From The Boomer & Echo Mailbag: Understanding Withholding Taxes On Foreign Investments
Q. What types of foreign investments can Canadian investors invest in their RRSP, TFSA and Non-Registered accounts that don’t charge withholding taxes?
Canadian investors get enormous benefit from diversifying their portfolios with U.S. and international stocks, but it can come at a cost – foreign withholding taxes.
In a nutshell, many foreign countries including the U.S. impose withholding taxes on dividends paid by their corporations to Canadian investors. This tax is generally 15% of the dividend. The tax you pay depends on two factors:
- the type of account your hold your investments in, and
- the structure of the investment.
So, let’s show an example.
Foreign Withholding Taxes
You want to buy 100 shares of Hershey Co. which is listed on the New York Stock Exchange. If you hold the shares in your RRSP you will receive the full amount of the dividend – US$61.75 per quarter, or approximately CD$82.
This is because the U.S. has a tax treaty with Canada that waives withholding taxes on dividends paid on stocks held in retirement (RRSP, RRIF, LIRA, etc.) or pension accounts.
If the shares are in a non-registered (taxable) account, the withholding tax ($12.30 in our example) will be taken and you will be paid $69.70. However, the tax amount you paid will appear on a T5 slip, and you can recover it by claiming a foreign tax credit on your income tax return.
If you purchase the shares for your TFSA, U.S. withholding tax will always be applied (you get a $69.70 dividend) – but you are not allowed to claim it.
Now, what if Hershey Co. (or other U.S. or foreign stock) is held in a mutual fund or ETF? Hold on to your hat because this is where it gets a bit more complicated. There are three different scenarios.
1. Canadian listed mutual funds and ETFs that hold U.S. and foreign securities directly
Example:
- TD US Index e-series fund
- BMO S&P 500 (ZUE)
RRSP: Since the fund itself pays the tax, you do not receive the exemption.
Non-registered account: Withholding tax is reported on a T3 slip and you can claim the foreign tax credit.
2. U.S. and International ETFs listed on a U.S. exchange
Example:
- Vanguard Total Market (VTI)
RRSP: You are exempt from U.S. withholding tax. But, if the ETF holds international stocks, each individual country will take its own tax amount.
Non-registered account: You’ll receive a T5 showing the U.S. amount paid and it is recoverable. International withholding tax is not recoverable.
3. Canadian listed ETFs that hold U.S.-listed ETFs (U.S. and International)
Example:
- iShares S&P 500 (XSP)
- Vanguard FTSE Developed Ex-N.A. (VEF)
RRSP: All U.S. and international withholding taxes are taken.
Non-registered account: You can recover the taxes withheld by the U.S., but the taxes from the non-U.S. countries are not recoverable.
Note: In all the above cases, U.S. and international dividends paid into a TFSA will have had the withholding taxes taken, and, because you won’t get T-slips for any security held in a TFSA, you are not able to recover the tax.
Final thoughts
Retirement accounts are exempt from U.S. withholding taxes but not non-U.S. taxes. TFSAs will always pay them.
Holding foreign equities in a non-registered account may allow you to claim the foreign tax credit, but the dividends are taxed as income at your highest marginal tax rate – you can’t claim the dividend tax credit – and you pay income tax on half your capital gains.
Most investors should take full advantage of tax-sheltered accounts before investing in non-registered accounts. Don’t avoid them just to save a few dollars in recoverable withholding tax.
Keep in mind that foreign withholding taxes are just one of many costs of investing. Don’t make an investment decision entirely for tax reasons. Consider also – MERs, currency conversion fees, U.S. estate taxes (for significant holdings in U.S.-listed ETFs), and your personal income tax situation.
Look at the whole picture and don’t focus on minutia.
From a tax efficiency perspective, the following is the best investment by account:
TFSA: Canadian listed ETFs investing in Canadian Securities
RRSP: US listed ETFs investing in US Securities
Non-Registered: Canadian listed ETFs investing directly in the underlying International Securities – not a fund of funds.
Surprisingly, there are too many Canadian listed ETFs investing in US Securities and too many Canadian listed ETFs that invest in International Securities via a fund of funds model. Vanguard being one of the worst in this regard.
