As an investor, you will invest in a stock, a business, a partnership that is based overseas.

These stocks, business or partnership are incorporated or domiciled in another country. These stocks, business or partnership may declare dividends, interests or capital payments to you as a shareholder in Singapore.

Once the dividends, interest or capital payments exit a specific country there is a withholding tax on these income, dividends, interest and capital payments.

There is no running away from withholding tax. I sort of validate this when I have the privilege to meet the subject matter experts that are recommending offshore investment bonds.

These bonds fulfills a specific tax planning role for expatriates, but also Singaporeans with assets in other countries. I shall not go too much into it.

Understanding withholding tax is something you cannot run away, whether you are a

1. individual stock investor
2. unit trust investor
3. DIY passive index portfolio investor
4. Robo- investor

This is particularly confusing if you are investing in a fund that is incorporated overseas. These fund manages a portfolio of stocks or bonds, which declare dividends as well.

So how does the withholding tax picture add up? In my Dimensional Fund Advisers article, I explained in depth. However, I think not a lot of people manage to read to that portion. So in this article I will try to talk specific about this.

Tax When Money Flows out of the Country

I think the best way I find to remember this is that every country, who choses to have a greater than 0 withholding tax, wishes to tax money when it flows out of the country.

So if you think about it this way

1. When a China incorporated subsidiary declares a dividend and pays a Singapore parent, there is withholding tax (10% for China)
2. A German unit trust owns a Spanish company. When the Spanish company declares a dividend to the German unit trust, there is a withholding tax when the money leaves Spain (20% for Spain)
3. A Singapore investor owns a company incorporated in United States. The company pays a dividend to the Singaporean. There is a withholding tax on the dividend

As you can see whether you are an individual stock investor in Singapore, or Hong Kong, or other countries, you are affected. This is because your stock have overseas subsidiary.

As a unit trust or exchange traded fund investor you are affected as well.

What is the Implication?

A lot of times, the implication means is that you get a smaller dividend.

For example, you have a stock that is domiciled in Spain that is at $50 and it gives a $3 dividend. Your dividend yield would be 6%.

When the money leaves Spain and reaches you in Singapore, your dividend yield will be (1-20%) x 6% = 4.8%.

The Withholding Tax around the World

Each country do change their tax rates from time to time. So as an investor, you can check with the company you are interested to invest in, or you can download the latest withholding tax table.

I find that it is better to check with the company you are interested in.

To help with today’s discussion, here are the latest withholding tax as current as 2019 from Deloitte:

You realize countries have different withholding tax for different kind of payments. There are also different rates if you belong to different country unions or two countries have a dual taxation agreement.

Bermuda is like one of the tax haven. You will realize a lot of listed company are incorporated in Bermuda. Their withholding tax is so friendly (0% for all). Barbados is also one.

Recall the USA REITs Manulife US REIT and Keppel KBS all switched to a Barbados based structure when the 2017 Tax and Jobs act was announced. (Explained more in detail here)

Singapore is pretty friendly as well.

Switzerland’s withholding tax is obscene.

It is not Where it is Listed but Where the Company is Domiciled!

One thing that bamboozled a lot of investor is that they think that all the stocks listed in the United States are automatically subjected to a 30% withholding tax (which is the withholding tax for United States)

The way to remember is where the company is domiciled or incorporated.

It means where this company calls its home.

A good example is Royal Dutch Shell ADR. The American Depository Receipts (ADR for short) is a scheme that can easily allow an American to own a foreign stock like Royal Dutch Shell.

The US investor can buy this Royal Dutch Shell ADR listed in a United States stock exchange.

As a Singaporean, you can also invest in Royal Dutch Shell ADR listed on the United States stock exchange. So how much withholding tax do you have to pay?

Royal Dutch Shell is incorporated in UK but is a tax resident of Netherlands. You can check out the company website to find out more.

Based on this the withholding tax you pay is 15%, and not the United States withholding tax.

How do we tell where a Stock or Fund is Domiciled or Incorporated?

