Foreign Withholding Taxes — the price of global diversification

Here’s my latest MoneySense blog, which focuses on one of the ETF sessions I participated in last week’s ETF & Mutual Funds conference in Chicago, hosted by BMO Global Asset Management. You can find earlier Hub blogs from the conference through these three links:

Secular bull market still very much alive: BMO’s Brian Belski

A murder mystery: who will kill the global economy? 

Why are all these Canadian financial experts converging on Chicago?

For convenience, we’ve included the new blog below. Note too that you can find the original PWL white paper on Foreign Withholding Taxes here. We hope to run a slightly condensed version here at the Hub in the near future. 

By Jonathan Chevreau

With Canada accounting for roughly 3.6% of the global stock market, most investors have accepted the need to “go global” and invest in U.S. and foreign securities. This has never been easier with the continued proliferation of exchange-traded funds.

Strictly from a sector diversification point of view, it makes sense to move beyond the three big sectors represented by Canadian stocks: energy, materials and financials. The U.S. market in particular offers a wealth of sectors that are minimal or non-existent in Canada: high-tech, pharmaceuticals and bio-tech, defense stocks, social media stocks and many more.

Certainly, any Canadian who loaded up on U.S. large-cap stocks back when the loonie was about par with the U.S. dollar will be happy today: all those dividends rolling in will be in highly valued U.S. dollars.

But there is one downside to investing outside Canada: foreign withholding taxes. For example, the U.S. government charges a 30% tax on U.S. dividends paid to Canadians, although this tax can be reduced to 15% by submitting those annoying IRS W-8BEN forms that Canadian brokerages insist you submit if you own such stocks.

Foreign withholding taxes also occur with mutual funds and exchange-traded funds listed on Canadian or U.S. exchanges, which is why this topic was featured in the ETF stream of a BMO Global Asset Management conference on ETFs and mutual funds that I participated in last week in Chicago.

The topic came up as part of a “More than just MERs” fireside chat I had with BMO vice president Kevin Prins. We referred the audience to an excellent white paper on the topic written by PWL Capital portfolio manager Justin Bender and investment adviser Dan Bortolotti, well known to MoneySense readers through his Canadian Couch Potato blog. Space precludes summarizing the paper’s full 12 pages in a short blog like this one but you can see the full paper at Dan’s site here. We may also post an abbreviated version soon at the Financial Independence Hub.

The topic is surprisingly complex but as Prins pointed out, things get a bit simpler if ETF investors seeking US or global equity exposure do so through ETFs listed on the TSX. As BMO points out, while Canadians are free to buy US or foreign ETFs trading on the NYSE, the product manufacturers have designed those ETFs with the needs of American investors in mind rather than the specific tax situation of Canadian investors.

Until a few years ago, there may have been a compelling cost advantage to using US-listed ETFs over higher-fee Canadian equivalent ETFs but that MER differential has all but disappeared since the ETF price war hit Canadian shores early in 2014. The arrival of Vanguard in Canada, the response of iShares’ Core ETFs and the response of BMO and other local players has meant Canadian investors need to consider ahead of MERs things like withholding tax treatment or U.S. estate taxes.

As Prins points out, by buying the TSX-list version of such ETFs, investors can avoid the hassle of submitting tax documents like the T1135,which kicks in on $100,000 or more of US or foreign investments listed in New York, and for which many accountants charge extra to process.

Domestically-listed foreign ETFs can also help you minimize the extensive currency conversion round trips that occur when Canadians use the C$ to buy US$ ETFs or stocks on US. Exchanges. Some Canadian brokerages, like RBC, mitigate this by having separate C$ and US$ RRSP accounts, for example, but many still do not.

US-listed ETFs held in RRSPs or RRIFs are exempt from withholding tax from the US, but not from overseas countries. However this exemption does not apply to TFSAs or RESPs.

Remember that outside registered plans, investors can get the withholding tax back if the assets are held directly in a Canadian trust. The annual T-3 or T-5 slips sent out early every year show the amount of foreign tax paid, which can be recovered by claiming the foreign tax credit on Line 405 of your tax return.

As the PWL paper notes, since no tax slips are issued for dividends received in registered accounts, any foreign withholding taxes incurred are not recoverable. Keep in mind that, unlike Canadian dividends, foreign dividends received in taxable accounts are taxed at your full marginal rate, just like interest or earned income, and there may also be capital gains tax. So as PWL notes, it will be better to pay 15% withholding tax in a TFSA than 46% income tax on dividends and 23% on capital gains in a taxable account.

Yes, it’s all horrendously complex but here’s a simple tip for those wishing to hold international equities: If all other things are equal, look for a Canadian ETF provider that offers a TSX-listed international equity ETF that holds the foreign securities directly. For U.S. equity ETFs, it doesn’t matter whether the stocks are held directly or not, PWL says.

MoneySense editor-at-large Jonathan Chevreau runs the Financial Independence Hub and can be reached at jonathan@findependencehub.com