Back in the fall of 2012, I wrote a pair of blog posts about the impact of foreign withholding taxes in US and international equity funds. The first explained the general idea of this tax on foreign dividends, while the second showed which funds are best held in which types of account (RRSP, TFSA, non-registered). This is a complicated and confusing topic, so I was surprised at the enormous interest these articles generated from readers, the media, advisors and even the ETF providers themselves.
What was missing from those articles, however, was hard numbers: it’s one thing to say this fund is more tax-efficient than that one, but by how much? To my knowledge no one has ever quantified the costs of foreign withholding tax in a comprehensive way—until now. Justin Bender and I have done this in our new white paper, Foreign Withholding Taxes: How to estimate the hidden tax drag on US and international equity index funds and ETFs.
The factors that matter
The amount of foreign withholding tax payable depends on two important factors. The first is the structure of the ETF or mutual fund. Canadian index investors can get exposure to US and international stocks in three ways:
- through a US-listed ETF
- through a Canadian-listed ETF that holds a US-listed ETF
- through a Canadian-listed ETF or mutual fund that holds the stocks directly
The second key factor is the type of account: RRSPs, personal taxable accounts, corporate accounts, TFSAs and RESPs are vulnerable to foreign withholding taxes in different ways. Their impact in corporate accounts, in particular, was little understood until Justin delved deeply into this matter with the expert help of Charles Berry, an accountant at Welch LLP.
We examine eight different fund structures in the paper, and for each one we estimate the total cost of a representative fund by adding the fund’s management fees to the foreign withholding taxes that apply in each account type. We’ll forgive you if you want to skip all the formulas and cut to the chase, and we’ve presented our estimates for many popular ETFs in a table at the end of the paper. Here’s a small sample:
US Equities | Market | RRSP | TFSA | Taxable |
Vanguard Total Stock Market (VTI) | US | 0.05% | 0.32% | 0.05% |
Vanguard US Total Market (VUN) | CDN | 0.44% | 0.44% | 0.17% |
TD US Index – e-Series (TDB902) | – | 0.65% | 0.65% | 0.35% |
Developed Markets Equities | Market | RRSP | TFSA | Taxable |
Vanguard FTSE Developed Markets (VEA) | US | 0.31% | 0.68% | 0.31% |
Vanguard FTSE Developed ex N. America (VDU) | CDN | 0.90% | 0.90% | 0.53% |
BMO MSCI EAFE (ZEA) | CDN | 0.67% | 0.67% | 0.34% |
iShares MSCI EAFE IMI (XEF) | CDN | 0.94% | 0.94% | 0.56% |
TD Int’l Index Fund – e-Series (TDB911) | – | 0.84% | 0.84% | 0.51% |
Emerging Markets Equities | Market | RRSP | TFSA | Taxable |
Vanguard FTSE Emerging Markets (VWO) | US | 0.49% | 0.85% | 0.49% |
Vanguard FTSE Emerging Markets (VEE) | CDN | 1.05% | 1.05% | 0.69% |
iShares MSCI Emerging Markets IMI (XEC) | CDN | 1.00% | 1.00% | 0.68% |
The first thing that jumps out is the large difference between US-listed and Canadian-listed ETFs when held in RRSPs. A fund like VUN is 39 basis points more expensive than VTI, while VDU adds an additional 59 basis points compared with VEA. In a large RRSP, therefore, it may be significantly more cost-effective to hold US-listed ETFs for your foreign equity exposure.
However—and this is important—this is only true if you can avoid the high cost of converting currency. If you’re investing relatively large sums and you’re comfortable doing Norbert’s gambit, then US-listed ETFs are an excellent option. But not everyone is keen to do this: in fact, after we explain the trade-off to clients of our DIY service, many decide they’re happy to pay more for the convenience of trading only Canadian-listed ETFs. And there’s nothing wrong with that decision.
Another important takeaway is that the tax advantages of US-listed equity ETFs are much smaller (or non-existent) in non-registered accounts. It probably makes sense for DIY investors to use Canadian-listed ETFs in their taxable accounts—even though their MERs are slightly higher—to avoid the cost of currency conversion.
Keep it in perspective
One of the common reactions to my earlier articles about foreign withholding taxes was to overestimate their significance. Let’s remember foreign equities are typically about 30% to 40% of a balanced portfolio, and the withholding taxes apply only to the dividends, which are likely to be in neighbourhood of 2% to 4%. So their impact on the overall portfolio may not be as large as you think.
