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Tax implications of investing abroad

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U.S.-tax

You can reap enormous benefits from diversifying a portfolio with U.S. and international stocks. But those benefits carry a cost: foreign withholding taxes.

Many countries tax dividends paid to foreign investors: for example, the U.S. government levies a 15% tax on dividends paid to Canadians. Since these taxes are withheld before dividends are paid, they often go unnoticed.

The withholding tax on U.S. dividends paid to Canadians is technically 30%, but this can be reduced to 15% if clients fill out the IRS’s W-8BEN form.

The amount of foreign withholding tax payable depends on two factors. The first is the structure of the ETF or mutual fund that holds the stocks. There are three common ways Canadian index investors can get exposure to U.S. and international stocks:

  • through a U.S.-listed ETF;
  • through a Canadian-listed ETF that holds a U.S.-listed ETF; or
  • through a Canadian-listed ETF or mutual fund that holds the stocks directly.

In all cases, you’re potentially subject to withholding taxes levied by the countries where the stocks are domiciled, whether that’s the U.S., developed markets outside North America (western Europe, Japan, Australia), or emerging markets (China, Brazil, Taiwan). We refer to this as Level I withholding tax.

When you hold international stocks indirectly via a Canadian-listed ETF that holds a U.S.-listed ETF, you may also be subject to what we call Level II withholding tax. This is an additional 15% withheld by the U.S. government before the U.S.-listed ETF pays the dividends to Canadian investors.

Think of Level I foreign withholding tax as a departure tax you pay when taking a direct flight to Canada from a foreign country (including the U.S.). Level II tax is like a second departure tax you pay when an overseas flight to Canada has a layover in the U.S.

The second key factor is the type of account used to hold the ETF or mutual fund.

Different account types—RRSPs, personal taxable accounts, corporate accounts and TFSAs—are vulnerable to foreign withholding taxes in different ways:

  • When U.S.-listed ETFs are held directly in an RRSP (or other registered retirement account, such as a RRIF or a locked-in RRSP), you’re exempt from withholding tax from the U.S. (but not from overseas countries).
  • This exemption does not apply to TFSAs or RESPs.
  • If you hold foreign equities in a personal taxable account, they’ll 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 Line 405 of your return. (Since no tax slips are issued for dividends received in a registered account, any foreign withholding taxes incurred are not recoverable.)
  • Holding foreign equities in taxable corporate accounts is generally less tax-efficient than holding them in taxable personal accounts.
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TJMACHADOO.7

Given the tax treatment of ETFs one would think the Canadian ETF market would have few to none ETFs that provide US exposure and many ETFs that provide international exposure by investing directly in the underlying securities. It is in fact quite the opposite. Real head scratcher. Additionally you really have to dig into the bowels of the documents to ascertain whether an ETF is a fund of funds.

Friday, Jul 10, 2015 at 4:28 pm Reply