Your Complete Guide to Index Investing with Dan Bortolotti

Foreign Withholding Taxes Revisited

2018-09-17T20:57:56+00:00July 11th, 2016|Categories: ETFs, Taxes|Tags: , |121 Comments

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.

The takeaways

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%.
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  • 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.
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  • 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.
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  • 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.

 

121 Comments

  1. Ernin March 18, 2018 at 5:25 am

    Hi Dan – thank you for being a key reason why I’m so interested in personal finance & investing!

    To optimize FWT in my portfolio, all my US-held ETFs would need to be in my RRSP. This means that my TFSA will be exclusively CAD Equity & Bond ETFs (VCN and ZAG). To keep things balanced, there will also be some VCN in my RRSP portfolio.

    Only having CAD Equity & Bond ETFs in my TFSA lowers that accounts’ diversification, but does that matter in the big picture? It makes me wonder if I’m not realizing any potential complications upon withdrawal (e.g., retirement). Do you have any thoughts on that?

    For fun, I worked out the MER & FWT difference if I swapped my CAD-listed ETFs XUU, XEF, XEC with US counterparts ITOT, IEFA, and IEMG in my portfolio. I hold them at 30%, 20%, 10% respectively of my overall portfolio.

    I calculated a difference of 0.35% overall, when taking those proportions into account. So it’s aligned with your blog! When looking at a 25-30 yr time horizon and regular contributions, it came out to quite the opportunity cost (>$25k lost on taxes & fees, assuming a 7% growth).

    In my opinion, the theoretical $1k / year ‘cost’ makes the effort of doing Norbert’s gambit and adjusting for fluctuating exchange rates is worth it but am feeling I must be missing something obvious! Too good to be true? :)

  2. Canadian Couch Potato March 18, 2018 at 8:34 am

    @Ernin: Thanks for the comment. Optimizing for foreign withholding taxes can be problematic because there are other factors that become less optimal when you use FWT as the only criterion for asset location. For example, filling up your TFSA with bonds (an asset classes that is likely to see much less growth over time than equities) is not the best way to take advantage of the permanent tax-free shelter this account offers. It probably makes more sense to keep the highest-growth assets there, even if it means paying a little foreign withholding tax.

    Also, over time, the size of a TFSA and an RRSP will often diverge greatly: RRSPs allow far more contributions room, so they will usually get much larger. At some point it becomes impossible to optimize because of limited room in each account.

    As for the cost differences between US-listed and Canadian ETFs, the advantage of US-listed ETFs is certainly compelling on a spreadsheet. The challenge (as with so much in investing) is that almost no one executes those plans with discipline. If you are comfortable doing Norbert’s gambit regularly and dealing with the other challenges of managing a more complex portfolio, it will be cheaper in the long run if you do everything right. But the reason I don’t recommend US-listed ETFs as the default choice anymore is that I have heard from countless investors who were not able to maintain their portfolio efficiently.

  3. Ernin March 18, 2018 at 11:30 am

    @Dan Wow, thank you for your quick response!!

    Yes, the relatively slower growth of bond ETFs was definitely a concern and why I originally put them in my RRSP. Right now, my remaining RRSP room and my entire TFSA are for equity ETFs, without worrying about putting more US/Intl/CAD ETFs in one or the other. They’re all CAD-listed.

    If I’m understanding correctly, if one is comfortable with doing Norbert’s gambit regularly and dealing with some additional complexity, then it can incur relatively high cost savings in the long run. In my case, I am estimating I can retire half a year earlier which would be quite a nice option to have! This of course assumes that the US-CAD dollar doesn’t go completely crazy for a long period of time when I’m about to retire.

    However, if I strive for having the same portfolio mix in my RRSP and TFSA while optimizing my RRSP for FWT, I need to be more mindful.

    1 – I would need to keep track of the exchange rate when balancing my overall accounts, to ensure my overall portfolio mix is on target
    2 – I essentially would go from 5 CAD-listed ETFs to 5 CAD-listed ETFS + 3 US-listed ETFs, so on paper / spreadsheet this might look more complicated
    3 – A bit of additional risk of highly fluctuating exchange rates when I’m close to retirement
    4 – Anything else?

