Updated: May 24, 2020
It's never been easier to be a DIY investor. Especially, if you only plan on investing In Canadian stocks and bonds. All you need to do is invest in a Candian stock market index fund and a Canadian bond market index fund and you are off to the races. However, as part of a well thought out diversification strategy, you may consider investing in ETFs that track foreign stock markets.
If you're a Canadian considering investing in foreign stocks, you need to be aware of a nasty three-letter word; "tax". Specifically, you need to be aware of the withholding tax applied to dividends you receive from ETFs that hold foreign stocks.
In this article, I am going to explain how Canadian investors can minimize foreign withholding tax when investing in international ETFs.
What is a withholding tax?
In the context of investing, a withholding tax is a tax levied by a foreign government when a Canadian investor receives dividends from a foreign company. Put simply, if a foreign company pays you a dividend a portion of that dividend is taxed before it ever gets to you. For that reason, many investors are not even aware that withholding taxes exist.
The level of withholding tax varies and depends on what agreements (if any) exist between the Canadian government and the government of the country where the dividend originated from.
Sadly, you can't avoid withholding taxes completely. If you are going to diversify your portfolio by investing in foreign stocks, you will pay withholding taxes.
However, you can minimize your withholding taxes by selecting ETFs with the right structure and make savvy decisions about where you hold those ETFs. By that I mean whether you hold these ETFs in your RRSP, TFSA, RESP or taxable investment accounts.
The two levels of withholding tax
There are two levels of withholding taxes that could potentially apply to dividends received from foreign companies.
Level 1 (L1) withholding tax: These are withholding taxes levied by a foreign government when a Canadian investor receives dividends from a company in that country.
Level 2 (L2) withholding tax: This is an additional withholding tax (typically 15%) applied by the U.S government. Level 2 withholding tax applies to dividends paid to a Canadian investor by a Canadian-listed ETF that owns a US-listed ETF. You still have to pay level 1 withholding tax in addition to this 15% withholding tax to the U.S government.
Obviously, the name of the game should be to avoid level 2 withholding tax.
Both level 1 and level 2 withholding tax are summarized in the following graphic.
The 3 types of ETFs available to Canadian investors
As a Canadian investor, there are generally 3 types of ETFs you can invest in.
A U.S listed ETF.
A Canadian-listed ETF (that holds a US-listed ETF).
A Canadian-listed ETF (that holds stocks directly).
The 4 investing account types available to Canadian investors
Registered Retirement Savings Plan (RRSP)
Tax-Free Savings Account (TFSA)
Registered Education Savings Plan (RESP)
Which type of ETF structure you invest and which investing account it's located in will determine if you pay withholding tax and whether that withholding tax is level 1 or level 2.
How smart asset location can minimize foreign withholding tax
Investing in U.S equities
The only way to completely avoid withholding tax when investing in non-Canadian stocks is to invest in a U.S listed ETF (that holds U.S stocks directly) and have that ETF held inside your RRSP.
Withholding tax in this situation does not apply due to a tax treaty between Canada and the U.S. It's important to note that withholding tax will apply if that same fund is held inside a TFSA, RESP, or taxable account.
If you invest in a U.S listed ETF that holds U.S stocks directly, the most tax-efficient location for that ETF is in your RRSP.
It is inefficient to hold a U.S listed ETF in your TFSA for two reasons:
Level 1 withholding tax still applies
You'll have to pay a fee to convert your Canadian dollars to U.S dollars
Investing in a fund invested in U.S equities (regardless of structure) in your taxable account will result in level 1 withholding taxes. However, you will receive a tax credit when you file your annual tax return.
Investing in international equities
When investing in foreign equity ETFs (outside the U.S), level 1 withholding tax becomes unavoidable.
When investing in your RRSP, the least efficient decision would be to invest in a Candian listed ETF that holds a U.S listed ETF inside it. That would result in level 2 withholding tax.
When investing in your TFSA or RESP the only way to avoid level 2 withholding tax is to invest in a Canadian listed ETF that holds foreign stocks directly.
All of the withholding tax permutations are summarized in the following infographic.
International diversification is important as it has been shown to reduce overall risk and volatility for a Canadian investor's portfolio. However, it comes at a cost in the form of withholding taxes.
In this article, we reviewed the most and least efficient way for Canadians to invest in international equities.
If you are a DIY investor it is worth reviewing your portfolio to ensure you are not paying more withholding tax than you need to be.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.