xecGlobal diversification is universally accepted as beneficial to investors,
but foreign withholding tax is a tricky little detail that can eat into your
investment returns. When a foreign company pays a dividend to a Canadian investor,
the company’s home country will often impose a tax on the dividend. The amount of tax
withheld by the foreign government depends on the arrangement between the two countries
For example, the US government keeps 15% of any dividend paid by a US company to a
Canadian resident investor. These taxes are withheld before the dividend is received in
your investment account, so it is easy to miss. Foreign withholding tax can have a
significant negative impact on returns if it is not managed properly - in many
cases the impact can be greater than the management expense ratio on most ETFs.
I’m Ben Felix, Associate Portfolio Manager at PWL Capital. In this episode of Common
Sense Investing, I’m going to tell you about foreign withholding tax.
The amount of damage that foreign withholding tax will do to your returns depends on the structure
of the vehicle that you are using to invest, and the type of account that the vehicle is owned
in. In the world of ETFs, there are three main structures that a Canadian investor will see. A
US listed ETF, a Canadian listed ETF that gets its exposure to the market by holding a US listed ETF,
or a Canadian ETF that gets its exposure to the market by holding stocks directly.
Depending on how the ETF is structured, you may be subject to two levels of withholding tax. In
their 2016 white paper titled Foreign Withholding Taxes, my PWL colleagues Justin Bender and Dan
Bortolotti explained it this way: You can think of Level One foreign withholding tax like a departure
tax that you pay when taking a flight to Canada from any foreign country. Level Two withholding
tax that you pay to the US government when an overseas flight has a layover in the US.
Level One withholding tax is the tax levied by any foreign country, including the US, on
dividends paid to a Canadian investor. Level Two withholding tax is an additional 15% withheld by
the US government on dividends paid to a Canadian investor by a Canadian listed ETF that owns a
US listed ETF. Taxes are first withheld when the dividend is paid from a foreign company to the US
listed ETF, and then again when the US listed ETF passes that dividend on to a Canadian investor.
The type of account matters for a few reasons. First, US securities held in
an RRSP or other retirement account like a RRIF or LIRA do not have any tax withheld
by the US on dividends. This is part of the Canada-US tax treaty. Based on this,
a US listed ETF of US stocks will not have any tax withheld on dividends paid
n an RRSP account. This same special treatment does not apply for the TFSA and RESP accounts.
Other countries do not have a similar arrangement for Canadian
resident investors. This means that foreign withholding tax will apply on dividends paid
from International stocks regardless of the account type. In a taxable account,
foreign taxes withheld are reported on your T3 or T5 and can generally be
used to offset your Canadian taxes. In that sense,
while foreign taxes are paid, they are recoverable.
In a registered account there are no T slips,
so the foreign tax that you pay cannot be used to offset your Canadian tax.
This makes foreign withholding taxes paid in your registered accounts unrecoverable.
Knowing which types of ETFs to hold in each type of investment account has the
potential to save you a lot of money in the long-term. I will not go through
every possible combination of ETF structures and account types in this video, but I will
highlight the ones that are most important to watch out for. For all of the details,
I highly recommend reading Justin and Dan’s white paper which I have linked in the description.
As I mentioned earlier, holding a US listed ETF that holds US stocks in your RRSP eliminates any
foreign withholding tax. The only thing to keep in mind here is that to purchase a US
listed ETF you will need US dollars. Obtaining US dollars also has a cost,
and that cost can outweigh the benefit of reducing your foreign withholding tax. You
can use a technique called Norbert’s Gambit to reduce the cost of currency conversion.
The process is not overly complicated, but I would not say it is appropriate for beginners,
either. Justin Bender has outlined how to execute Norbert’s Gambit on his YouTube channel.
To contrast, holding a Canadian listed ETF of US stocks in your RRSP results in
a zero point two five percent unrecoverable foreign withholding tax cost. Similarly,
holding a US listed ETF of US stocks in your TFSA account will result in an unrecoverable
foreign withholding tax cost of around zero point two five percent per year.
When we get out of the US, we have to start thinking about the potential for Level Two
withholding tax. That is, taxes withheld both by a foreign country other than the US, and taxes
withheld by the US. One of the worst offenders for Level Two withholding tax is a Canadian listed ETF
that owns a US listed ETF of International stocks, held within a TFSA or RESP account. In this case
there are two levels of foreign withholding tax applied, and both of them are unrecoverable.
There are ETFs in Canada that do hold international stocks directly
as opposed to holding their US listed counterpart, such as XEF and XEC from
iShares. Canadian index mutual funds, such as those from Dimensional Fund Advisors,
hold all securities directly, so there is only one level of withholding tax to worry about.
This is all interesting and important to know,
but what do you do now? There are many people who believe that optimizing for
which assets should be held in each type of account to minimize foreign withholding tax,
and taxes overall. This is a practice known as asset location. Asset location inevitably makes
your portfolio and your life more complicated. Is it worth it? Find out in my next video.
What have you done to minimize foreign withholding tax? Tell me about it in the comments.
Thanks for watching. My name is Ben Felix of PWL Capital and this is Common Sense
Investing. I’ll be talking about a lot more common sense investing topics in this series,
so subscribe, and click the bell for updates.