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.