Lately, I have received many emails from readers asking about foreign withholding taxes. Some readers are wondering where they should hold US stocks that pay dividends, while some readers are wondering if it makes sense to hold Canadian REITs and income trusts in taxable accounts. Many readers are also wondering how withholding taxes work for distributions from global equity ETFs.
I get it, taxes can be a complicated topic!
When it comes to investing, we all must pay attention to tax rules and regulations and develop a tax-efficient way to invest. This is especially important when you deal with dividends from a foreign source. After all, who wants to pay extra money to Johnny Canucks or Uncle Sam when we don’t have to?
Before I dive deeper into how foreign withholding taxes work on dividend stocks and equity ETFs, let’s go over some of the basics.
First, the different account types. Here in Canada, there are many different types of investment accounts but they fall under two categories – tax-sheltered and non-tax-sheltered (some people also call them registered vs. non-registered).
Canadian tax-sheltered accounts
The common tax-sheltered investment accounts include:
- Registered Retirement Savings Plan (RRSP)
- Tax Free Savings Plan (TFSA)
- Registered Educational Savings Plan (RESP)
- Registered Disability Savings Plan (RDSP)
- Registered Retirement Income Funds (RRIF)
- Locked-in Retirement Account (LIRA)
All of these accounts are considered tax-deferred accounts, except TFSA. Your investments can grow tax-free while inside a tax-deferred account like an RRSP. When you make withdrawals, the amount is taxed as regular income at your marginal tax rate.
Since you contribute after-tax money in TFSA and do not get any tax deductions for that contribution, TFSA withdrawals are tax-free.
Canadian non-tax-sheltered accounts
Non-tax-sheltered accounts have many different names – taxable accounts, non-registered accounts, margin accounts, or even open accounts. As the names suggest, you do not receive any income deductions when you make a contribution. Anything you earn inside non-tax-sheltered accounts is taxable, including capital gains, interest, dividends, and distributions.
Since you already pay taxes on capital gains, interest, dividends, and distributions, when you withdraw money from taxable accounts, it is not counted as income.
How Canadian dividends are taxed
After covering the two types of investment accounts, we need to understand how Canadian dividends are taxed. When it comes to Canadian companies that pay out dividends, the dividends received fall under two categories.
Canadian eligible dividends
Typically these are dividends from Canadian corporations. When Canadian corporations make profits, they pay taxes on the profits first before dividends are distributed to shareholders. When investors file for income tax, the dividend amount is “gross-up” by 138% which represents the corporate income tax already paid by the corporation. This is to avoid double taxation on the dividends. Investors then in term get dividend tax credits. The net result is that the marginal tax rate on eligible dividends is usually much lower than the marginal rate on working income. In fact, as Reader B pointed out in his epic interview, a couple in Ontario can receive eligible dividend tax free up to $110,500.
Canadian non-eligible dividends
Non-eligible dividends are usually paid out by REIT’s and income trusts. REIT’s and income trusts can distribute anywhere from 50 to 90% of their income directly to shareholders without first paying any corporate taxes. Because such income is not taxed on a corporate level, dividends or distribution from REIT’s and income trusts are taxed at a higher rate than eligible dividends, despite receiving dividend tax credits.
Comparing the two, Canadian eligible dividends are taxed more favourably than Canadian non-eligible dividends.
Distributions from ETFs can make up a combination of eligible dividends and non-eligible dividends. It depends on the underlying stocks and funds each ETF holds.
What is foreign withholding tax?
Almost every country in the world levies a tax on dividends paid to foreign investors. The rate can range anywhere from 15-30% with the average tax rate being 15%. For US dividends, the withholding tax rate is typically 15% for Canadians because there’s a tax treaty between the US and Canada. Note: For stocks like limited partnership stocks, REITs, and income trusts, in addition to the 15% withholding tax, you may have to file non-US-resident income returns.
Foreign dividends received are taxed as regular income at your marginal tax rate but investors will receive foreign tax credits, as long as they include the tax credits when filing for income tax.
Because the US and Canada have a tax treaty, foreign withholding taxes are exempt when you hold US dividend stocks in registered retirement accounts like RRSP and RRIF. The important thing to note is that this tax exemption does not apply to (when holding those same investments in either a) TFSA or RESP. So if you hold US dividend stocks in your TFSA or RESP, 15% withholding tax will be automatically applied on dividends received.
