In our newly revised white paper, Justin Bender and I explain the hidden cost of foreign withholding taxes on US and international equity ETFs. I gave an overview of the most important points in my previous blog post. Now let’s look at one of the more subtle ideas: how those taxes affect your personal rate of return.
Meet Julie, an investor who is looking to hold US equities in both her RRSP and non-registered account. After reading our paper, Julie knows the US imposes a 15% withholding tax on dividends paid to Canadians, and with US stocks yielding 2% these days, that would result in a drag of about 0.30%. So she decides on the following:
- In her RRSP, Julie uses the Vanguard Total Stock Market ETF (VTI), because this US-listed fund is exempt from withholding taxes.
. - In her taxable account, Julie uses the Vanguard U.S. Total Market Index ETF (VUN), the Canadian-listed equivalent of VTI. This ETF is denominated in Canadian dollars, which makes it cheaper and easier to trade. Although the fund is not exempt from the foreign withholding taxes in a non-registered account, Julie understands that these taxes are recoverable by claiming the foreign tax credit.
This is a good decision on Julie’s part. When choosing an ETF for maximum tax-efficiency, she is right to treat “exempt” and “recoverable” as though they were equivalent. In other words, whether Julie avoids foreign withholding taxes altogether (as she’s doing in her RRSP) or paying them upfront but later having them refunded (as in her non-registered account), the overall impact is the same. However, these two situations affect will affect her personal rate of return in different ways.
Phantom outperformance
Let’s look at Julie’s RRSP return first. We’ll assume her US-denominated holding in VTI is the equivalent of $10,000 CAD. If the ETF pays a dividend of 2% during the year, she’ll receive cash distribution of about $200. (I’m ignoring the effect of the ETF’s management fee to simplify.) Because US securities are exempt from withholding taxes in RRSPs, Julie will see the full $200 paid into her account. When she calculates her personal rate of return, that entire dividend will be included in her performance numbers.
Now let’s see how this differs in her non-registered account. Here we’ll assume Julie holds the same $10,000 worth of VUN. Because this fund uses VTI as its underlying holding, we can assume the gross dividend will be the same $200. (Again, we’re ignoring the small effect of fees to illustrate a point.) But in this case, the 15% withholding tax will apply, so Julie will receive only $170 in cash.
At tax time, Julie will receive a T3 slip from Vanguard indicating that she paid $30 in foreign taxes, and she can claim this on her tax return. She’ll then receive a credit for that amount, reducing her overall income tax bill by $30. That’s what we mean we when say foreign withholding taxes are “recoverable.”
However, if Julie were to measure her personal rate of return in her RRSP and non-registered account, she would find that the former outperformed by 0.30%. That’s because the $30 Julie recovered by claiming the foreign tax credit won’t change the value of her non-registered account, so it won’t figure into her calculation.
You should also understand that when Canadian ETF providers report performance, they do so after subtracting foreign withholding taxes: in other words, they do not presume these taxes will be subsequently recovered. That helps explain the larger-than-expected tracking error on foreign equity ETFs. Over the 12 months ending June 30, VUN reported a total return of 5.20%, compared with its benchmark return of 5.66%. We know that 15 basis points of that tracking error is explained by the fund’s MER. Almost all of the remaining 31 basis points is likely due to foreign withholding taxes. So if you hold this fund in a taxable account and successfully recover these taxes, your overall investment return would effectively be higher than what Vanguard reported.
For more about how to properly measure investment performance, see our earlier white paper, Understanding your portfolio’s rate of return and download our free rate of return calculators.
It’s worth pointing out that this is a *non-refundable* tax credit, not a refundable one. This means it can’t be used to increase your tax refund or to create a tax refund when you wouldn’t have already had one.
Hi Dan, I’ve been following your articles on foreign withholding taxes and I notice you use ETFs for all examples. Can you comment on how these taxes affect Mutual Funds? E.g. I’m using the TD e-series version of your portfolio in both an RRSP and TFSA. Do I need to worry about foreign witholding taxes? Thanks.
@Simon: Good question. We included mutual funds in the first version of the paper. But they are not fundamentally different from ETFs: for a US equity mutual fund such as TDB902, the implications are the same as for a Type B ETF (see the grey box on page 6 of the paper, which explains that holding US stocks directly versus an underlying ETF makes almost no difference). An international equity mutual fund like TDB911 holds its stocks directly, so it is the same as a Type E ETF.
Great article!! I have a professional corporation and most of my investing is done within the corporation (and I do hold both VUN and XEF there) to take advantage of the lower corporate tax rate. Since these dividends are taxable, are they also recoverable as they would be in a personal taxable account?
