The Couch Potato strategy calls for a significant allocation to US and international stocks. When you live in a country with a small, poorly diversified stock market, global diversification is extremely important. But it does carry a price in the form of foreign withholding taxes.
Many countries levy a tax on dividends paid to foreign investors: the rate varies, but for US stocks it is 15%. (Foreign withholding taxes do not apply to capital gains.) With broad-based US index funds now yielding about 2%, the withholding tax amounts to an additional cost of 30 basis points. As you can see, the impact of withholding taxes can be far greater than that of management fees, which get a lot more attention.
To learn how much tax is withheld by your fund, click the “Distributions” tab on its web page and look under the heading “Foreign Tax Paid.” Here’s what the table looks like for the iShares S&P 500 (XSP). Notice the amount of tax paid for 2011 ($0.04388 per share) is approximately 15% of the foreign income received ($0.26866):
Investors and advisors are often unaware of how foreign withholding taxes affect returns, and the reason is simple: they’re damned complicated. The amount of tax you pay varies with the type of account (taxable, RRSP, TFSA) and the structure of the fund.
What type of account?
Let’s start with account types. If you hold foreign stocks in a non-registered (taxable) account, withholding taxes always apply: if a company pays a 20-cent dividend each quarter, only 17 cents ends up in your account. The good news is you can recover some or all of it by claiming a foreign tax credit on your return. (This can be complex, and I’m unable to provide detailed instructions for recovering withholding taxes. If the amounts are significant, you should consult a professional for help.)
The other key point is that Canada has tax treaties with the US and many other countries that have agreed to waive withholding taxes on stocks held in registered retirement accounts, including RRSPs, RRIFs and Locked-In Retirement Accounts (LIRAs).
Note this exemption does not apply to Tax-Free Savings Accounts (TFSAs). As you will see when you look at the details below, your TFSA may actually be the worst place to hold foreign securities.
What type of fund?
The structure of the fund you’re using for your foreign investments is also extremely important—and even more confusing.
First consider Canadian funds that hold foreign securities directly, which includes mutual funds such as the TD e-Series and some (but surprisingly few) US and international equity ETFs on the Toronto Stock Exchange. Because these funds hold the individual stocks directly, the managers can track the withholding taxes and report them (through a T3 slip) to investors who hold the funds in a taxable account. That allows the investor apply for the foreign tax credit.
However, if you hold these funds in an RRSP, you forfeit the exemption you would otherwise receive on foreign withholding taxes. That’s because the fund itself pays the withholding taxes: you don’t pay it directly. And because you’re investing in an RRSP, the fund won’t issue a T3 slip that would allow you to recover it.
With US-listed ETFs the US withholding tax is recoverable in a non-registered account: you’ll receive a T5 slip that specifies the amount paid. Better yet, if you hold these ETFs in an RRSP, you’re exempt from US withholding taxes. The downside is that when a US-listed ETF holds international stocks there’s an extra layer of withholding tax applied by the stocks’ native countries. There is no way to recover that tax.
The final category is Canadian-listed ETFs that hold US-listed ETFs. These include a number of Canadian iShares and Vanguard funds. Rather than holding their underlying stocks directly, for example, the iShares S&P 500 (XSP) and Vanguard MSCI Emerging Markets (VEE) simply hold units of their New York–listed counterparts (IVV and VWO, respectively).
When you hold these in a taxable account, you can recover taxes withheld by the US-listed ETF, but those withheld by non-US countries are not recoverable. In an RRSP, you get two levels of withholding tax and neither is recoverable, which makes this structure particularly tax-inefficient for international equities.
Confused yet? You’re not alone. To provide you with a handy reference I’ve broken down all of the categories, provided examples of common funds in that category, and summarized the tax implications in each type of account.
A. Canadian fund that holds US or international stocks directly.
TD US Index Fund e-Series (TDB902 and TDB904)
iShares US Fundamental (CLU and CLU.C)
BMO S&P 500 (ZUE and ZSP)
TD International Index e-Series (TDB911 and TDB905)
iShares International Fundamental (CIE)
BMO International Equity (ZDM)
- In a taxable account, US or international withholding taxes apply, but are recoverable.
- In an RRSP or TFSA, US or international withholding taxes apply and are not recoverable.
B. US-listed ETF that holds US stocks.
iShares S&P 500 (IVV)
Vanguard Total Stock Market (VTI)
- In a taxable account, US withholding taxes apply, but are recoverable.
- In an RRSP, US withholding taxes do not apply.
- In a TFSA, US withholding taxes apply and are not recoverable.
