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Foreign Withholding Taxes in International Equity ETFs

2017-12-02T23:28:28+00:00September 12th, 2014|Categories: ETFs, Taxes|Tags: |64 Comments

It seems Canadian ETF providers are paying more attention to foreign withholding taxes these days. Not so long ago, you rarely heard anyone discussing this hidden drag on returns. But last month BlackRock announced a significant change to its iShares Core MSCI EAFE IMI Index ETF, ticker symbol XEF, which makes up the international equity component of my Global Couch Potato portfolio. The change was made specifically to reduce the impact of foreign withholding taxes.

When the fund was launched in April 2013 it simply held a US-listed ETF, the iShares Core MSCI EAFE (IEFA). That was a convenient way of getting exposure to the 2,500 or so stocks in this large index. Over the last three weeks, however, XEF has gradually bought up the individual stocks in the index and now holds them directly. According to BlackRock:

“XEF will generally no longer be subject to U.S. withholding taxes. While foreign withholding taxes will continue to apply to dividends paid on certain international equity securities included in the XEF Index, it is expected that the change in investment strategy implementation will reduce the overall amount of withholding taxes borne directly or indirectly by XEF.”

A refresher course on foreign withholding taxes

A few words of explanation will help here. Most countries impose a tax on dividends paid to foreign investors. But when a Canadian ETF holds a US-listed ETF of international stocks (sometimes called a “wrap” structure) there may be two levels of withholding tax. What we’ve called “Level I” tax is levied by the countries where the stocks are domiciled (in this case, European and Asian countries), while “Level II” is an additional 15% withheld by the US government before the US-listed ETF pays the dividends to the Canadian ETF.

In our recent white paper, Justin Bender and I used a metaphor: “You can think of Level I foreign withholding tax like a departure tax you pay when taking a direct flight to Canada from a foreign country. Level II tax is like a second departure tax you pay when an overseas flight to Canada has a layover in the US.”

When you hold international equities in a non-registered account, you may be able to recover the final level of withholding tax by claiming the foreign tax credit on your return. But there’s no opportunity to recover withholding taxes if you hold the fund in a RRSP or TFSA.

So when a Canadian ETF uses a wrap structure with an underlying US-listed ETF of international stocks, withholding taxes apply as follows:

Taxable account RRSP or TFSA
Level I (international) not recoverable not recoverable
Level II (US) recoverable not recoverable

When the international stocks are held directly rather than via a US-listed ETF, there is a significant tax advantage:

Taxable account RRSP or TFSA
Level I (international) recoverable not recoverable
Level II (US) does not apply does not apply

The other side of the story

Many of iShares’ other international equity funds still use a US-listed ETF as their underlying holding, and all of Vanguard Canada’s use this structure. In recent communications with advisors, Vanguard has pushed back against the suggestion that the wrap structure is inherently more costly, with some justification.

First, some investors may believe that holding a US-listed ETF results in “double taxation.” They correctly point out that’s not true: while there are two levels of foreign withholding tax with this structure, investors don’t pay twice as much. The amounts withheld by overseas governments is quite a bit less than the 15% levied by the US. Justin’s analysis (explained in detail in our white paper) estimates it at approximately 7.5% for developed markets in a US-listed ETF. So it’s not double taxation.

Vanguard and iShares also contend, reasonably, that the additional taxes have to be weighed against the cost savings from holding a US-listed ETF. Remember, many of the foreign equity ETFs we’re talking about here have thousands of holdings in dozens of countries. Replicating these indexes with individual stocks would be costly, and there is an argument to be made for using highly liquid US-listed ETFs to get the same exposure, at least until the Canadian ETF has gathered significant assets (XEF is now approaching $200 million).

Right now, a lot of this discussion is abstract: we won’t really be able to compare the all-in cost of the various ETFs until they have a longer track record. But in the meantime, it’s good to know that ETF providers are aware of the issues, and that they’re taking steps to improve their offerings.


  1. Dave April 7, 2015 at 3:21 pm

    I have become a couch potato in the past year my portfolio consists of about 15% US. My question is, I’m trying to minimize the foreign withholding taxes, and I’d like to know if it’s better to own an international or US ETF with the American cash? The third option would be to convert it back to CDN but that seems to me to be the worst of the three choices.

    Thanks for all your help and guidance.

