Jason, a reader of this blog, recently wrote to ask why an investor would want to invest in Canadian-listed  ETFs that hold US stocks when there are US versions with much lower fees.

For example, the iShares Canadian S&P 500 Index Fund (XSP) charges 0.24%, while the Vanguard Total Stock Market ETF (VTI) has an MER of just 0.09%. Jason had several specific questions—all very good ones—which I’ll attempt to answer.

Q: When one holds a US-based ETF, are the dividends paid out in US dollars and then converted to Canadian dollars by the brokerage, costing the investor conversion fees?

Yes, dividends earned from US-listed ETFs are paid in US dollars. If you hold the ETF in a taxable account, the dividends simply go onto the US-dollar side of the account. But if you hold the ETF in RRSP or other account that does not allow US dollar holdings, your broker automatically converts them before depositing them in your account. This usually incurs a fee of about 1% or more: check your broker’s website or call and ask.

While this conversion fee does cause a small drag on your dividend return, keep it in perspective. Broad-based ETFs of US stocks currently pay dividends of around 2% annually, and a 1% currency conversion fee would reduce your yield to 1.98%.

The bigger impact of foreign exchange fee comes during the purchase and sale of US-listed securities. Let’s say a Vanguard ETF is trading at $50 US per share and the loonie is currently worth 95 US cents. A straight conversion works out $52.93 Canadian, but a 1% conversion makes your price $53.46. You’ll lose another 1% when you sell the shares.

The trading commission on US securities is typically higher as well.

Q: Is this why some brokerages now offer RRSP accounts that can hold US dollars?

Currently only two discount brokerages—Questrade and QTrade—allow Canadian investors to hold US dollars inside registered accounts, which allows you to receive dividends in US dollars and sidestep the conversion fees. [Update: All online brokerages now offer this service.]

Questrade offers the service for free, but QTrade charges $50 annually. Paying that fee makes sense only if you do a lot of trading, or if you have significant US holdings.

Q: Would it be better to hold XSP if you have a Canadian dollar account, because you would not have these conversion fees?

It is true that buying and selling XSP is cheaper than trading US-listed ETFs for the reasons explained above.

In theory, at least, the dividends should be higher, too. XSP simply holds the US version of the iShares S&P 500 Index Fund (IVV), which means that XSP receives dividends from IVV and then converts them to Canadians dollars before distributing them. An iShares spokesperson I asked about this explained that XSP is able to convert currencies at the institutional rate, which means “there is almost no spread at all.” This, he explained, should allow investors to collect dividends at full value and avoid being charged a conversion fee by the broker.

Q: In a TFSA, would both the Canadian- and US-listed ETFs have foreign withholding tax taken off?

Yes, but in different ways.

Many countries, including the US, withhold taxes from dividends paid to foreign investors. For example, if you’re a Canadian holding a US-listed ETF in a taxable account, Uncle Sam deducts 15% of your dividends before you receive them. (You can typically claim the foreign tax credit tax when you file your return.)

The good news is that Canada and the US have a tax treaty that allows investors to avoid this tax if they hold their US investments in an RRSP or RRIF. However, that treaty does not apply to Tax-Free Savings Accounts or RESPs, so if you hold a US-listed ETF in one of these accounts you will indeed be subject to the withholding tax.

Now, here’s where it gets confusing. When a Canadian-listed ETF holds a US-listed ETF (such as XSP, which simply holds IVV), it too is subject to the withholding tax. The dividends are taxed at 15% before they are paid to the Canadian ETF sponsor, and then these reduced dividends are passed on to investors. So if you hold XSP in your Tax-Free Savings Account, you’re still getting dinged with the withholding tax: it just happens indirectly.

In fact, even If you hold XSP in your RRSP, you’ll see your dividends shrink by the amount of the withholding tax. Because the fund itself is being taxed here, not the individual who holds shares of the fund, the tax treaty doesn’t apply. This is an important consideration that even many advisors are clueless about. Canadian Capitalist wrote an excellent post on the topic last year.

Q: So what’s the bottom line?

For the long-term investor who wants to hold US stocks, and who is not concerned about currency risk, it is usually better to buy US-listed ETFs than their counterparts that trade on the TSX.

While currency conversion fees are not trivial, they are usually more than offset by the lower MERs and (in RRSPs) the preferential tax treatment. That is why most of the Model Portfolios on this site recommend Vanguard ETFs for US and international equities.

Canadian investors who worry about the loonie appreciating in value may be willing to pay more for XSP or other ETFs that use hedging strategies to smooth out currency fluctuations. But that’s a whole other discussion that will have to wait for a future post!

Thanks for the great questions, Jason.