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Asset Location Across Canada: Some Rules Are Made To Be Broken

August 28, 2017 - 4 comments

Aren’t GPS devices the best thing ever? You punch in your desired destination and they tell you exactly where to go. Then again, every so often, they’ll go wonky on you, insisting you turn on a street that doesn’t even exist, or sending you straight into a major traffic jam.

Just so with implementing asset location, as introduced in my last post. General guidelines can be useful when trying to understand complicated topics like tax-efficient investing. In practice, however, these rules of thumb can lead you astray – especially if you follow them blindly, without regard to what’s going on right around you.  

For example, you’ll often hear that it’s wise to fill up your taxable accounts with Canadian equities first and global equities next. Sometimes, this makes sense, as the Canadian company dividends receive preferential tax treatment (and global stock dividends don’t).

But where do you live? Depending on your actual tax rate and which province or territory you call home, there may be times when this “Canada first” rule of thumb might be a thumbs-down idea for you.

Today, I’ll explain how to estimate the taxable dividends on the equity ETFs in my model portfolios. We’ll then review the taxes payable in 2016 on each of the ETFs for residents across Canada. I’ll wrap up with suggested taxable account asset locations for top-rate taxpayers in each jurisdiction.

By the way, all yields and MERs below are annual; I’ll skip repeating that every time!

Canadian Equities

The Vanguard FTSE Canada All Cap Index ETF (VCN) follows the FTSE Canada All Cap Index, which has a gross dividend yield of 2.88%. Once we deduct the fund’s MER of 0.06%, we end up with a taxable dividend yield of 2.82%. Although this may seem high relative to the other asset classes below, you’ll recall that the eligible dividends receive preferable tax treatment, resulting in lower taxes than if the dividends were treated as ordinary income.

So … remember that rule of thumb, suggesting higher-income earners should first hold Canadian equities in their taxable accounts before all other asset classes? This really only applies in jurisdictions with relatively low eligible dividend tax rates (generally below 35%). Otherwise, you may be better off first holding certain foreign equities in your taxable accounts, even though their dividends are fully taxable as income.

Source: FTSE Russell Index Fact Sheet as of July 31, 2017

U.S. Equities

The iShares Core S&P U.S. Total Market Index ETF (XUU) follows the S&P Total Market Index, which has a measly gross dividend yield of only 1.90%. After deducting the fund’s expenses of 0.07%, the taxable dividend yield drops to about 1.83%. Even though taxes are initially withheld on the foreign dividends, they are generally recoverable at tax time, when you will be fully taxed on the dividends after the fund’s expenses have been deducted.

For provinces or territories with relatively high eligible dividend tax rates (i.e. above 35%), U.S. equities may be a more tax-efficient first choice to hold in your taxable accounts, instead of the Canadian-first rule of thumb.

Source: S&P Dow Jones Index Fact Sheet as of July 31, 2017

International Equities

The iShares Core MSCI EAFE IMI Index ETF (XEF) follows the MSCI EAFE IMI Index, which boasts an impressive dividend yield of 2.96%. As XEF holds the underlying stocks directly, any foreign withholding taxes are generally recoverable at tax time. Similar to U.S. equities, investors will be fully taxed on the gross dividends after deducting the product fees of 0.22%, for a taxable dividend yield of about 2.74%.

Although many investors love their dividends, this spells trouble for taxable investors throughout Canada. As I mentioned in my last blog post, if you’re going to hold any equities in your RRSP accounts, international equities should be your first choice (and your last choice for taxable accounts). This is one rule of thumb that applies nationwide, since there is not a single province or territory where holding international equities in taxable accounts first is expected to reduce the tax bill.

Source: MSCI Index Fact Sheet as of July 31, 2017

Emerging Markets Equities

The iShares Core MSCI Emerging Markets IMI Index ETF (XEC) follows the MSCI Emerging Markets IMI Index. With a gross dividend yield of 2.32%, it falls somewhere between U.S. and international equities.

As XEC doesn’t hold the underlying stocks directly, there’s one layer of unrecoverable foreign withholding taxes, with an estimated tax drag of 0.23%.

