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 the amount you paid will appear on your T3 and T5 slips and you can recover some or all of it by claiming a foreign tax credit on your return.
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).
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, they simply hold units of their New York–listed counterparts.
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 may incur 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.
Dan, you (and Mr Bender, if that is his real name) are a true hero to couch potatoes everywhere.
@Patrick: Thanks. Actually Justin’s real name is Bieber, but we use an alias for obvious reasons.
@Patrick: I couldn’t agree more. Every so often Dan puts together a bookmark-worthy post that I refer back to often. This is one of those posts. Thank you. Another post along similar lines is this one: https://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/
Thank you so much for putting this together. Incredibly useful and I hope all investors read it when deciding what to buy where.
One suggestion. Would it be possible to put together the same information in a slightly different format for easy reference? What are the best investments to hold in each of the three types of accounts? e.g. in a taxable account, the following investments are best and/or most appropriate; in an RRSP, the following investments; in a TFSA, the following.
And conversely, in a taxable account, the following investments should be avoided etc.
I know this isn’t black and white stuff but re-ordering it in that fashion would be a very useful quick reference for many.
@Mark: I have something like that planned for later in the week. It was all too much to include in a single post.
Dan, thank you for such a great post.
I would assume all US or international withholding taxes in an RESP account is not recoverbale?
@Karim: Great question. Your assumption is correct: an RESP is treated the same as a TFSA, with no exemption and no ability to claim the foreign tax credit.
It’s very helpful to receive this. One hypothetical question – persons with very large net worth – would it be worthwhile only from a tax perspective, irrespective of transaction costs, to purchase int’l ETFs directly in other non-US countres with which we have tax treaties to avoid this taxation? Would seem complicated & a PITA, but I’m still curious.
@David M: I don’t think this is possible. Remember, to qualify for the exemption it would need to be done within an RRSP framework, so you won’t be able to do it with huge amounts of money.
Great post for bookmarking.
Question: Is it possible to switch ETF between a non-taxable account and a RSP or RIF (or TFSA or RESP for that matter) without penalty? The idea is to put an ETF where it is better off from a tax perspective.
Hi,
Thank you very much for this great post.
Question:
I was going to set up Global Couch Potato style portfolio in my TFFA and RRSP account which would include XWD – ETF.
From what I can understand from your post, I just have to accept that the foreign tax paid will not be recoverable and there is nothing I can about it. Correct?
Should I consider a different investment strategy then?
Keep in the US/International Funds in non-registered accounts? Even though all my savings are in registered accounts and currently don’t have enough cash to make a purchase equal to 35% of my portfolio in a non-registered account?
Hopefully my question makes sense and is not too confusing : )
Best regards,
Hi Dan, great and informative post that I have yeared for a long time. The ultimate DIY guide for withholding taxes!! I have always had trouble with this topic with respect to the e-series, before this article that is.
Now, if there is contribution room in registered accounts, the disadvantage of withholding taxes not being recoverable in registered accounts (with the exception of US-listed ETF holding US stocks invested in RRSP) has to be weighed against the fact that capital gains are tax free and that any received dividends (after withholding taxes) are not taxed at all.
Dan, this is very useful information.
Do you know what happens if one holds a foreign bond ETF (such as ZEF) in a TFSA?
According to ZEF’s website, no foreign tax was paid in 2010 and 2011. So holding ZEF in a taxable account vs. TFSA should not matter re: withholding taxes. Is that true for all such funds and time periods?
@David M; @CCP: Excellent post – but that’s true for pretty much all of them.
I think David was thinking of a situation where instead of buy VEA (for example) one went out and bought ETF’s in Germany, Japan, UK, etc. and thereby try to avoid the withholding taxes that are being paid when distributions flow from the foreign country to the US ETF provider.
Hypothetically, yes – this should work. However, there are a number of things to keep in mind:
1) As CCP indiacted, this would only potentially work for funds inside an RRSP. For very high net worth individuals, RRSP’s often represent a fairly small percentage of their total assets;
2) You would have to familiarize yourself with the tax treaties that Canada has signed with all of the various countries. Not all countries exempt RRSP holdings the way that the Canada-US treaty does;
3) Finally, assuming a Complete Couch Potato allocation; $10M portfolio; 4% distribution rate; and a 10% WH tax rate, the total tax savings one is looking at is approximately $6,000 ( or 0.06% of the total portfolio). With a $10M portfolio, there are probably easier and more effective ways to save $6,000. :)
@CPP: Thank you for this very useful post!
