While Washington passed U.S. President Donald Trump’s “one big beautiful bill” last week without Section 899 — the so-called revenge tax provision that would have imposed new costs for Canadian investors — there’s plenty advisors can do to shield clients from existing taxes.
Advisors should be aware of U.S. withholding taxes under the current Canada-U.S. tax treaty and how to structure client portfolios effectively to minimize them. Another consideration is how to avoid withholding tax imposed by other foreign countries on their dividend payouts.
For ETFs investing in the U.S., Canadians can choose between three main product structures. One is Canadian-listed ETFs that invest directly in U.S. securities. Secondly, there are Canadian-listed ETFs that obtain their exposure by holding units of a U.S.-listed ETF. The third alternative is a U.S.-listed ETF.
Tax implications will vary, depending on the ETF structure and the type of account in which the ETF is held, such as a non-registered account, an RRSP or a TFSA.
“It does just come down to knowing your account types and tax outcomes to understand and to consciously decide on what structure is best suited for your client,” said Prerna Mathews, vice-president of ETF product strategy at Toronto-based Mackenzie Investments.
Non-registered accounts
In non-registered accounts, which are fully taxable, all ETF product structures are subject to a 15% withholding tax on U.S. dividends. However, they’re also eligible for foreign dividend tax credits for the amounts paid. For investors to obtain this relief under the Canada-U.S. tax treaty, advisors must ensure that their clients complete a U.S. form, W-8BEN, certifying the foreign status of the beneficial owner.
Non-registered accounts are generally the best place for investors to hold ETFs that pay U.S. dividend income, said Ian Calvert, a certified financial planner who is vice-president and principal with HighView Financial Group in Oakville, Ont. For example, “when it’s a Canadian-listed ETF that owns U.S. securities and you’re getting U.S. dividends, the taxable account is the only one that provides some relief.”
From a tax perspective, one ETF structure to avoid is a U.S.-listed ETF that invests outside North America. Canadian investors in these ETFs are subject to two levels of withholding tax.
Based on the MSCI EAFE Index of international stocks, the weighted-average blended withholding tax rate is just about 10%, said Chris McHaney, executive vice-president and head of investment management and strategy at Toronto-based Global X Investments Canada Inc.
Assuming a 3% dividend rate, Canadian investors would pay about 30 basis points of overseas withholding tax that would be deducted from their dividend yields and that would be non-recoverable. That’s in addition to the 15% U.S. withholding tax.
“By avoiding going through the U.S. market, you’re avoiding that second layer of withholding tax,” McHaney said. “You’re making it more efficient to invest globally.”
The same tax inefficiency would apply to a Canadian-listed ETF employing a wrap structure, holding a U.S. international equity ETF instead of investing directly in overseas stocks.
McHaney sounded a note of caution in comparing the performance of a Canadian-listed ETF to a U.S.-based one.
“When investors look at the return that a U.S.-listed ETF provides, they have to be aware that that headline number doesn’t include any withholding tax that they would be paying,” he said. With the Canadian-listed ETF, the withholding tax is built into its net asset value and its price.
Registered accounts
In RRSPs, RRIFs and other registered retirement accounts, the clear winner in U.S. dividend income in terms of tax efficiency is a U.S.-listed equity ETF, since it’s exempt from withholding tax. By contrast, Canadian-listed ETFs — whether investing directly in stocks or via a U.S.-listed ETF — are subject to the 15% withholding. Worse still, when held in a registered account, there’s no foreign dividend tax credit available.
For U.S. fixed-income exposure in retirement accounts, Canadian-listed or U.S.-listed ETFs that invest directly in U.S. bonds or other interest-paying securities will not be subject to withholding tax. But according to a Mackenzie guide for investors, tax will be withheld on distributions by a wrap-style Canadian-listed ETF that holds a U.S.-listed ETF.
Other types of registered accounts, including TFSAs, RESPs and RDSPs, are also subject to U.S. and other foreign withholding taxes on dividends, and there are no provisions for recovery via tax credits.
Neither U.S.-listed nor Canadian-listed ETFs are exempt. “It doesn’t really matter which way you go, you’re going to be paying withholding tax (on dividends),” said Mathews.
Although some registered accounts, such as TFSAs, are the least tax-efficient for U.S. dividends, that does not mean that U.S. equities should be avoided.
While withholding taxes are a factor in deciding what to hold in a TFSA, other considerations come into play in taking advantage of tax-free growth. “The U.S. market is the world’s largest stock market,” said Calvert. “So, you don’t want to limit your investment options.”
There’s no withholding tax, regardless of whether they are Canadian or U.S.-listed, on ETFs that invest in U.S. fixed income. The advantage of going with Canadian listings is that domestic ETF companies offer choices regarding currency exposure.
This has become a more important consideration, given the recent weakness of the U.S. dollar versus other major currencies. “We’ve seen a lot of advisors migrate to using some amount of hedged exposure in their portfolios this year, just given what’s happened with the CAD-USD (exchange rate),” Mathews said.
“Obviously you’ll only find a hedged-to-CAD ETF listed here in Canada,” McHaney said. “They’re not going to list them down south.” As well, Canadian ETF providers also offer U.S.-dollar-denominated classes of units for investors who have U.S. currency to invest.
Amid the uncertainty over what new tax rules might emerge in the U.S., Calvert said HighView is advising clients not to make any rash decisions on changing their asset mix. “Policies can change. We’ve seen that,” he said, citing as an example Ottawa’s flip-flop on capital-gains inclusion rates.
Mathews expressed confidence that the Canadian ETF industry will find ways to respond to whatever adverse tax changes the U.S. might impose. “There’s going to be undoubtedly innovation that pops up in the market,” she said. “It’s too early to say what that might look like.”