  2. Canadian Couch Potato April 7, 2015 at 3:49 pm

    @Dave: The first question should always be, “How much US and how much international equity is appropriate in my portfolio?” You should never choose one over the other because of foreign withholding taxes. The second question is, “What type of account is most appropriate for this asset (RRSP, TFSA or non-reg)?” Only then should you consider what type of fund to use.

  3. Dave April 7, 2015 at 3:59 pm

    i did a fairly terrible job of explaining myself. I own both US and international etfs (VUN/XEF/XEC). As well as smaller portions of the TD e-series International and US index. All in an RRSP.

    I have the last bit of evidence of my stock picking days remaining in a U.S. currency RRSP and I am going to sell it when I rebalance shortly.

    From what I am reading it seems to be its best to buy a U.S. ETF with the American dollars. Do you agree?

  4. Canadian Couch Potato April 7, 2015 at 4:11 pm

    @Dave: OK, now I understand. In general, if you are holding US or international equities in your RRSP, then US-listed ETFs will have the lowest foreign withholding taxes. With Canadian-listed ETFs or e-Series mutual funds, the foreign withholding taxes will be deducted and are not recoverable.

  5. Bibi August 26, 2015 at 11:08 pm

    @CCP could you please explain why the difference between VEA and XEF is so big in an RRSP account in this article?:

    iShares MSCI EAFE IMI (XEF) CDN 0.94%
    Vanguard FTSE Developed Markets (VEA) US 0.31%

    If the XEF now is going to hold international stocks directly shouldn’t be the difference be only the MER of the 2 ETF’s?

  6. Canadian Couch Potato August 27, 2015 at 8:34 am

    @Bibi: Yes, now that XEF no longer uses a US-listed ETF as its underlying holding its total cost is now lower than it was. This post was written before that change was made.

  7. Bibi August 30, 2015 at 2:42 pm

    Thanks for the quick reply!
    Vangaurd are changing the investment strategies (again!) for several ETF’s this year. They’re adding small cap and Canada to VEA. I may be okay with small cap but Canada is not something I wanted to see in VEA since it messes up my asset allocation to Canada. I don’t know yet how much Canadian equity they are actually adding but I’m starting to think about alternatives. XEF is on of them. Is XEF a good alternative to VEA? Also what else would you recommend as a replacement to VEA?

  8. Canadian Couch Potato August 31, 2015 at 8:16 am

    @Bibi: The allocation to Canada will be very small and probably trivial. You could simply adjust by reducing your Canadian equity allocation slightly, but even that is not necessary. If you really want to change, have a look at the EAFE ETFs from iShares. Also note that Vanguard Canada is launching new ETFs that exclude Canada.

  9. Bibi August 31, 2015 at 1:39 pm

    iShares has many ETF’s for specific countries such as Japan, Germany etc.. The MER is slightly higher around 0.48. VEA has almost 1/4 allocated to the UK and Australia, countries I was thinking to avoid for now due to indications of the housing bubble there. Would you recommend against specific countries selection?

  10. Canadian Couch Potato August 31, 2015 at 2:42 pm

    @Bibi: I was thinking of iShares ETFs that are comparable to VEA. These would include XEF (listed on the TSX) or EFA and IEFA (listed in the US). I would not recommend trying to anticipate housing bubbles in foreign countries.

  11. Allan B May 24, 2016 at 2:55 pm

    My question is how are the dividends paid by CUD [ iShares US Dividend Growers Index ETF (CAD-Hedged)] are taxed in a corporation. Are they treated as dividends from a Canadian Corporation and qualify for the Small Business Deduction tax rate, or are they taxed as interest income at the ~50% rate? So would the CUD ishares best be held in a small business, in a personal account, in a TFSA or in an RRSP? Does anyone know if there is an article or table on the internet that explains all of this?

  12. Canadian Couch Potato May 24, 2016 at 4:03 pm

    @Allan B: Because the dividends are from US companies (even though the ETF is Canadian) they are taxed as foreign dividends, which is taxed at the highest rate in a corporation.

  13. Chris June 19, 2017 at 3:01 am

    If I hold an US ETF that holds international securities in a TFSA, do I have to pay any tax on capital gains? If so,the only tax I have to pay is the 2 layers of withholding tax of dividends and those are automatically deducted?


  14. Canadian Couch Potato June 19, 2017 at 7:20 am

    @Chris: No capital gains are taxable in a TFSA. And the foreign withholding taxes are deducted automatically, so there’s nothing to report.

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