    Norbert’s Gambit is no problem, I’ve done it a few times and have helped a couple of friends figure their way around it as well. I’ve also found that balancing every quarter is about the right cadence for me, and I don’t fuss about the markets in between. My spreadsheet is set up to tell me what to do automatically, and I get a sense of satisfaction when I’m done. I find it fun in a weird way :)

  4. Miwo May 18, 2018 at 2:10 pm

    Hello Dan,

    My son is buying VGRO in his TFSA account. He can only small amounts weekly in questrade. Will he have more difficult time during tax season with keeping small purchases organized for the foreign withholding tax? I might be confusing what you are saying about the paperwork headache in taxable acccounts.

  5. Canadian Couch Potato May 18, 2018 at 2:17 pm

    @Miwo: You don’t have to worry about any tax reporting in a TFSA, so there’s nothing to be concerned about. VGRO is a great choice in a TFSA.

  6. Miwo May 18, 2018 at 4:42 pm

    Hello Dan,

    Just to show what a newbie I am, how does CRA take its withholding tax from VGRO in the TFSA? Is it taken only if we sell? Will Vanguard be sending us some reporting slip?

  7. Canadian Couch Potato May 19, 2018 at 11:50 am

    @Miwo: CRA does not deduct foreign withholding taxes. They are deducted at the fund level, like fees. In a TFSA there is nothing to report. In a taxable account, the amount for FWT deducted will appear on your T-slip and you can claim the foreign tax credit on that amount to receiver it.

  8. DP July 3, 2018 at 1:29 pm

    Hi Dan,
    I am having trouble understanding foreign withholding tax. I am new to investing as of this fall and in RRSP I have 45k split evenly between VCE and VSP. In TFSA I have 17k in VAB. I contribute 2500 / month and I want to have a 80/20 aggressive portfolio. In one year I will have maxed contributed to TFSA and RRSP and will start contributing to a taxable account. In 8 years I will want to live off of the dividends of my portfolio. Can you please advise me on your suggested holdings and their respective locations? I am grateful for all of the info I gather from your site and look forward to reading your reply.
    Thanks

  9. Canadian Couch Potato July 3, 2018 at 2:39 pm

    @DP: Your question is more complicated that it may appear on the surface, and FWT is just one small piece of the puzzle. FWT is only relevant in your RRSP, and to avoid it you would have to use a US-listed ETF in place of VSP, which you may not want to do. As long as you are using only an RRSP and a TFSA, then it makes sense to keep the bonds in the RRSP. Otherwise, there are just too many factors to consider in the decision.

  10. LC July 11, 2018 at 8:31 pm

    Hi Dan,

    Thx v much for all the great insight you are sharing. I have read the paper but have found conflicting/confusing information elsewhere so I figured I’d ask..

    I have a few index funds covering US equities (TDB902, TDB908), international equities (TDB911) and emerging mkts (CIB519), all of which in both RRSP, LIRA, RESP and TFSA.

    What I think I understand is that for US equities within the RRSP/LIRA, no tax withholding applies. However, it looks like it would within the RESP and TFSA. Is that the case even with these mutual funds I mentioned or is it only for funds listed in the US?

    Thanks so much for sharing your brain with us!

    LC

  11. Canadian Couch Potato July 17, 2018 at 10:57 am

    @LC: Foreign withholding taxes will always apply if you hold mutual funds. There is no exemption in an RRSP (or LIRA) unless you use US-listed ETFs.

  12. David August 6, 2018 at 11:31 am

    I have found this article quite helpful. However, I have a very basic, perhaps rather naïve question. Why do some ETFs not hold their stocks directly? I own some iShares which hold other US listed iShares instead of the US stocks. Why is that?