In the section before, Royal Dutch Shell ADR is incorporated in UK but calls Netherlands a tax resident.

The best way is to check with the company you are interested in, browse the website.

If not most of the time finding out where the company is incorporated or domiciled. Usually, the annual report or financial statements will show it.

Ping An Insurance is a Chinese stock listed in Hong Kong Stock Exchange. The withholding tax in Hong Kong is 0%. In China it is 10%.

A look at Ping An’s financials will show us that this company is incorporated in China. There is likely a 10% withholding tax on Ping an’s dividend.

The above is extracted from Dimensional’s annual report for their funds. Dimensional funds invest in stocks and bonds from all over the world but they are incorporated in Ireland.

A review of their annual reports will show you where they are incorporated in and whether there are any withholding taxes.

What about Dual Taxation Treaties?

You will observe that for some countries, there exist a dual taxation treaty. This enable you to enjoy a relief from getting tax in both countries.

The common ones that I encounter that affects some of the investors here are:

1. For those investors with ETF or unit trust domiciled in Ireland. These ETF and unit trust would own a basket of stocks, with some stocks in the United States. There is a dual taxation agreement between United States and Ireland. Thus, the dividends withheld is 15% instead of 30% when the dividend exit United States to Ireland
2. For those who purchase unfranked stocks in Australia, they are taxed at 15% instead of 30% due to a dual taxation agreement between Australia and Singapore

Unpacking the Withholding Tax on Exchange Traded Funds and Unit Trust

One of the reason I wrote the original post is to illustrate the advantage of Dimensional funds that are domiciled in Ireland. They are more tax efficient, when it comes to dividend withholding tax and estate duty/inheritance tax.

This fund dividend tax thing can be rather confusing and in this section I will try to explain it.

The investors who are affected are:

1. If you purchase an exchange traded fund (ETF) that is listed and domiciled in the United States. This ETF pays out a dividend. We know that United States have a withholding tax of 30%
2. If you purchase an ETF that is listed in UK and domiciled in Ireland. This ETF pays out a dividend or accumulates the dividend within the fund. Ireland has a 0% withholding tax
3. If you purchase an unit trust like Dimensional funds that is listed in UK and domiciled in Ireland. This ETF pays out a dividend or accumulates the dividend within the fund. Ireland has a 0% withholding tax

How much withholding tax in total do you pay?

There are many layers of withholding tax. I think it is better to explain in a diagram.

The most prevalent investing method for funds are:

1. DIY Investing: Buy 1 to 4 Low Expense Ratio ETF listed in United States
   1. ETF is domiciled or incorporated in United States (30% withholding tax)
   2. Both Equity and Bonds
   3. Covers the whole world
2. DIY Investing: Buy 1 to 4 Low Expense Ratio ETF listed in London
   1. ETF is domiciled or incorporated in Ireland (0% withholding tax)
   2. Both Equity and Bonds
   3. Covers the whole world

Based on the withholding tax, you would think that #2 is a better choice than #1. I think it is. But it is important that you understand the mechanics involved.

Let us use 2 prevalent ETF to illustrate:

1. Vanguard Total World Stock ETF (VT) listed in United States
2. iShares Core MSCI World UCITS ETF (IWDA) listed in London

#1 matches #1 in the DIY Investing I mentioned in the previous list. #2 matches #2 in the previous list. These two funds are equity funds that seeks to cover the large cap stocks in the world. So you will get a very diversified portfolio.

Suppose we take it that for these 2 funds they are made up of 3 stocks domiciled in 3 different countries. These 3 stocks all give a dividend of 3% before withholding taxes:

1. US Domiciled Stock – 3% dividend – 33% of fund
2. China Domiciled Stock – 3% dividend – 33% of fund
3. Germany Domiciled Stock – 3% dividend – 33% of fund

How to think about the different layers of withholding taxes considerations

There are many layers of withholding taxes considerations.

In the eyes of the professionals they look at it in 3 different layers:

1. Tier 1: Portfolio Level
2. Tier 2: Fund Level
3. Tier 3: Investor Level

You will hear them say they are taxed at Tier 1 and not taxed at Tier 2. To me that sounds all that confusing.