Here’s an example of the cost breakdown in two versions of the Complete Couch Potato: the first uses US-listed ETFs for the foreign equities, while the second uses their Canadian-listed equivalents:
With US-listed ETFs | % | RRSP | TFSA | Taxable |
Vanguard FTSE Canadian All Cap (VCN) | 20% | 0.14% | 0.14% | 0.14% |
Vanguard Total Stock Market (VTI) | 15% | 0.05% | 0.32% | 0.05% |
Vanguard FTSE Developed Markets (VEA)Â | 10% | 0.31% | 0.68% | 0.31% |
Vanguard FTSE Emerging Markets (VWO)Â | 5% | 0.49% | 0.85% | 0.49% |
BMO Equal Weight REITs (ZRE) | 10% | 0.62% | 0.62% | 0.62% |
iShares DEX Real Return Bond (XRB) | 10% | 0.39% | 0.39% | 0.39% |
Vanguard Canadian Aggregate Bond (VAB) | 30% | 0.22% | 0.22% | 0.22% |
Total cost | 0.26% | 0.35% | 0.26% | |
With Canadian-listed ETFs | % | RRSP | TFSA | Taxable |
Vanguard FTSE Canadian All Cap (VCN) | 20% | 0.14% | 0.14% | 0.14% |
Vanguard US Total Market (VUN) | 15% | 0.44% | 0.44% | 0.17% |
Vanguard FTSE Developed ex N. America (VDU) | 10% | 0.90% | 0.90% | 0.53% |
Vanguard FTSE Emerging Markets (VEE) | 5% | 1.05% | 1.05% | 0.69% |
BMO Equal Weight REITs (ZRE) | 10% | 0.62% | 0.62% | 0.62% |
iShares DEX Real Return Bond (XRB) | 10% | 0.39% | 0.39% | 0.39% |
Vanguard Canadian Aggregate Bond (VAB) | 30% | 0.22% | 0.22% | 0.22% |
Total cost | 0.40% | 0.40% | 0.31% |
I would argue that in a TFSA or taxable account the difference is trivial, and Canadian-listed ETFs are almost certainly the better choice. Even in an RRSP, the total difference of 14 basis points is not likely to outweigh the cost of currency conversion in smaller accounts.
In the end, it’s up to you to decide whether it’s worth using US-listed ETFs for your foreign equity holdings. But least now you have the numbers to help you make that choice.
Thanks, Dan. This is very helpful.
Very useful, thank you.
One question: here and in the white paper, I assume that the listed total cost of funds in taxable accounts assumes the full recovery through the foreign tax credit of those withholding taxes that are recoverable? You mention the foreign tax credit of course, but I didn’t see that assumption explicitly stated anywhere (my apologies if I missed it). It is potentially an important point: not everyone can fully benefit from the foreign tax credit (such as investors with minimal tax payable due to low income or large deductions) even if they paid quite a bit of withholding taxes – for these investors, the actual total cost of funds in taxable accounts will be higher than the costs listed, at the limit being the same as the costs of holding the same funds in a TFSA/ RESP (i.e., withholding taxes totally non-recoverable). This point should be made very clear to readers I think.
@Steve: Yes, the assumption is that recoverable taxes are actually recovered with the foreign tax credit. It is an important point, though probably not one that will affect many people. While there will be some investors who are unable to claim this credit, they are not likely to be the ones with large non-registered accounts that have significant holdings in foreign equities.
Thanks Dan, very informative as always.
Should I assume that VXUS (your choice in the Complete Couch Potato) is a C class ETF, so it should be preferable in a taxable account ?
@ CCP:
I’m not sure the situation is that uncommon – anyone who invested with money that did not attract RRSP contribution room when it was received, such as an inheritance or from the sale of a house, could end up with large unregistered accounts and significant unrecoverable foreign withholding taxes paid. I suppose the same might apply to someone with a Pension Adjustment that leaves little RRSP contribution room relative to a good salary (and thus savings) – are there still people with pensions like that out there? – resulting in significant unregistered investments.