C. US-listed ETF that holds international stocks.
iShares MSCI EAFE (EFA)
Vanguard MSCI EAFE (VEA)
iShares MSCI Emerging Markets (EEM)
Vanguard MSCI Emerging Markets (VWO)
Vanguard Total International Stock (VXUS)
- In a taxable account, international withholding taxes apply and are not recoverable. US withholding taxes apply, but are recoverable.
- In an RRSP, international withholding taxes apply and are not recoverable. US withholding taxes do not apply.
- In a TFSA, international and US withholding taxes apply and are not recoverable.
D. Canadian ETF that holds a US-listed ETF of US stocks.
iShares S&P 500 (XSP)
Vanguard S&P 500 (VSP and VFV)
Vanguard MSCI U.S. Broad Market (VUS)
- In a taxable account, US withholding taxes apply, but are recoverable.
- In an RRSP or TFSA, US withholding taxes apply and are not recoverable.
E. Canadian ETF that holds a US-listed ETF of international stocks.
iShares MSCI EAFE (XIN)
Vanguard MSCI EAFE (VEF)
iShares MSCI Emerging Markets (XEM)
Vanguard MSCI Emerging Markets (VEE)
- In a taxable account, international withholding taxes apply and are not recoverable. US withholding taxes apply, but are recoverable.
- In an RRSP or TFSA, US and international withholding taxes apply are not recoverable.
For tables suggesting the most tax-efficient account for each type of fund, see this post.
Many thanks to Justin Bender at PWL Capital for verifying the accuracy of this post. For more information, I also recommend this document from Dimensional Fund Advisors, which discusses international (non-US) withholding taxes in detail. This post is intended for educational purposes only and does not constitute tax advice for any individual. You should always consult with a specialist before making any investment for tax reasons.
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Hi this is a Great Reference Tool, Thanks. I’m also wondering about Tax Implications for Canadian buying US stocks without a broker.
I cashed in my US Pepsi stocks however they withheld taxes can I recover these taxes and if so how do I do it
Thanks for your help
@Alberta: You should have received a T5 slip indicating the amount of foreign tax withheld. You can then claim this amount as a foreign tax credit on your return.
Quick question regarding the following category:
A. Canadian fund that holds US or international stocks directly.
It is stated that “In an RRSP or TFSA, US or international withholding taxes apply and are not recoverable.”.
Would that statement also applies to funds held in a pension plan ? My employer offers the following funds:
TDAM U.S. Equity Index Fund
TDAM International Equity Index Fund
@Linda: Yes, the same principle would apply in a pension plan: any withholding taxes paid by the funds in the plan are not recoverable by the investor.
TDB902 TD US index e is listed in your example to demostrate the impact of withholding tax. I thought withholding tax only applies to dividends, right? I looked into TDB902 and there is no dividend (distribution information) so I assumed that this is not a dividend paying fund. Why would withholding tax apply to this particular fund?
@Soyean: TDB902 tracks the S&P 500 and many of the stocks in this index pay dividends: the current yield is just over 2%. Not sure where you looked up the distribution info, but it sounds like it was not accurate.
Thanks for a quick response, Mr Canadian couch potato.
Can you recommend TD e funds for both US and International that are non-dividend paying funds, therefore not subject to withholding tax? This is for my RSP portfolio and I would prefer funds that focus on capital growth considering the tax implications as you pointed out.
I was wondering about the TD e-Series US Index Currency Neutral fund, which has not paid any distributions since 2006. I am assuming the dividends earned by the underlying investments get rolled into the NAV, but does the fund not pay withholding taxes?
It would be interesting if TDB904 was doing the same thing as HXS, where I understand withholding tax does not apply because of the swap structure.
@soyean: There are no e-Series equity funds that pay no dividends. I’d warn you against making decisions primarily based on avoiding withholding taxes. These are simply one factor in a much bigger picture.
@andre: I looked into this and I agree it’s confusing. The fund’s Management Report of Fund Performance does indeed report no distributions. However, the Annual Financial Report does itemize the amount received in dividends and the foreign withholding tax paid. For 2012, the fund received about $2.6 million in foreign dividends and paid $350,000 in withholding taxes.
Thanks for looking into the withholding tax paid by the e-series fund. It looks like they receive the dividends, pay the withholding tax, and add the value of the dividends into the NAV. This sounds like a way to turn US dividend income (normally taxable at marginal rate) into capital gain.
@andre: No, that’s definitely not what’s happening: that would be tax fraud. If the fund reinvests the dividends rather than paying them out in cash, they must still send taxable investors a T-slip indicating the amount received in foreign income, and the investor must pay tax on it.