The Canadian ETF industry is seriously lacking in vision.
TJ – what are your thoughts on Vanguards VIU? My understanding is that this international ETF does not use a fund of funds model. It seemed to be that Vanguard Canada may also have recognized this gap and pulled together this ETF to cover the scenario highlighted above.
Marie – great article!
Vanguard does not explicitly state that their funds are inherently fund of fund structures. You have to ply it out of them by contacting them directly. They justify the structure based on efficiency (theirs not ours). I believe our regulators should force fund providers to make this very clear.
Can you share which ETFs you are personally referencing for each investment account?
TFSA: XIC
RRSP: SPY
Non-Registered: VEU – this is a US listed ETF but the non-recoverable Level 2 taxes (what the foreign government withholds) is compensated for by efficiency.
Excellent post and very timely as I am waiting for a market correction in order to buy equity ETF’s in my cash, RRSP, TFSA and LIRA accounts.
Do you have any thoughts on where REITs fit in? Not in registered account. Canadian owned companies on the TSX but with US holdings. One of my REITs, the company is in Vancouver but they own all US properties so I know there will be 15% tax on the dividends, but what about other REITs that are primarily Canadian holdings but with some in the US. Would REITs more closely follow #1 or #3 in your above scenario?
Hi Cheryl. Canadian REITs can hold not more than 20% foreign properties. Foreign and US withholding taxes will be applied to some distributions. In a non-registered account you can generally recover this amount by claiming the foreign tax credit. Taxes are paid but not recoverable in a RRSP or TFSA.
OK, thanks for letting me know about the taxes, will get the slip and let my accountant do the rest! The Vancouver based REIT I’m referring to with all US hotels – and this is in no way an endorsement! I have 100 shares because I thought it looked interesting and I didn’t want to deal with much more than that in taxes or as a risky investment – is the American Hotel Income Properties REIT. The hotels are all located in the states, none in Canada or anywhere else. Maybe the US designation is different than International for the 20% margin? Maybe that’s another blog post for you?
Great post. Where should I hold XAW? I believe this ETf holds a number of other ETFs which track Us and international markets.
@alana. XAW hold US and international ETFs, so it falls under scenario #3. I really can’t comment on where you should invest without knowing the details of your overall financial situation.
Thanks for getting back to me. I recently started investing and have opened both registered and non registered accounts. I am an index investor (VCN and XAW) with a long term investing horizon in mind (I’m in my early 30’s). My approach so far has been to max out my TFSA so I’ve purchased both VCN and XAW in my TFSA. I’m now focused on maxing out my RRSP with plans to put left over cash in my non registered account. I beginning to wonder however if this approach is the most tax efficient. Should I only have VCN in my TFSA and buy XAW in my RRSP or non-registered account? That’s where my questions came from, where would be the most tax efficient account to park XAW. Or does it not really make much of a difference since I’m investing long term and should I just focus on maintaining my desired asset allocation?
Marie, thank you for addressing these issues that have been plaguing my DIY investing journey. I now remember that I suggested this question for you and your readerships to help me find my answers. Your explanations really clear up some tax problems one encounters when investing in foreign investments.
I might add also that one can get charge with a ‘Non-Resident Tax’ when one invests in companies registered in the US ( in which we have tax treaty with ) but which do business outside of the continental US. One particular tech company which does business in Ireland docks the quarterly dividend income that you earn 20% of NRT and a Global REIT company withholds 39.6% of NRT! Ouch.
Yes, Wes that’s the problem with Canadian and US corporations doing business internationally. Each country has it’s own tax rates (which can be quite high) and they will all take their slice. The same applies to Deposit Receipts (ADRs). For non-registered accounts you may be able to recover up to 15% foreign tax credit. For RRSPs and TFSAs you are out of luck for recovering it.
Marie, as far as I know Canada has tax treaty with the US and UK. Is that correct? I’m holding all foreign stocks mainly US dividend aristocrats in my RIF account and Canadian Aristocrats in Non-Registered and TFSA accounts. I think even with the 15% withholding tax, it’s still worth it to hold US dividend aristocrats in all accounts when they can be bought at cheaper valuations. Thanks for your needed response.