How Foreign Withholding Taxes Affect Returns

In our newly revised white paper, Justin Bender and I explain the hidden cost of foreign withholding taxes on US and international equity ETFs. I gave an overview of the most important points in my previous blog post. Now let’s look at one of the more subtle ideas: how those taxes affect your personal rate of return.

Meet Julie, an investor who is looking to hold US equities in both her RRSP and non-registered account. After reading our paper, Julie knows the US imposes a 15% withholding tax on dividends paid to Canadians, and with US stocks yielding 2% these days, that would result in a drag of about 0.30%. So she decides on the following:

  • In her RRSP, Julie uses the Vanguard Total Stock Market ETF (VTI), because this US-listed fund is exempt from withholding taxes.
    .
  • In her taxable account, Julie uses the Vanguard U.S. Total Market Index ETF (VUN), the Canadian-listed equivalent of VTI. This ETF is denominated in Canadian dollars, which makes it cheaper and easier to trade. Although the fund is not exempt from the foreign withholding taxes in a non-registered account, Julie understands that these taxes are recoverable by claiming the foreign tax credit.

This is a good decision on Julie’s part. When choosing an ETF for maximum tax-efficiency, she is right to treat “exempt” and “recoverable” as though they were equivalent. In other words, whether Julie avoids foreign withholding taxes altogether (as she’s doing in her RRSP) or paying them upfront but later having them refunded (as in her non-registered account), the overall impact is the same. However, these two situations affect will affect her personal rate of return in different ways.

Phantom outperformance

Let’s look at Julie’s RRSP return first. We’ll assume her US-denominated holding in VTI is the equivalent of $10,000 CAD. If the ETF pays a dividend of 2% during the year, she’ll receive cash distribution of about $200. (I’m ignoring the effect of the ETF’s management fee to simplify.) Because US securities are exempt from withholding taxes in RRSPs, Julie will see the full $200 paid into her account. When she calculates her personal rate of return, that entire dividend will be included in her performance numbers.

Now let’s see how this differs in her non-registered account. Here we’ll assume Julie holds the same $10,000 worth of VUN. Because this fund uses VTI as its underlying holding, we can assume the gross dividend will be the same $200. (Again, we’re ignoring the small effect of fees to illustrate a point.) But in this case, the 15% withholding tax will apply, so Julie will receive only $170 in cash.

At tax time, Julie will receive a T3 slip from Vanguard indicating that she paid $30 in foreign taxes, and she can claim this on her tax return. She’ll then receive a credit for that amount, reducing her overall income tax bill by $30. That’s what we mean we when say foreign withholding taxes are “recoverable.”

However, if Julie were to measure her personal rate of return in her RRSP and non-registered account, she would find that the former outperformed by 0.30%. That’s because the $30 Julie recovered by claiming the foreign tax credit won’t change the value of her non-registered account, so it won’t figure into her calculation.

You should also understand that when Canadian ETF providers report performance, they do so after subtracting foreign withholding taxes: in other words, they do not presume these taxes will be subsequently recovered. That helps explain the larger-than-expected tracking error on foreign equity ETFs. Over the 12 months ending June 30, VUN reported a total return of 5.20%, compared with its benchmark return of 5.66%. We know that 15 basis points of that tracking error is explained by the fund’s MER. Almost all of the remaining 31 basis points is likely due to foreign withholding taxes. So if you hold this fund in a taxable account and successfully recover these taxes, your overall investment return would effectively be higher than what Vanguard reported.

For more about how to properly measure investment performance, see our earlier white paper, Understanding your portfolio’s rate of return and download our free rate of return calculators.

 

 

60 Responses to How Foreign Withholding Taxes Affect Returns

  1. Canadian Couch Potato August 18, 2016 at 7:51 am #

    @Michael: Taxes will be withheld and reported on your T5 slip. As long as you enter the info on the T-slip when filing you return the amount should be recoverable via the foreign tax credit.

  2. Michael August 19, 2016 at 9:02 pm #

    Thank you, Dan. For a global equity etf, such as ACWI, is it better off to hold it in a registered or non-registered account?

  3. Canadian Couch Potato August 22, 2016 at 2:37 pm #

    @Michael: That question depends on many factors that are more important than foreign withholding taxes. Consider the following:
    http://canadiancouchpotato.com/2015/01/30/the-wrong-way-to-think-about-withholding-taxes/
    http://canadiancouchpotato.com/2013/12/09/ask-the-spud-when-should-i-use-us-listed-etfs/

  4. BeSmartRich September 12, 2016 at 9:31 am #

    Hi Dan,

    Is there any other international ETFs other than XEF holding international stocks directly?

    Thanks!

  5. James January 24, 2017 at 6:42 pm #

    @BeSmartRich, I’d like to know the answer to this question too. Moreso, I’d like to know if there are Canadian-domiciled ETFs directly holding frontier and emerging market companies.

    I started out with a Canadian Couch Potato portfolio a few years ago when I was in my early 20s, but have since sold those holdings (chiefly VTI and XIC) and have invested in low-CAPE countries using ETFs like GVAL, DVYE, DVEM and EWS. In fact, those 4 ETFs make up my complete portfolio. Of course they represent roughly 1000 companies.

    Now, having reading Lifecycle Investing, I’m entering into a major new investment era for me: using margin (Interactive Brokers). An exciting time and a good time to re-evaluate the withholding taxes I somewhat unknowingly pay.

  6. Alex March 7, 2017 at 1:19 am #

    Hi,

    I understand I need to pay the withholding tax for dividends from my US mutual funds, but I am confused about exactly how much I am supposed to pay. It seems that I am paying more than 15% even though I am Canadian and use a Canadian account.

    I own some TD Dow Jones Industrial Index-e fund. It is a mutual fund so I receive a T3 slip for its dividend, but when I look at box 34 of the slip (foreign non-business income tax paid), the amount is quite a bit higher than 15% of my dividend. It’s close to 20%.

    So is the US withholding tax actually higher than 15% for mutual fund dividends? Or are there some other foreign taxes included in box 34 of T3?

    Any feedback would be much appreciated. Thanks a lot!

    Alex

  7. Canadian Couch Potato March 7, 2017 at 8:28 am #

    @Alex: The withholding tax for US dividends is 15%, so if you think more than that is being withheld you may want to contact TD for an explanation.

  8. Greg March 7, 2017 at 4:02 pm #

    Hi, Dan. Now that VDU/VEE holds all stocks directly, both for developed and emerging markets, would that be a better choice than XEF/XEC, with XEC still being held through the US-listed ETF. All other things being equal, of course.

  9. Canadian Couch Potato March 7, 2017 at 4:31 pm #

    @Greg: Neither VDU nor VEE hold their stocks directly: they hold VEA and VWO, respectively. Admittedly, this is not obvious from the way Vanguard presents the holdings on its website. VIU, however, is an option place of XEF, as it does hold its stocks directly, and also excludes Canada (which is included in VDU).

  10. Greg March 7, 2017 at 5:07 pm #

    @CCP: After reading the fine print, I guess they did disclose that fact. Thanks for the suggestion on VIU. This does seem like a good substitute and hopefully one day they will hold stocks directly as they gain in popularity.

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