Justin Bender and I have just completed the second edition of our popular white paper, Foreign Withholding Taxes: How to estimate the hidden tax drag on US and international equity ETFs.
Originally published in 2014, the paper explains how many countries impose a tax on dividends paid to foreign investors—most notably a 15% levy on US stocks held by Canadians. When the first edition appeared, foreign withholding taxes were not well understood by many investors and advisors, and even the ETF providers rarely discussed them. In the two years since, the issue seems to be getting more recognition. Both Vanguard and iShares, for example, have made changes to their international equity ETFs to make them more tax-efficient. That’s great news, though it also made the first version of our paper somewhat dated.
In this new edition, we’ve made some significant changes. First, we’ve removed corporate accounts from the discussion and focused on personal accounts only. We’ve also used some different ETFs in our examples, including the Vanguard U.S. Total Market (VUN), the Vanguard FTSE Developed All Cap ex U.S. (VDU) and the iShares Core MSCI EAFE IMI (XEF). Finally, we’ve added some additional commentary to help investors make better decisions.
We invite you to dive into the paper for all the details, but if you’re looking for a summary of the important points, here they are:
- In an RRSP, using US-listed ETFs for foreign equity holdings can bring a significant tax advantage. That’s because these securities are exempt from the usual 15% withholding tax on dividends imposed by the US government. Assuming a 2% yield on US stocks, the tax savings amounts to 0.30%.
- In taxable accounts, Canadian-listed ETFs are generally a better choice. US-listed ETFs offer little or no tax advantage, and in cases where there would be a small benefit it’s likely to be outweighed by other considerations, including currency conversion costs and additional record-keeping—more on this below.
- In a TFSA or RESP, you should always use Canadian-listed ETFs for foreign equities. US-listed ETFs offer no tax advantage whatsoever, and in some cases they’re significantly less tax-efficient.
- Finally, if you use Canadian-listed ETFs for international equities, look for funds that hold the stocks directly rather than through an underlying US-listed ETF. The “wrap” structure imposes a second level of foreign withholding tax that is not recoverable. To review the example we use in the paper, XEF holds its stocks directly, and Justin estimated its tax drag at 0.26% in an RRSP or TFSA. By comparison, VDU gets its exposure via an underlying US-listed ETF, resulting in foreign withholding taxes of 0.59%. (Note that Vanguard’s newer international equity fund, VIU, holds its stocks directly, so its tax drag should be similar to that of XEF.)
Understanding the trade-offs
US-listed ETFs have long been popular with Canadian investors because of their low fees, and if you’ve read through our paper you’ll understand they can also have significant tax benefits. With our clients, we regularly use US-listed ETFs in RRSPs and other retirement accounts for these reasons. But with DIY investors we usually don’t recommend this, unless you can be sure you understand the trade-offs. As for taxable accounts, the case for using US-listed ETFs is even weaker. Here’s why:
The cost of currency conversion. Any benefits from the lower fees and taxes on US-listed ETFs will be reduced or even eliminated if you fail to avoid the potentially high cost of converting currency before purchasing them. In most cases you should have a source of USD income or be comfortable using Norbert’s gambit—otherwise, stick with Canadian ETFs.
Here’s a bit of good news from our findings, which Justin explained in more detail in a recent blog. It turns out that in an RRSP, the foreign withholding taxes on XEF, a Canadian-listed ETF, are almost exactly the same as those of its US-listed equivalent, the iShares Core MSCI EAFE (IEFA). So this is one place where you really don’t need to use a US-listed fund.
Record-keeping and reporting. In taxable accounts, tracking the adjusted cost base of US-listed ETFs is significantly more difficult, because you will need to look up the exchange rate on the settlement date of every transaction. This adds an additional cost, especially if you pay a tax preparer to do it for you.
US-listed ETFs are also considered foreign property by the Canada Revenue Agency, and non-registered holdings with a book value of $100,000 CAD or more must be reported annually using the T1135 form. Additional reporting is required when the total cost of your US-listed ETFs is over $250,000 CAD.
US estate taxes. Granted, this isn’t a problem for most of us. But wealthy Canadians may be subject to US estate taxes if they have significant holdings in US-listed ETFs, even if these are held in an RRSP.