Thanks for your quick response. This is something I’ll have to look into. I’ve held the e-series fund since 2009 and I have never received a T-slip from TD for this fund. I’ll be sure to call TD this week to see if they missed sending the T-slip out.
@andre: Sorry if this is an obvious question, but do you hold this fund in an RRSP or a TFSA? If so, you wouldn’t have received a T-slip.
The fund is in a non-registered account. The other e-series funds held (TD Canadian Index – e and TD International Index – e) both appear on the T3 slip I receive each year.
Just a follow up regarding the TD US Index fund. I called TD Asset Management today and they confirmed that the fund did not issue any distributions and therefore no T-slip was issued. He also said that the dividends earned by the fund each period are not paid out to unit holders but instead are reflected as increases in the NAV. The result is that the only tax is possibly capital gains tax when the fund is eventually sold.
@andre: I looked into this and it is indeed true that the Currency Neutral (hedged) version of the fund did not distribute any foreign dividends in 2012. (The unhedged version did.) But the TD rep’s explanation is not correct: just because a dividend is reinvested (and therefore reflected in the NAV) that doesn’t make it disappear. The same is true with a DRIP: even if you receive your dividend in the form of new shares, it’s still taxed as a dividend in the year it’s received.
I will follow up with TD and see if I can get an explanation.
Hello,
I am thinking of using investing my wife’s LIRA into XGR, which as you know is a wrap-based ETF. So, if I understand you right, this would not be a good idea since the LIRA is a registered account and the taxes would not be recoverable?
@Brian: It’s true that withholding taxes from this fund would not be recoverable in an RRSP, though I’m not sure that’s the most important consideration. Only a small portion of the fund is US and international equities, so the cost would be very small. It’s far more important to consider the asset mix in the portfolio and decide whether it’s appropriate for your needs. The three largest holdings in XGR are US inflation-protected bonds, emerging market bonds and high-yield US corporate bonds. Is this what you want?
@Canadian Couch Potato: Thank you for looking into it. I appreciate your helpful replies and enjoy your website quite a lot. I look forward to reading what you find out. I agree that the TD reps explanation does not make sense, unless the fund is using derivatives or swaps to get the return of the index like HXS.
Perhaps I’m getting lost in the details, but it seems that if the dividends earned by the underlying investments were reinvested without distributing them to investors (and the NAV increases), then if you pay tax on the dividends, the adjusted cost base should be changed to reflect the reinvestment. Otherwise, you would be taxed twice on the same income.
Consider a simple example: An investor has a $10,000 investment and the fund’s underlying investments earn $300 in dividends. (1) If the fund distributes $300 and the amount is reinvested by buying additional units, the investor pays tax on the $300 distribution, but the ACB increases to $10,300. (2) If the fund keeps the dividend money and reinvests it internally without paying distributions, the market value is now $10,300; however the ACB is still $10,000. In case 2, if the investor pays tax on the $300 dividend income that was not distributed and also pays capital gains tax on the $300 capital gain, that seems like double taxation.
I noticed that there are a bunch of other funds that never pay distributions, bus as I don’t hold them I don’t know if they send out T3 slips or not for the earned dividends.
@andre: I have a question in to TD and expect to hear back from them soon.
RE: “It seems that if the dividends earned by the underlying investments were reinvested without distributing them to investors (and the NAV increases), then if you pay tax on the dividends, the adjusted cost base should be changed to reflect the reinvestment.” When a fund reinvests a dividend, the NAV doesn’t go up: usually it goes down and you receive more units to compensate. You may find this document useful, especially pages 11 and 12:
https://www.phn.com/portals/0/pdfs/FormsandDocuments/030-2013-rbc-1834-S-tax-invet-mutal-fund-final.pdf
The same principle applies to dividend stocks. Investors sometimes forget that a dividend is not like interest on a bond or GIC. If you have a $1,000 GIC and it pays 2% interest, then its value becomes $1,020. But in most cases a stock’s price will fall by approximately the same amount as the dividend to reflect that the company must be worth less once it pays out some of its cash:
http://canadiancouchpotato.com/2011/01/18/debunking-dividend-myths-part-1/
One benefit of mutual funds in taxable accounts is that these ACB calculations are done for you. With a stock or ETF you have to make them yourself if you use a dividend reinvestment plan (DRIP):
http://canadiancouchpotato.com/2013/04/08/why-you-should-avoid-drips-in-taxable-accounts/
@Canadian Couch Potato: Thank you very much for your informative response and directing me to those links. The first document was very educational.
Thanks again (and again and again) to CCP for posting such useful and relevant information.
The only part with which I disagree is the statement at the end regarding contacting a “professional” for specific tax information. To date I have never found that such a pink elephant actually exists (although many do claim to).
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