The idea is to think in terms of gateways. Every time when money leaves a country, there is a withholding tax consideration. Also when money enters a country, there is a certain tax consideration (this is probably not withholding tax but how your country chooses to tax foreign sourced income)

It would look something like this:

As an investor you may live or domiciled in Country D. suppose you own a stock listed in Country C with a subsidiary in Country B, which owns another subsidiary in Country A.

At every point there is an exit withholding tax consideration. At every point when cash flow is coming in, there may be a foreign sourced income consideration.

Typically, foreign sourced income entering a country is less of an issue. The focus tends to be on money leaving. Government are more concern about ensuring money just don’t flow out like that without some form of “control”

Let us go through the two examples with VT and IWDA.

Vanguard Total World Stock ETF (VT) Case Study

The illustration above shows the taxation at different levels.

Since VT is domiciled in US, when the dividends from the US stock is paid to the fund, there is 0% withholding tax. There are however 10% and 25% withholding taxes for the China and Germany stock. 

At the fund level to the investor’s tax office in Singapore, there is a 30% withholding tax. 

Since Singapore currently do not tax on investor’s foreign sourced income, there is 0% tax when the investor receives the dividend finally.

So this works out to:

1. US dividend: 3% x (1- 0.0) x (1-0.30) x (1 – 0.0) = 2.1%
2. China dividend: 3% x (1- 0.10) x (1-0.30) x (1 – 0.0) = 1.89%
3. Germany dividend: 3% x (1- 0.25) x (1-0.30) x (1 – 0.0) = 1.575%
4. Overall dividend: 1.836%
5. Dividend withholding tax cost: 3%-1.836% = 1.163%

The mileage would vary depending on the size of the average dividend, and the composition. 

New let us look at IWDA’s situation

iShares Core MSCI World UCITS ETF (IWDA) Case Study

IWDA is domiciled in Ireland, when the dividends from the US stock is paid to the fund, there is 15% withholding tax. Withholding tax on dividends in China is 10% and withholding tax on dividends in Germany is 25%.

Typical dividend withholding tax for United States domiciled companies is 30%, so why is the withholding tax only 15%?

This is because there is a dual taxation treaty between United States and Ireland.

Thus on US, they only withheld 15% of the dividends for taxes.

So this works out to:

1. US dividend: 3% x (1- 0.15) x (1-0.0) x (1 – 0.0) = 2.55%
2. China dividend: 3% x (1- 0.10) x (1-0.0) x (1 – 0.0) = 2.7%
3. Germany dividend: 3% x (1- 0.25) x (1-0.0) x (1 – 0.0) = 2.25%
4. Overall dividend: 2.475%
5. Dividend withholding tax cost: 3%-2.475% = 0.525%

IWDA in this regard, and for the Irish domiciled ETFs, should be the most tax efficient. 

Dividend Withholding Tax is just One Evaluation

It is important to realize that optimizing the withholding tax you will need to pay is important. However, you have to weigh other considerations as well:

1. The expense ratio (while US may be withholding tax inefficient, their ETF, due to their size may have lower expense ratio)
2. Tracking error to the index (Some more liquid ETF and exchanges may have lower tracking errors
3. The difference in the funds you are going for. You may lean towards certain investing philosophy
4. Dividends, might be a small proportion of the overall total return for the fund!
5. You have to consider the estate duty/inheritance/ death tax should you passed away

#5 tends to be a major component to think about and not easily bypass (But there are ways. Shall not discuss too much here)

Dimensional World Equity Fund Case Study

This is not in the realm of discussion but since I already done the work, I might as well put it here.

The local Dimensional funds you can purchase through MoneyOwl, Providend, iFast and GYC financial are domiciled in Ireland.

In a way, their withholding tax treatment is pretty similar to IWDA since both are domiciled in Ireland and their portfolio covers the world.