Canada does have tax treaties with other countries as well so withholding taxes are exempt for registered retirement accounts.
Dividend investing – tax efficiency
What can we do to be tax efficient when it comes to dividend investing and ETF investing? The simplistic view boils down to the following:
Accounts to hold companies that pay Canadian eligible dividends
- Best: Non-registered is the most obvious place so you can take advantage of the dividend tax credit.
- OK: RRSP/RRIF/TFSA/RESP are fine but you don’t get any dividend tax credits. Withdrawals from RRSP/RRIF/RESP count as regular income and are taxed at your marginal tax rate. TFSA withdrawals are tax-free.
Accounts to hold companies that pay Canadian in-eligible dividends
- Best: RRSP/RRIF/TFSA/RESP are preferred, especially you plan to enroll in DRIP
- So-so: Non-registered if you have no other choice but accounting gets messy if you enroll in DRIP (probably best to avoid altogether)
Accounts to hold companies that pay US dividends
- Best: RRSP/RRIF are best so you can avoid paying the 15% withholding tax
- OK: Non-registered. Dividends get deducted by 15% but you can recover through the foreign tax credit. The dividend amount is taxed as regular income.
- Avoid if you can: TFSA/RESP. This means you get hit by the 15% withholding tax and you don’t get any foreign tax credit.
Accounts to hold companies that pay foreign dividends
- Best: RRSP/RRIF are best if dividends are from a country that has a tax treaty with Canada
- OK: Non-registered. Dividends get deducted but you can recover through the foreign tax credit. The dividend amount is taxed as regular income.
- Avoid if you can: TFSA/RESP. This means you get hit by the withholding tax and you don’t get any foreign tax credit.
Best Canadian accounts to hold dividend stocks and ETFs
Here’s a very simplified summary of what I wrote in the previous section:
- TFSA: Good for Canadian dividend paying stocks, ETFs, REITs, and income trusts.
- RRSP: Good for US and foreign dividend paying stocks, ETFs, REITs, and income trusts.
- Taxable: Good for Canadian dividend paying stocks and ETFs that pay eligible dividends.
Foreign withholding taxes – Some complications
Most investors may think that foreign withholding taxes are not applied when you purchase stocks listed on the Canadian stock market. But foreign withholding taxes on dividends are not as simple as whether a company is a Canadian entity or not. It depends on where the income comes from.
Take Granite REIT (GRT.UN) for example. Although Granite REIT is structured as a Canadian Real Estate Investment Trust for Canadian tax purposes, a small portion of the monthly payout comes from US-sourced income. So that portion of income (around $0.0229 per share out of the $0.2583 per share monthly distribution at the time of writing, or about 8.9%) is subjected to the 15% withholding tax if you hold Granite REIT in non-registered or TFSA.
Since we currently hold Granite REIT in a TFSA, we lose about $0.003435 per share due to the foreign withholding tax, or about 1.3% of the overall distribution. At a 3.3% dividend yield, this means we incur a tax drag of 0.043%. If we hold $5,000 worth of Granite REIT, we’d lose roughly $2.15 to withholding tax each year.
It Is not ideal but at the same time, it is not a huge amount that might make us think of transferring Granite REIT from the TFSA to our RRSP.
What is the lesson here? In my mind, it is that one should always double check each company’s dividend tax information before investing in that business, especially in the case of REIT’s and income trusts.
What about equity ETFs and foreign withholding taxes?
How does the foreign withholding tax work for distributions from equity ETFs that hold foreign stocks that pay dividends?
Are investors subjected to foreign withholding taxes for all-in-one ETFs like VEQT, XEQT, VGRO, XGRO, etc? What about US-listed ETFs that hold foreign stocks? And what about global ex-Canada equity ETFs like XAW and VXC?
Not surprisingly, it is VERY complicated! It’s like going down a deep and dark rabbit hole.
First of all, how ETF distributions are taxed depends entirely on how the ETF is structured. There are three different structures:
- US-listed ETFs that hold foreign stocks
- Canadian-listed ETFs that hold US-listed ETFs that hold foreign stocks
- Canadian-listed ETFs that hold foreign stocks directly
Similar to US dividend dividend stocks, if you hold US-listed ETFs directly (Structure #1), you can avoid the 15% withholding tax on ETF distributions when you hold them inside a registered retirement account like RRSP and RRIF.
