FOREIGN WITHHOLDING TAXES: HOW TO ESTIMATE THE HIDDEN TAX DRAG ON U.S. AND INTERNATIONAL EQUITY INDEX FUNDS AND ETFS

Course summary: Justin Bender of PWL Capital and Dan Bortolotti of PWL Advisors explain the ins and outs of foreign withholding tax on U.S. and international equity index funds and ETFs.

INTRODUCTION

Canadian investors get an enormous benefit from diversifying their portfolios with US and international stocks. But this benefit carries a cost in the form of foreign withholding taxes.

Many countries impose a tax on dividends paid to foreign investors: for example, the US government levies a 15% tax on dividends paid to Canadians. Because these taxes are withheld before the dividends are paid in cash, they often go unnoticed by investors. But their impact can be far greater than that of management fees, which get much more attention.

The withholding tax on US dividends paid to Canadians is technically 30%, but this can be reduced to 15% if you fill out the Internal Revenue Service’s W-8BEN form. Your brokerage should have provided you with this form when you opened your account: if you are unsure, check with your brokerage before you purchase any US-listed securities.

The amount of foreign withholding tax payable depends on two important factors. The first is the structure of the ETF or mutual fund that holds the stocks. Canadian index investors can get exposure to US and international stocks in three ways:

through a US-listed ETF

through a Canadian-listed ETF that holds a US-listed ETF

through a Canadian-listed ETF or mutual fund that holds the stocks directly

In all of these cases, investors are potentially subject to withholding taxes levied by the countries where the stocks are domiciled, whether that is the US, developed markets outside North America (western Europe, Japan, Australia), or emerging markets (China, Brazil, Taiwan). We refer to this as Level I withholding tax.

When international stocks are held indirectly via a Canadian-listed ETF that holds a US-listed ETF, investors may also be subject to what we’ve called Level II withholding tax. This is an additional 15% withheld by the US government before the US-listed ETF pays the dividends to Canadian investors.

You can think of Level I foreign withholding tax like a departure tax you pay when taking a direct flight to Canada from a foreign country (including the US). Level II tax is like a second departure tax you pay when an overseas flight to Canada has a layover in the US.

The second key factor is the type of account used to hold the ETF or mutual fund. Different account types—RRSPs, personal taxable accounts, corporate accounts, Tax-Free Savings Accounts (TFSAs) and Registered Education Savings Plans (RESPs) — are vulnerable to foreign withholding taxes in different ways. For example:

When US-listed ETFs are held directly in an RRSP (or other registered retirement account, such as a RRIF or a locked-in RRSP) investors are exempt from withholding tax from the US (but not from overseas countries).

This exemption does not apply to TFSAs or RESPs.

If you hold foreign equities in a personal taxable account, you will receive an annual T3 or T5 slip indicating the amount of foreign tax paid. This amount can generally be recovered by claiming the foreign tax credit on Line 405 of your return. (Since no tax slips are issued for dividends received in a registered account, any foreign withholding taxes incurred are not recoverable.)

Holding foreign equities in taxable corporate accounts is generally less tax-efficient than holding them in taxable personal accounts.  A full explanation is beyond the scope of this course.  However, to make our cost comparisons more relevant, we have assumed the taxation of foreign income in a corporation has a similar effect to recovering approximately 50% of the final level of foreign withholding tax.  Throughout the course, we refer to this tax as “partially recoverable”.

We have written several articles about foreign withholding taxes on the PWL Capital and Canadian Couch Potato blogs, including explanations of which fund structures are best held in which types of account. However, to our knowledge no one has quantified the costs of foreign withholding tax in a comprehensive way until now. As a result, investors may not have had enough information to make good decisions.

In this course, we discuss eight different fund structures, which we have labeled Type A though Type H. For each structure and each account type, we estimate the total cost of a representative fund by adding the fund’s fee to the foreign withholding taxes that apply. The results are first explained in detail and then summarized in a table at the end of this course.

Always consider the big picture when making investment decisions. Foreign withholding taxes are just one of many costs of investing. Before choosing the right funds and account locations, consider the following factors as well:

The cost of currency conversion. In a large RRSP, it may be significantly more cost-effective to hold US-listed ETFs for your foreign equity exposure. However, this is only true if you can avoid paying large spreads to convert currency before purchasing the ETFs.

In taxable accounts, US-listed equity ETFs are not more tax-efficient than Canadian-listed ETFs that use US-listed equity ETFs. It may therefore make sense for DIY investors to use Canadian-listed ETFs in their taxable accounts—even though their MERs are slightly higher—to avoid the cost of currency conversion. (For a cheaper way to convert Canadian dollars to US dollars, refer to our series of white papers on Norbert’s gambit.)

Your income tax situation. While holding foreign equities in a taxable account allows you to recover at least some of the foreign withholding tax, the dividends are taxed at your full marginal rate, and you’ll face additional taxes on capital gains. For an investor in a high tax bracket, it is likely better to pay a 15% withholding tax on dividends in an TFSA (if you have the available contribution room) if the alternative is paying 46% income tax on dividends and 23% on capital gains.

US estate taxes. Wealthy Canadians may be subject to US estate taxes if they have significant holdings in US-listed ETFs. These investors may be better off holding Canadian-domiciled funds to avoid this risk, even if it means incurring foreign withholding taxes.