First things first: If your long-term investments are not yet globally diversified, they almost certainly should be. Robust evidence and common sense alike support the wisdom of managing your risks and expected sources of return by investing in both Canadian and international markets.
But, once you go global, there is a tricky little detail, often overlooked, which can eat into your investment returns. I’m talking about foreign withholding taxes.
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 you receive the dividend in your investment account. This makes them easy to overlook, but foreign withholding taxes can still do significant damage to your returns. Left unchecked, the impact can be even greater than the management expense ratio (MER) on most ETFs.
While you cannot eliminate foreign withholding taxes, you can seek to minimize them by tending to two main things: the structure of the investment vehicle you’re using, and the type of account in which the vehicle is held.
Thing One: Investment Structure
In the world of ETFs, there are three main structures that a Canadian investor can choose from to obtain global market exposure:
- A US-listed ETF
- A Canadian-listed ETF that holds a US-listed ETF
- A Canadian ETF that holds stocks directly
Depending on how the ETF is structured, you may be subject to two levels of withholding tax. In their 2016 white paper, Foreign Withholding Taxes, my PWL colleagues Justin Bender and Dan Bortolotti explained it this way:
- Level One Withholding Taxes – These are like a departure tax you pay when flying from a foreign country to Canada. Level One taxes are levied by any foreign country (including the US), on dividends paid to a Canadian investor.
- Level Two Withholding Taxes – These are like a tax you pay to the US government when an overseas flight has a layover in the US on its way to Canada. It’s 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. More taxes are paid when the US-listed ETF passes that dividend on to you, a Canadian investor.
Thing Two: Account Type
The account type also matters.
- Retirement Accounts – The US government does not withhold taxes on US security dividends if they’re held in an RRSP or other retirement account (like an RRIF or LIRA). This is thanks to the current Canada-US tax treaty. Thus, a US-listed ETF of US stocks will not have any tax withheld on dividends paid to an RRSP account. This special treatment does not apply to TFSAs and RESPs. Also, other countries do not have similar arrangements, which means that foreign withholding taxes will apply on dividends paid from non-US international stocks, regardless of the account type.
- Taxable Accounts – 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 any foreign tax you pay cannot be used to offset your Canadian tax. This makes foreign withholding taxes paid in your registered accounts unrecoverable.
Thing One and Thing Two: Putting the Pieces Together
Knowing which types of ETFs to hold in which accounts can save you a lot in the long-term. For details on the various possibilities, I highly recommend Justin and Dan’s white paper. Here are a few key caveats.
- Holding US-listed ETFs that hold US stocks in an RRSP account: As I mentioned earlier, you can employ this combination to eliminate any foreign withholding tax. But, as I explain in my video in more detail, you also need to manage additional currency conversion costs incurred by using a technique called Norbert’s Gambit. Once again, Justin’s YouTube channel is handy if you want to learn more.
- Holding Canadian-listed or US-listed ETFs in an RRSP account: To contrast, this combination will generate an annual 0.25% unrecoverable foreign withholding tax cost, as will holding a US-listed ETF of US stocks in your TFSA account.
- Canadian-listed ETFs that hold US-listed ETFs of international stocks, in a TFSA or RESP account: I know, that’s a mind-bender. But it’s worth wrapping your head around this scenario, because it’s among the worst offenders for generating double whammy, Level Two withholding taxes: Taxes are withheld by a non-US foreign country and by the US. Moreover, both taxes are unrecoverable.
On that last point, there are Canadian-listed funds that hold international stocks directly, so there is only Level One withholding. Examples include iShares’ XEF and XEC ETFs, and some Dimensional Fund Advisors’ funds.
Now what? There is both an art and a science to determining which assets should be held in which account to optimize foreign withholding and other tax efficiencies. This is a practice known as asset location. Is it worth it? Find out in my next installment. In the meantime, I’d like to know what you have done to minimize your foreign withholding taxes. Tell me in the video comments … right after you subscribe to receive more Common Sense Investing ideas.
Original post at pwlcapital.com