With fees of 0.26%, it’s also the most expensive ETF in my model portfolios. After deducting the fees and foreign withholding taxes, we end up with a taxable dividend yield of about 1.83% (which happens to be identical to the U.S. equity taxable dividend yield). This low yield may make emerging market equities even more tax-efficient than Canadian equities in many jurisdictions going forward (including Ontario, Manitoba, Quebec and Nunavut).

Source: MSCI Index Fact Sheet as of July 31, 2017

Our Model Portfolio Summary

So, in summary, below is the expected taxable dividend yields on the ETFs in my model portfolios. (Remember, VCN’s dividend yield is taxed at the lower eligible dividend tax rate, while the remaining ETFs are taxed at ordinary income tax rates.)

Expected Taxable Dividend Yields of ETFs

Exchange-Traded Fund Gross Dividend Yield Unrecoverable Foreign Withholding Tax Management Expense Ratio (MER) Taxable Dividend Yield
Vanguard FTSE Canada All Cap Index ETF (VCN) 2.88% - (0.06%) 2.82%
iShares Core S&P U.S. Total Market Index ETF (XUU) 1.90% - (0.07%) 1.83%
iShares Core MSCI EAFE IMI Index ETF (XEF) 2.96% - (0.22%) 2.74%
iShares Core MSCI Emerging Markets IMI Index ETF (XEC) 2.32% (0.23%) (0.26%) 1.83%

Sources: FTSE Russell, S&P Dow Jones and MSCI Index Fact Sheets as of July 31, 2017. BlackRock Canada and Vanguard Canada.

Going Local

Now, to the good stuff. What are the optimal asset location guidelines where you live?

For that, let’s estimate which asset class has the lowest expected annual tax liability in each province or territory by calculating 2016 taxes payable on a $10,000 investment for a taxpayer in the highest marginal tax bracket.

To make the comparison a little easier on the eyes, I’ve included a second chart below that provides the optimal 2016 asset location order for taxable accounts. (I’ve only considered annual income and its tax ramifications here, since we cannot accurately predict your unique long-term, unrealized gains.)

The compelling conclusions?

  • Most of the provinces and territories with the lowest eligible dividend tax rates tend to favour Canadian equities first (except Nunavut, which has relatively low ordinary income and low eligible dividend tax rates)
  • Jurisdictions with the highest eligible dividend tax rates favour U.S. equities first.
  • Throughout Canada, international equities place dead last in terms of tax-efficiency (due to the relatively high taxable dividend yield).
  • Going forward, emerging markets may swap places with Canadian equities in Manitoba, Nunavut, Ontario and Quebec.  

2016 taxes payable on a $10,000 investment (top marginal tax bracket)

Province of Territory Vanguard FTSE Canada All Cap Index ETF (VCN) iShares Core S&P U.S. Total Market Index ETF (XUU) iShares Core MSCI EAFE IMI Index ETF (XEF) iShares Core MSCI Emerging Markets IMI Index ETF (XEC)
Alberta $88 $93 $131 $101
British Columbia $87 $92 $130 $100
New Brunswick $95 $103 $145 $112
Northwest Territories $79 $91 $128 $99
Prince Edward Island $95 $99 $140 $108
Saskatchewan $84 $93 $131 $101
Yukon $69 $93 $131 $101
Manitoba $105 $97 $138 $106
Nunavut $92 $86 $121 $93
Ontario $109 $103 $146 $112
Quebec $111 $103 $145 $112
Newfoundland and Labrador $113 $96 $136 $105
Nova Scotia $116 $104 $147 $113

Sources: 2016 Personal TaxPrep, TaxTips.ca, CDS Innovations Tax Breakdown Service, BlackRock Canada, Vanguard Canada

