Dan Bortolotti (a.k.a. The Canadian Couch Potato) posted an incredible blog yesterday that will no doubt become the go-to resource for many investors (and advisors alike) who want to wrap their heads around the withholding tax implications of owning foreign ETFs and mutual funds. Although the concept is hard to digest for most people, those who battled through the article will no doubt be better investors for having done so.
One issue I see popping up for investors is basing their asset location decisions solely on foreign withholding tax implications. Although these can certainly be a drag on returns, we must remember that there are other costs to consider. In this post, I’m going to highlight one of the most obvious ones: foreign income tax.
In the examples that follow, we’ll see how an investor who makes their asset location decisions based on foreign income tax and foreign withholding tax implications can come out ahead of the game. We’ll assume the investor has a $600,000 RRSP and a $400,000 non-registered account (invested in a balanced Couch Potato portfolio). We’ll also assume:
In Option 1, the investor is of the opinion that by avoiding foreign withholding taxes, they will reduce their overall foreign tax liability. Since the Vanguard S&P 500 ETF (VOO) avoids foreign withholding tax when held in an RRSP, and the TD International Index Fund e-Series (TDB911) can recoup the foreign withholding taxes levied when held in a non-registered account, this seems like the most tax-efficient asset location choice.
Taxable Foreign Dividends: $7,380 ($200,000 × 3.69%)
Income Tax on Foreign Dividends: $3,395 ($7,380 × 46%)
Non-reclaimable Foreign Withholding Tax: $0
Total Foreign Tax Liability: $3,395
In Option 2, the investor is aware of foreign withholding tax implications, but also knows that the TD International Index Fund e-Series (TDB911) has a higher dividend yield and therefore a higher foreign tax liability, relative to the Vanguard S&P 500 ETF (VOO). They decide to take the hit on the 12% foreign withholding tax by holding the TD International Index Fund e-Series in their RRSP, thereby shielding their net dividend (approx. 3.25%) from immediate tax at their 46% marginal tax rate. The Vanguard S&P 500 ETF (VOO) is held in their non-registered account and the investor recoups the foreign tax withheld.
Taxable Foreign Dividends: $4,340 ($200,000 × 2.17%)
Income Tax on Foreign Dividends: $1,996 ($4,340 × 46%)
Non-reclaimable Foreign Withholding Tax: $886 ($7,380 × 12%)
Total Foreign Tax Liability: $2,882
As we can see, the optimal asset location choice when only considering foreign withholding taxes turned out to be the least optimal after we considered the overall tax consequences of holding higher dividend paying foreign securities in a non-registered account. The results would also change if we lowered the marginal tax of the investor, indicating that the optimal asset location could be different for each investor.