Anyway, if someone is doing that well financially, recovering or not every penny of foreign withholding tax would not likely make a material difference! (and potential US estate tax issues would make Canadian domiciled funds preferable in any case, notwithstanding cost)
I really appreciate the work you put into this. This is exceptionally clear and presented in a very comprehensible, practical way.
@Dimitris: No, VXUS is a US-listed fund, so its advantage would be greater in an RRSP. We did not include it in the white paper for a couple of reasons. First, there is no Canadian-listed equivalent so comparisons are less useful. (That’s why I used VEA and VWO in my Complete Couch Potato comparison in the post.) Also, because it holds both developed and emerging markets stocks it doesn’t fit into any of our categories: it’s a hybrid between Type D and Type G.
@Chris: Many thanks, great to know the effort is appreciated!
Hi Dan,
Thanks for the article. I noticed that you selected VDU instead of ZEA (the new BMO ETF) for the international portion of the portfolio even though ZEA seems to be much cheaper. Is this choice made because ZEA only recently started trading?
@Jeff: In the comparison above I suggested VDU only because it is equivalent to VEA. Yes, in theory ZEA should be cheaper, though it’s so new we really don’t know yet.
@Dan
I appreciate the clarification. I only came to Canada from Europe in January 2013 and I am most appreciative of your efforts, site and advice.
Thanks.
Thanks Dan! This is great information.
What a timely article, thank you very much! I was for a while sweating what Canadian listed ETF-s to use as a substitute for US listed ETF-s that I currently have in my version of Complete Couch Potato portfolio. Namely I currently hold VTI, VEA, VWO for foreign portion of portfolio. Needless to say I am more than happy to find the answer on eking question as many times before on this blog. Dan I am not sure how you manage to put out so much of so valuable investment information but I really thank you for your great work .
@Gordon and Raman: Thanks for the feedback. Justin deserves the credit for doing the heavy lifting on this one, for sure.
You guys did a great job – so much so that the website is down :) I’ll be sure to check back later since this will help in planning the best use of corporate accounts.
Gosh, thank you very much. This analysis is significantly insightful. Last year I spent time understanding different products in different account types. Dan, I found the Oct 2013 article on asset allocations to be very helpful from top-down perspective (https://canadiancouchpotato.com/2013/10/30/making-smarter-asset-location-decisions/) … but this recent one is fascinating from bottom-up perspective. Great thought leadership!
@Dimitris: I tried to repeat the Bender-Bortolotti calculations for VXUS. The 2013-10-31 annual report says that dividends collected net of FWT was $2,675,609,000, and FWT was $163,250,000. This makes the FWT rate 5.75%. With a dividend yield of 2.85%, this makes the Level I FWT 0.16%. Add this to the 0.16% MER to get total costs in an RRSP of 0.32% per year. I’ll leave the Level II stuff to the reader.
@Spud: Thanks for a great paper. I now have more good data to include in my personal spreadsheet to automate portfolio decisions.
Perfect timing Dan! I’m in the process of switching over to a discount brokerage and have been trying to figure out whether or not to do Norbert’s Gambit. Based on your calculations and my account size, 14 basis points isn’t worth the hassle right now.
This is a great help Dan. I’m trying to get started and kept hearing “watch out for withholding taxes”. Now I can stop worrying about it, because you have succinctly shown me there are bigger fish to fry!
Very interesting read. Just to be clear (and apologies if this is a dumb question), how would this work for a Canadian domiciled balanced mutual fund with Canadian, Intl and US equity holdings? Say, the Mawer Balanced Fund. Does the MER for such a fund include any foreign withholding taxes, or are they an additional cost as in the case of the TD e series funds you cite? Thanks.
Great article Dan!
Would you know if the recent FACTA deal between Canada and the US changes these calculations, specifically the withholding tax in TFSA or taxable accounts?
Here is a Google doc template for the different groups of ETF’s for the ones listed in the PWL paper.
The only tricky part is the “Yield” column. For your own ETF’s, you have to change the Google address in the function bar. For example in VTI it’s:
https://www.google.com/finance?q=NYSEARCA%3AVTI
If you want to see VUN, it’s:
https://www.google.com/finance?q=TSE%3AVUN
Make sure you have the right exchange (ie NYSEARCA/TSE) and the right ticker symbol.
