Why do mutual funds and ETFs in the U.S. not capitalize dividends?

Question

I am from Europe/Belgium and in Europe it is common to have funds and ETFs which capitalize/re-invest instead of distribute the dividends. I have been looking to the Vanguard ETFs and funds lately, and I noticed that all of them distribute the dividends, usually quarterly. Why is that?

Capitalizing the dividends is very interesting TAX-wise. Some calculations:

Say you have a dividend yield of 3%. Here in Belgium, we have to pay 25% on dividends. In essence, this means that the TER of the fund or ETF increases with 0.03 * 0.25 = 0.75%. Say the TER of the fund of ETF is 0.50%. Adding 0.75%, it is now 1.25%! Suddenly, your fund of ETF is very expensive (in my opinion).

Hence, I almost exclusively invest in funds or ETFs which capitalize the dividends. My only exception are funds or ETFs which have a low or no dividend yield (such as commodities, emerging markets small cap, ...).

Why is this uncommon in US? At first, Vanguards funds or ETFs are very interesting, because of their very low TER, but because of the distributions, it becomes very costly.

Thanks.

Answer 1

Under US tax laws, the dividends that a mutual fund receives from the stocks that it holds are taxable income to the mutual fund unless the dividends are distributed to to the shareholders of the mutual fund. This also applies to the net capital gains if the fund sells some of the shares it holds, but if the fund's activities result in a net capital loss to the fund, the loss is not distributed but carried forward by the fund for offsetting capital gains in future years. Mutual funds distribute all their net income to the shareholders because retaining the income and using it to capitalize the fund reduces the gain by the income tax, paid at corporate tax rates, by the mutual fund; and corporate tax rates are generally higher than personal income tax rates.

The dividends and capital gains distributed to the share holders of the funds are taxable as dividends and capital gains respectively to the share holders, that is, the favorable tax treatment, if any, for such kinds of income is available to the shareholders of the mutual fund. Mutual funds allow their shareholders to reinvest their distributions in the fund, (and many load funds do not charge the load on such reinvestments), but this reinvestment is a decision for the shareholder to make. But, regardless of whether the distribution is reinvested in the fund or taken in cash, the distribution is taxable income to the shareholder.