Ben Felix - Foreign Withholding Tax

Short Summary

Main recommendation: Canadian investors should hold US-listed ETFs of US stocks in their RRSP (not TFSA or RESP) to avoid foreign withholding tax, and generally avoid Canadian-listed ETFs that hold US-listed ETFs in TFSA or RESP accounts because they can trigger two unrecoverable levels of withholding tax. Foreign withholding tax is a hidden drag on returns that can exceed an ETF's management expense ratio, and its impact depends on the ETF's structure and the account type it is held in.

Key Points

• Foreign withholding tax is withheld by the foreign country before dividends reach your account, so it is easy to miss; for example, the US keeps 15% of dividends paid by a US company to a Canadian resident investor.
• Level One withholding tax is the tax a foreign country (including the US) levies on dividends paid to a Canadian investor, like a departure tax.
• Level Two withholding tax is the additional 15% the US withholds when a Canadian-listed ETF owns a US-listed ETF, like a layover tax; it applies because tax is withheld once when the dividend goes to the US ETF and again when it is passed to the Canadian investor.
• US securities in an RRSP, RRIF, or LIRA have no US withholding tax due to the Canada-US tax treaty, but TFSA and RESP accounts do not get this treatment.
• Taxes withheld in a taxable account are reported on a T3 or T5 and can generally offset Canadian taxes, while in registered accounts there are no T slips, so the foreign tax is unrecoverable.

Details Worth Noting

• Concrete instructions:
  • Hold US-listed ETFs of US stocks in an RRSP to eliminate foreign withholding tax; you will need US dollars to buy them.
  • Consider Norbert's Gambit to reduce currency conversion costs, but the speaker says it is not appropriate for beginners; Justin Bender has explained how to execute it on his YouTube channel.
  • Avoid holding a Canadian-listed ETF of US stocks in an RRSP, which results in about a 0.25% unrecoverable withholding tax cost per year.
  • Avoid holding a US-listed ETF of US stocks in a TFSA, which results in about a 0.25% unrecoverable withholding tax cost per year.
  • Avoid a Canadian-listed ETF that owns a US-listed ETF of international stocks inside a TFSA or RESP, as it is among the worst cases, with two unrecoverable levels of withholding tax.
  • Prefer Canadian-listed ETFs that hold international stocks directly (the speaker cites XEF and XEC from iShares) or Canadian index mutual funds such as those from Dimensional Fund Advisors, which hold securities directly and have only one level of withholding tax.
  • For full detail on ETF structures and account combinations, read the white paper "Foreign Withholding Taxes" by Justin Bender and Dan Bortolotti (2016), who are his colleagues at PWL Capital.
• The cost of obtaining US dollars can outweigh the benefit of reducing withholding tax, so compare currency conversion costs first.
• Asset location, optimizing which assets go in which account type, can reduce overall taxes but makes portfolios more complicated; the speaker says he will address whether it is worth it in a future video.

Bottom Line

Account type and ETF structure together decide how much foreign withholding tax you lose, and the worst outcomes come from Canadian-listed ETFs holding US-listed ETFs inside TFSA or RESP accounts.