Part I: Foreign Withholding Taxes for Equity ETFs

Whether you prefer podcasts, videos, or blog posts, we’ve got you covered in our most recent series on a subject that’s still foreign to many investors: foreign withholding taxes. If you’re a blog reader, just keep reading. Or, you’ll find the podcast and YouTube versions below:

The truth is, I’ve been a bit obsessed with foreign withholding taxes ever since I read a Dimensional Fund Advisors article on the topic in 2012. So inspired, I spent countless nights and weekends poring over the annual financial statements of my favourite ETFs, determined to create a methodology for estimating this mysterious, and usually hidden tax drag.

In 2013, Dan Bortolotti and I published the first edition of our Foreign Withholding Tax white paper (which we intend to update in 2020). Shortly after publication, ETF providers seemed to notice the spotlight our report cast on their foreign withholding tax distributions. Many of them started creating more tax-efficient fund structures, aimed at reducing the withholding tax drag on their existing products. Today, we’ll cover the gamut of options available.

Key Factors: Structure, Account Types, and Withholding Tax Levels

Before we dive in too deep, let’s review what I’m talking about here. Many countries impose a tax on dividends paid to foreign investors. For example, the U.S. government levies a 15% tax on dividends paid to Canadians. Because these taxes are sometimes withheld before dividends are paid in cash, they often go unnoticed. But their impact can be far greater than that of management fees, which get much more attention.

The amount of foreign withholding tax payable depends on two important factors. The first is the structure of the ETF that holds the stocks. The second is the account type used to hold the ETF. Both can be managed to minimize two layers of withholding tax levels.

Structure – Canadian ETF investors can gain exposure to U.S., international, and emerging markets stocks in three ways:

1. A U.S.-listed ETF that holds the foreign stocks
2. A Canadian-listed ETF that holds a U.S.-listed ETF that holds the foreign stocks
3. A Canadian-listed ETF that holds the foreign stocks directly

Withholding tax levels – In all three cases, investors are potentially subject to two layers of withholding tax levels:

1. Level I withholding taxes are those levied by the countries where the stocks are domiciled, whether in the U.S. or overseas.
2. Level II withholding taxes are incurred when international or emerging markets stocks are held indirectly via a Canadian-listed ETF that holds a U.S.-listed ETF. Specifically, there’s an additional 15% U.S. tax on the foreign dividends, before the U.S.-listed ETF pays the net dividends to Canada.

To visualize how this double-layer of withholding tax works, think of your Canadian investment portfolio as a movie theatre seat, with a U.S. concession stand found between the theatre entrance and your seat. The cost of your movie ticket is like your Level I withholding tax. The additional cost of your popcorn, soft drink, and bag of Twizzlers is your Level II tax.

Fortunately, as most frugal moviegoers know, you can avoid the extra expenses by sneaking in your own snacks. Similarly – but lawfully – there are ways to sidestep the Level II withholding taxes on your foreign dividends. In some cases, you may also be able to avoid Level I taxes.

Account Types – Different account types in which you’re holding the ETF (such as an RRSP, RRIF, TFSA, RESP, RDSP, or a taxable or non-registered account) are vulnerable to foreign withholding taxes in different ways. For example:

• When U.S.-listed ETFs are held directly in an RRSP, or other registered retirement account, such as a RRIF or locked-in RRSP, investors are exempt from withholding tax from the U.S. (but not from overseas countries).
• This exemption unfortunately does not apply to TFSAs, RESPs, or RDSPs. But it does hold for several other registered retirement accounts, such as a RRIF, locked-in RRSP (LIRA), or life income fund (LIF).
• If you hold foreign equity ETFs in a personal taxable account, you will receive an annual T3 or T5 slip indicating the amount of foreign tax paid. This amount can generally be recovered by claiming the foreign tax credit on your return. But what if your international or emerging markets equity ETF is subject to both Level I and Level II withholding taxes in a taxable account? Here, only the second layer of U.S. withholding tax is generally recoverable.
• Since no tax slips are issued for dividends received in a registered account, any foreign withholding taxes incurred in an RRSP, RRIF, TFSA, RESP, or RDSP are not recoverable.

Now that we’ve set the stage, let’s walk through some steps you might be able to take, to mitigate your tax drag without running afoul on CRA tax codes. In this post, we’ll cover the three main foreign equity asset classes: U.S., international, and emerging markets. For each, I’ll suggest which ETF structures are the most tax-efficient for the account type, as well as when it might make sense to make an exception to the rules of thumb.

