Did you know that your international ETF may be charging you upwards of 0.59% in foreign withholding taxes on top of fees? Foreign withholding taxes are charged on the dividend returns of foreign companies and funds. 

That can compound to high underperformance in the long run. This article will walk through the optimal ETF and account structure to hold international exposure, to minimize foreign withholding taxes on your portfolio.

Last post, we looked at withholding taxes for Canadian ETF investors seeking US exposure: 

Today we will look at international exposure excluding US, the most tax efficient ETF structure, and the best accounts to hold your international ETF exposure in. 

There are 2 main types of international exposure.

1. Developed foreign markets (focusing on this today)
2. Emerging Markets

You can own developed foreign market exposure through 3 structures using ETFs.

1. US ETF owns developed foreign stocks (IE: VEA)
2. Canadian ETF owns US ETF that owns foreign developed stocks (IE: VDU)
3. Canadian ETF that owns foreign developed stocks (IE: XEF)

To understand how these ETFs are taxed, you need to understand the tax structure of level 1 and level 2 withholding taxes. 

Level 1 withholding taxes are levied as capital leaves the original country where the money ends up. So, for example, if you owned a Canadian ETF, that owns a USA ETF that holds international stocks in Germany, your dividend return would be subject to any applicable withholding taxes levied by the German government. 

Level 2 taxes are levied by the second country that the capital flows to. In this example, once the capital returns to the US ETF, The USA would levy their own taxes on that return before finally re-directing the return back to your Canadian ETF. 

Non-Registered most tax-efficient structure:

1. Canadian ETF that owns foreign developed stocks (IE: XEF)

Assuming you have maxed out your TFSA and RRSPs. If you do this, you will likely get a tax credit offsetting the entire amount of foreign withholding tax that has been withheld.

I say this because while the foreign tax credit will offset the impact of level 1 withholding taxes, you will still have to pay Canadian tax on the dividend received in Canada. So even if you get a credit offsetting the foreign withholding tax, you would still be better off owning the ETF in an RRSP or TFSA. 

If you owned it in this structure:

• US ETF owns developed foreign stocks (IE: VEA)
• Canadian ETF owns US ETF that owns foreign developed stocks (IE: VDU)

Then level 1 withholding tax would apply and is unrecoverable. In the above mentioned ETFs that would result in approximate additional costs of: 0.19% for both VEA and VDU in 2022. That is considerably more then the expense ratio on VEA (0.05%) and almost double the expense ratio on VDU (0.22%)

RRSP Account Most tax Efficient Structure:

1. US ETF owns developed foreign stocks (IE: VEA)
2. Canadian ETF that owns foreign developed stocks (XEF)

Level 1 withholding taxes will be charged, but by owning them in the structure mentioned above you will avoid level 2 withholding taxes. 

If you owned it in this structure:

• Canadian ETF owns US ETF that owns foreign developed stocks (IE: VDU)

You will have a total withholding tax of 0.59% in 2022, that is on top of the fund’s expense ratio of 0.22%. 

TFSA, FHSA, RESP account most efficient tax structure:

• Canadian ETF that owns foreign developed stocks (IE: XEF)
• US ETF owns developed foreign stocks (IE: VEA)

Level 1 withholding taxes will be charged, but by owning them in the structure mentioned above you will avoid level 2 withholding taxes.

If you held it in this structure,

• Canadian ETF owns US ETF that owns foreign developed stocks (IE: VDU)

If you held it in this structure, level 1 and level 2 withholding taxes would apply 

• Canadian ETF owns US ETF that owns foreign developed stocks (IE: VDU)

The estimated withholding taxes in 2022 for investors in VDU was approximately 0.59% which is over double the expense ratio on the fund. 

The moral of this article is this. Expense ratios and fund fees are important, but are not the only determining factor in which fund to own. You need to look at things like foreign withholding tax efficiency, diversification and risk tolerance. 

Thanks to the following paper for the inspiration:

I am a licensed advisor with Portfolio Strategies Corporation and all investment products are provided through them. Investment products carry risk, always get professional advice. 

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