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The Couch Potato strategy calls for a significant allocation to US and international stocks. When you live in a country with a small, poorly diversified stock market, global diversification is extremely important. But it does carry a price in the form of foreign withholding taxes.

Almost all countries levy a tax on dividends paid to foreign investors: usually 15%. (Foreign withholding taxes do not apply to capital gains.) With broad-based US index funds now yielding about 2%, the withholding tax amounts to an additional cost of 30 basis points. And these days some international equity funds are yielding close to 4%, which would be reduced by 60 basis points. As you can see, the impact of withholding taxes can be far greater than that of management fees, which get a lot more attention.

To learn how much tax is withheld by your fund, click the Distributions tab on its web page and look under the heading Foreign Tax Paid. Heres what the table looks like for the iShares MSCI EAFE (XIN). Notice the amount of tax paid ($0.07689 per share) is approximately 15% of the foreign income received ($0.48562):

Investors and advisors are often unaware of how foreign withholding taxes affect returns, and the reason is simple: they’re damned complicated. The amount of tax you pay varies with the type of account (taxable, RRSP, TFSA) and the structure of the fund.

What type of account?

Let’s start with account types. If you hold foreign stocks in a non-registered (taxable) account, withholding taxes always apply: if a company pays a 20-cent dividend each quarter, only 17 cents ends up in your account. The good news is you can recover some or all of it by claiming a foreign tax credit on your return. (This can be complex, and I’m unable to provide detailed instructions for recovering withholding taxes. If the amounts are significant, you should consult a professional for help.)

The other key point is that Canada has tax treaties with the US and many other countries that have agreed to waive withholding taxes on stocks held in registered retirement accounts, including RRSPs, RRIFs and Locked-In Retirement Accounts (LIRAs).

Note this exemption does not apply to Tax-Free Savings Accounts (TFSAs). As you will see when you look at the details below, your TFSA may actually be the worst place to hold foreign securities.

What type of fund?

The structure of the fund you’re using for your foreign investments is also extremely important—and even more confusing.

First consider Canadian funds that hold foreign securities directly. which includes mutual funds such as the TD e-Series and some (but surprisingly few) US and international equity ETFs on the Toronto Stock Exchange. Because these funds hold the individual stocks directly, the managers can track the withholding taxes and report them (through a T3 slip ) to investors who hold the funds in a taxable account. That allows the investor apply for the foreign tax credit.

However, if you hold these funds in an RRSP, you forfeit the exemption you would otherwise receive on foreign withholding taxes. Thats because the fund itself pays the withholding taxes: you don’t pay it directly. And because you’re investing in an RRSP, the fund wont issue a T3 slip that would allow you to recover it.

With US-listed ETFs the US withholding tax is recoverable in a non-registered account: youll receive a T5 slip that specifies the amount paid. Better yet, if you hold these ETFs in an RRSP, youre exempt from US withholding taxes. The downside is that when a US-listed ETF holds international stocks theres an extra layer of withholding tax applied by the stocks’ native countries. There is no way to recover that tax.

The final category is Canadian-listed ETFs that hold US-listed ETFs. These include a number of Canadian iShares and Vanguard funds. Rather than holding their underlying stocks directly, for example, the iShares S&P 500 (XSP) and Vanguard MSCI Emerging Markets (VEE) simply hold units of their New York–listed counterparts (IVV and VWO. respectively).

When you hold these in a taxable account, you can recover taxes withheld by the US-listed ETF, but those withheld by non-US countries are not recoverable. In an RRSP, you get two levels of withholding tax and neither is recoverable, which makes this structure particularly tax-inefficient for international equities.

Confused yet? You’re not alone. To provide you with a handy reference I’ve broken down all of the categories, provided examples of common funds in that category, and summarized the tax implications in each type of account.

A. Canadian fund that holds US or international stocks directly.

iShares US Fundamental (CLU and CLU.C)

BMO US Equity (ZUE)

TD International Index e-Series (TDB911 and TDB905)

iShares International Fundamental (CIE)

BMO International Equity (ZDM)

• In a taxable account. US or international withholding taxes apply, but are recoverable .
• In an RRSP or TFSA. US or international withholding taxes apply and are not recoverable .

B. US-listed ETF that holds US stocks.

iShares S&P 500 (IVV)

Vanguard Total Stock Market (VTI)

• In a taxable account. US withholding taxes apply, but are recoverable .
• In an RRSP. US withholding taxes do not apply .
• In a TFSA. US withholding taxes apply and are not recoverable .

C. US-listed ETF that holds international stocks.

iShares MSCI EAFE (EFA)

Vanguard MSCI EAFE (VEA)

iShares MSCI Emerging Markets (EEM)

Vanguard MSCI Emerging Markets (VWO)

Vanguard Total International Stock (VXUS)

• In a taxable account. international withholding taxes apply and are not recoverable. US withholding taxes apply, but are recoverable .
• In an RRSP. international withholding taxes apply and are not recoverable. US withholding taxes do not apply .
• In a TFSA. international and US withholding taxes apply and are not recoverable .

D. Canadian ETF that holds a US-listed ETF of US stocks.

iShares S&P 500 (XSP)

Vanguard MSCI U.S. Broad Market (VUS)

• In a taxable account. US withholding taxes apply, but are recoverable .
• In an RRSP or TFSA. US withholding taxes apply and are not recoverable .

E. Canadian ETF that holds a US-listed ETF of international stocks.

Vanguard MSCI EAFE (VEF)

iShares MSCI Emerging Markets (XEM)

Vanguard MSCI Emerging Markets (VEE)

• In a taxable account. international withholding taxes apply and are not recoverable. US withholding taxes apply, but are recoverable .
• In an RRSP or TFSA. US and withholding taxes apply are not recoverable .

For tables suggesting the most tax-efficient account for each type of fund, see this post .

Many thanks to Justin Bender at PWL Capital for verifying the accuracy of this post. For more information, I also recommend this document from Dimensional Fund Advisors. which discusses international (non-US) withholding taxes in detail. This post is intended for educational purposes only and does not constitute tax advice for any individual. You should always consult with a specialist before making any investment for tax reasons.