U.S. Equity ETFs in an RRSP or RRIF Account

Remember, there are three ETF structures to choose from for this asset class:

1. A U.S.-listed ETF that holds U.S. stocks
2. A Canadian-listed ETF that holds a U.S.-listed ETF that holds U.S. stocks
3. A Canadian-listed ETF that holds U.S. stocks directly

In an RRSP or RRIF account, the first structure – a U.S.-listed ETF that holds U.S. stocks – is the winning one from a withholding tax perspective. Holding a U.S.-based U.S. equity ETF in your RRSP or RRIF exempts all dividends from the 15% U.S. withholding tax. Based on the current U.S. equity dividend yield of 1.8%, this should save you around 0.3% per year.

Some popular examples of this structure include the Vanguard Total Stock Market ETF (VTI) and the iShares Core S&P Total U.S. Stock Market ETF (ITOT). Both funds also have lower expense ratios than their Canadian-based counterparts.

But, as usual, there’s a catch: To purchase VTI or ITOT in your RRSP, you’ll first need to convert your loonies to U.S. dollars. And even if you use Norbert’s gambit to reduce the cost of buying U.S. dollars, there will be transaction costs.

As an example, suppose we’re converting $20,000 Canadian dollars to U.S. dollars. At most brokerages, you’ll pay two $10 commissions to buy and sell these ETFs for the gambit. These are DLR and DLR.U, respectively. There also will be the hidden trading cost of the bid-ask spreads. If properly executed, the total percentage cost will be roughly 0.3%. Given an annual withholding tax savings of 0.3%, you should be able to offset this cost in about a year.

But what if you’re converting a smaller amount, such as $2,000 CAD? The overall percentage cost of the conversion will be around 1.3%, which will take nearly 5 years to offset with your annual withholding tax savings of 0.3%. And remember, if and when you eventually convert your U.S. dollars back to Canadian dollars, you’ll be hit again with more transaction costs.

So, as an exception to these rules: If you have a smallish portfolio, you might want to stick with Canadian-listed U.S. equity ETFs for now.

U.S. Equity ETFs in TFSA, RDSP, or RESP Accounts

If you’re holding U.S. equity ETFs in a TFSA, RDSP or RESP, there’s nothing you can do about the withholding tax drag. U.S.-listed U.S. equity ETFs receive no preferential tax treatment in these account types, so they’re effectively the same as the other two ETF structures.

For this reason, we would recommend holding either a Canadian-listed ETF that holds a U.S.-listed ETF that holds U.S. stocks, or a Canadian-listed ETF that holds U.S. stocks directly. The Vanguard U.S. Total Market Index ETF (VUN) is one such fund with a U.S.-wrap structure. It simply holds the U.S.-listed ETF, VTI. Another example would be the iShares Core S&P U.S. Total Market Index ETF (XUU), which holds ITOT. The BMO S&P 500 Index ETF (ZSP) is an example of a fund that holds the underlying U.S. stocks directly. Its structure is very similar to that of VUN or XUU from a withholding tax perspective.

As an exception to these rules: If you already hold U.S. dollars in one of these account types, you could consider purchasing a U.S.-listed U.S. equity ETF to slightly reduce your product costs. Just keep in mind that the foreign dividends will still be subject to the 15% U.S. withholding tax.

U.S. Equity ETFs in Taxable Accounts

U.S. withholding tax also applies here no matter which ETF structure you choose. You can generally claim a foreign tax credit to offset this tax drag, but you will still pay income tax on the full dividend.

As mentioned earlier, a slightly lower product cost is the main benefit of holding U.S.-listed U.S. equity ETFs like VTI and ITOT. But, since it would take many years for these product cost savings to offset the currency conversion costs to buy U.S. dollars, we still recommend holding Canadian-listed U.S. equity ETFs like VUN or XUU in your taxable account.

As exceptions to these rules:

1. If you already have U.S. dollars available in your taxable account, you could consider purchasing U.S.-listed ETFs. Keep in mind, there may be additional CRA reporting requirements, such as completing a T1135 form each year. If you want to avoid the T1135 reporting, you could purchase a U.S. dollar version of a Canadian-listed U.S. equity ETF, like XUU.U. Either way, you would be required to track the cost base of your U.S. dollar-denominated ETF in Canadian dollars, which can be a bit of a pain.
2. If you’re a Canadian-U.S. dual citizen, you can potentially reduce your “passive foreign investment company” or PFIC reporting costs by holding U.S.-listed instead of Canadian-listed ETFs in your taxable accounts.

U.S. Equity ETFs Foreign Withholding Tax Overview

		RRSP, RRIF	TFSA, RDSP, RESP	Taxable Accounts
ETF Structure	Examples	Level 1	Level 2	Level 1	Level 2	Level 1	Level 2
U.S.-listed ETF holding U.S. stocks	VTI, ITOT	×	×	√	×	FTC	×
Canadian-listed ETF holding a U.S.-listed ETF holding U.S. stocks	VUN, XUU	√	×	√	×	FTC	×
Canadian-listed ETF holding U.S. stocks directly	ZSP	√	×	√	×	FTC	×
Optimal from a foreign withholding tax perspective

√          Withholding taxes will apply and are not recoverable

×          Withholding taxes will not apply

FTC     Withholding taxes will apply but may be recoverable

Enough said about U.S. foreign tax withholdings. Next, let’s look at tax-efficient international equity ETFs for your accounts.