My name is Adi and I have recently starting to research more about ETFs and want to thank you immensely for your content
I’m looking at holding ETF’s in my RRSP and TFSA accounts and looking at a long-term (“buy and hold”) strategy to save for my retirement. Specifically, I’m interested in CAD listed ETF’s which invest in US stocks-specifically-VFV, VUN, XUU. I was hoping to clarify some questions around taxation
1. I know you mentioned that if we invest in CAD listed ETF’s investing in US stocks, then we are subjected to withholding taxes. I’m planning to go with a DRIP for the above ETF’s I mentioned. In this case, will I still be paying withholding taxes if I choose DRIP
2. If I were to buy the US-listed ETF’s, I would be getting fewer units given that CAD currency has a lower value than US $ and the NAV of the US ETF’s is higher–> So, would this be a good strategy to hold fewer units of a US-listed ETF than owning more units of a CAD equivalent like VFV?
3. Let’s say, I retire 30 years from now and I plan to sell my CAD listed ETFs (e.g. VFV) to withdraw money for retirement–> In this scenario, will I be paying any tax on the US side?. I’m really concerned about this as paying US taxes on a huge amount at the end of 30 years will dent by retirement savings.
Thanks again for your help
@Adi: Thanks for the comment.
1. Using a DRIP has no effect on foreign withholding taxes. They will still apply even if you reinvest the dividends.
2. The unit price of an ETF is arbitrary and has no meaningful effect in your portfolio.
3. The only tax you will pay ion withdrawals from your RRSP is Canadian income tax. You will not owe any US taxes.
Hey in which account should i hold XUU etf ??
Thanks for this great post/paper. Within an RRSP, for the developed markets portion, is VEA (US exchange) or XEF.TO better? (I use Norbert’s Gambit.) The MER and withholding taxes are lower for VEA, but the currency risk is lower for XEF.TO, correct?
@Nigel: This is a good question, as these issues are the source of much confusion.
– Because XEF holds international stocks directly (rather than via an underlying US-listed ETF), the foreign withholding tax is very similar to that of VEA in an RRSP. VEA does have a lower MER, so if you are able to exchange currently cheaply using Norbert’s gambit, then it can be a good choice in an RRSP, but primarily because of its lower cost, not foreign withholding taxes. (For the record, the US equivalent of XEF is actually IEFA.)
– The currency risk in VEA and XEF are exactly the same. Assuming you measure your returns in CAD, they are equivalent. The fact that VEA trades in USD does not actually give you exposure to the USD/CAD exchange rate. This is not very intuitive, I realize! This should help: https://canadiancouchpotato.com/2014/01/16/currency-exposure-in-international-equity-etfs/
Great post and book! Please keep up the great content!
Question about U.S listed ETFs held in an RRSP/LIRA for Canadians. Do we need to complete form W-8BEN (for individuals) not to pay FWT?
@Mike: Many thanks for the comment. It’s best to check with your brokerage to confirm whether you need a W-8BEN for your RRSP. If you are already holding US-listed ETFs, you should be able to tell from your monthly statements whether FWT is being withheld. If it’s not, then you should be fine.
Thank you for the feedback Dan. I have a related question for FWT. I verified my statements in my TFSA, non registered and RRSP accounts and noticed for example XUU, VFV and XEF also did not appear to have FWT. I multiplied my number of shares by what was declared as a dividend on Vanguard/Ishares sites for these ETFs and it equalled what was paid as a dividend to me in my statements (as opose to a lower amount net of FWT). There was no other line on my statement that showed any FWT. This was true for both my brokers accross all these accounts. Does Ishares/Vanguard list the dividends on their site net of FWT? For my non registered account I receive the amount on my T3 of FWT paid but was suprised to see my units*dividend declared on Ishares/Vanguard site equal to what was paid to me with no other fees on my statements. Any other thoughts?
@Mike: You would only see FWT on a statement if you held US-listed securities. Canadian ETFs like XUU, VFV and XEF have FWT taken off at the fund level, not by your brokerage, so the distribution amounts they report are indeed net of FWT. That’s why the FWT is unrecoverable in RRSPs and TFSAs. If you hold these ETFs in a taxable account, however, then the amount of FWT will appear of the T3 slip and you can recover it when you file your tax return.
This blog should clarify: https://canadiancouchpotato.com/2016/07/18/how-foreign-withholding-taxes-affect-returns/