Otherwise, just insert MER, ER and Withholding tax, the spreadsheet will do the rest.
https://docs.google.com/spreadsheet/ccc?key=0AlAmBfTsdB3odGUxdGwwR0tpZ0RoT21QUGY3MUNiSmc&usp=sharing
Thanks CCP! You’ve somehow made a really confusing topic much easier to comprehend (especially the corporate tax part)!
Would there not be additional savings from tighter bid/ask spreads on US listed ETFs? They are much more liquid.
@ Steve very interesting, that helps me understand why I get such little fwt returned when I do my taxes. Do you know what the thresholds are for the levels of returned fwt? I guess being in a low tax bracket still helps with compounding as dividends are favorably taxed.
@CCP/Justin,
I understand that the US taxes witheld on US dividends is NOT fully recoverable for US based ETFs held in Canadian Corporations. In this case would HXS be most efficient for US content, and ZDM be most efficient for international content, as ZDM holds the int’l stocks directly thus at least avoiding the layer of US witholding taxes for ETFs such as VEA/VDU or VWO/VWO? Appreciate your work and comments. Looks to me that despite the higher MERs for HXS and ZDM, they may be more tax effecient in a corp., therefore cheaper overall. MER is not the be all and end all as far as costs.
Another valuable article, thank you.
For context, here’s what I figure the impact of US-listed vs. CA-listed ETFs for Complete Couch Potato at varying total portfolio sizes for taxable/TFSA accounts where the Total Cost difference is 0.05%:
10k portfolio -> $5.00/year
50k portfolio -> $25.00/year
100k portfolio -> $50.00/year
250k portfolio -> $125.00/year
500k portfolio -> $250.00/year
1M portfolio -> $500.00/year
I suppose if one has a very large portfolio to start with and many years ahead of them, you’re better off going with US-listed ETFs… especially if you can keep your currency/trade costs down…. which then reminded me of this 2010 CCP article that had a spreadsheet to calculate the breakeven point between CA- and US-listed ETFs (https://canadiancouchpotato.com/2010/10/19/reducing-the-cost-of-currency-exchange/).
Using VEA/VDU for a spreadsheet example, at 0.31% and 0.53% total costs in a taxable account, with a dividend yield of 1.67%, and removing the formulas in the withholding tax column (since this is already factored in the total costs), one’s currency conversion fee needs to be ~2.65% to break even buying US-listed over CA-listed in 30 years. The conversion fee has to decrease to ~1.89% to breakeven in 20 years. If I have 10k CAD to put into VEA/VDU, and Norbert’s Gambit can get me USD for the cost of 0.5% (or $50; 2 trades x $10 + ask/bid spread), with the above costs and yield, I break even in 5 years. I think this reinforces the point that minimizing currency conversion costs is the key to make US-listed ETFs worth considering.
Another though that’s closer to my asset allocation is a 85/15 stocks/bonds mix. Using the same ETFs as in the Complete portfolio mixed as: 35% VCN, 20% VUN/VTI, 10% VDU/VEA, 10% VEE/VWO, 10% ZRE, 5% XRB, and 10% VAB, the weighted total cost of CA-listed ETFs is 0.31% and US-listed is 0.24%. A mere 0.02% increase.
Excellent article ccc.
I own individual shares in some large us blue chips in a taxable account (non rrsp or tfsa) I pay the 15% witholding tax on the dividends but dont understand if the americans withold any capital gains taxes on these individual shares when i one day sell them. Any idea if so and how much?
Many thanks
Lester
@MD – I had considered including HXS in the analysis – however, the swap fee would have unfairly penalized it (as there would be no consideration in the paper for the favourable deferred capital gains treatment of the total return), so I decided to exclude it.
As far as international ETFs are concerned, you should first consider whether you want to trade in US dollars and whether you want currency-hedging, before making a decision based entirely on this analysis.
Excellent article & as is the linked ‘White Paper’.
In your White Paper’, considering category A (US-listed ETF of US Stocks) you assume that all the NRA tax withheld will be recovered in a Taxable account example.
However in the Corporate account example, you assume that only ~ 1/2 will be recovered.
I hold US-listed ETFs in a corporate account and have always been able to recover all NRA tax withheld through credits on my T2 return.
Could you please explain your reasoning?
Thank you for the excellent work!