And just like U.S. and foreign dividend stocks, you will get hit with the 15% withholding tax on ETF distributions when you hold these US-listed ETFs in a TFSA. You will also be subjected to the 15% withholding tax on distributions in taxable accounts but you can recover it through the foreign tax credits.
If you hold ETFs that are listed on the Canadian market (i.e. Structure #2 and #3), for the most part, foreign withholding tax will apply on distributions. The distributions that you see in your trading account are the net amount. In other words, the foreign withholding taxes are already applied. So while they’re invisible, you still pay them.
When you hold these ETFs in tax-sheltered accounts like a RRSP, RRIF and TFSA, there is usually a 15% withholding tax on these distributions. So for an ETF like VXC which has a distribution yield of 2%, the overall tax drag from withholding tax would be 0.3% (2% multiplied by 15%). And the tax drag can be recovered in the form of foreign tax credits if you hold these ETFs in non-registered accounts.
But that is a very general view of how withholding tax works on ETF distributions. Since ETF distributions are usually made up of capital gains, return of capital, and foreign dividends, the actual tax drag could be smaller than just multiplying 15% to the overall distribution yield.
For example, VXC’s distributions in 2020 and 2019 are broken down as below:
|Year||Eligible dividends||Non eligible dividends||Other income||Capital gains||Return of capital||Foreign Income||Foreign tax paid||Total distribution per unit|
In 2020, all the distributions came from foreign income and the withholding tax paid was about 15%. However, in 2019, some of the distributions came from a combination of capital gains ($0.95) and foreign income ($0.86), so the withholding tax is only applied to the foreign income amount. If we calculate how much withholding tax was paid as part of the total distribution per unit, foreign tax paid was only 7.7% of the total distribution per unit. Given a distribution yield of 2%, the overall tax drag is 0.3% in 2020 and 0.154% in 2019.
For these all-in-one ETFs or all-equity ETFs like VGRO and VEQT, since the ETF holds a combination of Canadian stocks and foreign stocks, the actual withholding tax as percentages of the total distribution is actually quite small.
|Year||Eligible dividends||Non eligible dividends||Other income||Capital gains||Return of capital||Foreign Income||Foreign tax paid||Total distribution per unit|
For VEQT, foreign tax paid was 8.7% of the total distribution per unit in 2020 and 10% in 2019. Assuming a 2% distribution yield, that means the overall tax drag is 0.174% and 0.2% respectively.
As mentioned earlier, this is like going down a very deep and dark rabbit hole. Dan Bortolotti and his team from PWL Capital wrote a couple of very detailed analyses on this topic you may want to check out:
- Foreign Withholding Taxes for Equity ETFs – Part 1
- Foreign Withholding Taxes for Equity ETFs – Part 2
If you want more details, you can check also out the foreign tax drag calculator from Canadian Portfolio Manager here.
Equity ETFs and foreign withholding taxes – A simplified view
Want a less-complicated explanation? Ok, let me give that a try.
|US-listed ETFs that hold foreign stocks||No withholding tax||Withholding tax||Withholding tax w/foreign tax credit|
|Canadian-listed ETFs that hold US-listed ETFs that hold foreign stocks||Withholding tax||Withholding tax||Withholding tax w/foreign tax credit|
|Canadian-listed ETFs that hold foreign stocks directly||Withholding tax||Withholding tax||Withholding tax (foreign tax credit or not depends on tax treaty between Canada and the foreign country)|
Please note, this is a VERY simplified explanation and I have avoided mentioning the two different levels of withholding tax completely. There are also some technical nuisances for taxable accounts that I did not mention in the table above. So take a look at PWL Capital’s articles if you want a more detailed analysis (or you want to confuse yourself ha!). And since I’m not a tax specialist, for more definitive advice, it is always best to consult with a CPA or a tax specialist.
For most investors, avoiding venturing down the deep dark rabbit hole in the first place and staying above the ground might be a wise decision. I think most investors should not worry too much about the small fraction of a percentage tax drag with these ETF distributions. At the end of the day, it is only a few dollars we’re talking about.
Is it better to just hold US listed ETFs for foreign exposure?
