As North American markets appear overvalued to many observers, investing outside Canada and the United States stands as an attractive alternative. However, for exchange-traded funds, this advantage carries the cost of withholding taxes applied to dividends, a cost ranging between zero and 69 basis points (0.69%) depending on the ETF and the type of account, according to a study by PWL Wealth Management.
The PWL study, titled Foreign Withholding Taxes – How to estimate the hidden tax drag on US and International equity ETFs, analyses all aspects of this issue and is written by Justin Bender and Dan Bortolotti, respectively portfolio manager and associate portfolio manager, in Toronto.
"Because these taxes are withheld before the dividends are paid in cash, they often go unnoticed," write the authors. "But their impact can be far greater than that of management fees, which get much more attention."
There are three factors that determine the level of withholding tax to which an ETF is subject: ETF type, account structure and taxation level.
1) Type of ETF
There are three types of ETFs in which Canadians can invest to access U.S., international and emerging markets stocks:
- U.S.-listed ETFs that directly hold stocks;
- Canada-listed ETFs that directly hold stocks;
- Canada-listed ETFs that hold units of U.S.-listed ETFs with the same mandate.
Some Canadian ETF providers like iShares, Vanguard and Invesco can choose to get their exposure by holding U.S.-listed ETFs sponsored by their U.S.-based affiliates rather than buying each individual stock. They do this to realize economies of scale, minimizing the cost of holding stocks individually.
2) Account structure
ETFs can reside in three types of accounts, which affect the amount of withholding taxes to which they are subject:
- Taxable accounts;
- RRSPs or other registered retirement accounts;
- TFSA (Tax-Free Savings Account) or RESP (Registered Education Savings Plan).
3) Taxation level
Two taxation levels apply. On level 1, there is a withholding tax that is levied by most countries and which is applied across the board, whatever the type of account in which an ETF is held. "A tax of 15% is typical, but it can vary by country," Justin Bender explained in an interview. "The UK doesn't withhold any tax on dividends paid to Canada, but others might withhold more, whether they are developed or emerging market countries."
At level 2, there is an additional 15% tax on ETFs that hold U.S.-listed ETFs of foreign stocks. This tax is withheld by the U.S. government before the U.S.-listed ETF pays dividends to Canadian investors. Note that the U.S. also imposes a Level 1 tax.
How do these three factors interact?
In a U.S.-listed ETF of U.S. stocks, for example, an investor faces only level 1 withholding taxes. In an RRSP, these do not apply; in a taxable account, they apply, but can be recovered at the time of tax filing. In a TFSA or RESP, they apply -- and cannot be recovered. (For a taxable account, an ETF owner receives a T5 slip from his or her investment dealer specifying the amounts of dividend earned and tax withheld, explains Dan Bortolotti. For an RRSP account, the investor simply does not receive a slip.)
To illustrate the above scenario, the study's authors use 
Vanguard Total Stock Market ETF (VTI), which at the time had a management-expense ratio of 0.05% and a dividend yield of 2.07%. Based on these numbers, they calculate the costs of the withholding tax in a TFSA or RESP account to be 0.30% or 30 basis points. Note that the real costs could be slightly different in other ETFs.
In the case of a Canadian-listed ETF that holds a U.S.-listed ETF of U.S. stocks, in an RRSP, TFSA or RESP, the basic Level 1 tax of 15% by the U.S. government is imposed and is not recoverable, while the Level 2 tax does not apply. In a taxable account, in which Level 1 tax is recoverable, the cost is zero.
The costliest structure applies in the case of a Canadian-listed ETF that holds a U.S.-listed ETF of international stocks. In an RRSP, TFSA or RESP, tax levels 1 and 2 apply and are not recoverable, while in a taxable account, both tax levels also apply, but only the first one is not recoverable.
The percentages below illustrate the estimated cost of withholding taxes under various scenarios, and are calculated using representative Vanguard and iShares ETFs.
| Type of account | ||||
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| RRSP | Taxable | TFSA/RESP | ||
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| US-listed ETF of US stocks | 0.00% | 0.00% | 0.30% | |
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| US-listed ETF holding developed markets stocks directly | 0.25% | 0.25% | 0.69% | |
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| US-listed ETF of emerging market stocks | 0.29% | 0.29% | 0.69% | |
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| Canadian-listed ETF holding a US-listed ETF of US stocks | 0.30% | 0.00% | 0.30% | |
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| Canadian-listed ETF holding a US-listed ETF of developed market stocks | 0.59% | 0.16% | 0.59% | |
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| Canadian-listed ETF holding a US-listed ETF of emerging market stocks | 0.69% | 0.29% | 0.69% | |
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| Canadian-listed ETF holding US stocks directly | 0.30% | 0.00% | 0.30% | |
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| Canadian-listed ETF holding developed market stocks directly | 0.26% | 0.00% | 0.26% | |
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| NOTE: Percentages are representative and can vary from one ETF to another. In this table, the higher percentages indicated in the PWL Capital study have been retained. |
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The authors note a few key takeaways for investors. In an RRSP account, investing directly in U.S.-listed ETFs has the most significant fiscal advantage. In a TFSA or RESP, and in a taxable account, investors should favour Canadian-listed ETFs for all foreign equities. As the above table shows, taxable accounts stand out as the most efficient across the board, in which Canadian-listed ETFs have a clear advantage.
But these links between account types and ETF categories are not set in epoxy glue. Before favouring an RRSP for U.S.-listed ETFs or a taxable account for Canadian-listed ones, investors should consider a larger perspective. Because, as the authors write, "foreign withholding taxes are just one of many costs of investing". One should consider the cost of currency conversion, his or her income tax situation and recordkeeping imperatives.
Justin Bender gives the example of an investor who stands in a relatively low tax bracket. Then, by all means, he should favour a taxable account for most ETF categories, which has the most favourable withholding tax footprint across the board, as the table shows. But if that individual’s tax bracket is high, submitting him to hefty capital gains and interest taxes, favouring a taxable account for his ETF holdings could cause him to pay even more income tax, in spite of his foreign dividend withholding tax savings.
