The drag on income from foreign withholding taxes is often not well understood.claudenakagawa/iStockPhoto / Getty Images
A conversation about taxation can be a drag for clients, but so is the “tax drag” from foreign assets held in registered retirement savings plans.
This drag on income from foreign withholding taxes is often not well understood, says Marc Henein, senior wealth advisor and portfolio manager with the Henein Group at Scotia Wealth Management in Mississauga.
“When we bring on new clients, at least half of the portfolios aren’t designed efficiently,” he says, noting that includes holding U.S. dividend funds domiciled in Canada inside an RRSP.
“Foreign withholding tax is like a silent enemy for these funds,” he says.
A strange quirk
Broadly, the U.S.-Canada tax treaty exempts U.S. income, dividends and capital gains in an RRSP.
However, dividend income from Canadian-domiciled exchange-traded funds and mutual funds with U.S. exposure remains subject to the 30-per-cent withholding tax, which is reduced to 15 per cent under the treaty, says Cynthia Kett, principal with Stewart and Kett Advisors Inc. in Toronto.
On a two-per-cent dividend yield, Mr. Henein says, 30 basis points of that sum would be paid in withholding tax (which is withheld at source). Compounded over 25 years, that could take away more than 7 percentage points from the total return.
The best way to hold income-generating U.S. market exposure in an RRSP, then, is to own a U.S. stock directly, Mr. Henein says, or to own a U.S.-domiciled mutual fund or ETF. The tax treaty applies in these instances, he adds.
That said, investors are required to fill out a W-8BEN form with the U.S. Internal Revenue Service certifying they’re not a U.S. citizen and fall under the tax treaty, Ms. Kett says.
The rule is a strange tax quirk, says Diana Orlic, senior portfolio manager with Orlic Harding Cooke Wealth Management Group at Richardson Wealth Ltd. in Burlington, Ont. “At first, it might seem like a non-issue, but the cost can add up over time.”
The IRS doesn’t recognize the tax treaty protections for dividend income generated from U.S. assets in funds domiciled in Canada, Ms. Orlic says, and the Canada Revenue Agency doesn’t recognize withholding taxes inside an RRSP as eligible for the foreign tax credit (FTC).
“There’s a lot of stuff in our tax system that seems unfair and probably should be addressed,” she says, “and this is one of them.”
If a client holds Canadian- or U.S.-domiciled income-generating funds in a non-registered account, the foreign tax credit can be used to reduce the withholding tax.
As with U.S. exposure, Canadian-listed funds with exposure to international stocks generally pay foreign withholding tax in those jurisdictions. But there’s also the possibility of paying double withholding tax if a fund listed in Canada invests in income-generating international stocks through a U.S. fund.
That “creates layers of withholding taxes,” Ms. Kett says. Generally, non-U.S. international exposures that produce income are best held in non-registered accounts where the FTC can help recover the withholding tax, she adds.
Rules of thumb for asset location
In addition to RRSPs, the tax treaty with the U.S. doesn’t apply to interest and dividend income in tax-free savings accounts (TFSAs), registered education savings plans, first-home savings accounts and registered disability savings plans. And the FTC isn’t applicable for withholding taxes paid in those accounts.
“We always consciously ensure we’re housing the right security in the right account because of these potential tax costs,” Mr. Henein says. Canadian equities and fixed income, and foreign growth assets that don’t generate income, are best placed in these registered accounts.
(The picture is less clear when the clients are U.S. citizens or green card holders, Ms. Kett says.)
In general, during a client’s accumulation years, equity exposure is preferred in RRSPs because of tax-deferred growth, Ms. Kett says. But fixed income with fully taxable interest is preferred when taking taxable withdrawals in decumulation years.
TFSAs are suitable for equities, provided they’re Canadian securities or foreign ones that don’t generate income, she says.
Canadian dividends are better suited for non-registered accounts because they’re eligible for the dividend tax credit.
Yet, Ms. Kett says other considerations may be more important in the big picture, particularly with respect to withholding tax.
“For example, an investor could minimize the non-recoverable foreign tax withholdings by holding foreign equity investments in a non-registered account,” she says.
This approach is especially beneficial for very large portfolios in which clients have maxed out registered accounts, she says.
That said, all related investment growth and income would be taxable. With smaller accounts, then, “perhaps the withholding tax is low relative to the tax that would otherwise be payable, so the investor is better off holding that asset in a TFSA instead,” she adds.
Tax-efficient portfolio construction is beneficial for long-term wealth accumulation, but advisors must tailor it to client preferences, Ms. Orlic says.
Some clients may be willing to endure withholding tax on foreign income because they prefer holding foreign exposures in Canadian-dollar-denominated funds for “simplicity’s sake,” she says.
“We always try to find the strategies that make the most sense for clients that are the most tax efficient,” Ms. Orlic says. “But at the end of the day, the decision does come down to what clients are comfortable with.”