IF YOU EVER fancy winding up a small-time Irish investor (and who wouldn’t), mention just two words – deemed disposal.

The result will likely be a furious rant decrying the measure and wishing a pox upon the house of the officials who dreamt it up.

Earlier this week, it was reported that Finance Minister Simon Harris may finally axe the measure in the upcoming budget, something which was widely cheered by the local investment community.

Taking a quick glance at the scheme, it’s easy to see where the frustration comes from.

Deemed disposal is a tax which applies to exchange-traded funds (ETFs).

ETFs are a specific type of fund which allows buyers to track the performance of a group of shares.

For example, lots of ETFs track the performance of the S&P 500 market in the US. Picking individual stocks is notoriously difficult – most investors who do this consistently fail to beat the market.

Buying into an ETF is an easy way to invest your money into the broader stock market, which tends to be a good investment over the long term.

After you’ve held for say 10 or 20 years, hopefully your investment has grown strongly and you have a nice profit. If you’re happy, you can sell, paying tax on any gains, and that’s that.

For this reason, ETFs are rapidly becoming the most popular investment products in many countries.

But in Ireland, the ‘Deemed Disposal’ rule means you have to pay tax on any gains in your ETF after eight years – even if you haven’t sold it. That tax is set at 38%.

For example, say you buy into an ETF and eight years later have a profit of €1,000, you must pay €380 in tax – even if you haven’t sold the ETF.

It’s important to recognise that even if deemed disposal didn’t exist, you’d still have to pay tax on your profits from an ETF.

The main problem is the eight-year rule, which interrupts the effect of compounding. There are plenty of explanations about why compounding is so important in finance, such as this one.

But the short of it is, by allowing your profits from one year to stack onto the next, your money grows much faster.

For example, an initial investment of €10,000 growing at 7% annually becomes about €20,000 after one decade, and almost €40,000 after two.

Deemed disposal negatively impacts compounding. It also creates an administrative headache, as investors are expected to track their trades to comply with the eight-year reporting rule.

The Irish government introduced the rule during the Celtic Tiger to avoid people keeping their money in funds for decades on end without triggering a tax.

The system gets plenty of criticism for being ‘bizarre‘ – an Irish solution to something which is a non-issue in most of the developed world. So how do other countries do it?

Before we look at some specific examples, it’s worth noting that Ireland’s deemed disposal is very much in the minority.

Some other countries also have some kind of tax on unrealised gains. But the amount charged tends to be quite small until the investment is actually sold, rather than the 38% which Ireland charges.

Denmark

Probably the closest to Ireland. However, here things are arguably worse for the compound-conscious investor, as officials can charge tax on unrealised gains every single year.

Taxes are set at between 27% and 42%, depending on the profits. You can read more on the exact workings here. Some changes are also planned to make the system more attractive for Danish investors.

Germany

Unrealised capital gains on ETFs are also taxed annually in Germany, but the amount due tends to be much smaller compared to Ireland or Denmark.

Rather than get into the relatively complicated workings, we’ll just do a quick comparison. Say your ETF shares make a paper profit of €1,000.

In Ireland, you owe €380 on year eight, as we said. In Denmark, we’ll assume you made a gain of €1,000 in one year for simplicity’s sake. You’d owe €270. In Germany if the value of your ETF rose by €1,000 in a year, you’d owe somewhere around €30 to €40 in tax.

The Netherlands

The Dutch government had planned to introduce a flat 36% annual tax on unrealised gains, passing a law on the issue in February.

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But in a major policy U-turn, the government reversed the plan earlier this week after heavy pushback from the investment community. Instead, the Dutch finance minister has pledged to introduce a system where a tax on investment profits will only apply once they are sold.

The UK

There is no tax on unrealised capital gains from ETFs in the UK. It is worth noting that you can pay tax on income you receive from a fund, but that’s a separate issue for another day.

Additionally, it’s best to acknowledge that most people in the UK would probably invest via an ISA, a special type of investment account.

People can put up to £20,000 (€23,000) per year into these accounts and keep 100% of their profits, a much more generous system than what is available in Ireland.

Other European nations

Most other countries in Europe are straightforward – you only pay tax on the profits you make from an ETF when you sell it.

This is the case in the likes of France, Italy, Finland, Poland, Slovenia, Luxembourg and many others.

Irish investors will now have to hold their breath for Budget day to see if the government actually acts on its promise of reforming deemed disposal.

Many investors are likely trying not to get their hopes up. Last year it was widely expected that the measure could be abolished. The actual end result was that the rate for the tax due dropped from 41% to 38%.

While paying a bit less in tax is nice, the change did not address the fundamental issue of the eight-year rule and the impact that has on compounding.

A report published by the Department of Finance explicitly recommended scrapping deemed disposal and reducing the exit tax on ETF profits to 33% [the rate which applies to shares in individual companies].

It remains to be seen, but with the government’s attention diverted by its own shiny new investment scheme, deemed disposal could fall by the wayside again.