Thanks!!
Hi Dan,
Thank you for aIl the information you have provided and your website. I’ve learned a great deal over time.
I heard it would be better to fill your RRSP and TFSA before even considering any investing in a non-registered account. That being said, I hold VTI and VXUS in my RRSP, and VCN in my TFSA. I do not have much RRSP room since I contribute to a DB plan.
I plan to retire in about 6 years, and then I will only have my TFSA to invest. Would it make sense to start putting VXUS in my TFSA along with VUN and VCN?
Thank you.
Simon: On your T3/(and RL-16 if living in Québec), box 34/(L for Québec) is filed with the foreign income tax paid. UFile/ImpôtExpert and TurboTax/ImpôtRapide softwares should fill a T2209 form automatically when you paid foreign taxes. Just make sure to specify the right country as source of taxes. UFile use United States by default when you do not specify a country.
Do a quick calculation to make sure you paid about 15% of taxes and not 30% for TD US Index – e. The math is simple: Box 34 / Box 25. If you paid about 30%, call TD and ask them to add a W-8BEN to your file: https://www.td.com/ca/document/PDF/forms/515874.pdf
I notice on the model portfolios that they seem to be directed for RRSP accounts.
What would you recommend as a model portfolio for TFSA accounts for:
– people who have not retired
– people who are now retired
Simon: Just to let you know that my previous post is useful for a non-registered account only.
Sebastien: Thanks for the info. I currently only have investments in RRSPs and TFSAs and I’ve never received any of the tax forms you mentioned. I’m assuming from your second post that that’s normal. Is it correct that I would only expect those forms if I held the funds discussed in a non-registered account? I.e. not in an RRSP or TFSA? Thanks.
@Murray: Corporate accounts add a whole new layer of complexity to this question. Justin and I are planning to write more about this in the future, but for now here are a few guidelines.
It’s not actually about foreign withholding taxes specifically. The issue is that US and international equities are somewhat less tax-efficient in corporate accounts because of the way the dividend refund mechanism works with foreign-source income. In other words, while $1 in Canadian interest and $1 in foreign income are essentially the same in a personal taxable account, this isn’t true in a corporate account. That $1 in Canadian interest is actually preferable in a corp.
Overall, then, it often makes sense to hold foreign equities in a personal non-registered account (or RRSP) and use the corp primarily for Canadian equities and fixed income. This may not be possible depending on your specific situation, but it’s often a good place to start.
@e: It might make sense for you to hold US and international equities in a TFSA, but it almost surely does not make sense to use VXUS there. One of the important takeaways from the white paper is to avoid US-listed ETFs in TFSAs.
My model portfolios are just a starting point and are not designed to be optimal for tax-efficiency, but they are no less appropriate for TFSAs than for RRSPs.
The “retired vs. pre-retirement” question has more to do with the asset allocation you choose, and that is not a simple question. It depends on many factors and can really only be determined after completing a financial plan.
@Simon: That’s correct. You only receive the T3/RL-16 slips for non-registered accounts.
Hi Dan, in follow up to E’s question, I undestand that asset allocation is tremendously important, but leaving it aside, which of the 3 equity choices, Canadian, U.S., or international would be the most tax efficient in a TFSA. Thank, Larry
Thanks Simon for a really good question. Mine exactly.
Thanks so much for this post.
My wife and I keep our investments in my wife’s name because I work and my wife does not. We were expecting to be able to recover the 15% withholding on VTI in her non-registered account, but were surprised to learn that we could not because she did not have a Canadian sourced income withholding to claim it from. At least that is what our accountant said….
I *think* this may be the problem that is raised in the first response here, but would appreciate it if you can confirm.
thanks again
@Larry: You can argue that Canadian equities are the most tax-efficient in a TFSA because there are no foreign withholding taxes. But there are always other considerations, such as where you plan to hold the US an international equities and what funds you are going to use to hold them.
@TD: The foreign tax credit is a non-refundable credit, which means it can reduce tax you otherwise would have paid, but it cannot get you a refund. If your wife pays no tax she cannot claim it.
@TD, If you wife does not work you can not abscond from your tax obligation by simply putting investments in her name. There is attribution on those amounts unless a spousal loan at prescribed rate has been established.
Assuming that has been established, as explained by Dan the issue is not the lack of income tax withholding but the fact she appears to pay no tax. If the size of the investments and distributions were to grow to the point where she became taxable, the FTC would be claimable and reduce those taxes, irrespective of any Canadian income withholding.
