Tax And Withholding Tax Payable In Your Investment Account
Different types of investment income are subject to differing tax treatment. Depending on the investments that you own, you could pay more tax on the same dollar amount of income. Even tax-sheltered accounts can be subject to avoidable withholding tax in some cases. Minimizing the tax on investment income is a consideration that can help maximize an investor’s returns.
Non-Registered Accounts
Taxable investment accounts have T5, T3, or T5013 slips issued each February to report interest, dividends, and other taxable distributions and T5008 slips and transaction reports to calculate realized capital gains and losses on security sales.
There is an advantage to earning Canadian dividends over foreign dividends in non-registered accounts. For 2022, the marginal tax rate savings for a dollar of Canadian dividends compared to a dollar of foreign dividends ranges from 17 to 26 per cent at $100,000 of income. As an extreme example of the potential tax savings, a taxpayer with only eligible Canadian dividend income could earn over $54,000 of dividends in 2022 before being subject to any federal tax.
Foreign dividends and interest income are fully taxable, like employment income. Capital gains are only 50 per cent taxable, so one-half of a capital gain is tax-free.
A Canadian investor can buy a Canadian stock inter-listed on a U.S. stock exchange in U.S. dollars, and the U.S. dividends paid would still qualify for the preferential tax treatment on Canadian eligible dividends.
A foreign currency investment in a non-registered account must have its purchase price and eventual sale price reported in Canadian dollars based on the exchange rate at the time of purchase and sale. As a result, an investor can have a foreign exchange gain or loss that impacts their capital gain or loss. This can result in more recordkeeping for foreign securities in a taxable account.
Holding more than $100,000 of foreign investments in a non-registered account can also lead to a Foreign Income Verification Statement Form T1135 filing requirement with the Canada Revenue Agency (CRA), resulting in further tax reporting complexity.
For exchange-traded fund (ETF) investors, a Canadian should consider holding Canadian-listed ETFs over U.S.-listed ETFs in their taxable accounts. In most cases, the management expense ratio (MER) fees are similar, and doing so avoids foreign exchange costs as well as the additional tax reporting mentioned above.
Another consideration in a non-registered account is that if an investor buys a U.S.-listed ETF that owns non-U.S. foreign stocks, or a Canadian-listed ETF that owns non-U.S. foreign stocks through a U.S. ETF, there may be unnecessary tax payable. This is because the U.S. ETF is considered a non-resident of the country of residence of the foreign stock, and withholding tax applies as dividends are paid into the ETF. This tax is generally 15 to 25 per cent of the dividends paid.
Foreign withholding tax on dividends would only be recoverable for a Canadian investor who owns foreign stocks directly or who owns a Canadian ETF that owns foreign stocks directly. So, these would be the preferred ways to own non-U.S. foreign stocks from a tax perspective.
Registered Retirement Savings Plans (RRSPs) And Other Retirement Accounts
Investment income and capital gains earned in retirement accounts are not reported on your tax return. At least not at the time the income is earned. Future withdrawals are taxable, generally in retirement. That said, in some cases, U.S. and foreign dividends can be subject to tax annually in an RRSP.
U.S. dividends paid to a Canadian resident’s RRSP can be tax-free if there is an up-to-date Form W8-BEN Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting on file with the brokerage. However, this tax exemption only applies to U.S. stocks owned directly or U.S.-listed ETFs that own U.S. stocks.
If a Canadian-listed ETF owns U.S. stocks, withholding tax would be levied on the U.S. dividends before being received by the ETF. There is no distinguishing between which account a Canadian-listed ETF is held in, as the ETF itself is a Canadian resident in the eyes of the Internal Revenue Service.
As a result, an ETF investor may want to consider buying a U.S.-listed ETF that owns U.S. stocks over a Canadian-listed U.S. stock ETF in an RRSP. The U.S. ETF will have no withholding tax on the dividends before receipt, and the ETF dividends paid into the RRSP will have no withholding tax either with an up-to-date Form W-8BEN.
Non-U.S. foreign stocks owned directly in an RRSP or owned by a Canadian or U.S.-listed ETF will generally be subject to withholding tax on dividends. The typical 15 to 25 per cent tax withheld might just be considered a cost of diversifying your investments.
Tax-Free Savings Accounts (TFSAs), Registered Education Savings Plans (RESPs), and Registered Disability Savings Plans (RDSPs)
TFSAs, RESPs and RDSPs have no Canadian tax payable on the annual investment income and capital gains earned. Future RESP and RDSP withdrawals will have a tax-free and taxable portion. TFSA withdrawals are always tax-free.
U.S. and foreign dividends are subject to withholding tax annually in all three accounts, with 15 to 25 per cent tax generally being withheld. An ETF investor should have the same withholding tax if they own U.S. stocks through a Canadian or U.S.-listed ETF. A Canadian-listed ETF that owns non-U.S. foreign stocks directly will avoid double-taxation that can apply for a U.S.-listed ETF that holds non-U.S. foreign stocks or a Canadian-listed ETF that holds non-U.S. foreign stocks through a U.S. ETF. So, for non-U.S. foreign stock exposure, consider Canadian-listed ETFs that buy foreign stocks directly.
Old Age Security Clawback
Old Age Security (OAS) clawback is a recovery tax that applies to high-income OAS recipients. Taxpayers whose net income on line 23600 of their tax return exceeds $81,761 for 2022 will have a 15 per cent repayment of OAS for every dollar their income is over the threshold. OAS is fully clawed back at $134,626 for 2022 income.
Canadian dividends are subject to unusual tax treatment on an individual’s tax return whereby 138 per cent of the actual dividend is reported as the taxable dividend received. The intention is to approximate the corporate income tax that was paid on the income earned by the corporation paying out the dividend. There is then an offsetting tax credit for the dividend recipient to reduce the tax payable on their grossed-up dividend.
This gross-up increases an OAS pensioner’s income and the resulting clawback recovery tax by about 6 per cent (15 per cent of 38 per cent). That said, the tax savings for receiving Canadian dividends compared to foreign dividends is generally in the range of 15 to 20 per cent depending on income and province or territory of residence. So, there is still a net benefit to earning Canadian dividends over foreign dividends for an OAS recipient.
Corporate-Class And
Total Return Swaps
Canadian mutual funds and ETFs typically flow through all of their income to investors. However, some funds use unique structures that can reduce tax or withhold tax.
Corporate-class mutual funds and ETFs aim to reduce taxable distributions by combining expenses and capital losses from multiple funds. This can result in lower taxable income to investors or a recharacterization of foreign dividends and interest to Canadian dividends, capital gains, or even a tax-free return of capital.
Some funds use derivatives known as total return swaps, where the fund does not own the securities directly. Instead the fund enters into a contract with a counterparty like a bank that provides the total return of a relevant index. This results in counterparty risk but can reduce tax and withholding tax.
In a non-registered account, current-year income can be converted to deferred capital gains. This can reduce OAS clawback, avoid foreign dividend withholding tax in registered accounts, and help corporate investors preserve their small business deduction.
Current-year income reduction in favour of deferred capital gains can also be achieved by investing in non-dividend-paying stocks like technology or healthcare companies that do not pay dividends. Warren Buffett’s Berkshire Hathaway is a well-known stock that does not pay a dividend, instead reinvesting in acquiring new businesses.
Summary
Investors should consider the tax they pay on their investment income, including the withholding tax in their tax-sheltered accounts. ETF investors, in particular, should consider whether to buy Canadian or U.S.-listed ETFs, as well as to review the underlying holdings of their ETFs to see if they own non-U.S. foreign stocks or U.S. ETFs that can add additional layers of withholding tax.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.