The illustration above shows the taxation at different levels. Since DFA funds available for Singaporeans is domiciled in Ireland, US withheld 30% of the dividend, China withheld 10% of the dividend, Germany withheld 25% of the dividend.

At the fund level to the investor’s tax office in Singapore, there is 0% withholding tax, since Ireland currently do not have withholding taxes. 

Since Singapore currently do not tax on investor’s foreign sourced income, there is 0% tax when the investor receives the dividend finally.

So this works out to:

1. US dividend: 3% x (1- 0.30) x (1-0.0) x (1 – 0.0) = 2.1%
2. China dividend: 3% x (1- 0.10) x (1-0.0) x (1 – 0.0) = 2.7%
3. Germany dividend: 3% x (1- 0.25) x (1-0.0) x (1 – 0.0) = 2.25%
4. Overall dividend: 2.326%
5. Dividend withholding tax cost: 3%-2.326% = 0.6735%

You will notice a difference between IWDA and the Dimensional fund. The United States withholding tax is 30% instead of IWDA’s 15%.

But both are domiciled in Ireland.

Why is there such a difference? I have no idea. I guess that is how its treated because the structure of ETF and unit trust in Ireland is different. One is a fund while the other is business.

This is why these tax stuff can drive you up the wall.

DFA funds available to investors are UCITS funds and they have certain advantages to guard investors interest.

The Handling of Withholding Tax on Interest Income – Prevalent in Bond Funds

How much interest income withholding tax the fund is subjected to depends on the withholding tax on interest income in each country.

In the early section, you can see for each country there are different treatments to dividends, interest and royalties possibly. 

In the USA, exchange traded funds that generate qualified interest income and short-term capital gains, may be exempted from United States withholding tax when distributed to non-US holders.

The US Tax law permits a regulated investment company (“RIC”) to designate the portion of distributions paid that represent interest related dividends (normally known as qualified interest income) and short term gain dividends as exempted.  

1. you need to be a regulated investment company and provide proper documentation to qualify. Thus, DIY investors would not be exempted
2. bond interest income from USA bond generally are exempted from dividend withholding tax

Here are some examples:

1. for US Government Bond ETFs, typically 100% of the interest income qualify as Qualified Interest Income. One example is the iShares 10-20 year Treasury Bond ETF (TLH) used by Stashaway
2. for US Corporate Bond ETFs, perhaps only 70-80% of interest income qualifies as Qualified Interest Income. One example is the iShares IBOXX Investment Grade Corporate bond ETF (LQD)
3. for international bond ETF domiciled in USA, the Qualified Interest Income may not be applied at all. One example is the iShares International Treasury Bond ETF (IGOV) used by AutoWealth

For those funds or ETF domiciled in Ireland, the USA bonds are subjected to withholding tax and that could be 30% or 15% depending on whether it is a fund or ETF. 

Do remember, while USA have been a popular discussion, the withholding tax treatment for other countries will mean that there may be withholding tax incurred there, which might be more or less than the United States withholding taxes.

The above is taken from Dimensional Global Short Term Fixed Income fund. The United States portion constitute 10% of the fund. You would have to contend with the interest income withholding for Canada, France and Germany as well for example.

What if your Fund is Accumulating and does not pay out a dividend to you?

The fund might not pay out a dividend to you. However, the underlying companies, owned by the fund, still pay a withholding.

IWDA is an accumulating ETF, which does not distribute dividends. But the underlying companies owned by the ETF will still get their dividends reduced.

Conclusion

Lastly, do not treat what I wrote as gospel.

A lot of work went into this through

1. What I researched myself
2. What others who are interested in investing researched
3. Other investors’ experiences
4. My experiences
5. What I can find out from my peers in the industry who I am grateful for to share

Let me just say…. even those in the investing industry… they are also trying to figure this out.

And your own personal situation may be different from mine or the general public.

This is why you would never get very clear cut answers about these stuff. The motherhood statement is Consult your Tax Adviser.

But to get started, you got to have a blue print to start going down the rabbit hole. So I hope this is enough.