Hi Dan: Thank you for all the useful information you provide. On following Sebastien’s posts, I realize that 30% foreign withholding tax is deducted on dividends of VTI and VEA my spouse and I own. The T2209 was completed by Turbotax on our tax returns. But, I do not think we have ever completed the W-8BEN. Are we losing out on this additional 15% withheld?
Great article again! Over the past several years, I have always looked forward to new articles on this blog.
I’m interested to hear about the tax implications for holding something like VUN vs VTI in a corporate account. I’d also be interested to hear about international equity ETF’s as well. Some of these topics seem so complex, but you always do a great job of explaining.
@Vas: Yes, it sounds like you are paying the full 30% rate because your brokerage has not filed the W-8BEN from. I would recommend contacting your brokerage and rectifying this.
@Diego: Justin is working on a blog post about corporate accounts that I think you and many others will find interesting. I will provide a link when it’s published. For now I can say that VTI vs. VUN is the same with regard to foreign withholding taxes. But in general we prefer to use Canadian-listed ETFs in corporate accounts for other reasons (easier recordkeeping, less reporting).
Thanks for this analysis. I hope the ETF industry takes this to heart and focusses less on US themed ETFs and more on International ETFs where they hold the underlying securities directly as opposed to a fund of fund model. Also, they need to do a better job of representing the Canadian market. Today I cannot even buy individual sector funds that cover the market completely – no Health Care, no Telecom, no Consumer Discretionary, and no Mid-Market fund.
Sometimes I really wonder about the quality of individuals that advice the ETF providers. They need more people who understand portfolio construction to help make the decisions.
Would that phantom under performance disappear if one would reinvest the tax credit ?
@CCP: In your white paper, you did not reveal the cost of a Canadian-listed ETF that holds emerging markets stocks directly. Am I right to think that the result would be like this ?
RRSP: Level 1 taxes (~0.30%), no level 2 taxes
TFSA: Level 1 taxes (~0.30%), no level 2 taxes
Taxable account: No level 1 and 2 taxes (0.00%)
If I am right, then BMO MSCI Emerging Markets ETF (ZEM) should be a better choice than VEE and XEC as its structure is a mix of direct and indirect holdings.
@Sebastien: The issue is that there is no Canadian-listed ETF that holds emerging stocks directly, so any estimate on our part would be unreliable. The average rate we assumed for Type F funds like VWO (9.63%) can’t be extrapolated because the tax treaties are different in the US and Canada.
You’ve got the concepts correct, but we can’t be more specific about the actual amount of tax drag.
@Linda Rocco: No because you add new money if you reinvest it later, so it would not change the past performance.
@CPP: As ZEM have some direct holdings (346 stocks), then it should have a small tax-efficiency advantage over VEE and XEC, right?
@Sebastien: Yes, you’re correct about ZEM. We just can’t quantify the advantage.
Hi Dan, big fan/long time reader.
My company forces us to automatically enroll in a Defined Contribution Pension Plan (DCPP) with Sun Life. When I enrolled I just followed one of their predefined target allocations (“growth”) but am now managing my own investments through Questrade so would like to change my holdings in the DCPP for maximum tax efficiency while maintaining my target allocations betweenQuestrade/Sun Life. Although it’s not an actual RRSP, is it still treated like an RRSP in terms of foreign withholding tax exemptions?
Great article. One question, I am debating between ZDB (BMO Discount Bond Index ETF) and ZHY (BMO High Yield US Corporate Bond Hedged to CAD Index ETF) for my RRSP/TFSA/Non-registered accounts. Any thoughts how FWT will impact ZHY for each type of account? Thanks again for the insights.
@Matt: Yes, a DCPP is treated the same as an RRSP in terms of foreign withholding taxes. However, unless you are planning to use US-listed ETFs in your self-directed RRSP you are probably not going to be able to improve anything. It might be better to just keep it simple and keep using the target allocation you originally chose for the pension.
@Vin: There is no withholding tax on bond interest: it only applies to stock dividends.
Dan
Its uncanny to me how many times a post concerns a question I have at the time I read it.
Thanks again.
Vanguard Canada’s position (I think) is that holding US ETFs rather than holding shares directly has efficiencies that offset or at least partially offset the added foreign tax withholding costs of the wrap structure. Any thoughts or comments??
@KISS: That is true to some extent, especially when the Canadian versions are new and have not yet attracted enough assets to allow them to trade the individual stocks efficiently. But at some point I think it makes sense to transition to direct-held stocks as XEF did, for example.
Another issue is that equity returns have been very good over the last few years, so some of these new funds when have to distribute large capital gains to their unitholders if they sold the underlying US-listed ETFs to buy individual stocks. For those holding these ETFs in taxable accounts that would not be a good thing.
