Hello all… I hope that everyone had a wonderful April. I for one am enjoying the warmer weather, and conclusion of tax season!
In my last commentary, I discussed how investors can increase the tax-efficiency of their portfolios through the use of Registered Retirement Savings Plans (RRSPs) and Tax Free Savings Accounts (TFSAs). Specifically, I discussed what has become a common strategy – holding the fixed-income component of one’s investment mix inside tax-sheltered accounts.
This commentary is along the same lines; however, I will be addressing a more specific component of a well-balanced investment portfolio – foreign content. A properly balanced portfolio will undoubtedly include some level of equity based investments; however, it is also prudent to ensure that investors spread their public company stock holdings across multiple geographic regions. Here at T.E. Wealth, this involves spreading our clients’ investable funds into instruments that offer U.S., European, Asian, Australian, and developing nation equity exposure.
Advising our clients to hold some level of foreign equity in their portfolios seems like fairly obvious advice; however, in doing so, we must (as always) consider the tax consequences. First and foremost, it is important to realize that when a Canadian investor holds stock in a foreign company, dividends received are not tax-free. Foreign jurisdictions want to ensure that their domestic corporations pay an appropriate level of tax to their home countries. As such, most countries administer a withholding tax on any dividends paid by their local corporations, to non-resident shareholders. As a basic example, assume a Canadian taxpayer holds shares in Coca-Cola (which, as we all know, is U.S.-based). If Coca-Cola were to pay that Canadian taxpayer a $1,000 dividend, the IRS would withhold 15% ($150) at source. As a result, the Canadian resident taxpayer would receive $850 ($1,000 less $150 of withholding tax).
The first question that pops into everyone’s head is “does that mean I pay tax twice, once to the IRS, and again to the CRA?” The answer to that question is no. Canadian resident taxpayers can claim a credit (on their Canadian income tax return) for the withholding tax that they paid on all of their reportable foreign-source dividends. As long as taxpayers are in a position to claim such a credit, this essentially means that any withholding tax paid becomes a wash.
The above example might seem simple, but things tend to get a little complicated when foreign-investments are held within a TFSA (where all income is tax exempt in Canada) or an RRSP (where all income is tax-deferred). The added complexity arises due to the fact that income earned within TFSAs and RRSPs is left off an individual’s Canadian tax return. If the income is not included on the Canadian tax return, then there is no opportunity to claim a foreign tax credit for foreign withholding on foreign-source dividends. There are ways to structure your foreign investments so as to alleviate these problems/concerns.
First and foremost, foreign dividends paid into a Canadian RRSP from treaty countries (countries with whom Canada shares a tax treaty) are exempt from the above-noted withholding tax. This is good news for Canadians who hold U.S. equities inside their RRSPs. Unfortunately, the same may not be true for other foreign content investments, as many broadly held foreign-based mutual funds and/or ETFs span across multiple countries, including some non-treaty countries. In those cases, foreign withholding can be administered and subsequently ‘lost in the mix’; even if such securities are held within Canadian RRSPs. One other benefit in keeping foreign investments inside an RRSP is that such serves to avoid the new T1135 reporting requirements. That said, such a discussion is beyond the scope of this commentary.
Also, and again, unfortunately, TFSAs do not boast the tax advantage noted above. In other words, if a taxpayer receives foreign dividends on securities held within their TFSA, withholding tax will be administered, and cannot be utilized as a foreign tax credit (as TFSA income is not reported on a Canadian tax return). One solution to this problem can be to hold foreign securities that do NOT pay dividends within one’s TFSA. Berkshire Hathaway is a good example of a blue chip American stock that does not pay a dividend. Such would be a suitable investment for one’s TFSA.
The moral of this story is that when structuring one’s investment mix, it is important to strategize which types of investments are to be held in which accounts. The following summarizes some of the strategies that we have covered to date, and are typical considerations when we here at T.E. Wealth structure our client’s investment portfolios:
Non-Registered Savings Accounts
a. Canadian Equities (to take advantage of the preferential rates on capital gains, as well as the dividend tax credit)
b. Foreign Equities (to take advantage of the preferred rates on capital gains, as well as to utilize foreign tax credits)
a. Fixed Income Investments (to defer taxation on high-rate forms of income – ie – interest income)
b. Foreign Equities from Treaty Countries (as the withholding tax on dividends received from treaty-country corporations is reduced to zero)
a. Canadian Equities (ideally, those that do not pay a dividend)
b. Foreign Equities (ideally, those that do not pay a dividend)
c. Fixed Income (as a secondary choice – the primary choice would be one’s RRSP)
In my next posting, I will address another common investing/tax planning question – should I hold my investments personally, or within a corporation. Stay tuned!
These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information. No endorsement or approval of any third parties or their advice, information, products or services should be implied by any references to third parties contained in any article. Trademarks cited in these articles are the respective properties of their owners.