Foreign Withholding Tax Explained

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):

XSP

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)
iShares MSCI EAFE IMI (XEF)

  • 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.

Vanguard Total Stock Market (VTI)
iShares S&P 500 (IVV)

  • 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 FTSE Developed Markets (VEA)

iShares MSCI Emerging Markets (EEM)

Vanguard FTSE 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.

Vanguard US Total Market (VUS and VUN)
Vanguard S&P 500 (VSP and VFV)
iShares S&P 500 (XSP and XUS)

  • 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 Emerging Markets IMI (XEC)
iShares MSCI EAFE (XIN)
Vanguard FTSE Developed ex North America (VEF and
VDU)
Vanguard FTSE 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.

168 Responses to Foreign Withholding Tax Explained

  1. Canadian Couch Potato September 3, 2014 at 7:56 pm #

    @Art: It’s impossible to say too much without knowing the details of your situation, but your plan sounds generally fine. A couple of observations: If you want to hold equal amounts of US and international stocks, you won;t be able to do that with a Us equity ETF in one account and VXC in another (you will always be overweight US stocks). So you might want to use separate ETFs for US and international in the RRSP. Similar issue with the 50/50 mix of REITs and bonds in the TFSA. The proportion of each asset class in the TFSA doesn’t really matter: it’s the proportion in the overall portfolio that is more important.

    http://canadiancouchpotato.com/2012/03/12/ask-the-spud-investing-with-multiple-accounts/
    http://canadiancouchpotato.com/2014/08/13/managing-multiple-family-accounts/

  2. art September 3, 2014 at 9:11 pm #

    My reasoning was that although the lira is 30% of the portfolio right now, i will never cobtribute to it. Therefore, as my canadian (tfsa, nonregistered) and us +international (rrsp) holdings grow, i will rebalance the portfolio. Is it really that bad to have some initial skew in %, if you know that cashflow rebalancing is imminent?

    The lira is my army pension and i just wanted to put an efficient fund into it and not worry as it becomes much smaller portion of the portfolio.

    As for tfsa, the 50/50 would give me a rough allocation of 15%/15% of the portfolio for now, but how would i maintain the proper ratio? Contribution room doesnt increase that quickly and tfsa seems to be the most efficient account for fixed income and reit.

    Thoughts?

  3. Canadian Couch Potato September 3, 2014 at 9:22 pm #

    @art: Again, impossible to say more without knowing all the details. Your asset location (i.e. which fund goes where) will have to evolve over the years, since the contribution room will increase at different rates in the RRSP and TFSA, and not at all in the LIRA. As you’ve discovered, managing multiple accounts like this is probably the hardest part of DIY investing. It sounds you’re on the right track so far.

  4. dan September 11, 2014 at 5:16 pm #

    Hello,
    if i wanted to invest equally in a US-listed ETF that holds US equity vs. US-listed ETF that holds international equity, which would go in RRSP and which in taxable account then?
    or should I just go half-half for each?
    thanks!

  5. Canadian Couch Potato September 11, 2014 at 6:14 pm #

    @dan: Currently the yield on international equities is higher, so it would likely make more sense to keep that asset class in the RRSP to reduce the amount of tax you’d pay on foreign dividends.

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