@Matt: Some Sunlife accounts have an RRSP-only (no withholding tax!) fund for US Equities – they made a big fuss about it when it came out…
They call it “TDAM US Mkt Index (Reg)” in my account, it might be available for you too?
All exisiting and new contributions are going only to this; I have a line in my rebalancing spreadsheet to enter the value for that account.
Sunlife is horrible but I only contribute enough to get the employer match, remainder is at Questrade.
http://www.sunlife.ca/Canada/GRS%20matters/GRS%20matters%20articles/2014/Investments%20@%20work/Sun%20Life%20Financial%20adds%20TDAM%20US%20Market%20Index%20Fund%20Registered%20to%20DC%20Core%20and%20DB%20investment%20platforms?vgnLocale=en_CA
Not sure if others have asked this already.
Is the $30 fully recoverable, or only the tax paid on the $30?
@Artur: The $30 is the 15% tax paid on the $200 dividend. So this full amount is potentially recoverable with the foreign tax credit.
Hi Dan,
I am still trying to find a way to efficiently invest US dollars in TFSA. So my last idea is to buy TD e-series mutual funds. There are two indexes available:
TD Dow Jones Industrial AverageSM Index ($US) – e
TD U.S. Index ($US) – e
So and as far as I understood foreign withholding taxes do not apply on mutual funds. However, these indexes are not diversified across the globe and holding only equities.
So what do you think?
Thanks.
@CPP Can you confirm whether Andrei’s point is accurate? If so, that’s significant. For me (and I suspect a significant number of people), the $30 wouldn’t be recovered because I always get a tax refund (significant RRSP and charitable donations).
@KJF: The foreign tax credit is non-refundable, which means that if you have no tax payable in a given year you will not get a refund of this amount. However, “no tax payable” is not the same as paying a lot of tax during the year (through source deductions or instalments) and then receiving a refund at tax time because you made RRSP or charitable contributions. “No tax payable” means you did not earn enough money to owe any tax at all. If you owe (for example) $30,000 in taxes and you have paid $32,000, you’ll get a refund, and you can still claim the foreign tax credit. Hope this is clear.
@Henry: Foreign withholding taxes apply to mutual funds just as they do with ETFs, so unfortunately this strategy won’t help you.
Thanks Dan! Actually I got this information from one CFP about the mutual funds. That strange that he told me that. Anyway, thanks a lot!
Hi, Dan, I am planning to invest through HXS.to for my corporation, would foreign withholding tax apply in any way and affect my future withdraw as capital gain.
thanks
Kevin
@Kevin: Foreign withholding taxes never apply to HXS because there is no dividend. However, the swap fee of 0.30% has a similar impact.
@Kevin: I hold HXS personally in a non-registered account (I haven’t worked out the possible further consequences, if any, of holding HXS in a corporation.) Not only is there no foreign withholding tax because, as Dan said, there is no dividend (to you, at least), but as a further consequence of no dividend paid to you, there is also no ongoing Canadian tax payable. There is Canadian tax payable eventually on selling the shares, but that is deferred at your discretion, unless you die, of course, and the return is treated as a Capital Gain, and taxed accordingly. (Dan probably didn’t mention this because the topic was foreign withholding tax and its consequences.) To me this appears to be a huge benefit and well worth the swap fee of 0.30%, if the RRSP option in US funds are for some reason not available, or not desired.
Hi,
Thanks for updating this. In the last table, it would be helpful to include another column of the drag you will face by paying income tax on the dividends in a taxable account. Obviously this is difficult to measure since people’s tax rates vary but it would help paint the picture of why it is bad or not so bad to toss your INTL equity into taxable account. More broadly, it will let us think about questions like “after all costs considered, what are the best funds to use if I *have* to put INTL equity into a TFSA or taxable account because my TFSA and RRSP are both maxed out and the splits are all over the place”.
^ oh, and also swap based funds (total MER including swap fee). That should paint the whole picture.
@Dan: What ETFs would be good choices then, for US and international in a TFSA? I am also curious about a REIT choice. Thanks!
@Que: If you are holding US and international equities or REITs in a TFSA, just use the same Canadian-listed ETFs you would use in a non-registered account: the international equity ETF should hold the stocks directly.
Hi Dan, If I hold VTI in my taxable account, what will happen in terms of withholding taxes? Can I still recover the taxes? Thanks!
@Michael: Taxes will be withheld and reported on your T5 slip. As long as you enter the info on the T-slip when filing you return the amount should be recoverable via the foreign tax credit.