@Juan: The effect of foreign withholding taxes is never included in a fund’s MER, which is fair because they are not “management expenses.” In an actively managed balanced fund, investors would be subject to the same withholding tax on dividends as they would be with ETFs or index funds, but the effects would be less predictable.
@SK: Tax compliance is definitely not my area of expertise, but I am not aware of any pending changes to the withholding tax rules that would affect these estimates.
@Paul: Tight bid-ask spreads only affect transaction costs, not the ongoing cost of holding a fund.
@Lester: There are no withholding taxes on capital gains, only dividends.
@John: This is a very complicated topic. You’re right that in a corporate account it’s not that 50% of foreign withholding taxes are actually recovered, but the end result is similar because foreign income is taxed less favourably than it is in a personal non-registered account. In the white paper we phrased it as follows: “We have assumed the taxation of foreign income in a corporation has a similar effect to recovering approximately 50% of the final level of foreign withholding tax. Throughout the paper, we refer to this tax as “partially recoverable.”
Justin and the accountant Charles Berry spent a lot of time getting this estimate as accurate as possible, and we struggled with how much to explain in the paper. In the end we decided most people would be more interested in the bottom-line advice and less concerned about the details of the calculation.
CCP I have done exactly what Steve described earlier. I sold a house and invested a large part of the proceeds in my non registered account. Could you explain how the amount of recoverable FWT is affected by low tax bracket situations?
Thanks phil
@Phil: The issue is that the foreign tax credit is non-refundable, which means it can reduce the amount of income tax you would otherwise pay, but if you do not owe any income tax then you can’t use it to get a refund. So if you happen to be in a situation where you pay no income tax but incurred, say, $1,000 in foreign withholding taxes on your investments, then you could not recover this with the foreign tax credit.
Thanks, I appreciate the info, makes sense, similar to other deductions.
This was a bit too technical for me and I’m not sure I understand it correctly.
So for many of us, it’s probably better to stick with CAD ETF even with the higher basis points?
@Chapman: I would have to agree that if you’re not comfortable with all of these issues it makes sense to stock with Canadian-listed ETFs in all cases.
I love the white paper. Thank you very much for sharing.
Really good info and analysis.
Though this post is raised related to the subject of Foreign Withholding taxes, I think it’s worth noting that even in the cases where your tables/calculations show savings resulting from holding a US listed ETF, that the majority of the savings in most cases come NOT from the better tax treatment but simply from the lower MER of the US fund. That should even further erode the argument that any of these decisions should be based on withholding tax. It’s more to do with the MER.
ZEA is the dark horse that could change some of this. Deleting that second layer of withholding tax, on international equities (which yield highly) could be worth several tens of basis points. Combined with that funds supposed low MER… could be a good option.
@Willy: “The majority of the savings in most cases come NOT from the better tax treatment but simply from the lower MER of the US fund.” I’m not sure that’s true: MERs are important, certainly, but in most cases they’re not a bigger factor than the foreign withholding tax.
In the case of VTI v. VUN, for example, the difference in MER is about 12 bps, while the FWT is 30 bps. And with international equities, the MER differences are typically about 20 bps, while the Level 2 withholding tax (which would be exempt in an RRSP if you use a US-listed fund) is about 25 to 36 bps.
@ phil:
Dan summarized the point as regards the deductibility of foreign withholding taxes. If you’re not familiar with how the foreign tax credit is calculated, have a look at CRA form T2209 (you can download it from the CRA website) – the calculation, at the top of the form under “Federal non-business foreign tax credit” is relatively short and straightforward and the instructions on the form are clear (if you’re in QC and have to file a separate return with Revenu Québec, things will get a bit more complicated). You’ll easily see why someone in your situation “falls through the cracks” as it were in terms of not recovering foreign withholding taxes.
The research in this post and in the white paper is still relevant to your case, so long as you remember to use it correctly – to calculate total fund costs, just use the “TFSA” column (even though your investments are unregistered) to reflect the fact you won’t be deducting withholding taxes, or use some blended “TFSA”/ “Taxable” cost in proportion to the % share deducted if that is the case.
And yes, being in a low tax bracket is a very good thing if you have a large unregistered portfolio!
@CCP:
Total cost for holding International equities inside TFSA seems quite high because of the non recoverable foreign witholdhing taxe(s) … would you suggest avoiding international ETFs inside TFSAs?
Where can i find these witholding taxes with VUN? They dont show up in my transactions like my individual US holdings did.
