Non-US dividend withholding tax
Tax authorities in Europe and many other countries take a similar approach to dividend withholding tax on foreign holders of shares. However, we can see that ETFs tracking the MSCI World Index are generally able to achieve better performance than would be assumed under application of these rates.
For physically replicating ETFs, withholding tax rates can once again be improved depending on fund domicile. Furthermore, some select investors may be able to obtain lower withholding tax rates and, if the physical ETF engages in stock lending, borrowers of shares may pass on a higher dividend percentage than the lender would receive on a physical holding. For ETFs that use synthetic replication, the index swap market will generally reflect the same enhanced economics available in the stock lending market. As such, the two models both can achieve outperformance, but neither model has an advantage.
Stamp duty and financial transaction taxes
The synthetic advantage re-emerges in the application of financial transaction taxes. An ETF that physically replicates the MSCI World Index will buy most or all the stocks in the index. When buying shares in the UK, the ETF will generally be subject to a 50 basis-point Stamp Duty. There are also financial transaction taxes applied to the purchase of shares in Italy (10 basis points if traded on-exchange, 20 basis points off-exchange) and France (30 basis points). These costs are reflected in the price of creating shares in the fund.
For a synthetically replicating ETF, the swap counterparties purchase the replicating portfolio, not the fund. As this transaction is executed as part of the hedging of a derivative, i.e. the swap with the fund, the banks are generally exempt from both UK Stamp Duty and the financial transaction taxes imposed by France and Italy. Being exempt from paying taxes on these shares means an up-front cost advantage to the end-investor.
Physical and synthetic replication models both have merits as well as potential drawbacks. The preference of one over the other will vary between investors and may even change over time. A huge number of investors still prefer physical replication regardless of any advantages to be gained elsewhere, due partly to the simplicity of the structure. A physical model is easy to understand and explain to clients.
However, investors have started to adopt a more pragmatic stance, which may be leading to a preference for synthetic replication in certain situations. Depending on the indices replicated and the country of domicile, synthetic replication may result in lower withholding taxes, Stamp Duties and financial transaction taxes, structural advantages to which investors are increasingly drawn
 Based on the impact of the difference in withholding tax rates on dividends given the 10-year average yield on US large caps (using the S&P 500 as a proxy), and the allocation of US equities in the MSCI World Index (64% as at 1 April 2020).
Chris Mellor Head of EMEA ETF Equity & Commodity Product Management at Invesco Ltd