Foreign withholding taxes

From finiki, the Canadian financial wiki

For Canadian investors foreign withholding taxes are a somewhat complex and confusing topic. In the context of asset location decisions, keep in mind that Canadian taxes are likely to have a much more significant impact on long-term after-tax investment returns than foreign withholding taxes. Therefore, withholding taxes may be more a consideration for product choices than for asset location decisions.

Foreign tax laws and treaties

Some foreign countries apply a withholding tax to payments, such as dividends or interest, paid to non-residents. The amount of tax withheld, if any, is specified by the foreign country’s tax laws. However, Canada has tax treaties in place with numerous countries that may supersede those foreign tax laws. For example, US tax legislation generally requires a 30% withholding on US-sourced dividends paid to “non-resident aliens”, but the Canada-US tax treaty reduces that withholding to 15% for Canadian residents[1].

Tax recovery on Canadian income tax return

Foreign tax paid may be recoverable through a foreign tax credit claimed against the normal Canadian tax payable, but only to a limit of 15%. If the withholding tax were 30%, only half of that can be claimed as a foreign tax credit, with the excess being deductible on line 232 of the tax return[2].

If the foreign income would not ordinarily be taxable in Canada, such as foreign dividends earned within a registered plan, the tax is not recoverable and is forever lost. Again, tax treaties may in some cases supercede this general rule. Under the Canada-US tax treaty, dividends and interest paid into a Registered Retirement Savings Plan (RRSP) or Registered Retirement Income Fund (RRIF) from a US source are exempt from US withholding.

In order to qualify for these US tax exemptions or reductions, Form W-8BEN (pdf) must be filled out and filed with your brokerage. Note that the exemption does not extend to RESPs or TFSAs[3], thus high-yielding US stocks or US-based Exchange-traded funds (ETF)s are better held elsewhere than in an Registered Education Savings Plan (RESP) or TFSA. Also note that using a Canadian based mutual fund to invest in US stocks would result in US tax being withheld, even in an RRSP or RRIF - in such a case the foreign tax would not be recoverable for a registered account, but would be for a taxable account. For a Canadian mutual fund, the capital gains inclusion rate applies on distributions from foreign stocks. For US-based ETFs, capital gain distributions are taxed as income.

Canadian versus US based ETFs

There is some debate about whether to hold US-based ETFs versus Canadian-based ETFs that invest in the US. In both instances, the withholding tax can be claimed against income in a taxable account. A U.S. based ETF would also be exempt from withholding tax in a registered account, but not a Canadian-domiciled ETF investing in the US.

When investing outside North America, the following considerations apply:[4]

  • a Canadian domiciled mutual fund will have paid withholding taxes to foreign governments, on the income it has received from foreign securities. The mutual fund will distribute the net amount; if the unitholders have the fund in a non-registered account, they will receive a tax slip including the foreign tax paid by the fund, which in most cases is fully recoverable from the CRA;
  • a non-Canadian mutual fund (e.g., U.S. based ETF) investing in EAFE securities will have also paid withholding taxes to foreign governments, on the income it received from foreign securities. Such a mutual fund / ETF will not issue information to a Canadian resident about foreign tax credits. In addition, there will be another level of tax withheld by the fund / ETF's country of residence (e.g., USA); as mentioned in the above paragraph, this latter tax is not applicable if the US based fund is held in a retirement account (but does apply to a TFSA), and this second level of tax may be recoverable from the CRA for a non-registered account.

The consequence of these issues is that US-based ETFs that hold non-US stocks have an additional irrecoverable tax burden that raises the effective management expense ratio (MER),[5] and may negate any nominal MER advantage. Moreover, Canadian-based ETFs that are wraps of US based ETFs will also have this irrecoverable foreign tax burden. Are you confused? The external links below should help. Also, Justin Bender has calculated the "total cost" of several Canadian-domiciled ETFs investing in international stocks, showing the effect of the two layers of withholding taxes[6].

Canadian controlled private corporation

Another consideration about foreign withholding taxes deals with holding foreign securities in an incorporated Canadian controlled private corporation (CCPC). Although the withholding tax is theoretically recoverable from the regular tax payable by the corporation, the intricacies of CCPC taxation lead, in most cases, to about three-quarters of the foreign tax credit being lost, thus any high-paying foreign securities that attract foreign withholding taxes are better held outside the corporation.[7]

See also

References

  1. ^ Department of Finance Canada, Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital, Article X, viewed November 26, 2012.
  2. ^ TaxTips.ca, Foreign Non-Business Income Tax and Foreign Tax Credit Line 405, viewed April 29, 2014.
  3. ^ Financial Wisdom Forum, Withholding Tax Questions - RESP, RRSP, TFSA, RRIF, viewed Feb. 17, 2009.
  4. ^ Dimensional Fund Advisors, Foreign Withholding Taxes, April 2012.
  5. ^ Financial Wisdom Forum, Tax Inefficiencies of ETFs for Canadian Investors, viewed June 9, 2012.
  6. ^ Canadian Portfolio Manager (a blog by Justin Bender), Vanguard Lowers Their Fees…Again, viewed December 4, 2014.
  7. ^ Financial Wisdom Forum, Investment income in a CCPC, viewed Feb. 17, 2009.

External links

Retrieved from "https://www.finiki.org/w/index.php?title=Foreign_withholding_taxes&oldid=23617"