About claiming a foreign tax credit for investments inside taxable accounts, it seems that you can only claim a very small portion of tax credit if you are investing inside a corporation (i.e if you are a business owner or an incorporated professional with retained earnings inside the CCPC ). This may affect somewhat your asset allocation inside a CCPC.
see the post by Adrian2 for more info:
http://www.financialwebring.org/forum/viewtopic.php?f=32&t=104316&p=178939
Thank you for your clear explanation.
Just curious, do you know why there are withholding taxes for Ishare S&P/TSX Capped Composite Index Fund (XIC) in some years?
Thanks Dan – this one of the most impressive posts in your blog, and your blog is full of quite useful posts – You helped to deconstruct a very complex topic and explain it in simple terms. Looking forward for your post on strategies of what ETF type to place in which type of account!
I like it!
Another interesting edge case is US ETFs that hold *Canadian* stocks. Why would you every buy one of those? I bet many of you own one – likely VXUS or VSS. In that case, the ETF pays Canadian withholding taxes on the Canadian portion’s dividends, and you pay (potentially recoverable, as Dan discusses) US withholding taxes on its distributions. What’s more, in a taxable account, the distributions are taxed as foreign income, even the portion that comes from Canadian dividends. So you lose out in three ways compared to holding the Canadian portion of the fund directly.
The Canadian portions of these funds are small (8.5% for VXUS and 17.2% for VSS), but the drag is still around 15bps for VXUS or 30 for VSS, in a taxable account.
For most people, this doesn’t change the fact that VXUS is currently the best option out there for international equities, but for large portfolios the difference is enough that it may make sense to use separate ETFs for international, international small, and emerging markets instead.
@Andrew: You can certainly transfer an asset from a non-registered account to an RRSP, though if there is a gain that becomes taxable. As for going the other way using a swap, this is not as straightforward as it used to be:
http://www.canadiancapitalist.com/td-waterhouse-disallows-rrsp-swap-transactions/
@HD: XWD is not terribly tax efficient in either an RRSP or a TFSA. You may want to consider using the TD e-Series funds if you are concerned about tax inefficiency. In fact, I think this discussion is a good reminder that the TD e-Series funds (hard as they are to access sometimes) can be superior to ETFs in many ways.
@Tommy P: The withholding tax in XIC is a mystery. My guess is that the fund had some tiny holding in a US security for short time, maybe for some hedging purpose. You’ll see that the tax is just a fraction of a cent, so nothing to be concerned about.
@SD: Did a little research on your question. As I understand it, there is no withholding tax on interest from sovereign bonds, only on on corporate bonds.
Thanks Dan! I was about to ask you why ZHY paid foreign taxes in 2009 and 2010, but this explains it. I’m still puzzled about why ZHY paid no foreign taxes in 2011 though.
@ST: Looking deeper into this for a future blog post, but here’s what I know: if a Canadian fund holds U.S. corporate bonds directly, it is exempt from withholding taxes. However, if the fund simply holds a US-listed ETF of corporate bonds, then the withholding taxes apply. ZHY currently holds its bonds directly now, but I’m not sure that it did in 2009 and 2010. But to be sure, I’d recommend emailing BMO directly. All the ETF providers will answer questions like this from investors.
I have my e-series account set up and was investing in all of option 2 of your model portfolios . I had only purchased the Canadian index before reading your foreign withholding tax explained post. I was going to keep all of the model portfolio (foreign included) in my RRSP . Now it seems as though I should invest in the International equity 20% TD International Index – e (TDB911) and US equity 20% TD US Index – e (TDB902) in a non-registered (taxable) account for foreign withholding taxes purposes. Does this make sense, as I am just starting investing.
@surette: Remember that withholding taxes are only one part of the equation. If you invest in a non-registered account you can reclaim the withholding tax, but your dividends will be fully taxed as income, and your capital gains will also be taxable. In an RRSP, you can defer all of these taxes until retirement.
It’s very important not to make asset location decisions based on only one factor: you need to consider the whole picture.