If you have more to volunteer, do let me know.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for first meeting to understand how it works

Trump said something. Then China did something.

So what we have is the DOW, S&P 500 and Nasdaq down 3%. But they been falling for a few days.

It gets even worse for me considering a large part of my equity holdings is in Hong Kong. And you know what is going on there.

This article is taking a look at what goes on in my brain. You might have some takeaway from this.

An Eye on the 10 Year US Treasury

Honestly, I can be rather myopic on things. Since Manulife US REIT is a rather large holding, I do keep an eye once in a while on some things relating to it.

They are likely to refinance their Figueroa loan (quite sizable based on their loan portfolio) in July. We just do not know when.

There was even a spike up above 2.10%.

So they are rather unlucky in that, if it is a refinance in August, they could refinance, for 5 years at a much better rate! A 30 basis point fall is not very small here.

But you got to practice some gratitude because 1 year ago people are worried about the DPU when they are refinancing at 3.10%.

So it is a matter of perspective.

Anyway, this is the monkey brain. Focus so much on something, that I totally missed my Hong Kong holdings.

Now I am getting a spanking there.

You can look upon it as a Curse or an Opportunity

When there is an uptick of volatility, it tends to send your heart beating faster.

For some wealth builders, this is an opportunity to collect the financial assets such as stocks, unit trust that they been interested in but could not bear to buy at “expensive prices”.

For others, they just made their purchases not too long ago. Some have even invested in a lump sum, made a specific individual stock purchases and are cursing their luck.

Either way, it is how you frame things. Some see this as an opportunity, some see it as a curse.

But it is more than that.

In a behavioral manner, you are affected by how much currently your net wealth is subjected to this “crazy downside”. And this might make it difficult for you to think.

Think about Your System of Building Wealth

Quietly ask yourself if you still remember what kind of game you are playing here:

1. Are you a low cost, passive portfolio investor? What is the system you are playing at here? What is the appropriate thing to do in this system at this trigger moment?
2. Are you a medium term speculator? What is the system you are playing at here? What is the appropriate thing to do in this system at this trigger moment ?
3. Are you a dividend investor? What is the system you are playing at here? What is the appropriate thing to do in this system at this trigger moment ?
4. Are you the so-call value investor? What is the system you are playing at here? What is the appropriate thing to do in this system at this trigger moment ?

If you have no idea what you should do at this trigger moment, then you are the game here. Regardless of which wealth building system you choose, there are a few appropriate things to do and not to do.

I tend to run through my head what the hell I am trying to do. Why it should give a good positive risk adjusted return. These days I tend to do that less. This is because I am pretty clear about things.

I have 2 systems mainly

1. Core Equity Holdings: Identifying financial assets that gives a positive expected return in the long run
   1. These are financial assets that I am comfortable in holding
   2. I purchase at fair value and below if the asset is higher quality
   3. I purchase at below fair value if the asset is lower quality
   4. They give a sustainable dividend
   5. Sell when you realize they are not resilient, or sit on them if there is a good story / momentum to it and watch them closely
   6. Sell when there is something that is even more core than this asset
2. Speculative Holdings: Identifying financial assets that gives a positive expected return in the short run
   1. They are special situation. You think there is a catalyst soon. For example, a fundamental sound company that have some insider buying or based on the news, some things might be on the move
   2. Stupidly cheap companies that has no quality. You do not wish to hold them for long. This is because at certain point you can see it turning in the opposite direction. Convert to longer term hold if you realize you made an error in your prospecting
   3. Earnings and market sentiments

Run this through in your head.

Think about your Net Wealth Allocation

Ultimately, you are putting your wealth in risky assets because for the market risk, you wish to be compensated with higher positive expected return.

This is so that you can build wealth.

Building wealth to achieve certain financial goal.

Be it saving for

1. Financial security
2. Financial independence
3. Your children’s education fund
4. Traditional retirement
5. Sabbatical in 5 years time

Be aware of that.

In financial planning we call this knowing your time horizon and knowing the amount you need.