So why do we use XAW, the global ex-Canada international ETF, a Canadian listed ETF rather than a US-listed international ETF like VT, Vanguard Total World Stock ETF? Why are we paying the tax drag?
Is it not far better to simply hold US-listed ETFs inside an RRSP and avoid the 15% withholding tax in the first place?
Well, we must take currency conversion and exchange rate into consideration. The most efficient way to convert from CAD to USD is to utilize Norbert’s Gambit. But there’s a cost to performing Norbert’s Gambit. First, there’s the commission cost for buying and selling DLR and DLR.U. Even if you can buy and sell ETFs for free from a discount broker like National Bank Direct Brokerage, there is still the ask-bid spread cost. If you look at DLR and DLR.U, there is usually an ask-bid spread of $0.01 for each leg of the conversion, or a total ask-bid spread cost of $0.02.
When it comes to Norbert’s Gambit, I’ve found that it is only worth it when you are converting a large sum of money, typically more than a few thousand Canadian dollars. The higher the amount, the better. When you convert a small amount of money, the overall conversion cost becomes a large percentage of the overall transaction. Taking the example from PWL’s analysis, when exchanging $20,000 CAD to USD, if done efficiently, the total percentage cost will be roughly 0.3% or $60.
With my earlier examples of VXC and VEQT above, the overall withholding tax drag on the distribution is lower than 0.3%. In fact, according to the tax drag calculator, Canadian listed international and global equity ETFs have an average tax drag of 0.371% (VEE has the highest tax drag at 0.65% and XIUU and VUN have the lowest tax drag at 0.26%).
Say there is a difference of 0.1% between holding Canadian listed ETFs vs holding US listed ETFs and you are performing Norbert’s Gambit. For a portfolio of $10,000, a 0.1% difference is $35 and a 0.1% difference for a $1M portfolio is $500. Would you lose sleep over $35? Would you lose sleep over $500 when you have a $1M portfolio? Or are there bigger fish to fry?
Let’s not also forget that in some instances, holding US listed ETFs might not actually save your money because of the overall transaction cost of Norbert’s Gambit.
Ultimately I think it comes down to this key question – how far do you go to save a small fraction of a percentage? Is it really worth your time and effort?
For us, it is far easier and simpler to hold equity ETFs with foreign exposures that are traded on the Canadian exchange. Since the distribution yields are low, we aren’t losing sleep over the small amount of tax drag on distributions. This is why we hold XEQT in RESPs, and XAW in both RRSPs and taxable accounts.
While being efficient is important, there is definitely a case against striving for extreme efficiency. In my opinion, it’s a question of diminishing marginal return.
Summary – Foreign withholding taxes for dividend stocks & equity ETFs
It is important to consider foreign withholding taxes for dividend stocks and equity ETFs. For most investors, the most tax efficient and easiest thing to do is to simply hold foreign dividend stocks and equity ETFs in the appropriate accounts. By doing so, you will save yourself a lot of money in taxes. Don’t lose sleep over withholding taxes since the overall tax drag is usually very small.
Another important thing to keep in mind is that the ETF companies have been improving the way they construct equity ETFs in order to improve their tax efficiency. For example, a few years ago, Vanguard changed its underlying holdings for VXC by holding Canadian-listed ETFs rather than US-listed ETFs. I believe such tax efficiency improvement trends will continue.
So what’s my final message to Canadian investors?
Remember there is always a cost when it comes to investing. You need to be a thoroughly informed investor and be aware of all the costs involved, including arguably most notably, taxes. In the final analysis, you always have to pay your fair amount of taxes to Johnny Canucks, Uncle Sam, Johnny Bull, etc. You should see paying taxes as an upside, because that means you have made money with your investments!
And that is a good thing!
When you make money with your investments, you have to pay a portion of it in taxes. But it is fair to learn how to structure your investment portfolio in such a way as to minimize the amount of taxes you have to pay.
As Benjamin Franklin pointed out many years ago, taxes are an inevitable part of life…
“In this world, nothing can be said to be certain, except death and taxes.”Benjamin Franklin
Look at the big picture. Don’t lose sleep over $5, $10, or even $500 a year in withholding taxes and lose the big opportunity to grow your money.
Please note, I am not a tax specialist so please always consult a CPA or a tax specialist on specific tax-related questions.