Last updated on January 11th, 2021 at 02:39 am
- The Basics of Foreign Withholding Tax
- Are You Paying?
- How Much Does Foreign Withholding Tax Cost?
- How to Reduce Foreign Withholding Tax?
- The Federal Foreign Tax Credit
- Reducing Withholding Taxes in Your RRSP
- Reducing Withholding Taxes in Your TFSA
- Avoiding Two Levels of Foreign Withholding Tax
- Foreign Withholding Tax Quick Guide
- Foreign Withholding Taxes on Bonds
- Is It Worth Avoiding Foreign Withholding Tax?
- Thanks for Reading!
The Basics of Foreign Withholding Tax
Most countries levy a withholding tax on dividends paid to foreign investors. These rates range from as low as 0% in Hong Kong to as high as 35% in Chile. Even Canada has a withholding tax: we charge foreign investors 25% of the dividends they earn from Canadian companies. A special tax treaty between Canada and the U.S. reduces the foreign withholding tax levied on Canadians from 30% to 15%.
Think of withholding tax as a fee that’s levied whenever dividends cross a border. For example, let’s say you own a few Apple shares. When Apple pays a dividend, U.S withholding tax applies and reduces the amount of dividends you receive. Consider if you earned $100 in dividends. The withholding tax would be $100 multiplied by the U.S. withholding tax rate applicable to Canadians, which is 15%. This means that you would only receive $85 in dividends after the withholding tax was levied. Depending on the account you use to hold these Apple shares, the withholding tax may be reduced or eliminated, but we’ll get into that later.
Often your dividends can experience a second level of foreign withholding tax. Consider this situation: you’re a DIY investor investing in international stocks using a U.S. listed ETF. Perhaps it has a lower MER, or it holds a more diverse basket of equities than its Canada listed counterparts. The dividends you earn from this fund would be subject to two levels of foreign withholding tax. One level of foreign withholding tax is paid when the dividends travel internationally and cross into the U.S. And there’s another withholding tax paid when the dividends cross the Canadian border to reach your account. All of a sudden that low MER fund now has a much higher cost of ownership.
Are You Paying?
If you invest in dividend-paying stocks in a non-registered account, you’ll likely receive a T3 or T5 slip depending on the type of assets you own. For example, the T5 tax slip, or Statement of Investment Income, will list the amount of foreign income you received and the amount of foreign tax you paid on this income. The same thing holds true for ETFs and mutual funds – the T3 or T5 tax slip you receive will state the amount of foreign tax paid.
If you’re holding an ETF or mutual funds in a registered account (like your TFSA or RRSP) it can be a little harder to tell if you’re paying foreign withholding tax. That’s because, unlike with a taxable account, you won’t receive a T3 or T5 tax slip. However, it’s still easy to find out just how much foreign withholding tax is costing you. One way to find out is to check the fund’s website for a list of its distributions. Often they’ll list the amount of foreign dividends the fund received and the amount of foreign tax paid. Here’s how that looks for Vanguard’s popular U.S. Total Market Index ETF (VUN):
As you can see, VUN pays approximately 15% of its investment income in foreign withholding taxes. This might not seem like a lot on the surface, but if you had thousands of dollars invested in this ETF, all of those dollars lost to foreign withholding taxes can add up to a significant amount of money.
How Much Does Foreign Withholding Tax Cost?
Foreign withholding tax can be a non-insignificant drag on your investments. Consider a diversified ETF like Vanguard’s Growth ETF Portfolio (VGRO). The MER of this fund is 0.25% per year, but this isn’t the entire carrying cost of the fund. The foreign withholding taxes paid on its U.S. and international assets add up and contribute to the costs of investing in the fund. As a result, if you’re holding the fund in a registered account, your actual annual costs are closer to 0.50%.
Foreign withholding taxes can have such a large impact because they’re applied not as a fee on your entire portfolio, but as a tax on the dividend income you receive. For example, the U.S. withholding tax of 15% reduces a 3% dividend to 2.55%. That can add up to hundreds or thousands of dollars lost to foreign withholding taxes per year, depending on the size of your portfolio.
The reason most DIY investors use ETFs is because of their low fee structure. And so going from an MER of 0.25% to an effective MER of 0.50% can make investors think twice about investing in a particular fund. Luckily, there are some good ways to avoid paying foreign withholding taxes on your investment income.
How to Reduce Foreign Withholding Tax?
There are a few different ways Canadians can reduce the burden of foreign withholding tax on their investments. It all comes down to understanding a little bit of tax code and using that knowledge to make informed investment decisions.
The Federal Foreign Tax Credit
The Federal Foreign Tax Credit is available for Canadians to offset the foreign withholding tax paid on their investment income. The purpose of the credit is to help prevent double taxation. That is, to prevent the income from being taxed twice: once by a foreign country and once by Canada. There also exists Provincial Foreign Tax Credits for all provinces except Quebec, which can further help to prevent double taxation on your foreign investment income.