2016 Taxable Account Asset Location Order

Province of Territory Ordinary income (top marginal tax rate) Eligible dividends (top marginal tax rate) 1st 2nd 3rd 4th
Alberta 48.00% 31.71% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
British Columbia 47.70% 31.30% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
New Brunswick 53.30% 34.20% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
Northwest Territories 47.05% 28.33% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
Prince Edward Island 51.37% 34.22% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
Saskatchewan 48.00% 30.33% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
Yukon 48.00% 24.81% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
Manitoba 50.40% 37.78% U.S. Equities Canadian Equities Emerging Markets Equities International Equities
Nunavut 44.50% 33.08% U.S. Equities Canadian Equities Emerging Markets Equities International Equities
Ontario 53.53% 39.34% U.S. Equities Canadian Equities Emerging Markets Equities International Equities
Quebec 53.31% 39.83% U.S. Equities Canadian Equities Emerging Markets Equities International Equities
Newfoundland and Labrador 49.80% 40.54% U.S. Equities Emerging Markets Equities Canadian Equities International Equities
Nova Scotia 54.00% 41.58% U.S. Equities Emerging Markets Equities Canadian Equities International Equities

Sources: 2016 Personal TaxPrep, TaxTips.ca, CDS Innovations Tax Breakdown Service, BlackRock Canada, Vanguard Canada

So, there you have it: A few jurisdiction-specific rules of thumb to guide you along your tax-wise way. But, as with that GPS that usually takes you where you want go, you may want to take a good look around at your personal circumstances before blindly following anyone’s general directions – even mine.

By: Justin Bender with 4 comments.
Comments
  01/11/2017 9:21:49 AM
Justin bender
@Jonathan L: The recommended asset location order is still valid when taking into account foreign withholding tax implications. Remember that foreign withholding tax implications shouldn’t be viewed in isolation (higher dividend yields can create an additional tax drag that is more than the foreign withholding tax drag in an RRSP account).
I ran some figures to see if holding another asset class in the RRSP account first rather than international equities would lead to a higher after-tax return after 20 years, and it didn’t.

Assumptions:
– Starting portfolio has $100,000 in an RRSP account and $100,000 in a taxable account
– One asset class is held in the RRSP account and one asset class is held in the taxable account
– Portfolio is not rebalanced
– Gross Dividend Yields – 2.92% for international equities, 1.90% for US equities, 2.77% for Canadian equities
– Foreign Withholding Tax Drag in RRSP account – 0.25% for international equities and 0.28% for US equities
– MERs – 0.22% for international equities, 0.07% for US equities, 0.06% for Canadian equities
– Tax Rates – 53.53% for foreign dividends and the taxable portion of capital gains and 39.34% for Canadian eligible dividends (Ontario top rates)
– Expected Return – 7% for each (this includes the gross dividend figures)
– Investment Period – 20 years (after which all gains are realized and the RRSP account is deregistered)

Results:
1. International equities in RRSP and US equities in taxable = $18,676 benefit after 20 years
2. International equities in RRSP and Canadian equities in taxable = $13,578 benefit after 20 years

Please keep in mind that these results can easily change, depending on your specific tax situation.
 
  24/10/2017 5:32:29 PM
Jonathan L.
Thank you for this very informative blog, Justin. I always enjoy and appreciate your insights. My question is...is your recommended asset location order still valid when taking into account foreign withholding tax implications?

From what I remember reading in your white paper on foreign withholding taxes, Canadian-listed ETFs that hold developed (i.e. international) markets stocks directly have withholding taxes that are entirely recoverable in taxable accounts. How does this savings compare to the taxes payable on its dividends?
 
  20/10/2017 11:16:56 AM
Justin Bender
@Don M: You make a very good point that investors must consider their overall tax situation when making these types of asset location decisions. As you’ve said, the rules may change for someone in a lower tax bracket. I tend to use the highest marginal tax bracket in my examples, as it is these investors that stand to benefit the most from optimizing their tax situation. Unfortunately, I only have so much time I can spend crunching numbers, so this limits my ability to offer a full analysis on my blog.
 
  13/10/2017 12:00:08 PM
Don M
Justin,
I want to thank you for your analysis on this interesting topic. Like your previous white papers etc., it is very detailed and cleared presented. My only criticism is that you only consider the extreme case in which the person has a taxable income in excess of $220,000. I could not find any discussion on whether you would come to the same asset location conclusions if assuming more "normal" taxable incomes of (for example) $50K, $75K or $100K. Would the results be the same, or would they change?
I appreciate that you cannot consider all scenarios, but by considering only the very highest income range, you have probably excluded the vast majority of your readership.
 



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