As Canadians we pay a lot in taxes. When you consider personal, sales, and property taxes and social security contributions, it really starts to add up, and I would argue, one reason why Canadians are finding it more difficult to make ends meet. Now we are incredibly lucky to live in such a great country like Canada where we, generally, have a good health care and education system, a robust social safety net including unemployment insurance, childcare benefits and pension benefits for seniors, and generally a peaceful and prosperous place to live. Given all this we should pay a healthy amount of taxes (how much we pay in taxes is for another day), but when we can, we should look to minimize taxes in every way (legally) we can. So today I cover a small but not insignificant tax that investors can try to minimize, known as withholding taxes on foreign investments.
When investing in stocks an important component of returns are dividends. Dividends paid by Canadian corporations can be eligible for the dividend tax credit, which reduces the taxes paid on the dividends. In contrast, dividends received from US or international equities are not eligible for the dividend tax credit and additionally are levied a ‘withholding tax’ from the countries where the companies are domiciled. This withholding tax therefore reduces the net dividends received by the investor and lowers the overall rate of return. Today I’ll cover ways to minimize this tax and improve after-tax returns on foreign investments.
The impact of US and international withholding taxes is complicated so some background is needed. There are three critical pieces to this puzzle.
First, with ETFs (the only vehicle we and all our readers should invest in) there are three different ETF structures related to foreign-based ETF investments. They include: 1) a US-listed ETF (the S&P 500 ETF (SPY-N) is an example of this), 2) a Canadian-listed ETF that holds a US-listed ETF (the iShares Core S&P 500 Index ETF (XSP-T) in an example of this), and 3) a Canadian-listed ETF that invests in the underlying US or international stocks directly (the BMO MSCI EAFE Hedged ETF (ZDM-T) is an example of this). Now that that is clear as mud, we need to move on to the different types of withholding taxes.
Second, for foreign withholding taxes there are two ‘levels’ of this tax. The ‘level one’ withholding tax is the tax that the US government levies on Canadian investors who hold US equities. This is currently 15% and is withheld before the dividend hits the account. The ‘level two’ withholding tax applies to international stocks that are held in a Canadian-listed ETF. In this case the Canadian investor pays two different withholding taxes of roughly 30%. The first one is withheld by the US government on the international company dividend (you don’t actually see this) and then the US government withholds their 15% (you see this in your account). This is the worst of all the options.
Finally, where the ETF is held (i.e. in an RSP or taxable account) will determine what the investor ends up actually paying. So it’s the combination of the ETF structure and the type of account that will determine the amount of withholding taxes paid.
Putting this all together here are the key takeaways on how to minimize the withholding tax for ETF investors:
- For a US-listed ETF it’s best to hold this in an RSP/RIF or a taxable account. The US government has a tax treaty with Canada where they will not withhold taxes on US dividends if held in an RSP account. For the taxable account you still pay the withholding tax at source but when you file your taxes at year-end you can offset this withholding tax against your overall taxes owed thus recouping some of this tax.
- For TFSA and RESP accounts it’s generally best to hold Canadian-listed international ETFs as US-listed ETFs offer no tax advantages in these accounts.
- Lastly when purchasing a Canadian-listed ETF that invests in international stocks (non-US), try to focus on the ETFs that invest directly in the underlying international stocks versus holding another international ETF. This will avoid that double taxation.
Admittedly, this isn’t the most exciting blog topic but hopefully you’ve learned a few things about withholding taxes and minimizing this drag on returns. Also sticking it to Uncle Sam is always a plus!
The last point I’ll leave you with is that withholding taxes is just one consideration when determining where to hold certain ETFs. You also have to consider things like currency transactions, how the funds are spread across each account, which accounts hold US dollars, the tax rates on other investments like bonds, and the potential growth rate of each investment.
Meaning, sometimes we’ll hold a US-ETF in a TFSA, for example, because the other factors like the potential growth of the investment will outweigh the hit of US withholding taxes.
So the main takeaways above are things to strive for but don’t lose perspective of all the other factors that go into where you should hold certain investments. Don’t lose the forest for the trees as they say!
Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.