How far away from these there are appropriate things to do. For some, just plonk in 100% of all the pay check if you can. For others, you should be de-risking and selling. You may not have taken care of these well.

Some articles to help:

• The Expected Return Model – How You can Refine Investment Decisions, Prospect Stocks Clearly, and Sleep Better at Night
• You Not Only Have Downside Risks. You have Upside Risks as Well
• My Definitive Guide to How Much Active Stock Portfolio Diversification and Concentration You Need
• Taming Portfolio Size Risk
• Execution, Position Sizing and Financially Irresponsible Stock Positions
• How Traditional Portfolio Allocation Strategies Can Alleviate Large Market Plunge Fears

If you have not thought about this, do consider it.

Many folks just look at what I do and think I am incredibly bearish. They failed to put on the financial planning hat and think about why my allocation is this way. (Those seasoned readers would know where I show my portfolio. I will not comment much)

And this is my gripe with the individual stock investor. They tend to think they are know-it-all.

But in truth, they only see the forest most of the time. You cannot blame the individual stock investor. You need a lot of time to get good so that you can have sustainable compounded growth.

However, most of the time, you tend to not take care of the portfolio allocation, or even the financial planning section.

I am almost a near retiree.

And if you understand what a retiree needs at different phase of retirement, you should have an understanding why the portfolio leans closer to the way it is.

I practically wrote a whole section here on what a person planning for retirement should consider. So the answer is deep in there somewhere.

Have that goal in mind. And what are fundamentally sound strategies to reach there. If you have no idea, man I think you need a good financial planner that is competent, have integrity and watch out for your interest

1. Low net wealth: MoneyOwl
2. High net wealth: Providend (disclosure: I work for Providend)
3. Somewhere in between: Wilfred Ling (disclosure: affiliate link)

Think about Past Mistakes

I tend to review in my head some of the things I think I did poorly in the past. I ran through why I did it.

Do I have a fundamentally sound solution to it? If I do not have, that is a grave problem. If I have, think about what I tell myself last time. Is it still valid?

The idea is to have positive expected return over the long run, make more good decisions than poor decisions.

It also means make more fundamentally sound decisions than unsound ones.

One of my past mistake is immobility. This is behavioral.

The solution is to feel the pain. Feel the uncomfortable nature. Be very sure what you are doing is fundamentally sound. Then just keep doing it.

Think about the Lock Step of Investing

This is in the context of individual stock investing.

Morgan Housel used to provide this table during his Motley Fool days. It shows an investor how much to invest based on the frequency of market draw downs.

Some frequency of draw down is very long. Some folks spend forever waiting for them. Keep this in mind.

Tend to the Garden

This is in the context of individual stock investing.

Look less upon the gains and the losses.

Frame it as how I can position your portfolio in the best way going forward.

Prevent sunk cost fallacy from setting in.

If my portfolio fall from $1 mil to $700,000, don’t think about the $300,000 realized or unrealized losses.

I only have $700,000. The $300,000 is gone.

But if you don’t position the $700,000 in a way that going forward, it give you a positive risk adjusted expected return, that is even worse.

If based on your wealth building method, these are just volatility, your financial assets is really diversified, then this is nothing.

So I do look at what I wish to be Core and what are Special Situations. What looks more attractive. Then I just sell and buy them. It is hard but try to look less of the losses. It means nothing (unless to evaluate your performance). Just think in terms of tending to the garden, sniping away the weeds, watering the plants.

Review Opportunities

The job of identifying the fundamentals of businesses has to take place before the opportunity arises.

During this period is to find out which is the ones you deploy to and how much. Perhaps also to review if going forward, the fundamentals are intact.

But we are always prospecting, so just keep prospecting, be it good times or bad times.

Look at Beautiful Charts

I tend to have an interest now to see what are the instruments that really do well when there is a draw down.

So it is good to indulge in a little side hobby.

So here are some charts.

Ok. Time for work. You can ask questions. I will not comment on my portfolio holdings. Better to ask about portfolio management and financial planning.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for first meeting to understand how it works