The true cost of foreign withholding taxes

Back in the fall of 2012, I wrote a pair of blog posts about the impact of foreign withholding taxes in US and international equity funds. The first explained the general idea of this tax on foreign dividends, while the second showed which funds are best held in which types of account (RRSP, TFSA, non-registered). This is a complicated and confusing topic, so I was surprised at the enormous interest these articles generated from readers, the media, advisers and even the ETF providers themselves. What was missing from those articles, however, was hard numbers: it’s one thing to say this fund is more tax-efficient than that one, but by how much? To my knowledge no one has ever quantified the costs of foreign withholding tax in a comprehensive way—until now. Justin Bender and I have done this in our new white paper, Foreign Withholding Taxes: How to estimate the hidden tax drag on US and international equity index funds and ETFs.

The factors that matter

The amount of foreign withholding tax payable depends on two important factors. The first is the structure of the ETF or mutual fund. Canadian index investors can get exposure to US and international stocks in three ways:

through a US-listed ETF
through a Canadian-listed ETF that holds a US-listed ETF
through a Canadian-listed ETF or mutual fund that holds the stocks directly

The second key factor is the type of account: RRSPs, personal taxable accounts, corporate accounts, TFSAs and RESPs are vulnerable to foreign withholding taxes in different ways. Their impact in corporate accounts, in particular, was little understood until Justin delved deeply into this matter with the expert help of Charles Berry, an accountant at Welch LLP. We examine eight different fund structures in the paper, and for each one we estimate the total cost of a representative fund by adding the fund’s management fees to the foreign withholding taxes that apply in each account type. We’ll forgive you if you want to skip all the formulas and cut to the chase, and we’ve presented our estimates for many popular ETFs in a table at the end of the paper. Here’s a small sample:

US Equities	Market	RRSP	TFSA	Taxable
Vanguard Total Stock Market (VTI)	US	0.05%	0.32%	0.05%
Vanguard US Total Market (VUN)	CDN	0.44%	0.44%	0.17%
TD US Index – e-Series (TDB902)	–	0.65%	0.65%	0.35%

Developed Markets Equities	Market	RRSP	TFSA	Taxable
Vanguard FTSE Developed Markets (VEA)	US	0.31%	0.68%	0.31%
Vanguard FTSE Developed ex N. America (VDU)	CDN	0.90%	0.90%	0.53%
BMO MSCI EAFE (ZEA)	CDN	0.67%	0.67%	0.34%
iShares MSCI EAFE IMI (XEF)	CDN	0.94%	0.94%	0.56%
TD Int’l Index Fund – e-Series (TDB911)	–	0.84%	0.84%	0.51%

Emerging Markets Equities	Market	RRSP	TFSA	Taxable
Vanguard FTSE Emerging Markets (VWO)	US	0.49%	0.85%	0.49%
Vanguard FTSE Emerging Markets (VEE)	CDN	1.05%	1.05%	0.69%
iShares MSCI Emerging Markets IMI (XEC)	CDN	1.00%	1.00%	0.68%

The first thing that jumps out is the large difference between US-listed and Canadian-listed ETFs when held in RRSPs. A fund like VUN is 39 basis points more expensive than VTI, while VDU adds an additional 59 basis points compared with VEA. In a large RRSP, therefore, it may be significantly more cost-effective to hold US-listed ETFs for your foreign equity exposure. However—and this is important—this is only true if you can avoid the high cost of converting currency. If you’re investing relatively large sums and you’re comfortable doing Norbert’s gambit, then US-listed ETFs are an excellent option. But not everyone is keen to do this: in fact, after we explain the trade-off to clients of our DIY service, many decide they’re happy to pay more for the convenience of trading only Canadian-listed ETFs. And there’s nothing wrong with that decision. Another important takeaway is that the tax advantages of US-listed equity ETFs are much smaller (or non-existent) in non-registered accounts. It probably makes sense for DIY investors to use Canadian-listed ETFs in their taxable accounts—even though their MERs are slightly higher—to avoid the cost of currency conversion.

Keep it in perspective

One of the common reactions to my earlier articles about foreign withholding taxes was to overestimate their significance. Let’s remember foreign equities are typically about 30% to 40% of a balanced portfolio, and the withholding taxes apply only to the dividends, which are likely to be in neighbourhood of 2% to 4%. So their impact on the overall portfolio may not be as large as you think. Here’s an example of the cost breakdown in two versions of the Complete Couch Potato: the first uses US-listed ETFs for the foreign equities, while the second uses their Canadian-listed equivalents:

With US-listed ETFs	%	RRSP	TFSA	Taxable
Vanguard FTSE Canadian All Cap (VCN)	20%	0.14%	0.14%	0.14%
Vanguard Total Stock Market (VTI)	15%	0.05%	0.32%	0.05%
Vanguard FTSE Developed Markets (VEA)	10%	0.31%	0.68%	0.31%
Vanguard FTSE Emerging Markets (VWO)	5%	0.49%	0.85%	0.49%
BMO Equal Weight REITs (ZRE)	10%	0.62%	0.62%	0.62%
iShares DEX Real Return Bond (XRB)	10%	0.39%	0.39%	0.39%
Vanguard Canadian Aggregate Bond (VAB)	30%	0.22%	0.22%	0.22%
Total cost		0.26%	0.35%	0.26%

With Canadian-listed ETFs	%	RRSP	TFSA	Taxable
Vanguard FTSE Canadian All Cap (VCN)	20%	0.14%	0.14%	0.14%
Vanguard US Total Market (VUN)	15%	0.44%	0.44%	0.17%
Vanguard FTSE Developed ex N. America (VDU)	10%	0.90%	0.90%	0.53%
Vanguard FTSE Emerging Markets (VEE)	5%	1.05%	1.05%	0.69%
BMO Equal Weight REITs (ZRE)	10%	0.62%	0.62%	0.62%
iShares DEX Real Return Bond (XRB)	10%	0.39%	0.39%	0.39%
Vanguard Canadian Aggregate Bond (VAB)	30%	0.22%	0.22%	0.22%
Total cost		0.40%	0.40%	0.31%

I would argue that in a TFSA or taxable account the difference is trivial, and Canadian-listed ETFs are almost certainly the better choice. Even in an RRSP, the total difference of 14 basis points is not likely to outweigh the cost of currency conversion in smaller accounts. In the end, it’s up to you to decide whether it’s worth using US-listed ETFs for your foreign equity holdings. But least now you have the numbers to help you make that choice.