International Equity ETFs in RRSP or RRIF Accounts

When choosing between the three international equity ETF structures for your RRSP or RRIF, you can immediately scratch one of them off your list: a Canadian-listed ETF that holds a U.S.-listed ETF that holds international stocks.

This U.S. wrap structure was originally how companies like Vanguard Canada and BlackRock Canada structured their international equity ETFs. And it’s how they still structure their U.S. and emerging markets equity ETFs.

When this fund type is held in an RRSP or RRIF, foreign dividends are first paid to the U.S.-based fund, generating a layer of withholding taxes in the process. The net dividends are then paid from the U.S.-based to the Canadian-based fund, creating another layer of withholding taxes in the process. The end result is a tax drag of around 0.7% per year. This fund structure can still be seen – although probably best avoided – in ETFs like the Vanguard FTSE Developed All Cap ex U.S. Index ETF (VDU).

The remaining two fund structures avoid the second layer of U.S. withholding tax in RRSPs and RRIFs, but for different reasons.

A Canadian-listed ETF that holds international stocks directly allows the foreign dividends to bypass the U.S. on their way to Canada. The second layer of withholding tax is thus avoided, although the first layer still applies, based on foreign companies paying dividends to the Canadian fund. The result is a tax drag of around 0.3% per year.

Examples of funds with this structure include the iShares Core MSCI EAFE IMI Index ETF (XEF), the Vanguard FTSE Developed All Cap ex North America Index ETF (VIU), and the BMO MSCI EAFE Index ETF (ZEA).

A side note: In February 2014, when BMO launched ZEA they held its underlying stocks directly, making it the most tax-efficient ETF on the block. Interestingly, BMO didn’t even set out to create a more tax-efficient fund. It just worked out that way. If you’d like, you can listen to the podcast version of this post (at minute 11:31), to hear BMO’s Managing Director and Head of ETF and Managed Accounts Kevin Prins share his perspective on how the fund has evolved.

Finally, there’s the U.S.-listed ETF that holds international stocks. This structure also avoids the additional tax drag when held in an RRSP or RRIF, where it is exempt from U.S. withholding tax.

An example is the iShares Core MSCI EAFE ETF (IEFA), which offers two additional benefits. First, IEFA has lower product fees. Its annual cost is 0.07%, compared to XEF’s cost of 0.22%. Second, IEFA is expected to have a lower tracking error relative to its index. It’s currently around 26 times bigger than XEF, and can arguably track its index more closely with this level of scale.

International Equity ETFs in TFSA, RDSP, RESP, or Taxable Accounts

When holding international equity ETFs in TFSA, RDSP, and RESP accounts, the preferred fund structure is a Canadian-listed ETF that holds international stocks directly. This structure results in only one layer of foreign withholding taxes, while the others have two layers. So, if you’re holding international equity ETFs in your TFSA, we’d suggest opting for XEF, VIU, or ZEA.

We prefer the same for taxable accounts. When you hold a Canadian-listed ETF that holds international stocks directly, only one layer of withholding taxes will apply – and even that one may be recoverable.

Compare that to the other two structures: (1) U.S.-listed ETFs like IEFA that hold international stocks, or (2) Canadian-listed ETFs like VDU that hold a U.S.-listed ETF that hold international stocks. Both of these are subject to two layers of withholding taxes, and only the second layer of U.S. withholding tax may be recoverable. So again, our vote for taxable account holdings goes to ETFs such as XEF, VIU, or ZEA.

The takeaway? If you don’t feel like messing around with Norbert’s gambit to convert your Canadian dollars to U.S. dollars, you may want to just hold XEF, VIU, or ZEA in ANY account type, as relatively tax-efficient choices.

International Equity ETFs Foreign Withholding Tax Overview

		RRSP, RRIF	TFSA, RDSP, RESP	Taxable Accounts
ETF Structure	Examples	Level 1	Level 2	Level 1	Level 2	Level 1	Level 2
U.S.-listed ETF holding international stocks	IEFA, VEA	√	×	√	√	√	FTC
Canadian-listed ETF holding a U.S.-listed ETF holding international stocks	VDU	√	√	√	√	√	FTC
Canadian-listed ETF holding international stocks directly	XEF, VIU, ZEA	√	×	√	×	FTC	×
Optimal from a foreign withholding tax perspective

√          Withholding taxes will apply and are not recoverable

×          Withholding taxes will not apply

FTC     Withholding taxes will apply but may be recoverable

Emerging Markets Equity ETFs in RRSP or RRIF Accounts

Before we dive into our take on emerging markets ETFs, we again direct you to the companion podcast to this post, if you’d like to hear from Steven Leong, Director and Head of Canada iShares Product at BlackRock. There (at minute 18:40), Steven discusses XEF’s transition away from the traditional U.S. wrap structure, as well as why BlackRock still uses the U.S. wrap structure on some of their other asset classes, like emerging markets equities.

