We all pay taxes. Some of us pay more than others, but everyone can avoid paying withholding tax if they hold their foreign equities in the correct registered account. Like most other forms of taxation, this one is somewhat complicated, but we will break it down into a simpler subject.
What Is Withholding Tax?
Note: this is for Canadians investing in U.S. listed securities.
When you invest in American companies, the IRS will take a cut of your gains by way of withholding tax. If you fill out the W-8 BEN form with your brokerage, they will only take 15% of your dividends. If you don’t have the form filled out, you will lose out on an additional 15%, for a total of 30%.
Don’t worry though, most brokerages fill this form out for you, but it is worth looking into to make sure you are keeping as much money as possible.
This tax means that the effective yield of American stocks is slightly lower, for example, an American equity with a 2% dividend yield would essentially have a yield of 1.7%.
Some account types will be able to recover this tax with a foreign dividend tax credit, but some accounts will not allow you to recover this tax.
US equities without a dividend are not eligible to be taxed via withholding tax, just capital gains tax.
So Which Accounts Does Withholding Tax Apply To?
Well, registered accounts recognized by the US as being exclusive for the purpose of retirement are not subject to withholding taxes. These accounts consist of:
Registered accounts not recognized by the US as being exclusively for retirement purposes are subject to withholding tax, and the tax is not recoverable. These accounts are:
Nonregistered accounts are subject to withholding tax as well; however, you can claim a foreign dividend tax credit so that you are not double taxed by the CRA. The forms you need are T2209 for the federal tax credit and the T2036 for the provincial tax credit. Keep in mind, these tax credits are non-refundable.
What about ETFs?
In a registered account recognized by the US as being exclusively used for the purpose of retirement (RRSP, RRIF), dividends from US listed ETFs are not taxed, but their Canadian equivalents are. For example, VOO:NYSE isn’t taxed, but VFV:TSX is.
In a registered account not recognized by the US as being exclusively for the purpose of retirement, (TFSA, RESP), The withholding tax applies and is not recoverable with foreign tax credits.
In a nonregistered account, the US withholding tax applies and is only eligible for a foreign tax credit if the ETF is listed on an American exchange (for example, the withholding tax is recoverable for VOO, but not for VFV).
The effect of withholding taxes on Canadian ETFs is subtle, because they are paid internally by the ETF. This is usually reflected in the yield of the ETF. For example, VOO currently has a yield of 1.29%, while VFV has a yield of 1.22%.
If you have an ETF comprised of Canadian and American stocks that pay dividends, you will only be paying withholding tax on the US dividends payed from the ETF.
What About Cross Listed Equities?
Many of the largest TSX stocks are listed on the TSX and NYSE. In this case, withholding taxes don’t apply if you purchase the shares on the American exchange. You are better off just buying the Canadian shares so you don’t incur an exchange fee if your broker has one.
Don’t forget, you can journal cross listed shares between exchanged free of charge with most brokerages, as if you would while executing Norbert’s Gambit.
The Bottom Line
Yes, tax can be boring. But understand taxes and how they can impact your gains and compound interest can save you thousands and possibly millions over the course of your life.
Understanding withholding tax is a small part of this puzzle, it is very beneficial to have your securities placed in the correct account so you can obtain the full effects of compound interest with your dividends.