax the same income. Say one state taxes you at 5%, and the other at 7%. If the first state collects 5% from you, the the latter state will tax you so that the total amount you pay is 7%. It does this by giving you credit for the 5% tax you already paid.
Same idea with the foreign tax. You've already paid tax to another country on the income. So the US says that it will give you credit for that portion of your income taxes. But it won't give you credit for more than you would owe in US taxes. You cannot reduce your US tax on this particular income below zero. You wind up paying in toto the higher of the two rates, US and foreign. (This is the foreign tax credit limitation - Form 1116 - that your Schwab page is talking about.)
Either theory - tax credit or tax deduction - makes sense. One of them, the tax deduction, leads to the same after tax result in the IRA and in the taxable account.
I'm ignoring the issue of funds taxed as corporations (per IRC Section 851(b)(3)(B)(iii)) since that gets into accounting (accrued liability affecting NAV), which is a rather different animal from operating expenses. Though I suppose one could argue that it's nothing but a timing issue, again.
As for Schwab saying (at link in OP): How is that any different from holding a fund with a higher expense ratio, rather than a lower expense ratio? Could I, for example, say the following with a straight face?: Which is precisely my point.
If I was trying to convince someone of the wisdom of buying a fund with a 12b-1 fee [*] as opposed to buying the same fund without the 12b-1 fee, would they find it convincing if I said Think of it as a timing issue?
It's not a timing issue. I believe that it's effectively a higher expense ratio, caused by the decision to hold an asset subject to foreign tax withholding in a retirement account.
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[*] www.investopedia.com/terms/1/12b-1fees.asp
PS: I think that the only case where it would be a "timing issue" is the one where you paid taxes at a rate of 100% on the money withdrawn from the retirement account. Well ... we're not there .... yet.
1. VTRIX - International Value Fund
2. VFWAX - FTSE All World Ex US Index Fund Admiral
3. VGRLX - Global Ex US Real Estate Index Fund Admiral
The funds yields are as of Sep 2015, tax information from last year, with expense ratios as noted below. 2014 tax info for each fund is from VG's Foreign Tax Center. The "unclaimable" foreign tax credit (for investors who hold the funds in tax -advantaged retirement accounts) appears in the last column of the above table, and is equal to the product of the [Dividend Yield] and [Foreign Tax Paid].
Compare this cost (for that is what it is, no?) with the investments' stated expense ratio.
While not "large" in absolute levels, it is about one-third of the ER of the actively managed fund, MORE than the ER of the world index fund, and more than half of the ER of the Global R/E fund.
Think that this sort of information should be disclosed by the funds for benefit of shareholders that don't have the time or resources to gather the information and calculate the numbers themselves.
In order to call for the reporting of two different ERs, it was necessary for you to establish two points: that foreign taxes paid should be included in the ER reported, and that (given that taxes paid are included in the ER) that the reported amount of foreign taxes paid by the fund should be different depending on whether the owner holds the fund in a taxable or tax-deferred account.
Stated that way, the second part sounds silly. A fund pays the same amount of dollars per share (of given share class) in expenses independent of who owns it.
Regardless, all I needed to do to address your original question was demonstrate a problem with either of the two points (include taxes in ER, and report them two different ways). I spoke primarily to the latter, though I touched tangentially on the former.
You cited Schwab (presumably with approval), that said the difference between a taxable account and a tax-deferred account was merely a timing issue - that in the tax deferred account "there's no deduction or credit currently available", but that nevertheless a foreign tax paid " reduces the amount of tax the IRS is able to collect when you start making withdrawals."
I simply explained what you had cited as a reference. Suggestion for the future - if you doesn't agree with everything on a page provided as a reference, don't cite it, or say explicitly what you are citing it for. "Resource" opens the whole page up to use.
The posts tossed in a lot of extraneous items, some of which generated more heat than light. For example, 12b-1 fees as the exemplar expense. Those fees come with a lot of baggage. You might have used almost any other fund expense instead.
Ideally, one might try to find another fund expense that closely resembled a foreign tax. I've an idea - how about a domestic government assessment (tax or fee) paid by a fund? There's the SEC Section 31 fee that brokers tack onto your sale of securities on an exchange. (It's that little fee, typically a few cents that you see on your sell trade confirms.)
Funds pay this government charge when they trade securities, so that's a similar expense. Oh wait, that isn't included in the ER either. Oh well
Regarding the thesis that the "only case where it would be a 'timing issue' is the one where you paid taxes at a rate of 100% on the money withdrawn from the retirement account", it's easy enough to show that isn't correct.
We'll stay on point here and filter out as much noise as possible. We'll focus strictly comparing the impact of foreign taxes paid in a taxable account with their impact in an IRA by eliminating other sources of tax liability.
Assume that the original contribution was nondeductible (so that there's no tax due on the principal when withdrawn). Assume that all income generated by the fund comes in the form of nonqualified dividends (so the tax rate for the taxable and IRA accounts are the same). Assume no growth of principal. We'll assume that taxes are paid from another pocket, so that this extra cash doesn't clutter calculations either.
Getting back to my original example - in year 1, your investment earns dividends (after expenses other than foreign taxes) of $1.10. The investment pays $0.10 in foreign taxes, and distributes $1 in cash, while declaring that you have $1.10 in income. In year 2, assume no growth, no dividends. For our final assumption, we'll say that in year 2 you close out the IRA (and are over age 59.5 - no penalties).
Remember that I'm showing only that the result in the IRA is the same as taking a deduction (not a credit) in the taxable account.
Year 1:
Taxable account, have an extra $1 nonqualified cash dividend in your account. You declare income of $1.10 and a deduction of $0.10, for net taxable ordinary income of $0.025 (assuming 25% tax bracket).
IRA: You have an extra $1 in your account.
Year 2:
Taxable account - no change. You have the extra $1 in your taxable account, no taxes due.
IRA: No growth. You have your original post-tax investment and $1 of increased value. You close your account. You owe ordinary income of $0.025 on that $1 (which again comes from another pocket).
Same taxes owed. Just deferred a year. Timing.
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The conceit is that the fund is a pass through entity. It passes some of the tax liability through to you. Notably, foreign taxes, but only sometimes. When it does, it is you not the fund paying the taxes. That happens by the fund giving you the full distribution (here $1.10), and then taking back the tax amount so that it can pay it for you.
That's not an expense of the fund (i.e. one included in the calculation of fund income passed through to you). It's your expense. As the IRS writes, "You can claim a credit only for foreign taxes that are imposed on you".
For the IRA investor, that foreign tax is a fee like any other - a brokerage commission, a load, a redemption fee, etc. The investor gets to treat that foreign tax collected from the IRA the same way as any other expense incurred by the IRA.
For the investor with a taxable account, the foreign tax is again an expense borne by the account, not by the fund. It is precisely because the investor (not the fund) is paying the tax that the investor gets to take a deduction or credit.
There are other costs not included in the ER, like trading costs. See WSJ, "The Hidden Cost of Mutual Funds". I think all this information should be readily accessible.
That applies to all funds, not just funds that pass through the foreign taxes paid. Just because a fund has only 30% of its assets in foreign countries, like VGENX, doesn't mean that the fund isn't paying foreign taxes, or that your net returns aren't getting correspondingly reduced.