  13. Canadian Couch Potato August 6, 2018 at 2:52 pm

    @David: The wrap structure allows for economies of scale. Since many of the US ETFs have enormous assets under management, the smaller Canadian ETFs can piggyback on them. Using an underlying US-listed ETF is much more efficient than buying the hundreds or thousands of stocks individually. In the past, some index ETFs would use “representative sampling” for large indexes. That is, instead of buying all the stocks they would buy a subset of them hoping to capture similar performance with fewer trades. But this proved to be unreliable compared with the wrap structure.

  14. Jashan Oberoi September 17, 2018 at 5:11 pm

    This blog is very informative. Thank you for providing us with so many valuable articles. May you please answer my one question.

    May you comment on the withholding tax on fund?

    U.S. Dividend Appreciation Index ETF (VGG) vs U.S. Dividend Appreciation Index ETF (CAD-hedged) (VGH). Because these funds are Canada based, does it mean that there wont be any tax to be paid on the dividends? What would be the difference between these two funds if we consider it for our tfsa account?

    Thanks

  15. Canadian Couch Potato September 17, 2018 at 9:00 pm

    @Jashan: Both of the funds you mention are what we call Type B funds in the white paper: Canadian ETFs that hold US-listed ETFs of US stocks. In a TFSA, 15% withholding tax applies on dividends and this is not recoverable.

  16. Albert September 26, 2018 at 1:01 pm

    Thank you Dan and Justin for this very informative paper (and all that I have learned at Couch Potato)!

    My question is about the fluctuation of CAD vs USD. Wouldn’t this whole tax saving by using US-traded ETF in RRSP just be wiped out if the Canadian dollar is strong (stronger than today) when I finally decide to cash out? I recognize this is a big IF and we will never be able to predict what way the CAD vs USD conversion will go. However, at the current $1CAD hoovering around 75 cents US it seems quite realistic that even if I cashed out at $1CAD= 80 cents US that tax savings of 0.3% (on assumed 2% yields) would be wiped out and then I also lose some because a stronger CAD. Norbert’s Gambit is a doable and efficient low-cost way of converting currencies but it doesn’t change the fact that there is fluctuation in the CAD vs USD.

  17. Canadian Couch Potato September 26, 2018 at 2:35 pm

    @Albert: The key point here is that if you hold US equities using a Canadian-listed ETF you have exactly the same currency exposure as a US-listed ETF. (Unless you specifically use a Canadian ETF that employs currency hedging, which I don’t recommend.)

    This idea is not very intuitive, and it trips up many investors. But it’s important to understand that whether you use VTI (US-listed) or VUN (Canadian-listed), for example, you have the exact same exposure to the US dollar.

    https://canadiancouchpotato.com/2014/01/13/how-a-falling-loonie-affects-us-equity-etfs/

  18. Linda Browne November 8, 2018 at 4:21 pm

    Hi Dan,

    I just received confirmation from ishares Canada that XEF uses an underlying US-listed ETF in combination with individually-listed stocks. It’s also the largest holding. Would you still recommend it?

  19. Canadian Couch Potato November 9, 2018 at 1:48 pm

    @Linda: Many ETFs do this for cash management: they hold a small amount in an ETF to maintain exposure to the index until they have a sufficient amount to buy up the individual stocks cost-efficiently. This might be 3% to 4% of the ETF’s assets on some days, but as of November 8, it was 0.02% of the XEF. It’s a trivial concern for investors in the fund.

  20. gocanada November 11, 2018 at 11:17 am

    Hi Dan,

    Great info. Have you looked at how foreign withholding taxes work for US ETFs that are essentially “funds-of-funds”?

    For example:
    1. US-listed ETF composed of other US-listed ETFs, that in turn hold US Equities
    2. US-listed ETF composed of other US-listed ETFs, that in turn hold Developed Market Equities
    3. US-listed ETF composed of other US-listed ETFs, that in turn hold Emerging Market Equities

    Thanks!

  21. Canadian Couch Potato November 11, 2018 at 2:50 pm

    @gocanada: In example 1 there would be no effect. In the other two there would presumably be Level 1 FWT, but these would be based on the tax treaties between the US and the overseas countries. But this all sounds hypothetical: there is no reason for Canadians to use ETFs with this structure when there are plenty of alternatives that hold the stocks directly.

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