Thanks for the information, very helpful indeed, but I have a question. If we avoid the high cost of converting currency using Norbert’s gambit with high sums of money we are not cost averaging the currency exchange rates CAD/USD. Doesn’t it makes sense to use Canadian etfs to “buy” USD at different rates, I am taking this idea because like you explained before the currency exposure is the one of the underlying ETFs.
Thanks and keep the good work.
thank you very much, very useful info here as always
As I understand it US reits such as O are treated the same way, 15% withholding for small individual non registered holdings and similar capital gains treatment?
@Jas: One should still hold international equities as part of the portfolio, but TFSAs are clearly not the ideal place to hold them. An RRSPs is often better, and in a large portfolio where registered accounts are maxed out, it often makes sense to keep them in a non-registered account.
@bob: The withholding tax is taken off before the dividend is paid to the fund and it doesn’t show up in your list of brokerage transactions. If you hold VUN in a non-registered account, the amount paid will be on your T3 slip.
@k-dev: I don;t see any benefit in “cost averaging” currency conversions, which is really just a form of market timing.
@lester: Yes, income from US REITs is also subject to the 15% withholding tax. Income from global (non-US) REITs is subject to the withholding tax imposed by the other countries, just as with international stocks. Justin has written about this here:
http://bit.ly/1h9aKV2
Thanks Dan, this is extremely helpful. I was getting a bit tied in knots obsessing over these details, so it’s nice to see the issue is largely irrelevant.
For small accounts, only the most fanatical will bother with Norbert’s gamble and likely not benefit much, if any (but it will give them something to do on Wednesday afternoon). And for the larger accounts, well… if you’re account is in the millions, a few hundred here or there isn’t really going to break you. In fact, those with a high net worth are probably costing themselves more money delving into the nuances of currency conversions and withholding taxes as they relate to registered/non-registered accounts than spending that same time in their respected fields.
Unless, of course, they are also bored and want to do something on a Wednesday afternoon.
:)
CCP : I think there something important that you miss in taxable account cost calculation that should be taken in consideration. In taxable account the foreign dividend are tax like income, so the total cost is lot more expensive that what is look like.
I know you want to isolate the withholding tax factor but I fell this issue should be more about the total cost with all the tax you have to pay.
@CCP:
Can you confirm that an ETF’s management fee is tax deductible as explained in this blog post from steadyhand? The article is about mutual funds but I would guess it is also true for ETFs?
http://www.steadyhand.com/industry/2010/07/08/management_fee_deductibility_clearing_the_air/
The reason is that the management fee is deducted from the most tax expensive distribution (income, foreign dividend) instead of capital gains or eligible dividends.
This means that the absolute “aftertax” MER inside taxable accounts for US and international ETFs is a considerably lower than what is reported in your white paper.
One further wrinkle for those with very large portfolios: if your total net worth at death is USD 5.3 Million or more (as of 2014), then any US assets over USD$60k are subject to US estate duty. US assets includes stocks, ETFs etc bought from US stock exchanges. Even if your US assets are less than $60k, I understand that your executers are obliged to file a US return, and the US IRS are pretty inflexible. You may not care, as this is only a burden on your executers after your death; but if you do care, this might be one factor to lead you to avoid owning any US domiciled ETFs.
@Francis: First, the amount of income tax payable would depend on the individual investor’s circumstances. And second, the main point of the paper was to compare differences between similar Us and Canadian-listed ETFs, and these are subject to the same income tax rules. Whether you hold VTI or VUN makes a difference in terms of withholding taxes, but no significant difference in terms of income taxes.
@Jas: Here’s a response from Justin: “MERs are technically tax-deductible in taxable (as well as registered accounts). As your reader mentioned, the fund company offsets their expenses first with interest income or foreign dividends, then with Canadian dividends, and finally with capital gains. This includes active mutual fund MERs, passive ETF MERs and fee-only management expenses. If readers want to run their own personal cost calculation, they could multiply the ending MER or ER in the equations by (1 – marginal tax rate).”
The upshot is if you’re in a high tax bracket, Canadian-listed ETFs could look even better in taxable accounts and RRSPs. It just becomes very hard to present this in a white paper since everyone’s income tax situation is different. At some point the analysis becomes unwieldy and no longer helps people make good decisions.