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.
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.
@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.
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?
@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.
@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?
@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.
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?
@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.
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?
@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.
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?
@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.
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?
@Chris: No capital gains are taxable in a TFSA. And the foreign withholding taxes are deducted automatically, so there’s nothing to report.
Hi, we finally took a close look at our finances and are now planning to transfer our investments (as cash) from our mutual fund provider to Questrade. Once we confirm our risk tolerance an asset allocation, I think our most simple and most efficient option for our TFSAs and RESPs is to buy TSX listed ETFs (for Canadian, U.S., and other international equity exposure).
For our US and other international exposure (approx 30-40K) in our RRSPs, we aren’t sure if we should buy the TSX listed version or the US listed version of an ETF. My understanding is, If we buy the US listed version in USD we pay a lower MER, are exempt from 15% withholding tax, but get dinged converting currency (unless I can pull off a Norbert’s Gambit). If we buy the TSX version in CAD, we don’t have to convert currency but the fund is subject to 15% withholding tax and we pay a higher MER.
1) I read elsewhere that, roughly, if we were going to hold the ETF for <10 years, the TSX version is better, but if planning to hold for more than 10 years (which is our plan), the US listed version is better. Does this sound like a reasonable ballpark estimate to you?
2) Is it a good idea to convert our current 30K to USD and buy the US listed version now, regardless what we do with our approx $2-2500/yr contribution for the next 20 years?
3) If I think the CAD will appreciate significantly vs the USD in the next couple years, should I buy the TSX listed version now, and if the CAD does indeed appreciate significantly, sell the TSX version, convert to USD, and buy the US listed versions, or would that be pointless?
4) Would the tax efficiency/ your recommendation change any if the ETF holds all/mostly International ex N.A. stocks vs. only US stocks? (ie. for our ex-N.A. equity exposure, assuming we could find 3 ETFS with the same equities we wanted, is it best to buy the TSX ETF that owns the ex-N.A. stocks directly, the TSX ETF that simply owns the US listed ETF (wrap structure you noted in original post I think), or the US listed ex-N.A. ETF? If I understand your original post, the best option would be the TSX ETF that owns the ex-N.A. stocks directly?
I realize that's a lot of questions for a couple small potatoes, but any insight would be greatly appreciated!
@Dan: Congratulations on making the move. You’ve already taken the biggest step, and I want to encourage you not to get stuck in the weeds, as is so common with new DIY investors.
My inclination is to suggest you not US-listed ETFs for now. You will be complicating your experience a great deal for a pretty marginal benefit. As you note, the savings in withholding taxes are quite small for international ETFs if you use a fund like XEF or VIU. It’s onlt the US equity portion where you are saving 15% of the dividend, which works out to less thasn 0.30% overall these days (based on a yield under 2%). So do the math first to see if it is worth it. If the holding is $20,000, your savings would be about $60 a year.
Very important to understand that the USD/CAD exchange rate has nothing to do with the decions to use US-listed ETFs:
You may want to get everything set up with TSX-listed funds first and make sure you’re comfortable. Then, if you want, try Norbert’s Gambit for a small amount and see how it goes. If you find it easy, you can consider it for larger amounts later:
Great. Thank You. I’m still wrapping my head around your link to your post on exchange rate and exposure, but I think I get one of the main points, that my exposure is to the underlying equities in the ETF, not to the currency the ETF is trading in. Eventually, I’d still like to figure out a way to benefit long term off the fluctuating exchange rate, maybe by increasing my % allocation of monthly contributions to US equities in years when the loonie is approaching parity, and cutting back on contributions to US equity when the loonie is low? But that will have to wait until I better understand what I am doing.
Right now we are going to take your advice and keep it simple, steer clear of the weeds, buy TSX listed ETFs for all our accounts and basically follow the CCP Individual ETF Portfolio. Thanks again!