These tax credits are the perfect tool for reducing your foreign withholding taxes. But there’s just one issue: you can only apply for the credits on investment income earned in a taxable account. Any income earned in your registered accounts, like your RRSP or TFSA, will not benefit from the Federal Foreign Tax Credit or Provincial Foreign Tax Credits. As a result, if you’re registered accounts are full, it could be beneficial to move some of your higher dividend-paying investments to your taxable account. That way you can minimize foreign withholding taxes paid on these investments.
Reducing Withholding Taxes in Your RRSP
Your RRSP is uniquely positioned to help you reduce or eliminate withholding taxes on your investments. Thanks to a tax treaty signed by the U.S. and Canada, you can earn dividend income in your RRSP without being subject to U.S. withholding tax. This benefit also applies to Registered Retirement Income Funds (RRIF) and Locked-In Retirement Accounts (LIRA).
Not being subject to U.S. foreign withholding taxes makes the RRSP a great account for holding U.S. stocks and U.S. listed ETFs or mutual funds. Just be sure to use Norbert’s Gambit or have some other method for cheaply obtaining U.S. dollars.
Reducing Withholding Taxes in Your TFSA
Unfortunately, there is no way to eliminate foreign withholding taxes in your TFSA; whenever your dividend income crosses a border you will subject to withholding tax. However, that doesn’t mean you can’t avoid some withholding tax.
Avoiding Two Levels of Foreign Withholding Tax
To reduce foreign withholding taxes in your TFSA (and your other accounts) it’s best to avoid funds that expose themselves to two levels of withholding tax. This situation sometimes arises when investing in a fund that holds U.S. or international stocks.
A good example is the iShares Core MSCI Emerging Markets IMI Index ETF (XEC). This is a fund that invests in international equities, so you should expect some exposure to withholding taxes. If the fund held these international equities directly you would be exposed to one level of withholding tax. But, unfortunately, XEC invests in international stocks by investing in the U.S. listed iShares Core MSCI Emerging Markets ETF (IEMG). This “wrap” structure is common, and it means you’ll be exposed to two levels of withholding tax. There’s one withholding tax when the international stocks pay dividends to IEMG, and another when IEMG pays dividends to XEC.
The worst thing about this structure is that even if you held XEC in a taxable account you would only be able to recover one level of withholding tax – the tax paid when your dividend crosses the border into Canada. The withholding tax paid when dividends cross into the U.S. from international markets is unrecoverable.
As you can see, each time your dividends cross a border there is a potential for paying foreign withholding tax. Minimizing the number of borders your investment income crosses can help reduce and even eliminate foreign withholding taxes.
Foreign Withholding Tax Quick Guide
Here’s an easy to use guide that will help you understand how foreign withholding taxes will affect your investments.
- The first column describes where the ETF (or mutual fund) is domiciled. “Canada” indicates the ETF is listed in Canada, like VGRO. “U.S.” indicates the ETF is listed in the U.S, like IEMG.
- The second column describes the type of equities the ETF invests in.
- The third column describes whether the ETF invests in the equities directly or if they invest in another ETF. For example, Vanguard’s U.S. Total Market Index ETF (VUN) is a Canadian listed ETF that invests in its U.S. listed counterpart, VTI. This “wrap” structure can expose you to additional levels of withholding tax.
- In the remaining columns:
- “Yes” means withholding taxes apply but can be recovered via the Federal and Provincial Foreign Tax Credits.
- “No” means foreign withholding taxes apply and cannot be recovered.
- “N/A” means foreign withholding taxes do not apply.
- “No, Yes” means the first level of foreign withholding taxes (when your dividend crosses into the U.S.) is not recoverable. The second level of foreign withholding taxes (when crossing the border into Canada) is recoverable.
Foreign Withholding Taxes on Bonds
In general, the U.S. does not levy foreign withholding taxes on bonds held by Canadian investors. Other countries sometimes do levy foreign withholding taxes on bond interest, but this shouldn’t be a major concern for Canadian investors. Canadians typically invest in Canadian fixed income and only occasionally in the U.S fixed income.
Is It Worth Avoiding Foreign Withholding Tax?
When it’s easy, yes. In your taxable account make sure you apply for the Federal and Provincial Foreign Withholding Tax Credits. Consider holding some of your U.S. assets in the form of a U.S. listed ETF in your RRSP. And finally, do your best to avoid funds that have a “wrap” structure when investing in the U.S. or internationally.
Reducing withholding taxes can be worthwhile, but doing so shouldn’t dictate your investment decisions. Adding diversification to your portfolio by investing outside of Canada is worth it – even if that means paying some withholding taxes.
Thanks for Reading!
I hope my article has helped you make sense of foreign withholding taxes. If you’re a DIY investor like me, understanding withholding taxes can help you make better investment and portfolio decisions. Please consider checking out some of my other recent articles. Find out how I saved up a down payment in a high cost of living area or read my review of the best Canadian dividend ETFs! Finally, consider signing up for my newsletter or following me on social media if you’d like to be notified when I post new articles.