You have ZDM in category A but from BMO website:
” ZDM may hold other underlying ETFs”
And in fact ZDM contains amongst other direct holdings:
iShares MSCI Italy
iShares MSCI Sweden
iShares MSCI Singapore
iShares MSCI Hong Kong
iShares MSCI Netherland
iShares MSCI Australia
iShares MSCI UK Idx Fnd
iShares MSCI Japan
Wouldn’t ZDM produce the double taxation drag on at least a portion of the the fund as in scenario E if it was held in an RRSP?
Unfortunately I hold VEF in my RRSP and I will be selling it after it goes ex div in a few days in favour of a more tax efficient option, perhaps ZDM? Thank you for a fantastic post!!
@BRI: Yes, there would be double withholding tax on the underlying ETFs, but these represent a tiny portion of ZDM’s overall holdings, so the amounts are virtually insignificant.
Yes, ZDM is more tax-efficient than VEF in an RRSP, because there is no US withholding tax.
Hey Dan, I have a question stemming from your disclaimer. “You should always consult with a specialist before making any investment for tax reasons.” I know this is great advice but I am not sure how to go about this.
I have a taxable account with VTI and VEA so my US foreign withholding taxes are recoverable (but not INTL). Come tax season I’m going to take my stuff to a tax company instead of doing NETFILE myself for this reason. So I’ve already made the investment decision and are dealing with the taxes after the fact.
In terms of making an investment for tax reasons, who should I speak too? My experience is that investment advisor’s (assuming I can find one that is index friendly in Saskatchewan) are not tax specialists and tax specialists wouldn’t know anything about the types of investments I’m looking at. I need to get these two groups into a room and layout a plan for me.
What’s your advice/experience?
Great post BTW. Definitely bookmarked and flagged for tax season next year!
@Sterling: Great point about investment advisors and tax specialists—often they former don’t know enough about taxes, and the latter know little about ETF structure. That said, any tax specialist should be able to help you claim the foreign tax credit with the information on your T3 and T5 slips.
As for getting help designing a tax-optimized portfolio, stay tuned for my next post!
@CCP: Awesome! I can’t wait.
I read the “claiming a foreign tax credit” link you provided and it has a scary comment in it. The second paragraph says “The calculation of this non-refundable tax credit may not be automatically done by your tax software, if you have foreign non-business income which is not reported on a T-slip.” How would I ever claim itif it wasn’t reported on a T-slip or how would I know that I have some????
Also a good note for anyone who didn’t want to read it. “When the tax credit has to be calculated separately for more than one country (if it is below $200 you can combine the calculation), the tax return is no longer eligible for NetFile” So heads up for all you do-it-yourselfer’s out there.
On a separate note I have a question about rebalancing. I’ve been contributing bi-monthly into 4 index mutual funds (one at a time really; which ever one needs the allocation boost). I should have enough to sell them off and put the money into one or two ETF’s. I’m wondering if you have any recommendations when I should do this? Should I do it in December and deal with the taxes in the coming April? Or do it in January (or later) and post-pone it? Is there a benefit one way or the other or is it just a matter of when I want to deal with the capital gains taxes? Mr. Malkiel in a Random Walk says he likes to sell of his losers in December and off-set his capital gains.
I know that that is probably too general of question to give a blanket answer that will work in most situations but I’m still curious.
The higher management fees for ZDM seems to negate the benefit of the more efficient tax structure of this ETF vs VEF.
management fees:
ZDM .46%
VEF .37%
withholding taxes 2011:
ZDM 11.84%
VEF 14.99%
@Sterling: In most cases, it should not make a huge difference when you do your tax-loss harvesting. Indeed, sometimes it makes sense to do it opportunistically (i.e. after a significant market drop) regardless of the time of year.
@BRI: Indeed, you always need to consider the whole picture, not just the withholding tax. Remember, the two funds also track different indexes, may have relatively higher or lower tracking errors, etc. I encourage people not to make hasty decisions based on one factor.
Probably one of the best posts I’ve read all year. Well done Dan and Justin. I will be including this article as the first post in my Weekend Reading roundup tonight.
(Oh yeah, not just writing that because I’m looking for the first beer from you this weekend Dan). See you at CPFC soon.
Mark
Thanks, Mark. I think I owe a lot of people beer. I might just bring my own two-four to distribute.
I heard back from BMO earlier today. Your hunch was right. ZHY held JNK, a US-listed ETF, when it was launched in October 2009 and switched to holding bonds directly in November 2010. That’s why ZHY paid foreign taxes in 2009 and 2010, but not in 2011.
