# Tax Inefficiencies of ETFs for Canadian Investors



## Doug (May 31, 2009)

I was interested in the new Vanguard Canada emerging markets ETF, so I emailed them about its taxation. The following is the response that I got:

"The US ETF (VWO), which (VEE) is wrap of, will pay a dividend to the Canadian ETF (VEE) net of foreign tax and net of US tax (at a witholding rate of 15%). The distributions paid by VEE will be decreased by foreign taxes and US taxes, but Canadian investors can receive a tax credit for the amount of the US withholiding tax."

I was interested in the taxation of iShares Canadian domiciled ETFs, so I sent them a similar email. The following is the response:

"Our wrapped products such as XEM, XSP, XIN and XWD are subjected to 15% US withholding taxes.

Investors in these ETFs will see a credit on their T3 tax slip on a annual basis. This is assuming that clients are holding these securities in a taxable investment account.

However, the only tax credit clients will receive are for the amounts withheld by the US, as the tax treaty is between Canada and the U.S. So even though funds such as XEM hold securities of other countries, the taxes that are withheld between the US and other countries is not claimable (no tax credit)."

Basically, the same answer as Vanguard. If you are investing in a Vanguard or iShares Canadian domiciled ETF that invests in foreign stocks other than those of the USA, the governments of those foreign countries will likely withhold tax on dividends. 
So you decide that you'll buy the US ETF directly. I haven't emailed any ETF provider to find out about taxation. But I am very confident that what applies above also applies to the US ETF. 

I surfed the web, and the present dividend yield that I got on the EAFE index is 3.51%. I couldn't find a dividend history on the EAFE index, but I found one on the S&P500 index. In 1981, the dividend yield on the S&P500 index was 5.57%. I would use that number of 5.57% as a maximum to which the EAFE dividend yield could go.

XWD is iShares developed markets fund, and is about 5% Canadian. The Canadian component of XWD is ISHARES MSCI CANADA INDEX FUND, which looks like it is a US domiciled fund. And the 2011 estimated distribution schedule of XWD is consistent with this. None of the distributions of XWD are eligible or ineligible dividends. It's all foreign income and return of capital. So the Canadian dividends in XWD are subject to a withholding tax by the CRA that's not recoverable; that tax might be 15%. Those dividends are then subject to a second tax as foreign income by the CRA. So if you're in at 45% marginal tax rate, you may be paying 61% tax on eligible dividends; in a tax efficient structure, you would pay perhaps 26%.

It has been pointed out to me that Vanguard's US domiciled Emerging Markets Fund paid 10.7% foreign withholding tax in 2010. Vanguard's US domiciled Developed Markets (EAFE) Fund paid 4.9% foreign withholding tax in 2010. It has also been pointed out to me that what matters is the after tax cost, so subtract your marginal tax rate from 10.7% and 4.9%. 

I think this is an issue that investors need to be aware of. What that in mind, I have posted this on another internet discussion board. Tax efficiency is an important part of investing. Over decades, small tax inefficiencies may no longer be small. Investors should be aware that there is an added hidden cost to some of Vanguard's and iShares' ETFs. This will allow an apples to apples comparison with other index funds, such as TD eseries, which I doubt are subject to this problem. Perhaps the added cost of creating truly Canadian domiciled ETFs would negate the greater tax efficiency, and so the present structures are in the best interests of Canadian investors. But I think it would be in the best interests of Canadian investors for them to be aware of the costs (including taxes) of the present quasi Canadian domiciled ETFs versus those of truly Canadian domiciled ETFs.


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## Brian Weatherdon CFP (Jan 18, 2011)

You've done your homework Doug, thanks for sharing  
Much to ponder here as dividend withholding varies among foreign jurisdictions.


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## doc987 (Nov 23, 2011)

Doug:
You've done some good due diligence on a topic I was recently investigating as well. To use the VWO example again, we can surmize the posted dividend yield for this ETF has already factored in the foreign witholding tax. Therefore, the only WHT us Canadians are subject to would be the 15% tax we have with the US. 
In an RRSP, this 15% is not applicable if you've signed the W8BEN form. So if you hold WHO in a RRSP, the posted yield is the one you should receive. If you hold WHO in a non registered account, you will have to apply for a foreign tax credit to get that 15% US WHT back. So in either account, the final distribution should be the same
If you own the Canadian equivalent of VWO, you don't have to worry about any WHT, the yield you see is the yield you get.
Do I have this right?


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## Doug (May 31, 2009)

Another tax inefficiency of quasi-Canadian domiciled ETFs has been pointed out to me. The US ETFs, of which the quasi-Canadian domiciled ETFs are a wrap of, will receive income in the form of dividends, capital gains and return of capital. If these ETFs were truly Canadian domiciled, investors would be able to take advantage of the decreased tax on capital gains and return of capital. With these wrap structures, the distributions of the quasi-Canadian domiciled ETFs will be taxed as foreign income at one's marginal tax rate. This would also apply to distributions from US domiciled ETFs that Canadian investors receive.

Doc987, you raise good questions. Unfortunately, I am very far from a tax expert.


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## humble_pie (Jun 7, 2009)

it's hair-splitting finger-nail chewing stuff but so essential.  I try as best i can to never make a single investment move without understanding all the tax consequences. Another reason why i don't like etfs btw.

basically there seem to be 2 approaches with non-domestic etfs. One is to retain the analytics here & offer a congratulatory glass of new year's bubbly to the poster who took the trouble to write all this up.

the other approach is short & sweet. Jacko over on another thread (british adrs) avers that foreign dividend concerns are "rubbish" & only poor people are paying the less-favourable taxes arising from foreign income. The rich, says our jacks, do not pay.

it's holiday time, so between champagne & getting rich, i think i'll take champagne.


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## Donny (Dec 14, 2011)

Doug said:


> I think this is an issue that investors need to be aware of. What that in mind, I have posted this on another internet discussion board.


Link for others, there are several replies on that post too: http://www.financialwebring.org/forum/viewtopic.php?f=32&t=114375


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## arrow1963 (Nov 22, 2011)

The focus in this thread has been on ETFs. But are the tax repercussions different for mutual funds or individual stocks? 

For example, if you buy a mutual fund with an emerging market focus, or you buy a pool of Samsung, Huawei, etc... in order to get emerging market exposure.


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## Jungle (Feb 17, 2010)

Thank you for this discussion Doug. Can you help me understand what I will lose per year, if I buy $10,000 of VEE at today's price? Non reg account. MTR is 31%.


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## heyjude (May 16, 2009)

Important subject Doug. Thanks for posting!


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## Doug (May 31, 2009)

There is a tax inefficiency of truly Canadian domiciled funds that invest in foreign stocks and are held in a tax advantaged account.

The governments of foreign countries will very likely impose withholding taxes on dividends of those foreign stocks. Outside tax advantaged accounts, you may be able to get tax credits for those withholding taxes. Inside your tax advantaged accounts, you won't. However, in an RRSP, US domiciled ETFs that invest in US stocks will not have any withholding taxes imposed by the IRS.

My guess is that quasi Canadian wrap funds will have the same tax inefficiency as truly Canadian domiciled funds.


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