Here, we note that BlackRock Canada’s emerging markets equity ETFs do not hold the emerging markets stocks directly. The same can be said of Vanguard Canada’s emerging markets equity ETFs. So, although the main ETF providers have all taken action to improve the tax efficiency of their international equity ETFs, so far only BMO has taken the leap into creating a more tax-efficient emerging markets equity ETF.

Even so, in RRSPs and RRIFs, the rules work the same for emerging markets as they do for international equity ETFs. The most tax-efficient structure would either be a U.S.-listed ETF that holds emerging markets stocks, or a Canadian-listed ETF that holds the emerging markets stocks directly. In both cases, you avoid the second layer of U.S. withholding tax, so your overall tax drag is around 0.3% per year.

Examples of U.S.-listed ETFs include the iShares Core MSCI Emerging Markets ETF (IEMG) and the Vanguard FTSE Emerging Markets ETF (VWO). Both of these invest in large-, mid-, and small-cap emerging markets stocks. The BMO MSCI Emerging Markets Index ETF (ZEM) is a Canadian-listed ETF that holds the emerging markets stocks directly. ZEM only invests in large- and mid-cap emerging markets stocks, so it is not as diversified as IEMG or VWO.

What if you choose to hold a Canadian-listed ETF that holds a U.S.-listed ETF that holds the emerging markets stocks? For that, there’s the iShares Core MSCI Emerging Markets IMI Index ETF (XEC), which holds IEMG, or the Vanguard FTSE Emerging Markets All Cap Index ETF (VEE), which holds VWO. With either, your withholding tax drag will increase from 0.3% to around 0.7% annually.

Emerging Markets Equity ETFs in TFSA, RDSP, or RESP Accounts

In TFSA, RDSP, and RESP accounts, the most tax-efficient fund structure is a Canadian-listed ETF like ZEM, which holds the emerging markets stocks directly. It will result in only one layer of foreign withholding taxes, while the other structures will have two layers of tax drag.

However, along the theme of Steven’s comments, it’s worth noting that this structure generates other, indirect costs to consider. As such, while ZEM’s structure is arguably the most tax-efficient from a withholding tax perspective, that doesn’t mean it’s the optimal structure when all costs are considered (I’ll be posting a separate blog post shortly which compares ZEM and XEC).

Emerging Markets Equity ETFs in Taxable Accounts

Last up, in taxable accounts, only one layer of withholding taxes will apply – and may be recoverable – if you hold a Canadian-listed ETF like ZEM, which holds emerging markets stocks directly. There are U.S.-listed ETFs like IEMG or VWO that hold emerging markets stocks, or Canadian-listed ETFs like XEC or VEE that hold a U.S.-listed ETF that holds emerging markets stocks. Both of these types will be subject to two layers of withholding taxes, and only the second layer of U.S. withholding tax may be recoverable. Even so, I’ve still chosen to hold XEC or VEE in my clients’ taxable accounts … at least for the time being.

Emerging Markets Equity ETFs Foreign Withholding Tax Overview

		RRSP, RRIF	TFSA, RDSP, RESP	Taxable Accounts
ETF Structure	Examples	Level 1	Level 2	Level 1	Level 2	Level 1	Level 2
U.S.-listed ETF holding emerging markets stocks	IEMG, VWO	√	×	√	√	√	FTC
Canadian-listed ETF holding a U.S.-listed ETF holding emerging markets stocks	XEC, VEE	√	√	√	√	√	FTC
Canadian-listed ETF holding emerging markets stocks directly	ZEM	√	×	√	×	FTC	×
Optimal from a foreign withholding tax perspective

√          Withholding taxes will apply and are not recoverable

×          Withholding taxes will not apply

FTC     Withholding taxes will apply but may be recoverable

Up Next in Part II: Global Equity, Global Bond, and Asset Allocation ETFs

Wow. We’ve now covered three kinds of fund structures for U.S., international, and emerging markets stock ETFs, across a range of investment account types available. That’s a lot of ground covered! In Part II in this series, we’ll take on global equity, global bond, and asset allocation ETFs in similar fashion. Hang onto your hat. We’ll be back with that soon.