ETF Taxation: Foreign Withholding Taxes

Many countries withhold taxes on income paid to foreign investors, whether it be interest, dividends or other forms of income. The tax rate varies from country to country, and often depends on whether a tax treaty exists between Canada and the foreign country and type of income. A typical rate is 15% but can be more, or less, depending on the circumstances. For taxable non-registered accounts, because Canadian investors are normally required to include foreign income on their Canadian tax returns, a foreign tax credit (FTC) is often available in Canada to reduce double taxation. Tax-advantaged registered accounts like RRSPs, RRIFs and TFSAs are not eligible for FTCs given that the income is not immediately taxable in Canada (or, in the case of the TFSA, never taxable).

The way in which an ETF gains exposure to foreign investments, and the type of account in which the ETF is held (i.e., registered or non-registered), affects foreign withholding taxes. Three common options for Canadians who seek foreign exposure via ETFs include:

• U.S.-listed ETF that holds foreign securities directly;
• Canadian-listed ETF that holds foreign securities indirectly via a U.S. ETF;
• Canadian-listed ETF that holds foreign securities directly.

Generally, gaining foreign exposure through U.S.-listed ETFs or Canadian-listed ETFs that invest through U.S. ETFs have an added cost that doesn’t exist when exposure is directly through Canadian ETFs. When foreign income¹ is paid to U.S. ETFs, the foreign country often withholds tax with respect to the income – we’ll call this “level 1” tax. Thereafter, when the income is paid to the Canadian investor, U.S. withholding taxes normally apply – we’ll call this “level 2” tax. Two levels of withholding taxes increase the cost of the investment and reduces net returns when compared to direct exposure through Canadian ETFs.

U.S.-listed ETF that holds foreign securities directly

For illustrative purposes only

Canadian-listed ETF that holds foreign securities indirectly via a U.S. ETF

For illustrative purposes only

Canadian-listed ETF that holds foreign securities directly

For illustrative purposes only

Where foreign exposure is gained through U.S. ETFs (options 1 and 2 above), level 1 taxes are not recoverable by the Canadian investor; that is, no FTC is available in Canada to offset this tax. Level 2 taxes are normally recoverable via the FTC for non-registered accounts. Where foreign exposure is gained directly through a Canadian ETF, only level 1 withholding taxes apply when the FTC is normally available for non-registered accounts. The following table illustrates how ETF structure and account type (i.e., registered and non-registered) may impact withholding taxes and the availability of FTCs.

ETF structure and account type may impact after-tax returns. For more information on ETFs and foreign withholding taxes, please refer to our whitepaper, "ETFs and foreign withholding taxes."

¹ Non-U.S. income. U.S. income is not normally subject to U.S. withholding taxes when paid to a U.S. ETF.
² "w/h" means "withholding"
³ U.S. withholding taxes do not apply to U.S. dividends paid directly to RRSPs and RRIFs.