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.