Do you pay withholding tax on U.S. ETFs?

Withholding tax on U.S. ETFs for Canadians

U.S. equity markets represented about 46% of global equity market capitalization as of the third quarter of 2022. The S&P 500 total return in Canadian dollars over the past 50 years as of Dec. 31, 2021 was 2.1% higher than the S&P/TSX Composite total return for the same period (11.7% vs. 9.6%). It only makes sense for Canadian investors to have an allocation to U.S. stocks.

One problem with owning U.S. stocks is withholding tax. To answer your question directly, Neil, buying a Canadian-domiciled U.S. stock exchange traded fund (ETF) will generally not avoid U.S. withholding tax. Under the tax treaty between Canada and the U.S., there is 15% withholding tax on dividends paid from a “company resident” in one country to a resident of the other.

A Canadian-domiciled ETF—so, an ETF that trades on the Toronto Stock Exchange, for example—is considered a Canadian resident. So, if a Canadian-listed ETF receives a dividend from a U.S. stock, as would be the case for a U.S. stock ETF domiciled in Canada, there is 15% withholding tax.

Registered or non-registered account: Does it matter?

If this investment is held in a non-registered account, the 15% withholding tax would probably not matter. This is because it can be claimed as a foreign tax credit that reduces the Canadian tax otherwise payable. This avoids double taxation. Even at a low level of income, Canadian taxpayers generally pay 20% to 25% tax at minimum. So, this first 15% just reduces the ultimate tax liability.

If you hold a Canadian-domiciled U.S. stock ETF in a registered retirement savings plan (RRSP), tax-free savings account (TFSA), or registered education savings plan (RESP), the 15% withholding tax cannot be recovered. The S&P 500 has a dividend yield of about 1.7% currently, so that suggests about a 0.25% reduction in return. Mind you, that could be a small price to pay for diversification, given how difficult it is to access sectors like technology and health care for an investor investing only in Canada.

Withholding tax on RRSP investments

Interestingly, Neil, there may be a way around this withholding tax for an investor in their RRSP. U.S. stocks and U.S.-domiciled U.S. stock ETFs are not subject to withholding tax for a Canadian investor holding them in their RRSP, registered retirement income fund (RRIF), or similar retirement accounts. Buying U.S. stocks and U.S.-listed stock ETFs can therefore boost returns for a Canadian investor—by 0.25% per year for a typical S&P 500 ETF or S&P 500 constituent. The higher the dividend, the greater the benefit, Neil.

However, in order to buy U.S.-domiciled investments, a Canadian investor has to contend with foreign exchange costs. These can range from 1.5% to 2% to buy U.S. dollars with Canadian dollars in a brokerage account based on the foreign exchange rate provided. These foreign exchange costs can be reduced by using a strategy commonly referred to as Norbert’s Gambit, in which ETFs or stocks are bought in one currency and sold in another currency. In this case, the cost may be as little as the brokerage commissions to buy and sell.

The withholding tax exemption for RRSPs does not carry over to TFSAs or RESPs, Neil.

Consider incremental taxation

It is worth noting that if a Canadian investor buys a Canadian ETF that owns U.S. ETFs that own foreign stocks, there is the potential for incremental levels of taxation. This is because the foreign stocks may have foreign withholding tax on dividends before they arrive in the U.S. ETF, and then a second layer of withholding tax once dividends are paid from the U.S. to the Canadian ETF. As a result, for international stock exposure, a Canadian investor should probably consider Canadian-domiciled ETFs that own foreign stocks directly rather than owning them indirectly through U.S. ETFs. It may be worth looking under the hood at what your ETF owns.

It also bears mentioning there are products that may mitigate U.S. withholding tax. Probably the best known example for a Canadian looking for U.S. stock exposure is Horizons S&P 500 Index ETF, a swap-based ETF that does not hold the underlying securities of the index. According to Horizons:

“. . . investors are only expected to receive the total return of the Index, which is reflected in the ETF’s unit price. Investors are not expected to receive any taxable distributions directly.

“[It] would not be subject directly to the U.S. withholding tax since it does not actually receive physical dividends.”

Final thoughts

In summary, Neil, a Canadian-domiciled ETF would almost always be subject to withholding tax on U.S. dividends. A swap-based ETF is an example of a potential exception. There may be ways to avoid withholding tax in some accounts, like an RRSP, by holding U.S.-listed securities directly. And in other accounts, like non-registered accounts, it may not matter given investors can claim a foreign tax credit.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.

Read more from Jason Heath:

• Should you collect CPP and OAS while working in your 60s?
• Can you save tax by moving into your rental property?
• How to avoid OAS clawbacks when you’ve had a temporary increase in income

• Should RRIF withdrawals be based on the younger spouse’s age?

About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.

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