My previous post on foreign withholding taxes included a lot of information for investors to puzzle over. But unless you’re an accountant, you probably don’t care too deeply about the finer details. Most investors just want to answer a simple question: which fund should I put in which account?
Recall from the earlier post that there are five broad categories of funds you can use for US and international equities:
A. Canadian mutual fund or ETF that holds US or international stocks directly.
B. US-listed ETF that holds US stocks.
C. US-listed ETF that holds international stocks.
D. Canadian ETF that holds a US-listed ETF of US stocks.
E. Canadian ETF that holds a US-listed ETF of international stocks.
To help you make the most tax-efficient choice for each type of account, see the tables below. I’ve specified which of the above fund categories are the most tax-efficient, and which ones carry the largest withholding tax burden. Then I’ve included some comparisons of specific funds. In each case, the pairs track the same index and use the same currency hedging strategy. Once again, a big thanks to Justin Bender at PWL Capital for helping me sort through these details.
An important note before you make your decision: foreign withholding taxes are just one of many costs of investing, so they should not be the only factor in your fund choices. Management expense ratios are just as important: it makes no sense to pay an extra 0.50% in MER to save 0.30% in withholding taxes. Similarly, a US-listed ETF may be more tax-efficient than a Canadian one, but your overall cost will still be higher if you’re paying 1.5% in currency exchange fees. Make sure you’ve thought this through before making any changes to your portfolio.
Even more important, you need to consider your income tax situation when deciding where to hold your fund. While holding foreign equities in a non-registered account (as opposed to an RRSP) allows you to claim the foreign tax credit, the dividends are taxed at your full marginal rate, and any capital gains are also taxable. In an RRSP, these taxes can be deferred until retirement. Justin illustrates this idea with a dramatic example on his blog.
US Equities
For non-registered accounts choose A, B or D.
For RRSPs choose B. Avoid A and D.
| iShares S&P 500 (IVV) | is more tax-efficient than | TD U.S. Index (TDB902) |
| iShares S&P 500 CAD-Hedged (XSP) | is equal to | TD U.S. Index Currency Neutral (TDB904) |
| BMO S&P 500 Hedged to CAD (ZUE) | is equal to | iShares S&P 500 CAD-Hedged (XSP) |
| PowerShares FTSE RAFI 1000 (PRF) | is more tax-efficient than | iShares US Fundamental (CLU.C) |
International equities
For non-registered accounts choose A. Avoid C and E.
| TD International Index (TDB911) | is more tax-efficient than |
Vanguard MSCI EAFE (VEA) |
| TD International Index Currency Neutral (TDB905) | is more tax-efficient than |
iShares MSCI EAFE CAD-Hedged (XIN) |
| iShares International Fundamental (CIE) | is more tax-efficient than |
PowerShares FTSE RAFI Developed Mrkts ex-U.S. (PXF) |
| Vanguard MSCI Emerging Markets (VWO) | is equal to | Vanguard MSCI Emerging Markets (VEE) |
For RRSPs choose A or C. Avoid E.
| TD International Index (TDB911) | is equal to | Vanguard MSCI EAFE (VEA) |
| TD International Index Currency Neutral (TDB905) | is more tax-efficient than |
iShares MSCI EAFE CAD-Hedged (XIN) |
| iShares International Fundamental (CIE) | is equal to | PowerShares FTSE RAFI Developed Mrkts ex-U.S. (PXF) |
| Vanguard MSCI Emerging Markets (VWO) | is more tax-efficient than |
Vanguard MSCI Emerging Markets (VEE) |
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@couch potato
@ nathan
Thanks for the advice. I’m ok for a little inefficiency as long as it’s simplistic. As for dumping XBB, I don’t mind assets that fluctuate in value since I’m in it for the long haul and I have a strong enough stomach to take the swings. Eventually, XBB will be the better choice again and I will be already in it by then by rebalancing.
Thanks this is great information.
Where is it most beneficial (regarding taxes) to hold individual US stocks, inside RRSP or in a non-registered account?
@Maria: If the US stocks are held directly, the withholding tax should not be an issue whether it’s a nonregistered account (recoverable) or an RRSP (exempt). But since you can defer taxes on foreign dividends and capital gains in an RRSP, in some cases for decades, that is likely to be the best place to keep US equities.
In Canada, there are very few choices of international equities “category A” funds (canadian mutual fund or ETF that holds international stocks directly). Investors with significant assets in taxable accounts have very limited choices for unhedged international equities if they prefer Canadian mutual funds than buying US-listed equities.
This is one sector where, I think, a low-cost active mutual funds could make sense sense even for a passive investor. For example, Mawer and Beutel Goodman offer low cost international funds with low turnover with MER around 1.45%. If those funds make up only 25-35% of one’s portfolio, and the rest is invested in low cost index funds/etf, the over MER for the complete portfolio would still be quite reasonable.
http://www.mawer.com/mutual-funds/fund-profiles/mawer-international-equity-fund/
http://www.mawer.com/mutual-funds/fund-profiles/mawer-global-equity-fund/
http://www.beutelgoodman.com/MutualFunds/ExpressSheets/ESwfocus.pdf
Similar to Jas, it’s difficult to find international ETFs that are in category A. From http://canadiancouchpotato.com/2012/09/17/foreign-withholding-tax-explained/ lists a few ETFs. Interesting to see the TD e-series listed.
Unfortunately I am following the Uber-Tuber portfolio. I’m trying to determine the best investments to use in my taxable account that follows the Fama-French research.
I remember a year or two ago the Uber-Tuber portfolio held CIE, but now uses a lot of Vanguard funds. I checked a couple of the Vanguard funds used and they do not fit in Category A.
Has anyone figured out the effective MER including the loss due to foreign withholding taxes? Tax season is coming, I might run some examples of the percentage of foreign withholding taxes I could recover.
@Brad: There are precious few Canadian ETFs that hold EAFE stocks directly, and some of those that do (such as ZDM) use currency hedging. And they’re all expensive, especially CIE. The international withholding tax is quite small: it’s typically been less than 10%, compared with 15% for US equities. So on balance using US-listed ETFs is generally the way to go: whatever you give up in withholding taxes you more than make up for in lower MERs.
@CCP:
How does using US-listed ETFs will affect tracking down the ACB (Adjusted cost basis) for non-registered/taxable accounts?
I would assume it is a bit more trouble since you then will then have to keep track of the currency exchange commissions when you buy and when you sell as well as for the dividends you receive?
Jas
@Jas: Yes, it is a little more complicated to track your ACB in US dollars. Stay tuned for a detailed post about this later in the week.
@CCP:
If only Vanguard Canada could offer an unhedged version of VEF or even better, an unhedged version of VXUS. But then, you would still have the problem of double levels of withholding taxes for international equities…
@CCP:
I’m looking forward for your post on ACB tracking in taxable accounts!
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