Investing Abroad - Canadian or U.S. Listed ETFs?

Some Tax Considerations

by Pauline Shum Nolan, Founder, Warner Wen, Wealthscope alumnus and ETF expert, and Armaan Zaffino, Product Manager

 

For those looking to diversify their investments beyond Canada and use exchange-traded funds (ETFs) to build a global portfolio, they have the option to select Canadian listed or U.S. listed funds. There are some important factors to consider. 

 

First, currency. Are you looking for a currency-hedged ETF (i.e., immunizing the returns from fluctuations in the exchange rate) or an unhedged version? There is empirical evidence that exposure to the U.S. dollar could benefit Canadians investors, as long as the USD stays as the world's major reserve currency and maintains its countercyclical properties. See this Harvard study for details. 

 

Second, the management expense ratio. How do the fund fees compare? For example, ETFs that track large-cap U.S. equities (unhedged) currently have MERs that range from 0.03% to 0.10%, depending on the fund provider.

 

Third and the main discussion in this article, are the tax implications. Let’s review the types of taxes you are subject to as a Canadian investor in foreign securities. Table I below summarizes the three main types: tax on foreign income, capital gains tax, and foreign withholding tax.

Type of tax.jpg

Therefore, if held in a taxable investment account, all distributions from a U.S. listed ETF - including dividends, capital gains, and return of capital - are taxable subject to your marginal tax rate.* And when you sell a U.S. listed ETF, 50% of the capital appreciation (if any) will be taxed. The foreign withholding tax warrants additional scrutiny, as it is more complicated.

 

Foreign Withholding Taxes (FWT)

 

Thanks to Canada’s long standing tax treaty with the U.S. government, Canadian investors are entitled to a reduced FWT on U.S. dividends at 15%, from 30%. (For other international markets, the weighted average is 12%.)** Further, if the U.S. securities are held in a taxable account, Canadians can claim a foreign tax credit to avoid double taxation on U.S. dividends.

 

In general, for foreign securities held in an ETF (Canadian or U.S. listed), there are three major factors that determine how much FWT is levied:

  1. where the underlying securities are domiciled;

  2. the structure of the ETF; and

  3. the account type you hold the ETF in.

 

Table II offers a useful visualization of the FWT implications, based on these three factors:

Foreign Withholding Tax.jpg

Notes: 

NR” denotes non-recoverable tax whereas “R” indicates the withholding tax can generally be recovered by claiming the foreign tax credit on your tax return.


 

Note that for international equity ETFs, there could be a second layer of FWT, levied by the U.S. government (at 15%) on the distribution if it is listed in the U.S., on top of the FWT levied by international governments where the stocks are domiciled.

 

So is there a tax advantage holding U.S. versus Canadian listed ETFs?

 

U.S. Equity

 

Let’s consider your retirement investment accounts (RRSP, RRIF, and LIRA). If you are investing in U.S. domiciled securities, there is a FWT exemption for U.S listed ETFs, but not for Canadian listed ETFs.

 

So with a hypothetical investment of $10,000 within an RRSP in a broad U.S. market ETF, which is yielding at say, 1.33%, you would receive $133 or 100% of that distribution per year. It will not be taxed until you start drawing down your funds in retirement. 

 

For other account types (TFSA, RESP, and taxable), the FWT always applies. However, in a taxable account, since a Canadian foreign income tax is already levied on U.S. dividends, the FWT is recoverable via a foreign tax credit to avoid double taxation. (TFSA and RESP are registered accounts and income is not taxed by the Canada Revenue Agency.)

 

International Equity

 

For securities domiciled overseas, you can see from the table above that Canadian listed International Equity ETFs that wrap a U.S. listed ETF are always subject to both the international and U.S. FWT, as are U.S. listed ones when they are held in a TFSA/RESP or a taxable account. Therefore, Canadian listed ETFs for international equities would be the way to go unless you want exposure to the U.S. dollar within a registered retirement account.

 

Conclusion

 

At Wealthscope, we believe that an informed investor is a better investor. For ETF investors especially, understanding the tax implications should always be a cornerstone of your investment process. 

Disclaimer: the information contained in this article should not be considered investment advice. Consult a financial advisor or a tax expert for more information.


 

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* However, if it is a Canadian listed foreign equity ETF, only 50% of the capital gains distribution is taxable.

** Blackrock, Understanding Foreign Withholding Tax, retrieved from:

https://www.blackrock.com/ca/individual/en/literature/brochure/withholding-tax-reference-guide-en-ca.pdf on May 5, 2022.