So I read this (and the followup post) and am having some trouble deciding on international holdings of an UNREGISTERED part of my portfolio.
I had been previously considering using VXUS as a single core holding for both EAFE & Emerging markets.
If I understand it right, I do not ideally want a C or E as categorized above (VXUS would be a C item). Better would be a category A item. Problem is, I am having trouble locating as good an offering, and at as low a fee. I could use CIE for EAFE holdings, but the fees as listed by iShares are 0.73%! Then, for emerging market exposure, I could use CWO, but its fee is high as well at 0.69%, compared to VXUS at just 0.18%. Plus, I will slightly increase my trading fees as a result of having two holdings instead of a single one. Are there any better options for “category A” EAFE & emerging market ETFs in Canada that I am missing?
So I guess my question is, is it really worth it to consider CIE & CWO (or some better option) instead of VXUS in an unregistered account? I doubt that the slight tax advantage will outweigh the 0.4+% higher MER. What do you think?
@Danno: You’re right that there really are no good international equity ETFs listed in Canada. You are either dealing with currency hedging, securities held indirectly through US-listed ETFs, high fees, or some combination of all three. That’s why I include VXUS in my Complete Couch Potato. Even if you add another 40 bps to the all in cost due to withholding taxes, you are likely to be better off with this fund than the Canadian alternatives.
It is also worth remembering that fundamental indexes (like those tracked by CIE and CWO) are likely to have more turnover than a total-market index (like the one tracked by VXUS), and therefore may be more prone to capital gains distributions. In a nonregistered account, it often makes sense to choose an index with the least possible turnover.
Thanks for the very quick feedback. Seems like VXUS is the way to go.
Does LIRA account has same tax implications as RRSP in regards to foreign/US withholding tax?
@Manny: Yes, a LIRA is considered a retirement account by the tax treaty and therefore it too is exempt from withholding taxes.
How can I find out how much withholding tax there is on the TD US index e-series and investor series funds?
I understand the tax is non-recoverable because its Canadian-held — but would the fund pay 15% or 30% in withholding tax?
If it’s 30% then that, plus paying tax at your marginal rate when withdrawing from an RRSP, would seem like a very large tax hit so I’m thinking 15% is more logical?
@Dana: The withholding tax on US dividends is 15%, not 30%. Note that the tax is recoverable if the fund is held in a non-registered account.
Thank you! I really appreciate you taking the time to answer.
Wow, it’s tough to be a Canadian investor! I didn’t realize holding TD International Index e-Series in an RRSP was that bad!
I would like to know, if I invest into an US-listed ETF that contains international equities including Canadian stocks, such as VT (Vanguard Total World Stock), do withholding taxes apply for the Canadian equities if the ETF is hold in an RRSP account?
@Pierre-Luc: That’s a good question, and I’m not sue I know the answer. I would assume that there is a withholding tax payable, since in the context of VT or VXUS, Canada is treated like any other foreign country. However, let’s do the math to see what effect this would have on your portfolio:
– Assume that Canadian stocks yield 2.1% (the current yield on XIC).
– Assume a withholding tax of 15%: this amounts to a cost of about 32 bps on those stocks
– Canada makes up 4.3% of VT, so the total cost to the fund is 4.3% x 0.32% = 0.0135%.
– Assume VT makes up 20% of your overall holdings, that’s a cost of 0.0027% at the portfolio level
– This equals $2.70 annually on a $100,000 portfolio
All of which to say I think this can be safely considered a trivial cost.
Thank you! This was my guess as well (because it is hold in the context of an US-listed ETF). Yes, I know that unless the proportion of the Canadian stocks was significant in the US-listed ETF, the overall effect of the withholding tax would be quite small…
Does it apply for ING Streetwise portfolio?
@bettrave: Yes, foreign withholding taxes apply to the Streetwise Portfolios, too. If you hold them in an RRSP or TFSA the tax is not recoverable.
I am confused. If withholding tax applies to the TD US index fund and is not recoverable if held in either the TFSA or RRSP, could you please clarify how the section below relates to this situation:
“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.”
Thanks!
@Justin: The key point here is that US securities are exempt from withholding taxes if they are held in an RRSP directly. That means you need to own the actual US stock or US-listed ETF. If you own a Canadian-domiciled fund (such as the TD US Index Fund), and that fund holds the US stock or US-listed ETF, then you still pay the withholding tax.
Hope that makes sense.